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Corporate Finance

Tutorial 6: Derivatives

Suggested Solutions

Solutions to Exercises on Derivation Assets: Properties and Pricing

A1.

a)

Fk = So (1 + r)k

3

F3 = $12.50(1.06 )

= $14.89

5

F5 = $12.50(1.06 )

= $16.73

b)

A2.

Short a 3-year forward contract and buy Robotronics stocks at spot. Hold

until maturity of forward contract for delivery.

0.64 = $1

rd = 6%

rf = 4%

5

&1.06 #

F5 = 0.64 $

! = 0.7040

%1.04 "

&1.06 #

F10 = 0.64 $

!

%1.04 "

10

= 0.7743

Corporate Finance

A3.

a)

Exercise Price = $120

Current price = $100

If things go well : Price will be $150

Else : Price will be $90

Rf = 10%

Option Pay-Offs

Bad State: $0 as option is out-of-money i.e. St ($90) < Exercise Price ($120)

Good State: $30 as option is in-the-money i.e. St ($150) > Exercise Price ($120)

Constructing replicating portfolio:

a=

KH " KL

SH " SL

a=

$30 " $0

= 0.5

$150 " $90

b=

SL KH " SH KL

(1+ rf )(SL "S H )

b=

= "40.91

(1.1)($90 " $150)

We can buy 0.5 unit of stock & short 40.91 units of the risk-free asset.

= 0.5 ($100) 40.9 ($1)

= $9.09

Corporate Finance

b)

Exercise Price = $100

Current Price = $100

If things go well : Price $150

Else : Price $90

Rf = 10%

Option Pay-Offs

Bad State: $10 as option is in the money i.e. St ($90) < Exercise Price ($100)

Good State: $0 as option is out-of-money i.e. St ($150) > Exercise Price ($100)

Constructing replicating portfolio:

a=

KH " KL

SH " SL

a=

$0 " $10

= "0.1667

$150 " $90

b=

SL KH " SH KL

(1+ rf )(SL "S H )

b=

= 22.73

(1.1)($90 " $150)

We can short 0.167 unit of stock & buy 22.73 units of the risk-free asset.

= 0.1667 ($100) + 22.73 ($1)

= $6.06

Corporate Finance

A4.

S = $17.50

X = $15

! = 15%

r = 7%

d1 =

# 17.50 &

ln% "0.07(5) (

$ 5e

'

(0.15)

(0.15)

0.5042 0.3354

+

= 1.5033 + 0.1677

0.3354

2

= 1.6710

d1 =

d2 = d1 ! T

= 1.6710 0.15 5

= 1.3356

c = $17.50 N(1.6710) [$15e-0.07(5)] N(1.3356)

N(1.6710) = N(1.67) + (0.10)[N(1.68) N(1.67)]

= 0.9525 + (0.10)(0.9535 0.9525)

= 0.9526

N(1.3356) = N(1.33) + (0.56)[N(1.34) N(1.33)]

= 0.9082 + (0.56)(0.9099 0.9082)

= 0.9092

c = ($17.5 x 0.9526) ($15e 0.35 x 0.9092)

= $16.67 $9.61

= $7.06

S + p = c + Xe rT

p = $7.06 + $15e-(0.07)(5) $17.50

= $0.13

If r increases to 10%

d1 = 1.9503 + 0.1677 = 2.118

d2 = 2.118 (0.15) 5 = 2.118 0.335 = 1.783

N(d1) = 0.9830

N(d2) = 0.9625

c = ($17.50 x 0.9830) [$15e (0.10)(5) x 0.9625]

= $17.20 $ 8.76 = $8.44

= $0.04

Corporate Finance

(a)

= 0.10

= 10%

stock = ER(Stock) - Rf

Rm - Rf

= 0.10 - 0.05

0.10 - 0.05

(b)

=1

CALL

SH = 130

So

(100)

X = 100

SL = 90

Equation 1 2

KH = 30

KL = 0

aSL + b(1 + Rf) = KL

Equation 1

Equation 2

90a + b(1 + 0.05) = 0

40a

= 30

a = 0.75

Equation 1

Equation 2

0.05b = -90 x 0.75

b = -67.5/(1 + 0.05)

= - 64.29

Replicating Portfolio

c = aSo + b

= (0.75 x 100) + (- 64.29)

= $10.71

Corporate Finance

(c)

c + PV(X) = p + So

p = c + PV(X) - So

= 10.71 + 100 - 100

1.05

= $5.95

(d)

=> => c

p

Although extremely good outcomes (i.e. underlying asset price very high) are

rewarded highly, extremely bad outcomes are not penalized due to the kink

in the option payoff profile. This would imply that an increase in likelihood

of extreme outcomes should increase option prices as large payoffs are

increased in likelihood. From the put-call parity equation above, if call price

increases, while all other things being equal, p price should also increase to

maintain the equilibrium.

Corporate Finance

Assume S = current asset price

r = risk free interest rate

k = period of the forward contract

Consider the following two portfolios :

Portfolio A : Long forward contract

Portfolio B : Buy underlying asst at spot and finance by borrowing Fk (1 + r) -k

at risk-free rate

At maturity, the pay-off profiles for the two investment strategies are as follows:

Strategy

Portfolio A

Portfolio B

Positions

Now *

Maturity *

Long forward

Sk Fk

Fk (1 + r) -k

-Fk

Borrow PV of Fk

Long underlying

asset

* Represent cash flows for the two strategies.

- S0

Sk

Under no-arbitrage strategy, two investment portfolios with the same outcome

should have the same value.

Value (Portfolio A) = Value (Portfolio B)

0

= Fk (1+ r)-k - S0

Fk

= S0 (1+ r)k

Hence, that is the k-period forward price.

Corporate Finance

Part (a)

Put-call parity states that, under the arbitrage free condition, the price of a put plus the

current underlying asset price is equal to the price of a call plus the present value of the

exercise price. This relationship will hold when both options (call and put) have the same

exercise price, and are written on the same underlying asset with the same time to

maturity. The put-call parity formula is given as:

S0 + P = C + XerT

The implication of the put-call parity is that given the respective options and an

underlying asset, a risk-free position can be created from the relationship.

Xe-rT= P C + S0

This relationship can be shown in the following position diagram:

Payoff

Long Stock

+S

Rf

Investment

ST

Long PUT

+P

Short CALL - C

Corporate Finance

Part (b)

Assume S = current spot price of the stock index

r = risk free interest rate

y = dividend yield

k = period of the future contract

Under no-arbitrage strategy, two investment strategies with the same outcomes should

have the same value. Consider the following two portfolios:

Portfolio A

Portfolio B

:

:

Buy underlying stock index at spot and finance by borrowing

Fk (1 + r - y) k at risk-free rate

At maturity, the pay-off profiles for the two investment strategies are as follows:

Strategy

Portfolio A

Portfolio B

Positions

Long future contract

Borrow PV of Fk

Long underlying asset

Now *

Maturity *

Sk Fk

Fk (1 + r - y) k

Fk

- S0

Sk

Both strategies, with the same outcome on maturity, should have the same

current value under no arbitrage condition:

Portfolio A = Portfolio B

0 = Fk(1 + r - y)-k S0

Fk = S0(1 + r - y)k

y = 0.045/4 = 0.0113

Hence,

F3-month = 4210 x (1 + 0.0123 0.0113)

= 4214.42 > 4190 Arbitrage opportunity exists

As the theoretical price of the futures is greater than the actual futures price, one

should buy the futures, sell the stock index and lend the difference of the cashflows at time 0 at the risk free rate. The arbitrage profit would be the difference

between the actual and the theoretical futures price.

Corporate Finance

If there is a rise in the interest rate, the theoretical futures price will rise

according to the pricing equation above. However, a rise in interest might also

suggest a weaker than expected economy or a potential rise in inflation. As such,

spot price might fall which will reduce the price of the futures. If markets are

informationally efficient, the pricing relationship between spot and futures will

maintain.

Part (c)

Let u = upside change

d = downside change

Hence,

T

(.20 ) 1 / 2

(1 + u ) = e

(1 d ) = e

=e

=e

= 1.1519

(.20 ) 1 / 2

= 0.8681

u = 0.1519

d = 0.1319

Given,

= 10 :

= 10 (1.1519)

= 11.519

= 10 (0.8681)

= 8.681

Therefore,

K

K

= 11.519 - 8 = 3.519

= 8.681 - 8 = 0.681

q=

r+d

0.075 + 0.1319

=

= 0.7290

u + d 0.1519 + 0.1319

Hence,

C=

q K H + (1 q) K L

1+ r

0.729(3.519) + (1 0.729)(0.681)

1 + 0.075

= 2.558

10

Corporate Finance

Delta Ratio

K

S

H

H

KL

SL

3.519 0.681

11.519 8.681

2.838

=1

2.838

11

Corporate Finance

(a)

C = S 0 N (d1 ) Xe rT N (d 2 )

where

S 0

ln rT

Xe T

d1 =

+

2

T

d 2 = d1 T

Hence,

d1

d2

In (

5____)

4/1.15 _____ + 0.2 H1___

0.2 1

0.2

0.2

1.9150

N(d1) = 0.50 + 0.4719 + 0.0050 (0.4726 0.4179)

0.01

= 0.9723

N(d2) = 0.50 + 0.4564 + 0.0050 (0.4573 0.4564)

0.01

= 0.9569

Therefore,

C

= 4.8615 - 3.3284

= $ 1.5331

12

Corporate Finance

(b)

There are five determinants which would influence the price of a call

option in the above model:

(i)

Price of the underlying asset: The higher the underlying asset price

implies the option gives the holder a claim on a more valuable

asset, hence call price increases.

(ii)

the option at maturity, hence call price is lower.

(iii)

greater probability for an out-of-the-money call option being in-themoney or an in-the-money call option ended up deeper in-themoney. Given that price of underlying asset remains unchanged,

the lower the PV(X) will result in higher call value.

(iv)

decrease in the PV(X). And given that the value of S remains

unchanged, the value of the call will increase. This relationship can

be seem from C = SN(d1) Xe-rTN(d2). That is increase in risk-free

rate lead to a decrease in Xe--rT and given unchanged value in S, the

value of C will increase.

(v)

lead to an increase in the value of the call option. Increase in the

underlying asset price volatility will increase the opportunity for the

option to move from out-of-the-money to in-the-money or move from inthe-money to deeper in-the-money. Hence, an increase in the volatility of

the underlying asset price presents opportunity for the option. Call price

therefore increases.

All the above determinants have positive relationships with value of call option

except for exercise price which has an inverse relationship.

(c)

stock

Assume that:

p

Upper bound for an European put option is p Xert, given that the put

option cannot be exercised until maturity. Using PV argument, the value

13

Corporate Finance

of a European put should be less than or equal to the present value of the

exercise price. At maturity, the maximum value of European put will be X,

the exercise price.

Lower bound of a European put option:

p > max [0, XerT S]

Under no-arbitrage strategy, two investments with the same outcomes

ought to have the same prices. Consider the following two portfolios:

Portfolio A

Long in one unit of the underlying asset

Portfolio B

at risk-free rate r

At maturity of the put option, the pay-offs for the two investment

portfolios are as follows:

Investments

Position Now

Portfolio A,

VA

Portfolio B,

VB

At Maturity

ST > X

ST < X

p+S

ST

XerT

value of portfolio B, that is VA VB. Therefore, under no arbitrage notion,

price of portfolio A price of portfolio B at time 0.

p + S XerT

p XerT S

Since an option cannot be negatively valued, therefore the lower bound of

a European put option is p max [0, XerT S].

14

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