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Corporate Finance

Tutorial 6 Suggested Solutions

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

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A3.
a)

European Call Option on ABC Stock


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=

($90 # $30) " ($150 # $0)


= "40.91
(1.1)($90 " $150)

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

Option Price = Cost of Constructing Replicating Portfolio


= 0.5 ($100) 40.9 ($1)
= $9.09

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b)

Tutorial 6 Suggested Solutions

European Put Option on ABC Stock


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=

($90 # $0) " ($150 # $10)


= 22.73
(1.1)($90 " $150)

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

Option Price = Cost of Constructing Replicating Portfolio


= 0.1667 ($100) + 22.73 ($1)
= $6.06

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A4.

S = $17.50

Tutorial 6 Suggested Solutions

X = $15

! = 15%

r = 7%

c = SN (d1) Xe-rT N(d2)

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

p = $8.44 + $15e (0.10)(5) $17.50


= $0.04

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Tutorial 6 Suggested Solutions

Suggested Solution to FE 2007 Zone B Question A4


(a)

ER (Stock) = 0.50 (30%) + 0.5 (-10%)


= 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

aSH + b(1 + Rf) = KH


aSL + b(1 + Rf) = KL

Equation 1
Equation 2

130a + b(1 + 0.05) = 30


90a + b(1 + 0.05) = 0
40a
= 30
a = 0.75

Equation 1
Equation 2

Substitute a = 0.75 into Equation 2 to solve for b


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

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(c)

Tutorial 6 Suggested Solutions

Put : Using Put-Call Parity


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.

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Tutorial 6 Suggested Solutions

Suggested Solution to FE 2008 Zone B Question A3(a)


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.

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Tutorial 6 Suggested Solutions

Suggested Solution to FE 2009 Zone B Question A1


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

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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

:
:

Long future contract


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

* Represent cash flows for the two strategies.


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

Given the information, we have: S = 4210, r = (1 + 0.05)1/4 1 = 0.0123,


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.

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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

The risk neutral probability:

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

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Delta Ratio

K
S

H
H

KL
SL

3.519 0.681
11.519 8.681

2.838
=1
2.838

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Corporate Finance

Tutorial 6 Suggested Solutions

Suggested Solution to FE2010 Zone B Question A1


(a)

Black-Scholes formula for European call option is given as follows:

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

In (1.4375) + 0.1 = 0.363 + 0.10


0.2
0.2

1.9150

1.9150 0.2 1 + 1.7150

Given the attached normal distribution table :


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

= (5) (0.9722) 3.4783 (0.9569)


= 4.8615 - 3.3284
= $ 1.5331

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(b)

Tutorial 6 Suggested Solutions

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)

Exercise price: A higher exercise price implies lower payoff from


the option at maturity, hence call price is lower.

(iii)

Time to maturity: When the time-to-maturity increases, there is a


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)

Risk-free interest rate: Increase in risk-free rate will lead to a


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)

Volatility: An increase in the volatility of the underlying asset price will


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

price of an European put on a non-dividend paying

current asset price

exercise price of the put option

risk-free interest rate

maturity period or time to maturity

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

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Tutorial 6 Suggested Solutions

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 a put option with strike price of X and


Long in one unit of the underlying asset

Portfolio B

Invest present value of the exercise price X, i.e. XerT,


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

At maturity, the value of portfolio A is greater than or at least equal to the


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].

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