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GB622 Autumn 2011 There are 5 Homework assignments.

The questions and problems below are the same as in the textbook. Due dates will be announced in class.

HW#1 1. Explain carefully the difference between (a) hedging, (b) speculation, and (c) arbitrage. 2. What is the difference between (a) entering into a long futures contract when the futures price is $50 and (b) taking a long position in a call option with a strike price of $50? 3. You would like to speculate on a rise in the price of a certain stock. The current stock price is $29 and a three-month call with a strike price of $30 costs $2.9. You have $5800 to invest. Identify two alternative strategies. Briefly outline the advantages and disadvantages of each. 4. A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmers viewpoint, what are the pros and cons of hedging? 5. Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a long position in the option depends on the stock price at the maturity of the option. 6. Suppose that a June put option on a stock with a strike price of $60 costs $4 and is held until June. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option. 7. Options and futures are zero-sum games. What do you think is meant by this statement? 8. The price of gold is currently $800 per ounce. Forward contracts are available to buy or sell gold at $1000 for delivery in one year. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. 9. Distinguish between the terms open interest and trading volume. 10. Suppose that in September 2010 a company takes a long position in a contract on May 2011 crude oil futures. It closes out its position in March 2011. The futures price (per barrel) is $68.30 when it enters into the contract, $70.50 when it closes out the position and $69.10 at the end of December 2010. One contract is for the delivery of 1,000 barrels. What is the companys profit? When is it realized? How is it taxed if it is (a) a hedger and (b) a speculator? Assume that the company has a December 31 year end. 11. What are the most important aspects of the design of a new futures contract? 12. Explain how margins protect investors against the possibility of default. 13. The forward price of the Swiss franc for delivery in 45 days is quoted as 1.1000. The futures price for a contract that will be delivered in 45 days is 0.9000. Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss francs? 14. Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? 15. Explain what is meant by basis risk when futures contracts are used for hedging.

16. Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a three-month contract? What does it mean? 17. If there is no basis risk, the minimum variance hedge ratio is always 1.0. Is this statement true? Explain your answer. 18. Companies A and B have been offered the following rates per annum on a $20 million five-year loan:

Company A: Company B:

Fixed rate 5.0% 6.4%

Floating rate LIBOR+0.1% LIBOR+0.6%

19. 20.

21.

22. 23. 24.

25. 26.

Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap that will net a bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both companies. Explain the difference between the credit risk and the market risk in a financial contract. An investor buys a European put on a share for $3. The stock price is $42 and the strike price is $40. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the maturity of the option. An investor sells a European call on a share for $4. The stock price is $47 and the strike price is $50. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the maturity of the option. An investor sells a European call option with strike price of K and Maturity T and buys a put with the same strike price and maturity. Describe the investors position. Explain why brokers require margins when clients write options but not when they buy options. A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the variation of the traders profit with the asset price. Explain why an American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date. Explain why an American option is always worth at least as much as its intrinsic value.

HW#2 1. List the six factors affecting stock option prices. 2. What is a lower bound for the price of a four-month call option on a non-dividend-paying stock when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8% per annum? 3. What is a lower bound for the price of a one-month European put option on a nondividend-paying stock when the stock price is $12, the strike price is $15, and the riskfree interest rate is 6% per annum? 4. A four-month European call option on a dividend-paying stock is currently selling for $5. The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one month. The risk-free interest rate is 12% per annum for all maturities. What opportunities are there for an arbitrageur? 5. A one-month European put option on a non-dividend-paying stock is currently selling for $2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per annum. What opportunities are there for an arbitrageur? 6. The price of an American call on a non-dividend-paying stock is $4. The stock price is $31, the strike price is $30, and the expiration date is in three months. The risk-free interest rate is 8%. Derive upper and lower bounds for the price of an American put on the same stock with the same strike price and expiration date. 7. Explain two ways in which a bear spread can be created. 8. When is it appropriate for an investor to purchase a butterfly spread? 9. Call options on a stock are available with strike prices of $15, $17.5, and $20 and expiration dates in three months. Their prices are $4, $2, and $0.50, respectively. Explain how the options can be used to create a butterfly spread. Construct a table showing how profit varies with stock price for the butterfly spread. 10. What is the difference between a strangle and a straddle? 11. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7, respectively. How can the options be used to create (a) a bull spread and (b) a bear spread? Construct a table that shows the profit and payoff for both spreads. 12. Use put-call parity to show that the cost of a butterfly spread created from European puts is identical to the cost of a butterfly spread created from European calls. 13. A call with a strike price of $60 costs $6. A put with the same strike price and expiration date costs $4. Construct a table that shows the profit from a straddle. For what range of stock prices would the straddle lead to a loss? 14. An investor believes that there will be a big jump in a stock price, but is uncertain as to the direction. Identify six different strategies the investor can follow and explain the differences among them. 15. Draw a diagram showing the variation of an investors profit and loss with the terminal stock price for a portfolio consisting of: a. One share and a short position in one call option b. Two shares and a short position in one call option c. One share and a short position in two call options d. One share and a short position in four call options In each case, assume the call option has an exercise price equal to the current stock price.

HW#3 1. A stock price is currently $40. It is known that at the end of one month it will be either $42 or $38. The risk-free interest rate is 8% per annum with continuous compounding. What is the value of a one-month European call option with a strike price of $39? 2. What is meant by the delta of a stock option? 3. A stock price is currently $100. Over each of the next two six-month periods it is expected to go up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous compounding. What is the value of a one-year European call option with a strike price of $100? 4. For the situation considered in Problem 3, what is the value of a one-year European put option with a strike price of $100? Verify that the European call and European put prices satisfy put-call parity. 5. What does the Black-Scholes stock option pricing model assume about the probability distribution of the stock price in one year? What does it assume about the continuously compounded rate of return on the stock during the year? 6. The volatility of a stock price is 30% per annum. What is the standard deviation of the percentage price change in one trading day? 7. Calculate the price of a three-month European put option on a non-dividend-paying stock with a strike price of $50 when the current stock price is $50, the risk-free interest rate is 10% per annum, and the volatility is 30% per annum. 8. What difference does it make to your calculations in the previous question if a dividend of $1.50 is expected in two months? 9. What is meant by implied volatility? How would you calculate the volatility implied by a European put option price? 10. What is the price of a European call option on a non-dividend-paying stock when the stock price is $52, the strike price is $50, the risk-free interest rate is 12% per annum, the volatility is 30% per annum, and the time to maturity is three months? 11. What is the price of a European put option on a non-dividend-paying stock when the stock price is $69, the strike price is $70, the risk-free interest rate is 5% per annum, the volatility is 35% per annum, and the time to maturity is six months? 12. (optional) A stock price is currently $50 and the risk-free interest rate is 5%. Use the DerivaGem software to translate the following table of European call options on the stock into a table of implied volatilities, assuming no dividends. Are the option prices consistent with the assumptions underlying Black-Scholes? Maturity(months) Strike price ($) 3 6 12 45 7.00 8.30 10.50 50 3.50 5.20 7.50 55 1.60 2.90 5.10 13. What is an Ito process? Collect 40 daily closing prices of your favorite stock and check if these prices follow an Ito process. 14. Outline the derivation of the Black-Scholes option pricing formula.

HW#4 1. A portfolio is currently worth $10 million and has a beta of 1.0. The S&P 100 is currently standing at 800. Explain how a put option on the S&P 100 with a strike price of 700 can be used to provide portfolio insurance. 2. Once we know how to value options on a stock paying a dividend yield, we know how to value options on stock indices and currencies. Explain this statement. 3. Explain how corporations can use range-forward contracts to hedge their foreign exchange risk. 4. Calculate the value of a three-month at-the-money European call option on a stock index when the index is at 250, the risk-free interest rate is 10% per annum, the volatility of the index is 18% per annum, and the dividend yield on the index is 3% per annum. 5. Calculate the value of an eight-month European put option on a currency with a strike price of 0.50. The current exchange rate is 0.52, the volatility of the exchange rate is 12%, the domestic risk-free interest rate is 4% per annum, and the foreign risk-free interest rate is 8% per annum. 6. Consider a stock index currently standing at 250. The dividend yield on the index is 4% per annum, and the risk-free rate is 6% per annum. A three-month European call option on the index with a strike price of 245 is currently worth $10. What is the value of a three-month put option on the index with a strike price of 245? 7. An index currently stands at 696 and has a volatility of 30% per annum. The risk-free rate of interest is 7% per annum and the index provides a dividend yield of 4% per annum. Calculate the value of a three-month European put with an exercise price of 700. 8. Explain the difference between a call option on yen and a call option on yen futures. 9. Why are options on bond futures more actively traded than options on bonds? 10. A futures price is like a stock paying a dividend yield. What is the dividend yield? 11. How does the put-call parity formula for a futures option differ from put-call parity for an option on a non-dividend-paying stock? 12. Calculate the value of a five-month European put futures option when the futures price is $19, the strike price is $20, the risk-free interest rate is 12% per annum, and the volatility of the futures price is 20% per annum.

HW#5 1. What does it mean to assert that the delta of a call option is 0.7? How can a short position in 1,000 call options be made delta neutral when the delta of each option is 0.7? 2. Calculate the delta of an at-the-money six-month European call option on a nondividend-paying stock when the risk-free interest rate is 10% per annum and the stock price volatility is 25% per annum. 3. Can the vega of a derivatives portfolio be changed by taking a position in the underlying asset? Explain your answer. 4. What is meant by the gamma of an option position? What are the risks in the situation where the gamma of a position is large and negative and the delta is zero? 5. Explain why portfolio insurance may have played a part in the stock market crash of October 19, 1987. 6. What volatility smile is likely to be observed when: a. Both tails of the stock price distribution are less heavy than those of the lognormal distribution? b. The right tail is heavier, and the left tail is less heavy, than that of a lognormal distribution? 7. What volatility smile is observed for equities? 8. What volatility smile is likely to be caused by jumps in the underlying asset price? Is the pattern likely to be more pronounced for a two-year rather than a three-month option? 9. A European call and put option have the same strike price and time to maturity. The call has an implied volatility of 30% and the put has an implied volatility of 25%. What trades would you do? 10. Explain carefully why a distribution with a heavier left tail and less heavy right tail than the lognormal distribution gives rise to a downward sloping volatility smile. 11. Explain what is meant by crashophobia. 12. What volatility smile is likely to be observed for six-month options when the volatility is uncertain and positively correlated to the stock price? 13. What problems do you think would be encountered in testing a stock option pricing model empirically? 14. Option traders sometimes refer to deep-out-of-the-money options as being options on volatility. Why do you think they do this? 15. Consider a position consisting of a $300,000 investment in asset A and a $500,000 investment in asset B. Assume that the daily volatilities of the assets are 1.8% and 1.2%, respectively, and that the coefficient of correlation between their returns is 0.3. What is five-day 95% value at risk for the portfolio?