Sie sind auf Seite 1von 162

Solution to Derivatives Markets: for Exam FM

Yufeng Guo June 24, 2007

www.guo.coursehost.com

c Yufeng Guo

ii

Contents
Introduction 1 Introduction to derivatives 2 Introduction to forwards and options vii 1 7 29 79 129 141

3 Insurance, collars, and other strategies 4 Introduction to risk management 5 Financial forwards and futures 8 Swaps

iii

CONTENTS

CONTENTS

www.guo.coursehost.com

c Yufeng Guo

iv

Preface
This is Guos solution to Derivatives Markets (2nd edition ISBN 0-321-28030X) for Exam FM. Unlike the ocial solution manual published by AddisonWesley, this solution manual provides solutions to both the even-numbered and odd-numbered problems for the chapters that are on the Exam FM syllabus. Problems that are out of the scope of the FM syllabus are excluded. Please report any errors to yufeng_guo@msn.com. This book is the exclusive property of Yufeng Guo. Redistribution of this book in any form is prohibited.

PREFACE

PREFACE

www.guo.coursehost.com

c Yufeng Guo

vi

Introduction
Recommendations on using this solution manual: 1. Obviously, youll need to buy Derivatives Markets (2nd edition) to see the problems. 2. Make sure you download the textbook errata from http://www.kellogg. northwestern.edu/faculty/mcdonald/htm/typos2e_01.html

vii

CHAPTER 0. INTRODUCTION

www.guo.coursehost.com

c Yufeng Guo

viii

Chapter 1

Introduction to derivatives
Problem 1.1. Derivatives on weather are not as farfetched as it might appear. Visit http: //www.cme.com/trading/ and youll nd more than a dozen weather derivatives currently traded at CME such as "CME U.S. Monthly Weather Heating Degree Day Futures" and "CME U.S. Monthly Weather Cooling Degree Day Futures." a. Soft drink sales greatly depend on weather. Generally, warm weather boosts soft drink sales and cold weather reduces sales. A soft drink producer can use weather futures contracts to reduce the revenue swing caused by weather and smooth its earnings. Shareholders of a company generally want the earnings to be steady. They dont want the management to use weather as an excuse for poor earnings or wild uctuations of earnings. b. The recreational skiing industry greatly dependents on weather. A ski resort can lose money due to warm temperatures, bitterly cold temperatures, no snow, too little snow, or too much snow. A resort can use weather derivatives to reduce its revenue risk. c. Extremely hot or cold weather will result in greater demand for electricity. An electric utility company faces the risk that it may have to buy electricity at a higher spot price. d. Fewer people will visit an amusement park under extreme weather conditions. An amusement park can use weather derivatives to manage its revenue risk. How can we buy or sell weather? No one can accurately predict weather. No one can deliver weather. For people to trade on weather derivatives, weather indexes need to be invented and agreed upon. Once we have weather indexes, we can link the payo of a weather derivative to a weather index. For more information on weather derivatives, visit: http://hometown.aol.com/gml1000/wrms.htm http://www.investopedia.com 1

CHAPTER 1. INTRODUCTION TO DERIVATIVES Problem 1.2. Anyone (such as speculators and investors) who wants to earn a prot can enter weather futures. If you can better predict a weather index than does the market maker, you can enter weather futures and make a prot. Of course, its hard to predict a weather index and hence loss may occur. Two companies with opposite risks may enter weather futures as counter parties. For example, a soft drink company and a ski-resort operator have opposite hedging needs and can enter a futures contract. The soft drink company can have a positive payo if the weather is too cold and a negative payo if warm. This way, when the weather is too cold, the soft drink company can use the gain from the weather futures to oset its loss in sales. Since the soft drink company makes good money when the weather is warm, it doesnt mind a negative payo when the weather is cold. On the other hand, the ski resort can have a negative payo if the weather is too cold and a positive payo if too warm. The ski resort can use the gain from the futures to oset its loss in sales.

Problem 1.3. a. 100 41.05 + 20 = 4125 b. 100 40.95 20 = 4075 c. For each stock, you buy at $41.05 and sell it an instant later for $40.95. The total loss due to the ask-bid spread: 100 (41.05 40.95) = 10. In addition, you pay $20 twice. Your total transaction cost is 100 (41.05 40.95) + 2 (20) = 50 Problem 1.4. a. 100 41.05 + 100 41.05 0.003 = 4117. 315 b. 100 40.95 100 40.95 0.003 = 4082. 715 c. For each stock, you buy at $41.05 and sell it an instant later for $40.95. The total loss due to the ask-bid spread: 100 (41.05 40.95) = 10. In addition, your pay commission 100 41.05 0.003 + 100 40.95 0.003 = 24. 6. Your total transaction cost is 10 + 24. 6 = 34. 6 Problem 1.5. The market maker buys a security for $100 and sells it for $100.12. If the market maker buys 100 securities and immediately sells them, his prot is 100 (100.12 100) = 12 Problem 1.6. www.guo.coursehost.com c Yufeng Guo 2

CHAPTER 1. INTRODUCTION TO DERIVATIVES Your sales proceeds: 300 (30.19) 300 (30.19) (0.005) = 9011. 715 Your cost of buying 300 shares from the market to close your short position is: 300 (29.87) + 300 (29.87) (0.005) = 9005. 805 Your prot: 9011. 715 9005. 805 = 5. 91 Problem 1.7. a. Consider the bid-ask spread but ignore commission and interest. Your sales proceeds: 400 (25.12) = 10048 Your cost of buying back: 400 (23.06) = 9224 Your prot: 10048 9224 = 824 b. If the bid-ask spread and 0.3% commission Your sales proceeds: 400 (25.12) 400 (25.12) (0.003) = 10017. 856 Your cost of buying back: 400 (23.06) + 400 (23.06) (0.003) = 9251. 672 Your prot: 10017. 856 9251. 672 = 766. 184 Prot drops by: 824 766. 184 = 57. 816 c. Your sales proceeds stay in your margin account, serving as a collateral. Since you earn zero interest on the collateral, your lost interest is If ignore commission: 10048 (0.03) = 301. 44 If consider commission: 10017. 856 (0.03) = 300. 54 Problem 1.8. By signing the agreement, you allow your broker to act as a bank, who lends your stocks to someone else and possibly earns interest on the lent stocks. Short sellers typically leave the short sale proceeds on deposit with the broker, along with additional capital called a haircut. The short sale proceeds and the haircut serve as a collateral. The short seller earns interest on this collateral. This interest is called the short rebate in the stock market. The rebate rate is often equal to the prevailing market interest rate. However, if a stock is scarce, the broker will pay far less than the prevailing interest rate, in which case the broker earns the dierence between the short rate and the prevailing interest rate. This arrangement makes short selling easy. Also short selling can be used to hedge nancial risks, which is good for the economy. By the way, you are not hurt in any way by allowing your broker to lend your shares to short sellers. Problem 1.9. According to http://www.investorwords.com, the ex-dividend date was created to allow all pending transactions to be completed before the record date. If an investor does not own the stock before the ex-dividend date, he or she will www.guo.coursehost.com c Yufeng Guo 3

CHAPTER 1. INTRODUCTION TO DERIVATIVES be ineligible for the dividend payout. Further, for all pending transactions that have not been completed by the ex-dividend date, the exchanges automatically reduce the price of the stock by the amount of the dividend. This is done because a dividend payout automatically reduces the value of the company (it comes from the companys cash reserves), and the investor would have to absorb that reduction in value (because neither the buyer nor the seller are eligible for the dividend). If you borrow stock to make a short sale, youll need to pay the lender the dividend distributed while you maintain your short position. According to the IRS, you can deduct these payments on your tax return only if you hold the short sale open for a minimum period (such as 46 days) and you itemize your deductions. In a perfect market, if a stock pays $5 dividend, after the ex-dividend date, the stock price will be reduced by $5. Then you could buy back stocks from the market at a reduced price to close your short position. So you dont need to worry whether the dividend is $3 or $5. However, in the real world, a big increase in the dividend is a sign that a company is doing better than expected. If a company pays a $5 dividend instead of the expected $3 dividend, the companys stock price may go up after the announcement that more dividend will be paid. If the stock price goes up, you have to buy back stocks at a higher price to close your short position. So an unexpected increase of the dividend may hurt you. In addition, if a higher dividend is distributed, you need to pay the lender the dividend while you maintain your short position. This requires you to have more capital on hand. In the real world, as a short seller, you need to watch out for unexpected increases of dividend payout. Problem 1.10. http://www.investopedia.com/articles/01/082201.asp oers a good explanation of short interest: Short Interest Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. This can be expressed as a number or as a percentage. When expressed as a percentage, short interest is the number of shorted shares divided by the number of shares outstanding. For example, a stock with 1.5 million shares sold short and 10 million shares outstanding has a short interest of 15% (1.5 million/10 million = 15%). Most stock exchanges track the short interest in each stock and issue reports at months end. These reports are great because by showing what short sellers are doing, they allow investors to gauge overall market sentiment surrounding a particular stock. Or alternatively, most exchanges provide an online tool to calculate short interest for a particular security. www.guo.coursehost.com c Yufeng Guo 4

CHAPTER 1. INTRODUCTION TO DERIVATIVES Reading Short Interest A large increase or decrease in a stocks short interest from the previous month can be a very telling indicator of investor sentiment. Lets say that Microsofts (MSFT) short interest increased by 10% in one month. This means that there was a 10% increase in the amount of people who believe the stock will decrease. Such a signicant shift provides good cause for us to nd out more. We would need to check the current research and any recent news reports to see what is happening with the company and why more investors are selling its stock. A high short-interest stock should be approached for buying with extreme caution but not necessarily avoided at all costs. Short sellers (like all investors) arent perfect and have been known to be wrong from time to time. In fact, many contrarian investors use short interest as a tool to determine the direction of the market. The rationale is that if everyone is selling, then the stock is already at its low and can only move up. Thus, contrarians feel that a high short-interest ratio (which we will discuss below) is bullish - because eventually there will be signicant upward pressure on the stocks price as short sellers cover their short positions (i.e. buy back the stocks they borrowed to return to the lender). The more likely that investors can speculate on the stock, the higher the demand for the stock and the higher the short interest. A broker can short sell more than his existing inventory. For example, if a broker has 500 shares of IBM stocks, he can short sell 600 shares of IBM stocks as long as he knows where to nd the additional 100 shares of IBM stocks. If all the brokers simultaneously lend out more than what they have in their stock inventories, then the number of stocks sold short might exceed the total number of the stocks outstanding. NASDAQ short interest is available by issue for a rolling twelve months and is based on a mid-month settlement date. For more information, visit http://www.nasdaqtrader.com/asp/short_interest.asp. Problem 1.11. You go to a bank. The bank uses its customers deposits and lends you an asset worth $100. Then 90 days later you buy back the asset at $102 from the open market (i.e. you come up with $102 from whatever sources) and return $102 to the bank. Now your short position is closed. Problem 1.12. We need to borrow an asset called money from a bank (the asset owner) to pay for a new house. The asset owner faces credit risk (the risk that we may not be able to repay the loan). To protect itself, the bank needs collateral. The house is collateral. If we dont pay back our loan, the bank can foreclose the house. www.guo.coursehost.com c Yufeng Guo 5

CHAPTER 1. INTRODUCTION TO DERIVATIVES To protect against the credit risk, the bank requires a haircut (i.e. requires that the collateral is greater than the loan). Typically, a bank lends only 80% of the purchase price of the house, requiring the borrower to pay a 20% down payment.

www.guo.coursehost.com

c Yufeng Guo

Chapter 2

Introduction to forwards and options


Problem 2.1. Long a stock=Own a stock (or buy a stock). If you own a stock, your payo at any time is the stocks market price because you can sell it any time at the market price. Let S represent the stock price at T = 1. Your payo at T = 1 is S. Your prot at T = 1 is: Payo - FV(initial investment)= S 50 (1.1) = S 55. You can see that the prot is zero when the stock price S = 55. Alternatively, set S 55 = 0 S = 55.

CHAPTER 2. Payo=S
80

INTRODUCTION TO FORWARDS AND OPTIONS

Prot=S 55

60

40

Payoff

20

0 10 -20 20 30 40 50 60

Stock Price

70

80

-40

Profit
Payo and prot: Long one stock

www.guo.coursehost.com

c Yufeng Guo

CHAPTER 2. Problem 2.2.

INTRODUCTION TO FORWARDS AND OPTIONS

Short a stock=Short sell a stock. If you short sell a stock, your payo at any time after the short sale is the negative of the stocks market price. This is because to close your short position youll need to buy the stock back at the market price and return it to the broker. Your payo at T = 1 is S. Your prot at T = 1 is: Payo - FV(initial investment)= S + 50 (1.1) = 55 S You can see that the prot is zero when the stock price S = 55. Alternatively, set 55 S = 0 S = 55.

Payoff or Profit

50 40 30 20 10 0 10 -10 -20 -30 -40 -50 -60 20 30 40 50 60

Profit

Stock Price

Payoff

Payo and prot: Short one stock

www.guo.coursehost.com

c Yufeng Guo

CHAPTER 2. Problem 2.3.

INTRODUCTION TO FORWARDS AND OPTIONS

The opposite of a purchased call is written call (or sold call). The opposite of a purchased put is written put (or sold put). The main idea of this problem is: The opposite of a purchased call 6= a purchased put The opposite of a purchased put 6= a purchased call Problem 2.4. a. Long forward means being a buyer in a forward contract. Payo of a buyer in a forward at T is P ayof f = ST F = ST 50 ST P ayof f = ST 50 40 10 45 5 50 0 55 5 60 10

b. Payo of a long call (i.e. owning a call) at expiration T is: P ayof f = max (0, ST K) = max (0, ST 50) ST 40 45 50 55 60 P ayof f = max (0, ST 50) 0 0 0 5 10

c. A call option is a privilege. You exercise a call and buy the stock only if your payo is positive. In contrast, a forward is an obligation. You need to buy the stock even if your payo is negative. A privilege is better than an obligation. Consequently, a long call is more expensive than a long forward on the same underlying stock with the same time to expiration.

www.guo.coursehost.com

c Yufeng Guo

10

CHAPTER 2. Problem 2.5.

INTRODUCTION TO FORWARDS AND OPTIONS

a. Short forward = Enter into a forward as a seller Payo of a seller in a forward at T is P ayof f = F ST = 50 ST ST P ayof f = 50 ST 40 10 45 5 50 0 55 5 60 10 b. Payo of a long put (i.e. owning a put) at expiration T is: P ayof f = max (0, K ST ) = max (0, 50 ST ) ST 40 45 50 55 60 P ayof f = max (0, 50 ST ) 10 5 0 0 0

c. A put option is a privilege. You exercise a put and sell the stock only if your payo is positive. In contrast, a forward is an obligation. You need to sell the stock even if your payo is negative. A privilege is better than an obligation. Consequently, a long put is more expensive than a short forward on the same underlying stock with the same time to expiration.

www.guo.coursehost.com

c Yufeng Guo

11

CHAPTER 2. Problem 2.6.

INTRODUCTION TO FORWARDS AND OPTIONS

91 (1 + r) = 100 r = 0.0989 The eective annual interest rate is 9.89%. If you buy the bond at t = 0, your payo at t = 1 is 100 Your prot at t = 1 is 100 91 (1 + 0.0989) = 0 regardless of the stock price at t = 1. If you buy a bond, you just earn the risk-free interest rate. Beyond this, your prot is zero.
101.0

Payoff

100.5

100.0

99.5

99.0 0 10 20 30 40

Stock Price

50

60

Payo: Long a bond

www.guo.coursehost.com

c Yufeng Guo

12

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

Profit

1.0 0.8 0.6 0.4 0.2 0.0 10 -0.2 -0.4 -0.6 -0.8 -1.0 20 30 40 50 60 70 80

Stock Price

90

100

Prot of longing a bond is zero.

www.guo.coursehost.com

c Yufeng Guo

13

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

If you sell the bond at t = 0, your payo at t = 1 is 100 (you need to pay the bond holder 100). Your prot at t = 1 is 91 (1 + 0.0989) 100 = 0 regardless of the stock price at t = 1 If you sell a bond, you just earn the risk-free interest rate. Beyond this, your prot is zero.

10

20

30

40

Stock Price
50

60

Payoff

-99.0

-99.5

-100.0

-100.5

-101.0

Payo: Shorting a bond

www.guo.coursehost.com

c Yufeng Guo

14

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

Profit

1.0 0.8 0.6 0.4 0.2 0.0 10 -0.2 -0.4 -0.6 -0.8 -1.0 20 30 40 50 60 70 80

Stock Price

90

100

Prot of shorting a bond is zero.

www.guo.coursehost.com

c Yufeng Guo

15

CHAPTER 2. Problem 2.7.

INTRODUCTION TO FORWARDS AND OPTIONS

a. It costs nothing for one to enter a forward contract. Hence the payo of a forward is equal to the prot. Suppose we long a forward (i.e. we are the buyer in the forward). Our payo and prot at expiration is: ST F = ST 55

Payoff (Profit)

40 30 20 10 0 10 -10 -20 -30 -40 -50 20 30 40 50 60 70

Stock Price

80

90

100

Payo (and prot) of a long forward

www.guo.coursehost.com

c Yufeng Guo

16

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

Suppose we short a forward (i.e. we are the seller in the forward), our payo and prot at expiration is: F ST = 55 ST

Payoff (Profit)

50 40 30 20 10 0 10 -10 -20 -30 -40 20 30 40 50 60 70

Stock Price

80

90

100

Payo (and prot) of a short forward

www.guo.coursehost.com

c Yufeng Guo

17

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

b. If the stock doesnt pay dividend, buying a stock outright at t = 0 and getting a stock at T = 1 through a forward are identical. Theres no benet to owning a stock early. c. Suppose the stock pays dividend before the forward expiration date T = 1. Please note that if you own a stock prior to the dividend date, you will receive the dividend. In contrast, if you are a buyer in a forward contract, at T = 1, youll get a stock but you wont receive any dividend. If the stock is expected to pay dividend, then the stock price is expected to drop after the dividend is paid. The forward price agreed upon at t = 0 already considers that a dividend is paid during (0, T ); the dividend will reduce the forward rate. Theres no advantage to buying a stock outright over buying a stock through a forward. Otherwise, there will be arbitrage opportunities. If the stock is not expected to pay dividend but actually pays dividend (a surprise dividend), then the forward price F agreed upon at t = 0 was set without knowing the surprise dividend. So F is the forward price on a non-dividend paying stock. Since dividend reduces the value of a stock, F is higher than the forward price on an otherwise identical but dividendpaying stock. If you own a stock at t = 0, youll receive the windfall dividend. If you buy a stock through a forward, youll pay F , which is higher than the forward price on an otherwise identical but dividendpaying stock. Hence owning a stock outright is more benecial than buying a stock through a forward. Problem 2.8. r =risk free interest rate Under the no-arbitrage principle, you get the same prot whether you buy a stock outright or through a forward. Prot at T = 1 if you buy a stock at t = 0 is: ST 50 (1 + r) Prot at T = 1 if you buy a stock through a forward: ST 53 ST 50 (1 + r) = ST 53 50 (1 + r) = 53 r = 0.06

www.guo.coursehost.com

c Yufeng Guo

18

CHAPTER 2. Problem 2.9.

INTRODUCTION TO FORWARDS AND OPTIONS

a. Price of an index forward contract expiring in one year is: F Index = 1000 (1.1) = 1100 To see why: If the seller borrows 1000 at t = 0, buys an index, and holds it for one year, then hell have one stock to deliver at T = 1. The sellers cost is 1000 (1.1) = 1100. To avoid arbitrage, the forward price must be 1100. Prot at T = 1 of owning a forward on an index: ST F Index = ST 1100 If you buy an index at t = 0, your prot at T = 1 is ST 1000 (1.1) = ST 1100 So you get the same prot whether you buy the index outright or buy the index through a forward. This should make sense. If owning a stock outright and buying it through a forward have dierent prots, arbitrage opportunities exist. b. The forward price 1200 is greater than the fair forward price 1100. No rational person will want to enter such an unfair forward contract. Thus the seller needs to pay the buyer an up-front premium to incite the buyer. The 1200 1100 buyer in the forward needs to receive = 90. 91 at t = 0 to make 1.1 the forward contract fair. Of course, the buyer needs to pay the forward price 1200 at T = 1. c. Now the forward price 1000 is lower than the fair forward price 1100. You can imagine thousands of bargain hunters are waiting in line to enter this forward contract. If you want to enter the forward contract, you have to pay the 1100 1000 = 90. 91 at t = 0. In addition, seller a premium in the amount of 1.1 youll need to pay the forward price 1000 at T = 1. Problem 2.10. a. Prot=max (0, ST 1000) 95.68 Set prot to zero: max (0, ST 1000) 95.68 = 0 ST 1000 95.68 = 0 ST = 1000 + 95.68 = 1095. 68 b. The prot of a long forward (i.e. being a buyer in a forward): ST 1020 ST 1020 = max (0, ST 1000) 95.68 If ST > 1000, theres no solution If ST 1000: ST 1020 = 0 95.68 ST = 1020 95.68 = 924. 32 www.guo.coursehost.com c Yufeng Guo 19

CHAPTER 2. Problem 2.11.

INTRODUCTION TO FORWARDS AND OPTIONS

a. Prot of a long (i.e. owning) put is max (0, 1000 ST ) 75.68 max (0, 1000 ST ) 75.68 = 0 1000 ST 75.68 = 0 ST = 924. 32 b. Prot of a short forward (i.e. being a seller in a forward) is 1020 ST max (0, 1000 ST ) 75.68 = 1020 ST If 1000 ST 1000 S 75.68 = 1020 S If 1000 ST 75.68 = 1020 ST no solution

ST = 1020 + 75.68 = 1095. 68

www.guo.coursehost.com

c Yufeng Guo

20

CHAPTER 2. Problem 2.12.

INTRODUCTION TO FORWARDS AND OPTIONS

Table 2.4 is: Position Long forward (buyer in forward) Short forward (seller in forward) Long call (own a call) Short call (sell a call) Long put (own a put) Short put (sell a put)

Maximum Loss -Forward price Unlimited -FV (premium) Unlimited -FV(premium) PV(premium)-Strike Price

Maximum Gain Unlimited Forward Price Unlimited FV(premium) Strike Price - FV(premium) FV(premium)

If you are a buyer in a forward, the worst that can happen to you is ST = 0 (i.e. stock price at T is zero). If this happens, you still have to pay the forward price F at T to buy the stock which is worth zero. Youll lose F . Your best case is ST = , where you have an unlimited gain. If you are a seller in a forward, the worst case is that ST = ; youll incur unlimited loss. Your best case is that ST = 0, in which case you sell a worthless asset for the forward price F . If you buy a call, your worst case is ST < K, where K is the strike price. If this happens, you just let the call expire worthless. Youll lose the future value of your premium (if you didnt buy the call and deposit your money in a bank account, you could earn the future value of your deposit). Your best case is that ST = , where youll have an unlimited gain. If you sell a call, your worst case is ST = , in which case youll incur an unlimited loss. Your best case is ST < K, in which case the call expires worthless; the call holder wastes his premium and your prot is the future value of the premium you received from the buyer. If you buy a put, your worst case is that ST K, in which case youll let your put expire worthless and youll lose the future value of the put premium. Your best case is ST = 0, in which case you sell a worthless stock for K. Your prot is K F V (premium). If you sell a put, your worst case is ST = 0, in which case the put holder sells you a worthless stock for K; your prot is F V (premium) K. Your best case is ST K, where the written put expires worthless and your prot is F V (premium).

www.guo.coursehost.com

c Yufeng Guo

21

CHAPTER 2. Problem 2.13.

INTRODUCTION TO FORWARDS AND OPTIONS

Let S represent the stock price at the option expiration date. Ill draw a separate diagram for the payo and a separate diagram for the prot. a. Suppose you long a call (i.e. buy a call). 0 if S 35 if Your prot at expiration= Payo - FV (premium) = (0, S 35) 9.12 (1.08) = max (0, S 35) 9. 849 6 max 0 if S < 35 9. 849 6 if = 9. 849 6 = S 35 if S 35 S 44. 849 6 if (i) Payo at expiration is max (0, S 35) =
60 50 40 30 20 10 0 10 -10 20 30 40 50 60 70 80

S < 35 S 35 S < 35 35 S

Payoff

Profit

Stock Price

90

100

Payo and Prot: Long a 35 strike call

www.guo.coursehost.com

c Yufeng Guo

22

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS S < 40 S 40 S < 40 S 40

0 if S 40 if Your prot at expiration= Payo - FV (premium) = (0, S 40) 6.22 (1.08) = max (0, S 40) 6. 717 6 max 0 if S < 40 6. 717 6 if = 6. 717 6 = S 40 if S 40 S 46. 717 6 if (ii) Payo at expiration is max (0, S 40) =

60

50

40

Payoff

30

20

Profit

10

0 10 20 30 40 50 60

Stock price at expiration

70

80

90

100

Payo and Prot: Long a 40 strike call

www.guo.coursehost.com

c Yufeng Guo

23

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS S < 45 S 45 S < 45 S 45

0 if S 45 if Your prot at expiration= Payo - FV (premium) = (0, S 45) 4.08 (1.08) = max (0, S 45) 4. 406 4 max 0 if S < 45 4. 406 4 if = 4. 406 4 = S 45 if S 45 S 49. 406 4 if (iii) Payo at expiration is max (0, S 45) =

50

40

Payoff

30

20

Profit

10

0 10 20 30 40 50 60

Stock price at expiration

70

80

90

100

Payo and Prot: Long a 45 strike call b. The payo of a long call is max (0, S K). As K increases, the payo gets worse and the option becomes less valuable. Everything else equal, the higher the strike price, the lower the call premium.

www.guo.coursehost.com

c Yufeng Guo

24

CHAPTER 2. Problem 2.14.

INTRODUCTION TO FORWARDS AND OPTIONS

Suppose we own a put (i.e. long put). a. Payo at expiration is max (0, 35 S) =

35 S if S 35 0 if S > 35 Your prot at expiration = Payo - FV (premium) = (0, 35 S) 1.53 (1.08) = max (0, 35 S) 1. 652 4 max 35 S if S 35 33. 347 6 S if S 35 = 1. 652 4 = 0 if S > 35 1. 652 4 if S > 35

30

20

10

0 10 20 30 40 50 60

Stock price at expiration

70

80

90

100

Payo and prot: Long a 35 strike put The blue line is the payo. The black line is the prot.

www.guo.coursehost.com

c Yufeng Guo

25

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

40 S if S 40 0 if S > 40 Your prot at expiration = Payo - FV (premium) = (0, 40 S) 3.26 (1.08) = max (0, 40 S) 3. 520 8 max 40 S if S 40 36. 479 2 S if S 40 = 3. 520 8 = 0 if S > 40 3. 520 8 if S > 40 b. Payo at expiration is max (0, 40 S) =
40

30

20

10

0 10 20 30 40 50 60

Stock price at expiration

70

80

90

100

Payo and prot: Long a 40 strike put The blue line is the payo. The black line is the prot.

www.guo.coursehost.com

c Yufeng Guo

26

CHAPTER 2.

INTRODUCTION TO FORWARDS AND OPTIONS

c. Payo at expiration is max (0, 45 S) =

45 S if S 45 0 if S > 45 Your prot at expiration = Payo - FV (premium) = (0, 45 S) 5.75 (1.08) = max (0, 45 S) 6. 21 max 45 S if S 45 38. 79 S if S 45 = 6. 21 = 0 if S > 45 6. 21 if S > 45

40

30

20

10

0 10 20 30 40 50 60

Stock price at expiration

70

80

90

100

Payo and prot: Long a 45 strike put The blue line is the payo. The black line is the prot. As the strike price increases, the payo of a put goes up and the more valuable a put is. Everything else equal, the higher the strike price, the more expensive a put is.

www.guo.coursehost.com

c Yufeng Guo

27

CHAPTER 2. Problem 2.15.

INTRODUCTION TO FORWARDS AND OPTIONS

If you borrow money from a bank to buy a $1000 S&R index, your borrowing cost is known at the time of borrowing. Suppose the annual eective risk free interest rate is r. If you borrow $1000 at t = 0, then at T you just pay the bank 1000 (1 + r)T . You can sleep well knowing that your borrowing cost is xed in advance. In contrast, if you short-sell n number of IBM stocks and use the short sale proceeds to buy a $1000 S&R index, you own the brokerage rm n number of IBM stocks. If you want to close your short position at time T , you need to buy n stocks at T . The cost of n stocks at T is nST , where ST is the price of IBM stocks per share at T . Since ST is not known in advance, if you use short selling to nance your purchase of a $1000 S&R index, your borrowing cost nST cannot be known in advance. This brings additional risk to your position. As such, you cant determine your prot. Problem 2.16. Skip this problem. SOA is unlikely to ask you to design a spreadsheet on the exam.

www.guo.coursehost.com

c Yufeng Guo

28

Chapter 3

Insurance, collars, and other strategies


Problem 3.1. The put premium is 74.201. At t = 0, you spend 1000 to buy an S&R index spend 74.201 to buy a 1000-strike put borrow 980.39 take out (1000 + 74.201) 980.39 = 93. 811 out of your own pocket. So your total borrowing is 980.39 + 93. 811 = 1074. 20. The future value is 1074. 20 (1.02) = 1095. 68 S&R index 900 950 1000 1050 1100 1150 1200 S&R Put 100 50 0 0 0 0 0 Payo 1000 1000 1000 1050 1100 1150 1200 -(Cost+Interest) 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 Prot 1000 1095. 68 = 95. 68 1000 1095. 68 = 95. 68 1000 1095. 68 = 95. 68 1050 1095. 68 = 45. 68 1100 1095. 68 = 4. 32 1150 1095. 68 = 54. 32 1200 1095. 68 = 104. 32

29

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Payo. The payo of owning an index is S, where S is the price of the index at the put expiration The payo of owning a put is max (0, 1000 S) at expiration. Total payo: 1000 S if S 1000 1000 if S 1000 S+max (0, 1000 S) = S+ = 0 if S > 1000 S if S > 1000 Prot is: 1000 if S 1000 95. 68 if S 1000 1095. 68 = S if S > 1000 S 1095. 68 if S > 1000

Payoff (Profit)

2000

Payoff
1500

1000

Profit
500

0 200 400 600 800 1000 1200 1400 1600 1800 2000

Stock price at expiration

Payo and Prot: index + put

www.guo.coursehost.com

c Yufeng Guo

30

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.2. At t = 0 you short sell one S&R index, receiving $1000 sell a 1000-strike put, receiving $74.201 deposit 1000 + 74.201 = 1074. 201 in a savings account. This grows into 1074. 201 (1.02) = 1095. 68 at T = 1 The payo of the index sold short is S The payo of a sold put: max (0, 1000 S) The total payo at expiration is: 1000 S if S 1000 1000 if S 1000 Smax (0, 1000 S) = S = 0 if S > 1000 S if S > 1000 The prot at expiration is: 1000 if S 1000 95. 68 if S 1000 + 1095. 68 = S if S > 1000 1095. 68 S if S > 1000 S&R index 900 950 1000 1050 1100 1150 1200 S&R Put 100 50 0 0 0 0 0 Payo 1000 1000 1000 1050 1100 1150 1200 -(Cost+Interest) 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 1095. 68 Prot 1000 + 1095. 68 = 95. 68 1000 + 1095. 68 = 95. 68 1000 + 1095. 68 = 95. 68 1050 + 1095. 68 = 45. 68 1100 + 1095. 68 = 4. 32 1150 + 1095. 68 = 54. 32 1200 + 1095. 68 = 104. 32

www.guo.coursehost.com

c Yufeng Guo

31

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 1000 if S 1000 S if S > 1000

Payo=

1000 if S 1000 Prot= + 1095. 68 S if S > 1000


200 0 400 600 800 1000 1200 1400 1600

Index Price
1800

2000

Profit
-500

-1000

-1500

Payoff
-2000

short index +sell put You can verify that the prot diagram above matches the textbook Figure 3.5 (d).

www.guo.coursehost.com

c Yufeng Guo

32

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.3. Option 1: Buy S&R index for 1000 and buy a 950-strike put Option 2: Invest 931.37 in a zero-coupon bond and buy a 950-strike call. Verify that Option 1 and 2 have the same payo and the same prot. Option 1: If you own an index, your payo at any time is the spot price of the index S. The payo of owning a 950-strike put is max (0, 950 S). Your total payo at the put expiration is 950 S S+max (0, 950 S) = S+ 0 if S 950 = if S > 950 950 if S 950 S if S > 950

To calculate the prot, we need to know the initial investment. At t = 0, we spend 1000 to buy an index and 51.777 to buy the 950-strike put. The total investment is 1000 + 51.777 = 1051. 777. The future value of the investment is 1051. 777 (1.02) = 1072. 81 So the prot is: 950 if S 950 122. 81 if S 950 1072. 81 = S if S > 950 S 1072. 81 if S > 950

www.guo.coursehost.com

c Yufeng Guo

33

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 950 if S 950 S if S > 950 950 if S 950 Prot= 1072. 81 S if S > 950

Payo=

2000

1500

Payoff

1000

500

Profit

0 200 400 600 800 1000 1200 1400 1600 1800

Index

2000

index + put

www.guo.coursehost.com

c Yufeng Guo

34

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Option 2: Payo of the zero-coupon bond at T = 0.5 year is: 931.37 (1.02) = 950 Payo of owning a 950-strike call: max (0, S 950) 950+max (0, S 950) = 950+ Total payo: 0 if S 950 = S 950 if S > 950 950 if S 950 S if S > 950

To calculate the prot, we need to know the initial investment. We spend 931.37 to buy a bond and 120.405 to buy a 950-strike call. The future value of the investment is (931.37 + 120.405) 1.02 = 1072. 81. The prot is: 950 if S 950 1072. 81 = S if S > 950 122. 81 if S 950 S 1072. 81 if S > 950

Option 1 and 2 have the same payo and the same prot. But why? Its because the put-call parity: C (K, T ) + P V (K) = P (K, T ) + S0 Option 1 consists of buying S&R index and a 950-strike put Option 2 consists of investing P V (K) = 950 1.021 = 931. 37 and buying a 950-strike call. Due to the put-call parity, Option 1 and 2 have the same payo and the same prot.

www.guo.coursehost.com

c Yufeng Guo

35

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.4. Option 1: Short sell S&R index for 1000 and buy a 950-strike call Option 2: Borrow 931.37 and buy a 950-strike put Verify that Option 1 and 2 have the same payo and the same prot. Option 1: At t = 0.5, your payo from the short sale of an index is S, where S is the index price at T = 0.5. At T = 0.5, your payo from owning a 0 if S < 950 call is max (0, S 950) = . S 950 if S 950 Your total payo is 0 if S < 950 S if S < 950 S + = S 950 if S 950 950 if S 950 Please note that when calculating the payo, well ignore the sales price of the index $1, 000 and the call purchase price 120. 405. These two numbers aect your prot, but they dont aect your payo. Your payo is the same no matter whether you sold your index for $1 or $1000, and no matter whether you buy the 950-strike call for $10 or $120. 41. Next, lets nd the prot at T = 0.5. At t = 0, you sell an index for 1000. Of 1000 you get, you spend 120. 405 120. 41 to buy a 950-strike call. You have 1000 120. 41 = 879. 59 left. This will grow into 879. 59 1.02 = 897. 18 at T = 0.5 At T = 0.5, your prot is 897. 18 plus the payo:

Prot =897. 18 +

S if S < 950 = 950 if S 950

897. 18 S 52. 82

if S < 950 if S 950

www.guo.coursehost.com

c Yufeng Guo

36

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES S if S < 950 Payo= 950 if S 950 S if S < 950 Prot =897. 18+ 950 if S 950

800 600 400 200 0 200 -200 -400 -600 -800 400 600 800 1000 1200 1400 1600

Profit

Index Price

1800

2000

Payoff
Payo and Prot: Short index + Long call

www.guo.coursehost.com

c Yufeng Guo

37

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Option 2 payo. At t = 0.5, you need to pay the lender 931.37 1.02 = 950, so, a payo of 950 (youll write the lender a check of 950). At T = 0.5, the pay950 S if S < 950 o from buying a 950-strike put is max (0, 950 S) = . 0 if S 950 Your total payo at T = 0.5 is: 950 + 950 S 0 if S < 950 = if S 950 S if S < 950 . 950 if S 950

This is the same as the payo in Option 1. Option 2 prot. There are two ways to calculate the prot. Method 1. The total prot is the sum of prot earned from borrowing 931.37 and the prot earned by buying a 950-strike put. The prot from borrowing 931.37 is zero; you borrow 931.37 at t = 0. This grows into 931.37 1.02 = 950 at T = 0.5 in your savings account. Then at T = 0.5, you take out 950 from your savings account and pay the lender. Now your savings account is zero. So the prot earned from borrowing 931.37 is zero. Next, lets calculate the prot from buying the put. The put premium is $51.78. So your prot earned from buying the put option is 51.78 1.02 + max (0, 950 S) = 52. 82 + max (0, 950 S) = 52. 82 + 950 S 0 if S < 950 = if S 950 897. 18 S 52. 82 if S < 950 if S 950

S if S < 950 . We just 950 if S 950 need to deduct the future value of the initial investment. At t = 0, you receive 931.37 from the lender and pay 51.78 to buy the put. So your total cash is 931.37 51.78 = 879. 59, which grows into 879. 59 1.02 = 897. 18 at t = 0.5. Hence, your prot is: Method 2. We already know the payo is S if S < 950 + 897. 18 = 950 if S 950 897. 18 S 52. 82 if S < 950 if S 950

No matter whether you use Method 1 or Method 2, the Option 2 prot is the same as the Option 1 prot. You might wonder why Option 1 and Option 2 have the same payo and the same prot. The parity formula is Call (K, T ) P ut (K, T ) = P V (F0,T K) = P V (F0,T ) P V (K) Rearranging this equation, we get: www.guo.coursehost.com c Yufeng Guo 38

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Call (K, T ) + P V (K) = P ut (K, T ) + P V (F0,T ) Since P V (F0,T ) = S0 , now we have: Call (K, T ) + P V (K) = P ut (K, T ) + {z } | | {z } | {z }
own a call own PV of strike price own a put

own one index

The above equation can also be read as; Call (K, T ) + P V (K) = P ut (K, T ) + {z } | | {z } | {z }
buy a call invest PV of strike price buy a put

S0 |{z}

buy one index

Rearranging the above formula, we get: Call (K, T ) + S0 = P ut (K, T ) + |{z} {z } | | {z }


own a call sell one index own a put

S0 |{z}

b orrow PV of strike price

The above equation can also be read as: Call (K, T ) + | {z }


buy a call

P V (K) | {z } P V (K) | {z }

sell one index

According to the parity equation, Option 1 and Option 2 are identical portfolios and should have the same payo and the same prot. In this problem, Option 1 consists of shorting an S&R index and buying a 950-strike call. Op tion 2 consists of borrowing P V (K) = 950 1.021 = 931. 37 and buying a 950-strike put. As a result, Option 1 and 2 have the same payo and the same prot.

S0 |{z}

= P ut (K, T ) + | {z }
buy a put

b orrow PV of strike price

www.guo.coursehost.com

c Yufeng Guo

39

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.5. Option 1: Short sell index for 1000 and buy 1050-strike call Option 2: Borrow 1029.41 and buy a 1050-strike put. Verify that Option 1 and 2 have the same payo and the same prot. Option 1: Payo: 0 if S < 1050 S if S < 1050 S+max (0, S 1050) = S+ = S 1050 if S 1050 1050 if S 1050 Prot: Your receive 1000 from the short sale and spend 71.802 to buy the 1050-strike call. The future value is: (1000 71.802) 1.02 = 946. 76 So the prot is: S if S < 1050 946. 76 S + 946. 76 = 1050 if S 1050 103. 24 if S < 1050 if S 1050

www.guo.coursehost.com

c Yufeng Guo

40

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES S if S < 1050 Payo= 1050 if S 1050 S if S < 1050 Prot= + 946. 76 1050 if S 1050

800 600 400 200 0 200 -200 -400 -600 -800 -1000 400 600 800 1000 1200 1400 1600

Profit

Index Price

1800

2000

Payoff
Payo and Prot: Short index + Long call

www.guo.coursehost.com

c Yufeng Guo

41

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Option 2: Payo: If you borrow 1029.41, youll need to pay 1029.41 (1.02) = 1050 at T = 0.5 So the payo of borrowing 1029.41 is 1050. Payo of the purchased put is max (0, 1050 S) Total payo is: 1050 S = 1050 + 0 if S < 1050 = if S 1050 S if S < 1050 1050 if S 1050

Initially, you receive 1029.41 from a bank and spend 101.214 to buy a 950strike put. So your net receipt at t = 0 is 1029.41 101.214 = 928. 196. Its future value is 928. 196 (1.02) = 946. 76. Your prot is: S if S < 1050 + 946. 76 = 1050 if S 1050 946. 76 S 103. 24 if S < 1050 if S 1050

Option 1 and 2 have the same payo and the same prot. This is because the put-call parity: Call (K, T ) + S0 = P ut (K, T ) + P V (K) |{z} | {z } | {z } | {z }
buy a call sell one index buy a put b orrow PV of strike price

www.guo.coursehost.com

c Yufeng Guo

42

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.6. (a) buy an index for 1000 (b) buy a 950-strike call, sell a 950-strike put, and lend 931.37 Verify that (a) and (b) have the same payo and the same prot. (a)s payo is S. Prot is S 1000 (1.02) = S 1020 (b)s payo: buy a 950-strike call sell a 950-strike put lend 931.37 Total Payo max (0, S 950) max (0, 950 S) 931.37 (1.02) = 950 Initial receipt 120.405 51.777 931.37 120.405 + 51.777 931.37 = 1000

Total payo: max (0, S 950) max (0, 950 S) + 950 = 0 if S < 950 S 950 if S 950 950 S 0 if S < 950 + 950 if S 950

(950 S) + 950 if S < 950 =S S 950 + 950 if S 950

Total prot: S 1000 (1.02) = S 1020 (a) and (b) have the same payo and the same prot. Why? Call (K, T ) + | {z }
buy a call

sell one index

buy one index

S0 |{z}

S0 |{z}

Call (K, T ) + P ut (K, T ) + {z } {z } | |


buy a call sell a put

= P ut (K, T ) + | {z }
buy a put

b orrow PV of strike price

P V (K) | {z }

lend PV of strike price

P V (K) | {z }

www.guo.coursehost.com

c Yufeng Guo

43

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES (a) and (b) have the following common payo and prot.

Payo=S
2000

Prot=S 1020

Payoff
1000

0 200 400 600 800 1000 1200 1400 1600

Profit

Index Price

1800

2000

-1000

www.guo.coursehost.com

c Yufeng Guo

44

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.7. (a) short index for 1000 (b) sell 1050-strike call, buy a 1050-strike put, and borrow 1029.41 Verify that (a) and (b) have the same payo and the same prot. (a) Payo is S. Prot is S + 1000 (1.02) = 1020 S (b) Payo: max (0, 1050 S) max (0, S 1050) 1029.41 (1.02) = 1050 S 0 if S < 1050 if S 1050 0 if S < 1050 1050 S 1050 if S 1050 S S if S < 1050 = S if S 1050

(1050 S) 1050 if S < 1050 = (S 1050) 1050 if S 1050

We need to calculate the initial investment of (b). At t = 0, we Receive 71.802 from selling a 1050-strike call Pay 101.214 to buy a 1050-strike put Receive 1029.41 from a lender Our net receipt is 71.802 101.214 + 1029.41 = 1000. The future value is 1000 (1.02) = 1020 So the prot at T = 0.5 is S + 1020 = 1020 S. You see that (a) and (b) have the same payo and the same prot. Why? From the put-call parity, we have: Call (K, T ) + S0 = P ut (K, T ) + P V (K) |{z} | {z } | {z } | {z }
buy a call sell one index buy a put b orrow PV of strike price

sell one index

S0 |{z}

Call (K, T ) + P ut (K, T ) + {z } | | {z }


sell a call buy a put

b orrow PV of strike price

P V (K) | {z }

www.guo.coursehost.com

c Yufeng Guo

45

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Payo= S.


1000

Prot= 1020 S

Profit
0 200 400 600 800 1000 1200 1400 1600

Index Price

1800

2000

-1000

Payoff

-2000

www.guo.coursehost.com

c Yufeng Guo

46

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.8. Put-call parity: Call (K, T ) + {z } |
buy a call

invest PV of strike price

109.2 + P V (K) = 60.18 + 1000 P V (K) = 60.18 + 1000 109.2 = 950. 98 P V (K) = K 1.02

P V (K) | {z }

= P ut (K, T )+ | {z }
buy a put

buy one index

S0 |{z}

K = 950. 98 (1.02) = 970

Problem 3.9. Buy a call (put) a lower strike + Sell an otherwise identical call (put) with a higher strike=Bull call (put) spread Option 1: buy 950-strike call and sell 1000-strike call Option 2: buy 950-strike put and sell 1000-strike put. Verify that option 1 and 2 have the same prot. Option 1: Payo=max (0, S 950) max S 1000) (0, 0 if S < 950 0 if S < 1000 = S 950 if S 950 S 1000 if S 1000 if S < 950 if 0 0 S 950 if 1000 > S 950 0 if = S 950 if S 1000 S 1000 if S < 950 1000 > S 950 S 1000

if S < 950 if S < 950 0 0 S 950 if 1000 > S 950 = S 950 if 1000 > S 950 = S 950 (S 1000) if S 1000 50 if S 1000 Initial cost: Spend 120.405 to buy 950-strike call Sell 1000-strike call receiving 93.809 Total initial investment: 120.405 93.809 = 26. 596 The future value is 26. 596 (1.02) = 27. 127 92 Prot is: if S < 950 if S < 950 0 27.13 S 950 if 1000 > S 950 27.13 = S 950 27.13 if 1000 > S 950 = 50 if S 1000 50 27.13 if S 1000 if S < 950 27.13 S 977. 13 if 1000 > S 950 = 22. 87 if S 1000

www.guo.coursehost.com

c Yufeng Guo

47

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES if S < 950 0 S 950 if 1000 > S 950 Payo= 50 if S 1000

if S < 950 0 S 950 if 1000 > S 950 27.13 Prot= 50 if S 1000

50 40 30 20 10 0 200 -10 -20 400 600 800 1000 1200

Payoff

Profit

1400

1600

Index Price

1800

2000

www.guo.coursehost.com

c Yufeng Guo

48

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Option 2: buy 950-strike put and sell 1000-strike put. The payo: max (0, 950 S) max (0, 1000 S) 950 S if S < 950 1000 S if S < 1000 = 0 if S 950 0 if S 1000 950 S 0 = 0 if S < 950 1000 S if 1000 > S 950 1000 S if S 1000 0 if if if S < 950 1000 > S 950 S 1000

Initial cost:

if S < 950 (950 S) (1000 S) if S < 950 50 (1000 S) if 1000 > S 950 = S 1000 if 1000 > S 950 = 0 S 1000 0 if S 1000

Buy 950-strike put. Pay 51.777 Sell 1000-strike put. Receive 74.201 Net receipt: 74.201 51.777 = 22. 424 Future value: 22. 424 (1.02) = 22. 872 48 The prot is: if S < 950 50 S 1000 if 1000 > S 950 + 22. 87 0 if S 1000

if S < 950 if S < 950 50 + 22. 87 27. 13 S 1000 + 22. 87 if 1000 > S 950 = S 977. 13 if 1000 > S 950 = 22. 87 if S 1000 22. 87 if S 1000

www.guo.coursehost.com

c Yufeng Guo

49

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES if S < 950 50 Payo= S 1000 if 1000 > S 950 0 if S 1000

if S < 950 50 Prot= S 1000 if 1000 > S 950 + 22. 87 0 if S 1000

20

Profit

10

0 200 -10 400 600 800 1000 1200 1400 1600

Index Price

1800

2000

-20

-30

-40

Payoff

-50

www.guo.coursehost.com

c Yufeng Guo

50

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES The payo of the rst option is $50 greater than the payo of the second option. However, at t = 0, we pay 26. 596 to set up option 1; we pay 22. 424 (i.e. we receive 22. 424) to set up option 2. It costs us 26. 596 (22. 424) = 49. 02 more initially to set up option 1 than option 2. The future value of this initial set up cost is 49. 02 (1.02) = 50. As a result, option 1 and 2 have the same prot at T = 0.5. This should make sense in a world of no arbitrage. Consider two portfolios A and B. If for any stock price P ayof f (A) = P ayof f (B) + c, then InitialCost (A) = InitialCost (B) + P V (c) to avoid arbitrage. P rof it (A) = P ayof f (A) F V [InitialCost (A)] = P ayof f (B) + c F V [InitialCost (B)] c = P ayof f (B) F V [InitialCost (B)] = P rof it (B) Similarly, if InitialCost (A) = InitialCost (B) + P V (c) P ayof f (A) = P ayof f (B) + c P rof it (A) = P rof it (B) Finally, lets see why option 1 is always $50 higher than option 2 in terms of the payo and the initial set up cost. The put-call parity is: Call (K, T ) + P V (K) = P ut (K, T ) + S0 |{z} | {z } | {z } | {z }
buy a call invest PV of strike price buy a put buy one index

The timing of the put-call parity is at t = 0. The above equation means Call (K, T ) + P V (K) {z } | | {z }
Cost of buying a call at t=0 Cost of investing PV of strike price at t=0

Cost of buying a put at t=0

P ut (K, T ) | {z }

Cost of buying an index at t=0

S0 |{z}

If we are interested in the payo at expiration date T , then the put-call parity is: Call (K, T ) + K = P ut (K, T ) + S |{z} |{z} {z } | | {z }
Payo a call at T strike price at T Payo of a put at T Index price at T

Now we set up the initial cost parity for two strike prices K1 < K2 Call (K1 , T ) {z } | Call (K2 , T ) {z } | + P V (K1 ) | {z } + P V (K2 ) | {z } = P ut (K1 , T ) + {z } | P ut (K2 , T ) + {z } | S0 |{z} S0 |{z}

cost of buying a call

invest PV of K1

cost of buying a put

cost of buying one index at t=0

cost of buying a call

invest PV of K2

cost of buying a put

cost of buying one index at t=0

www.guo.coursehost.com

Call (K1 , T ) {z } |

cost of buying a call

cost of buying a call

Call (K2 , T ) + [P V (K1 ) P V (K2 )] {z } | c Yufeng Guo

51

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES

= P ut (K1 , T ) {z } |

cost of buying a put

cost of buying a put

P ut (K2 , T ) {z } |

Call (K1 , T ) {z } | = P ut (K1 , T ) {z } | | |

{z

cost of buying a call

cost of buying a call

Call spread

Call (K2 , T ) {z } | } }

{z

cost of buying a put

cost of buying a put

Put spread

P ut (K2 , T ) + [P V (K2 ) P V (K1 )] {z } |

Call (K1 , T ) {z } | = P ut (K1 , T ) {z } | | |

cost of buying a call

Call spread

cost of buying a put

Put spread

So the initial cost of setting up a call bull spread always exceeds the initial set up cost of a bull put spread by a uniform amount P V (K2 ) P V (K1 ). In this problem, P V (K2 ) P V (K1 ) = (1000 950) 1.021 = 49. 02 Set up the payo parity at T : Call (K1 , T ) + K1 = |{z} {z } |
Payo a call at T strike price at T

{z

+ P ut (K2 , T ) + [P V (K2 ) P V (K1 )] {z } |


cost of selling a put

{z

+ Call (K2 , T ) {z } |
cost of selling a call

} }

Payo of a put at T

P ut (K1 , T ) {z } | P ut (K2 , T ) {z } | }

Index price at T

S |{z} S |{z}

Payo a call at T

Call (K2 , T ) + {z } |

strike price at T

K1 |{z} {z

Payo of a put at T

Index price at T

Payo a long call at T

Call (K1 , T ) {z } |

Payo a long call at T

Call bull payo at T

Call (K2 , T ) {z } |

www.guo.coursehost.com

c Yufeng Guo

52

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES | }

Payo of a long put at T

P ut (K2 , T ) {z } |

{z

Payo of a long put at T

Put spread payo at T

P ut (K1 , T ) {z } |

+ K2 K1

= | |

Payo a long call at T

Call (K1 , T ) {z } |

Call spread payo at T

Payo of a long put at T

P ut (K2 , T ) {z } |

{z

+ Call (K2 , T ) {z } |
Payo short call at T

+ {z

Payo of a short put at T

Put spread payo at T

P ut (K1 , T ) {z } |

+ K2 K1

In this problem, K2 K1 = 1000 950 = 50 So the payo of a call bull spread at T = 0.5 always exceeds the payo of a put bull spread by a uniform amount 50.

www.guo.coursehost.com

c Yufeng Guo

53

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.10. Buy a call (put) a higher strike + Sell an otherwise identical call (put) with lower strike=Bear call (put) spread. In this problem, K1 = 1050, K2 = 950 (a bear spread) P V(K2 ) P V (K1 ) = (950 1050) 1.021 = (100) 1.021 = 98. 04 |
cost of buying a call Call spread

Call (K1 , T ) {z } | = P ut (K1 , T ) {z } | = P ut (K1 , T ) {z } | | = = | | | |

cost of buying a put

Put spread

{z {z

+ P ut (K2 , T ) + [P V (K2 ) P V (K1 )] {z } |


cost of selling a put

{z

+ Call (K2 , T ) {z } |
cost of selling a call

} } }

cost of buying a put

Put spread

+ P ut (K2 , T ) 98. 04 {z } |
cost of selling a put

Payo a long call at T

Call (K1 , T ) {z } |

Call spread payo at T

Payo of a long put at T

P ut (K2 , T ) {z } | P ut (K2 , T ) {z } |

{z

+ Call (K2 , T ) {z } |
Payo short call at T

} } }

+ {z {z

Payo of a short put at T

Put spread payo at T

P ut (K1 , T ) {z } | P ut (K1 , T ) {z } |

+ K2 K1 100

Payo of a long put at T

Payo of a short put at T

Put spread payo at T

For any index price at expiration, the payo of the call bear spread is always 100 less than the payo of the put bear spread. Consequently, as we have seen, to avoid arbitrage, the initial set-up cost of the call bear spread is less than the initial set-up cost of the put bear spread by the amount of present value of the 100. The call bear spread and the put bear spread have the same prot at expiration.

www.guo.coursehost.com

c Yufeng Guo

54

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Next, lets draw the payo and prot diagram for each spread. Payo of the call bear spread: Payo=max (0, S 1050) max (0, S 950) Buy 1050-strike call = Sell 950-strike call Total 0 950 S = 100 S < 950 0 0 0 950 S < 1050 0 950 S 950 S 1050 S S 1050 950 S 100

if S < 950 if 950 S < 1050 if S 1050

The initial set-up cost of the call bear spread: Buy 1050-strike call. Pay 71.802

Sell 950-strike call. Receive 120.405 Net receipt: 120.405 71.802 = 48. 603 Future value: 48. 603 (1.02) = 49. 575 06 So the prot of the call bear spread at expiration is if S < 950 0 49. 58 950 S if 950 S < 1050 +49. 58 = 999. 58 S = 100 if S 1050 50. 42

if S < 950 if 950 S < 1050 if S 1050

www.guo.coursehost.com

c Yufeng Guo

55

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 0 950 S Payo= 100 0 950 S Prot= 100 if S < 950 if 950 S < 1050 if S 1050 if S < 950 if 950 S < 1050 + 49. 58 if S 1050

40 20 0 200 -20 -40 -60 -80 400 600 800 1000 1200 1400 1600

Index Price

1800

2000

Profit

Payoff
-100

Payo and Prot: Call bear spread

www.guo.coursehost.com

c Yufeng Guo

56

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Payo of the put bear spread: Payo=max (0, 1050 S) max (0, 950 S) Buy 1050-strike put = Sell 950-strike put Total 100 1050 S = 0 S < 950 1050 S S 950 100 950 S < 1050 1050 S 0 1050 S 1050 S 0 0 0

if S < 950 if 950 S < 1050 if S 1050

Payoff

100 90 80 70 60 50 40 30 20 10 0 0 200 400 600 800 1000 1200 1400 1600 1800 2000

Index Price

Payo of the put bear spread

www.guo.coursehost.com

c Yufeng Guo

57

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES The initial set-up cost: Buy 1050-strike put. Pay 101.214 Sell 950-strike put. Receive 51.777 Net cost: 101.214 51.777 = 49. 437 Future value: 49. 437 (1.02) = 50. 42 The prot at expiration is: if S < 950 100 49. 58 1050 S if 950 S < 1050 50. 42 = 999. 58 S = 0 if S 1050 50. 42

if S < 950 if 950 S < 1050 if S 1050

We see that the call bear spread and the put bear spread have the same prot.

www.guo.coursehost.com

c Yufeng Guo

58

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.11. Buy S&R index Buy 950-strike put Sell 1050-strike call Total FV (initial cost) Initial Cost 1000 51.777 71.802 1000 + 51.777 71.802 = 979. 975 979. 975 (1.02) = 999. 574 5 Payo S max (0, 950 S) max (0, S 1050)

The net option premium is: 51.777 71.802 = 20. 025. So we receive 20. 025 if we enter this collar. Payo S < 950 950 S < 1050 1050 S Buy S&R index S S S Buy 950-strike put 950 S 0 0 Sell 1050-strike call 0 0 1050 S Total 950 S 1050 The payo at expiration is: 950 if S < 950 S if 950 S < 1050 1050 if S 1050

if S < 950 49. 57 S 999. 57 if 950 S < 1050 = 50. 43 if S 1050

The prot at expiration is: 950 if S < 950 950 999. 57 if S < 950 S if 950 S < 1050 999. 57 = S 999. 57 if 950 S < 1050 1050 if S 1050 1050 999. 57 if S 1050

www.guo.coursehost.com

c Yufeng Guo

59

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES if S < 950 49. 57 S 999. 57 if 950 S < 1050 Prot= 50. 43 if S 1050

Profit

50 40 30 20 10 0 200 -10 -20 -30 -40 -50 400 600 800 1000 1200 1400 1600

Index Price

1800

2000

Prot: long index, long 950-strike put, short 1050-strike call The net option premium is 20. 025. So we receive 20. 025 if we enter this collar. To construct a zero-cost collar and keep 950-strike put, we need to increase the strike price of the call such that the call premium is equal to the put premium of 51.777.

www.guo.coursehost.com

c Yufeng Guo

60

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.12. Buy S&R index Buy 950-strike put Sell 1107-strike call Total FV (initial cost) Initial Cost 1000 51.777 51.873 1000 + 51.777 51.873 = 999. 904 999. 904 (1.02) = 1019. 902 08 Payo S max (0, 950 S) max (0, S 1050)

The net option premium is: 51.777 51.873 = 0.096 . So we receive 0.096 if we enter this collar. This is very close to a zero-cost collar, where the net premium is zero. Payo Buy S&R index Buy 950-strike put Sell 1050-strike call Total S < 950 S 950 S 0 950 950 S < 1107 S 0 0 S 1107 S S 0 1107 S 1107

The prot is: if S < 950 950 if S < 950 69. 9 S if 950 S < 1107 1019. 90 = S 1019. 90 if 950 S < 1107 1107 if S 1107 87. 1 if S 1107

www.guo.coursehost.com

c Yufeng Guo

61

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES if S < 950 69. 9 S 1019. 90 if 950 S < 1107 Prot= 87. 1 if S 1107

Profit

80 60 40 20 0 200 -20 -40 -60 400 600 800 1000 1200 1400 1600

Index Price

1800

2000

Prot: long index, long 950-strike put, short 1107-strike call

www.guo.coursehost.com

c Yufeng Guo

62

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.13. a. 1050-strike S&R straddle Straddle = buy a call and put with the same strike price and time to expiration. Buy1050-strike call Buy 1050-strike put Total FV (initial cost) Payo Buy1050-strike call Buy 1050-strike put Total S < 1050 0 1050 S 1050 S S 1050 S 1050 0 S 1050 Initial Cost 71.802 101.214 71.802 + 101.214 = 173. 016 173. 016 (1.02) = 176. 476 32 Payo max (0, S 1050) max (0, 1050 S)

The prot is: 1050 S if S < 1050 873. 52 S if S < 1050 176. 48 = S 1050 if S 1050 S 1226. 48 if S 1050

Profit

900 800 700 600 500 400 300 200 100 0 200 -100 400 600 800 1000 1200 1400 1600 1800 2000 2200

Index Price

Prot: long 1050-strike call and long 1050-strike put

www.guo.coursehost.com

c Yufeng Guo

63

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES b. written 950-strike S&R straddle Initial revenue short 950-strike call 120.405 short 950-strike put 51.777 Total 120.405 + 51.777 = 172. 182 FV (initial cost) 172. 182 (1.02) = 175. 625 64 Payo sell 950-strike call sell 950-strike put Total S < 950 0 S 950 S 950 S 950 950 S 0 950 S if S < 950 if S 950

Payo max (0, S 950) max (0, 950 S)

The prot is: S 950 if S < 950 S 774. 34 + 175. 66 = 950 S if S 950 1125. 66 S

Profit

100 0 200 -100 -200 -300 -400 -500 -600 -700 -800 -900 -1000 400 600 800 1000 1200 1400 1600 1800 2000 2200

Index Price

Prot: short 950-strike call and short 950-strike put

www.guo.coursehost.com

c Yufeng Guo

64

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES c. simultaneous purchase of 1050-straddle and sale of 950-straddle Prot = Prot of purchase of 1050-straddle + Prot of Sale of 950-straddle Prot 873. 52 S if S < 1050 S 774. 34 if S < 950 + S 1226. 48 if S 1050 1125. 66 S if S 950 if S < 950 873. 52 S S 774. 34 873. 52 S if 950 S < 1050 + 1125. 66 S S 1226. 48 if S 1050 1125. 66 S if 873. 52 S + (S 774. 34) 873. 52 S + (1125. 66 S) if = S 1226. 48 + (1125. 66 S) if if if if S < 950 950 S < 1050 S 1050 if S < 950 if 950 S < 1050 if S 1050

99. 18 1999. 18 2S = 100. 82

S < 950 950 S < 1050 S 1050

Profit

100 80 60 40 20 0 950 -20 -40 -60 -80 -100 1000 1050 1100

Index Price

1150

1200

Prot: long 1050-strike straddle and short 950 straddle

www.guo.coursehost.com

c Yufeng Guo

65

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.14. The put-call parity is: Call (K, T ) + P V (K) | {z } | {z }
buy a call

invest PV of strike price

Call (K1 , T ) + {z } |
buy a call

invest PV of strike price

Call (K2 , T ) + {z } |
buy a call

P V (K1 ) | {z } P V (K2 ) | {z }

= P ut (K, T ) + | {z }
buy a put

buy one index

= P ut (K1 , T ) + {z } |
buy a put

S0 |{z}

buy one index

invest PV of strike price

Call (K1 , T ) Call (K2 , T )+P V (K1 K2 ) = P ut (K1 , T ) P ut (K2 , T ) {z } | {z } {z } | {z } | |


buy a call buy a call buy a put buy a put

= P ut (K2 , T ) + {z } |
buy a put

S0 |{z} S0 |{z}

buy one index

Call (K1 , T ) + Call (K2 , T )+P V (K1 K2 ) = P ut (K1 , T ) + P ut (K2 , T ) {z } | {z } {z } | {z } | |


buy a call sell a call buy a put sell a put

Call (K1 , T ) + Call (K2 , T )P ut (K1 , T ) + P ut (K2 , T ) = P V (K2 K1 ) {z } | {z } {z } | {z } | |


buy a call sell a call buy a put sell a put

The initial cost is P V (K2 K1 ) at t = 0. The payo at expiration T = 0.5 is K2 K1 . The transaction is equivalent to investing P V (K2 K1 ) in a savings account at t = 0 and receiving K2 K1 at T , regardless of the S&R price at expiration. So the transaction doesnt have any S&R price risk. We just earn the risk free interest rate over the 6- month period. In K = this problem, K1 = 950 and 2 1000 Call (K1 , T ) + Call (K2 , T ) + P ut (K1 , T ) + P ut (K2 , T ) {z } | {z } {z } | {z } | | buy a call sell a call buy a put sell aput = P V (1000 950) = P V (50) = 50 1.021 = 49. 02

Call (K1 , T ) + Call (K2 , T )+P ut (K1 , T ) + P ut (K2 , T ) = P V (K2 K1 ) {z } | {z } {z } | {z } | |


buy a call sell a call sell a put buy a put

So the total initial cost is 49.02. The payo is 49.02 (1.02) = 50. The prot is 0. We earn a 2% risk-free interest rate over the 6-month period. www.guo.coursehost.com c Yufeng Guo 66

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.15. a. Buy a 950-strike call and sell two 1050-strike calls Initial cost buy a 950-strike call 120.405 sell two 1050-strike calls 2 (71.802) = 143. 604 Total 120.405 143. 604 = 23. 199 FV (initial cost) 23. 199 (1.02) = 23. 662 98 Payo buy a 950-strike call sell two1050-strike calls Total S < 950 0 0 0 950 S < 1050 S 950 0 S 950 S 1050 S 950 2 (S 1050) S 950 2 (S 1050) = 1150 S Payo max (0, S 950) 2 max (0, S 1050)

The prot is: if S < 950 if S < 950 0 23. 66 S 950 if 950 S < 1050 +23. 66 = S 950 + 23. 66 if 950 S < 1050 1150 S if S 1050 1150 S + 23. 66 if S 1050 23. 66 S 926. 34 = 1173. 66 S if S < 950 if 950 S < 1050 if S 1050

Profit 120
100 80 60 40 20 0 850 -20 900 950 1000 1050 1100

Index Price

1150

1200

long 950-strike call and short two1050-strike calls

www.guo.coursehost.com

c Yufeng Guo

67

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES b. Buy two 950-strike calls and sell three 1050-strike calls Initial cost Payo buy two 950-strike calls 2 (120.405) = 240. 81 2 max (0, S 950) sell three 1050-strike calls 3 (71.802) = 215. 406 3 max (0, S 1050) Total 240. 81 215. 406 = 25. 404 FV (initial cost) 25. 404 (1.02) = 25. 912 08 Payo buy two 950-strike calls sell three 1050-strike calls Total S < 950 0 0 0 950 S < 1050 2 (S 950) 0 2 (S 950) S 1050 2 (S 950) 3 (S 1050) 2 (S 950) 3 (S 1050) = 1250 S

Prot: if S < 950 if S < 950 0 25. 91 2 (S 950) if 950 S < 1050 25. 91 = 2 (S 950) 25. 91 if 950 S < 1050 1250 S if S 1050 1250 S 25. 91 if S 1050 if S < 950 25. 91 2S 1925. 91 if 950 S < 1050 = 1224. 09 S if S 1050

Profit

160 140 120 100 80 60 40 20 0 950 -20 1000 1050 1100 1150

Index Price

1200

1250

long two 950-strike calls and short three1050-strike calls

www.guo.coursehost.com

c Yufeng Guo

68

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES c. Buy n 950-strike calls and short m 1050-strike calls such that the initial premium is zero. n 71.802 120.405n = 71.802m = = 0.596 3 m 120.405 Problem 3.16. A spread consists of buying one option at one strike price and selling an otherwise identical option with a dierent strike price. A bull spread consists of buying one option at one strike and selling an otherwise identical option but at a higher strike price. A bear spread consists of buying one option at one strike and selling an otherwise identical option but at a lower strike price. A bull spread and a bear spread will never have zero premium because the two options dont have the same premium. A buttery spread might have a zero net premium. Problem 3.17. According to http://www.daytradeteam.com/dtt/butterfly-options-trading. asp , a buttery spread combines a bull and a bear spread. It uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both puts and calls can be used. A very large prot is made if the stock is at or very near the middle strike price on expiration day. When you enter a buttery spread, you are entering 3 options orders at once. If the stock remains or moves into a dened range, you prot, and if the stock moves out of the desired range, you lose. The closer the stock is to the middle strike price on expiration day, the larger your prot. K2 = K1 + (1 ) K3 For the strike price K1 < K2 < K3 So for each K2 -strike option sold, there needs to be units of K1 -strike options bought and (1 ) units of K3 -strike options bought. In this problem, K1 = 950, K2 = 1020, K3 = 1050 1020 = 950 + (1 ) 1050 = 0.3 For every ten 1020-strike calls written, there needs to be three 950-strike calls purchased and seven 1050-strike calls purchased (so we buy three 950 1020 bull spreads and seven 1020 1050 bear spreads). sell ten 1020-strike calls three 950-strike calls seven 1050-strike calls Total FV (initial cost) www.guo.coursehost.com Initial cost 10 (84.47) = 844. 7 3 (120.405) = 361. 215 7 (71.802) = 502. 614 844. 7 + 361. 215 + 502. 614 = 19. 129 19. 129 (1.02) = 19. 511 58 c Yufeng Guo Payo 10 max (0, S 1020) 3 max (0, S 950) 7 max (0, S 1050)

69

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Payo S < 950 950 S < 1020 950-strike calls 0 3 (S 950) 1020-strike calls 0 0 1050-strike calls 0 0 Total 0 3 (S 950) 3 (S 950) 10 (S 1020) = 7350 7S 3 (S 950) 10 (S 1020) + 7 (S 1050) = 0 if if if if 1020 S < 1050 3 (S 950) 10 (S 1020) 0 7350 7S 1050 S 3 (S 950) 10 (S 1020) 7 (S 1050) 0

A key point to remember is that for a buttery spread K1 < K2 < K3 , payo is zero if S K1 or S K3 . The prot is: if S < 950 0 19. 51 3 (S 950) if 950 S < 1020 3 (S 950) 19. 51 19. 51 = 7350 7S if 1020 S < 1050 7350 7S 19. 51 0 if 1050 S 19. 51 19. 51 3S 2869. 51 = 7330. 49 7S 19. 51 if if if if S < 950 950 S < 1020 1020 S < 1050 1050 S

0 3 (S 950) The payo = 7350 7S 0

S < 950 950 S < 1020 1020 S < 1050 1050 S the

if if if if

S < 950 950 S < 1020 1020 S < 1050 1050 S

www.guo.coursehost.com

c Yufeng Guo

70

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 0 3 (S 950) Payo = 7350 7S 0 0 3 (S 950) Prot= 7350 7S 0 if if if if S < 950 950 S < 1020 1020 S < 1050 1050 S S < 950 950 S < 1020 19. 51 1020 S < 1050 1050 S

if if if if

200 180 160 140 120 100 80 60 40 20 0 850 -20 900 950 1000 1050 1100 1150 1200

Stock Price

Buttery spread K1 = 950, K2 = 1020, K3 = 1050 The black line is the prot line. The blue line is the payo line.

www.guo.coursehost.com

c Yufeng Guo

71

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.18. The option price table is: Strike Call premium 35 6.13 40 2.78 45 0.97 Put premium 0.44 1.99 5.08

Time to expiration is T = 91/365 0.25 The annual eective rate is 8.33% The quarterly eective rate is 4 1.0833 1 = 2 02% a. Buy 35strike call, sell two 40-strike calls, and buy 45-strike call. Lets reproduce the textbook Figure 3.14. Initial cost 6.13 2 (2.78) = 5. 56 0.97 6.13 5. 56 + 0.97 = 1. 54 1. 54 (1.0202) = 1. 571 108

buy a 35-strike call sell two 40-strike calls buy a 45-strike call Total FV (initial cost) Payo

S < 35 35 S < 40 35-strike call 0 S 35 40-strike calls 0 0 45-strike call 0 0 Total 0 S 35 S 35 2 (S 40) = 45 S S 35 2 (S 40) + S 45 = 0 The payo 0 S 35 45 S 0 The prot 0 S 35 45 S 0 is: if if if if is: if if if if S < 35 35 S < 40 40 S < 45 45 S S < 35 35 S < 40 1. 57 = 40 S < 45 45 S

40 S < 45 S 35 2 (S 40) 0 45 S

45 S S 35 2 (S 40) S 45 0

1. 57 S 36. 57 43. 43 S 1. 57

if if if if

S < 35 35 S < 40 40 S < 45 45 S

www.guo.coursehost.com

c Yufeng Guo

72

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 0 S 35 Payo= 45 S 0 0 S 35 Prot= 45 S 0 if if if if S < 35 35 S < 40 40 S < 45 45 S S < 35 35 S < 40 1. 57 40 S < 45 45 S

if if if if

Black line is Payoff Blue line is Profit

0 25 -1 30 35 40 45 50

Stock Price

55

60

Buttery spread K1 = 35, K2 = 40, K3 = 45

www.guo.coursehost.com

c Yufeng Guo

73

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES b. Buy a 35strike put, sell two 40-strike puts, and buy a 45-strike put. Lets reproduce the textbook Figure 3.14. Initial cost buy a 35-strike put 0.44 sell two 40-strike puts 2 (1.99) = 3. 98 buy a 45-strike put 5.08 Total 0.44 3. 98 + 5.08 = 1. 54 FV (initial cost) 1. 54 (1.0202) = 1. 571 108 Payo 35-strike put 40-strike puts 45-strike put Total S < 35 35 S 2 (40 S) 45 S 0 35 S < 40 0 2 (40 S) 45 S S 35 40 S < 45 0 0 45 S 45 S 45 S 0 0 0 0

35 S 2 (40 S) + 45 S = 0 2 (40 S) + 45 S = S 35 0 S 35 The payo = 45 S 0 0 S 35 The prot = 45 S 0 if if if if if if if if S < 35 35 S < 40 40 S < 45 45 S

S < 35 35 S < 40 1. 57 = 40 S < 45 45 S

1. 57 S 36. 57 43. 43 S 1. 57

if if if if

S < 35 35 S < 40 40 S < 45 45 S

www.guo.coursehost.com

c Yufeng Guo

74

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES 0 S 35 Payo = 45 S 0 0 S 35 Prot = 45 S 0 if if if if S < 35 35 S < 40 40 S < 45 45 S S < 35 35 S < 40 1. 57 40 S < 45 45 S

if if if if

0 25 -1 30 35 40 45 50

Stock Price

55

60

Buttery spread K1 = 35, K2 = 40, K3 = 45 The black line is the payo; the blue line is the prot.

www.guo.coursehost.com

c Yufeng Guo

75

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES c. Buy one stock, buy a 35 put, sell two 40 calls, and buy a 45 call. The put-call parity is: Call (K, T ) + P V (K) = P ut (K, T ) + S0 |{z} | {z } | {z } | {z }
buy a call invest PV of strike price buy a put buy one stock

Buy stock + buy 35 put=buy 35 call + PV(35) as:

Buy one stock, buy a 35 put, sell two 40 calls, and buy a 45 call is the same buy a 35 call , sell two 40 calls, and buy a 45 call, and deposit PV(35) in a savings account. We already know from Part a. that "buy a 35 call , sell two 40 calls, and buy a 45 call" reproduces the textbook prot diagram Figure 3.14. Depositing PV(35) = 35 1.02021 = 34. 31 wont change the prot because any deposit in a savings account has zero prot. Hence the prot diagram of "Buy one stock, buy a 35 put, sell two 40 calls, and buy a 45 call" is Figure 3.14.

www.guo.coursehost.com

c Yufeng Guo

76

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES Problem 3.19. a. The parity is: Call (K, T ) P ut (K, T ) = P V (F0,T K) We are told that Call (K, T ) P ut (K, T ) = 0 P V (F0,T K) = 0 P V (F0,T ) = P V (K) Since P V (F0,T ) = S0 P V (K) = S0 b. Buying a call and selling an otherwise identical put creates a synthetic long forward. c. We buy the call at the ask price and sell the put at the bid price. So we have to pay the dealer a little more than the fair price of the call when we buy the call from the dealer; well get less than the fair price of put when we sell a put to the dealer. To ensure that the call premium equals the put premium given theres a bid-ask spread, we need to make the call less valuable and the put more valuable. To make the call less valuable and the put more valuable, we can increase the strike price. In other words, if theres no bid-ask spread, then K = F0,T . If theres bid-ask spread, K > F0,T . d. A synthetic short stock position means "buy put and sell call." To have zero net premium after the bid-ask spread, we need to make the call more valuable and the put less valuable. To achieve this, we can decrease the strike price. In other words, if theres no bid-ask spread, then K = F0,T . If theres bid-ask spread, K < F0,T . e. Transaction fees is not really a wash because theres a bid-ask spread. We pay more if we buy an option and we get less if we sell an option. Problem 3.20. This problem is about building a spreadsheet. You wont be asked to build a spreadsheet in the exam. Skip this problem.

www.guo.coursehost.com

c Yufeng Guo

77

CHAPTER 3. INSURANCE, COLLARS, AND OTHER STRATEGIES

www.guo.coursehost.com

c Yufeng Guo

78

Chapter 4

Introduction to risk management


Problem 4.1. Let S= the price of copper per pound at T = 1 P BH =Prot per pound of copper at T = 1 before hedging P AH =Prot per pound of copper at T = 1 after hedging For each pound of copper produced, XYZ incurs $0.5 xed cost and $0.4 variable cost. P BH = S (0.5 + 0.4) = S 0.9 XYZ sells a forward. The prot of the forward at T = 1 is: F0,T S = 1 S P AH = (S 0.9) + (F0,T S) = F0,T 0.9 We are told that F0,T = 1 P AH = 1 0.9 = 0.1

79

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT P BH = S 0.9


0.3

P AH = 0.1

Profit

0.2

fo Be
After hedging

re

ing dg he

0.1

0.0 0.7 -0.1 0.8 0.9 1.0

Copper price

1.1

1.2

-0.2

-0.3

Prot: before hedging and after hedging

www.guo.coursehost.com

c Yufeng Guo

80

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.2. P AH = F0,T 0.9 If F0,T = 0.8 P AH = 0.8 0.9 = 0.1 If XYZ shuts down its production, its prot at T = 1 is 0.5 (it still has to pay the xed cost) If XYZ continues its production, its after hedging prot at T = 1 is 0.1 0.1 > 0.5 XYZ should continue its production If F0,T = 0.45 P AH = 0.45 0.9 = 0.45 If XYZ shuts down its production, its prot at T = 1 is 0.5 (it still has to pay the xed cost) If XYZ continues its production, its after hedging prot at T = 1 is 0.45 0.45 > 0.5 XYZ should continue its production Problem 4.3. The prot of a long K-strike put at = 1: T K S max (0, K S)F V (P remium) = 0 P AH = P BH + = S 0.9 + = K S K S 0 if S < K F V (P remium) if S K

if S < K F V (P remium) if S K if S < K F V (P remium) if S K

K S 0

if S < K 0.9 F V (P remium) if S K

www.guo.coursehost.com

c Yufeng Guo

81

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K = 0.95 P AH =


0.28 0.26 0.24 0.22 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.6 0.7 0.8 0.9 1.0

F V (P remium) = 0.0178 (1.06) = 0.02 0.95 if S < 0.95 0.92 S if S 0.95

Profit

Copper Price

1.1

1.2

Long 0.95-strike put

www.guo.coursehost.com

c Yufeng Guo

82

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K=1 P AH


0.26 0.24 0.22 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.6 0.7 0.8 0.9 1.0 1.1 1.2

F 0.04 V (P remium) = 0.0376 (1.06) = 1 if S < 1 0.06 if S < 1 = 0.9 0.04 = S if S 1 S 0.94 if S 1

Profit

Copper Price

Long 1-strike put

www.guo.coursehost.com

c Yufeng Guo

83

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K = 1.05 P AH = F V (P remium) = 0.0665 (1.06) = 0.07 1.05 if S < 1.05 0.90.07 = S if S 1.05 0.08 if S < 1. 05 S 0.97 if S 1.05

Profit 0.22
0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.6 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

Long 1.05-strike put

www.guo.coursehost.com

c Yufeng Guo

84

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.4. The prot of a short K-strike call at T = 1: 0 max (0, S K)+F V (P remium) = SK P
AH

=P

BH

= S 0.9 = S K

if S < K +F V (P remium) if S K

0 SK

if S < K + F V (P remium) if S K if S < K + F V (P remium) if S K

0 SK

if S < K 0.9 + F V (P remium) if S K

www.guo.coursehost.com

c Yufeng Guo

85

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K = 0.95 P AH = F V (P remium) = 0.0649 (1.06) = 0.07 S if S < 0.95 0.9+0.07 = 0.95 if S 0.95 S 0.83 if S < 0.95 0.12 if 0.95 S

Profit

0.1

0.0 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

-0.1

-0.2

Short 0.95-strike call

www.guo.coursehost.com

c Yufeng Guo

86

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K=1 P AH = F V (P remium) = 0.0376 (1.06) = 0.04 S 1 if S < 1 0.9 + 0.04 = if S 1 S 0.86 if S < 1 0.14 if 1 S

Profit
0.1

0.0 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

-0.1

-0.2

Short 1-strike call

www.guo.coursehost.com

c Yufeng Guo

87

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT K = 1.05 P AH = F V (P remium) = 0.0194 (1.06) = 0.02 S if S < 1.05 0.9+0.02 = 1.05 if S 1.05 S 0.88 if S < 1. 05 0.17 if 1. 05 S

Profit
0.1

0.0 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

-0.1

-0.2

Short 1.05-strike call

www.guo.coursehost.com

c Yufeng Guo

88

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.5. P AH = P BH + P Collar P BH = S 0.9 Suppose XYZ buy a K1 -strike put and sells a K2 -strike call. The prot of the collar is: P Collar = P ayof f F V (N et Initial P remium) = [max (0, K1 S) max (0, S K2 )] F V (P ut P remium) + F V (Call P remium)

a. Buy 0.95-strike put and sell 1-strike call The payo is max (0, 0.95 S) max (0, S 1) S < 0.95 0.95 S < 1 long 0.95-strike put 0.95 S 0 short 1-strike call 0 0 Total 0.95 S 0 F V (P ut P remium) + F V (Call P remium) = (0.0178 + 0.0376) 1.06 = 0.02 0.95 S 0 = 1S if S < 0.95 if 0.95 S < 1 + 0.02 if S 1

S1 0 1S 1S

P Collar

P AH = P BH + P Collar 0.95 S 0 = S 0.9 + 1S =

if S < 0.95 if 0.95 S < 1 + 0.02 if S 1

0.07 if S < 0.95 S 0.88 if 0.95 S < 1 0.12 if 1S

www.guo.coursehost.com

c Yufeng Guo

89

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 0.07 if S < 0.95 S 0.88 if 0.95 S < 1 0.12 if 1S

P AH =

Profit

0.12

0.11

0.10

0.09

0.08

0.07 0.6 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

Long 0.95-strike put and short 1-strike call

www.guo.coursehost.com

c Yufeng Guo

90

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. Buy 0.975-strike put and sell 1.025-strike call The payo is max (0, 0.975 S) max (0, S 1.025) S < 0.975 0.975 S < 1.025 long 0.975-strike put 0.975 S 0 short 1-strike call 0 0 Total 0.975 S 0 F V (P ut P remium) + F V (Call P remium) = (0.0265 + 0.0274) 1.06 = 0.000 954 = 0.001 0.975 S 0 = 1.025 S if S < 0.975 if 0.975 S < 1.025 + 0.001 if S 1.025

S 1.025 0 1.025 S 1.025 S

P Collar

P AH = P BH + P Collar

0.076 S 0.899 = 0.126

0.975 S 0 = S 0.9 + 1.025 S

if S < 0.975 if 0.975 S < 1.025 + 0.001 if S 1.025

if S < 0.975 if 0.975 S < 1.025 if 1. 025 S

www.guo.coursehost.com

c Yufeng Guo

91

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 0.076 S 0.899 = 0.126


0.12

P AH

if S < 0.975 if 0.975 S < 1.025 if 1. 025 S

Profit

0.11

0.10

0.09

0.08 0.6 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

Long 0.975-strike put and short 1.025-strike call

www.guo.coursehost.com

c Yufeng Guo

92

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT c. Buy 1.05-strike put and sell 1.05-strike call The payo is max (0, 1.05 S) max (0, S 1.05) S < 1.05 S 1.05 long 1.05-strike put 1.05 S 0 short 1.05-strike call 0 1.05 S Total 1.05 S 1.05 S F V (P ut P remium) + F V (Call P remium) = (0.0665 + 0.0194) 1.06 = 0.05 P Collar = (1.05 S) 0.05 = 1 S P AH = P BH + P Collar = S 0.9 + 1 S = 0.1

www.guo.coursehost.com

c Yufeng Guo

93

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT P AH = 0.1

Profit

1.0 0.8 0.6 0.4 0.2 0.0 0.7 -0.2 -0.4 -0.6 -0.8 0.8 0.9 1.0

Copper Price

1.1

1.2

Long 1.05-strike put and short 1.05-strike call

www.guo.coursehost.com

c Yufeng Guo

94

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.6. a. Sell one 1.025-strike put and buy two 0.975-strike puts The payo is 2 max (0, 0.975 S) max (0, 1.025 S) S < 0.975 0.975 S < 1.025 long two 0.975-strike puts 2 (0.975 S) 0 short 1.025-strike put S 1.025 S 1.025 Total 0.925 S S 1.025 Initial net premium paid=2 (0.0265) 0.0509 = 0.002 1 Future value: 0.002 1 (1.06) = 0.002 2 0.925 S S 1.025 = 0 if S < 0.975 if 0.975 S < 1.025 0.002 2 if S 1.025

S 1.025 0 0 0

P P aylater

P AH = P BH + P P aylater

if S < 0.975 0.022 8 2S 1. 927 2 if 0.975 S < 1.025 = S 0.902 2 if 1. 025 S

0.925 S S 1.025 = S 0.9 + 0

if S < 0.975 if 0.975 S < 1.025 0.002 2 if S 1.025

www.guo.coursehost.com

c Yufeng Guo

95

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT if S < 0.975 0.022 8 2S 1. 927 2 if 0.975 S < 1.025 = S 0.902 2 if 1. 025 S
0.3

P AH

Profit

0.2

0.1

Hedged Profit
0.0 0.7 -0.1 0.8 0.9 1.0

Copper Price

1.1

1.2

-0.2

Unhedged Profit

-0.3

www.guo.coursehost.com

c Yufeng Guo

96

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. Sell two 1.034-strike puts and buy three 1-strike puts The payo is 3 max (0, 1 S) 2 max (0, 1.034 S) S<1 long three 1-strike puts 3 (1 S) short two1.034-strike puts 2 (S 1.034) Total 3 (1 S) + 2 (S 1.034) = 0.932 S Initial premium paid: 3 (0.0376) 2 (0.0563) = 0.000 2 Future value: 0.000 2 (1.06) = 0.000 212 0.932 S if S<1 2 (S 1.034) if 1 S < 1.034 0.000 2 0 if 1.034 S

1 S < 1.034 0 2 (S 1.034) 2 (S 1.034)

S 1.034 0 0 0

Prot:

P AH = P BH + P P aylater

= S 0.9 +

if S < 1 0.031 8 3S 2. 968 2 if 1 S < 1.034 = S 0.900 2 if 1. 034 S

0.932 S if S<1 2 (S 1.034) if 1 S < 1.034 0.000 2 0 if 1.034 S

www.guo.coursehost.com

c Yufeng Guo

97

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT if S < 1 0.031 8 3S 2. 968 2 if 1 S < 1.034 = S 0.900 2 if 1. 034 S
0.3

P AH

Profit

0.2

0.1

Hedged Profit
0.0 0.7 -0.1 0.8 0.9 1.0

Copper Price

1.1

1.2

-0.2

Unhedged Profit

-0.3

www.guo.coursehost.com

c Yufeng Guo

98

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.7. Telco buys copper wires from Wirco. Telcos purchase price per unit of wire is $5 plus the price of copper. Telco collects $6.2 per unit of wire used. Telcos unhedged prot is: P BH = 6.2 (5 + S) = 1. 2 S If Telco buys a copper forward, the prot from the forward at T = 1 is S F0,T The prot after hedging is P AH = P BH + S F0,T = 1. 2 S + S F0,T = 1. 2 F0,T F0,T = 1 P AH = 1. 2 1 = 0.2

www.guo.coursehost.com

c Yufeng Guo

99

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT P AH = 1. 2 F0,T P AH = 1. 2 1 = 0.2

Profit

0.6

0.5

Un hed ged P

rofi t

0.4

0.3

0.2

Hedged Profit
0.1

0.0 0.6 0.7 0.8 0.9 1.0

Copper Price

1.1

1.2

www.guo.coursehost.com

c Yufeng Guo

100

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.8. P BH = 1. 2 S Telco buys a K-strike call. The prot from the long call is: max (0, S K) F V (P remium) P AH = 1. 2 S + (0, S K) F V (P remium) max 0 if S < K = 1. 2 S + F V (P remium) S K if S K P
AH

= 1. 2 F V (P remium)

S K

if S < K if S K

www.guo.coursehost.com

c Yufeng Guo

101

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT a. K = 0.95 P AH F V (P remium) = 0.0649 (1.06) = 0.069 S if S < 0.95 1. 131 S = 1. 20.069 = 0.95 if S 0.95 0.181

if S < 0.95 if S 0.95

Profit
0.5

0.4

0.3

0.2 0.6 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

1.3

1.4

www.guo.coursehost.com

c Yufeng Guo

102

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. K = 1 P AH P V (P remium) = 0.0376 (1.06) = 0.039 856 S if S < 1 1. 16 S if S < 1 = 1. 2 0.04 = 1 if S 1 0.16 if 1 S

Profit
0.5

0.4

0.3

0.2 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4

Copper Price

www.guo.coursehost.com

c Yufeng Guo

103

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT c. K = 1.05 P AH F V (P remium) = 0.0194 (1.06) 0.020 564 = S if S < 1.05 1. 18 S if S < 1. 05 = 1. 20.02 = 1.05 if S 1.05 0.13 if 1. 05 S

Profit
0.5

0.4

0.3

0.2

0.6

0.7

0.8

0.9

1.0

1.1

1.2

Copper Price

1.3

1.4

www.guo.coursehost.com

c Yufeng Guo

104

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.9. P BH = 1. 2 S Telco sells a put option with strike price K. The prot from the written put is: max (0, K S) + F V (P remium) P AH = 1. 2 S (0, K S) + F V (P remium) max K S if S < K = 1. 2 S + F V (P remium) 0 if S K K if S < K = + 1. 2 + F V (P remium) S if K S P
AH

K S

if S < K + 1. 2 + F V (P remium) if K S

www.guo.coursehost.com

c Yufeng Guo

105

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT a. K = 0.95 F V (P remium) = 0.0178 (1.06) = 0.018 868 0.95 if S < 0.95 0.269 P AH = +1. 2+0.019 = S if 0.95 S 1. 219 S

if S < 0.95 if 0.95 S

Profit
0.2

0.1

0.0 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

1.3

1.4

-0.1

www.guo.coursehost.com

c Yufeng Guo

106

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. K = 1 P AH F V (P remium) = 0.0376 (1.06) = 0.039 856 1 if S < 1 0.24 = + 1. 2 + 0.04 = S if 1 S 1. 24 S

if S < 1 if 1 S

Profit
0.2

0.1

0.0 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

1.3

1.4

-0.1

www.guo.coursehost.com

c Yufeng Guo

107

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT c. K = 1.05 F V (P remium) = 0.0665 (1.06) = 0.070 49 1.05 if S < 1.05 0.22 P AH = +1. 2+0.07 = S if 1.05 S 1. 27 S

if S < 1. 05 if 1. 05 S

Profit

0.2

0.1

0.0 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

1.3

1.4

-0.1

www.guo.coursehost.com

c Yufeng Guo

108

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.10. Suppose Telco sells a K1 -strike put and buys a K2 -strike call. The prot of the collar is: P Collar = P ayof f F V (N et Initial P remium) = [ max (0, K1 S) + max (0, S K2 )] + F V (P ut P remium) F V (Call P remium) a. Sell 0.95-strike put and buy 1-strike call The payo is max (0, 0.95 S) + max (0, S 1) S < 0.95 0.95 S < 1 S 1 short 0.95-strike put (0.95 S) 0 0 long 1-strike call 0 0 (1 S) Total (0.95 S) 0 (1 S) F V (P ut P remium)F V (Call P remium) = (0.0178 0.0376) 1.06 = 0.02 P Collar S 0.95 if S < 0.95 0 if 0.95 S < 1 0.02 = S1 if S 1

P AH = P BH + P Collar

S 0.95 if S < 0.95 0.23 if 0.95 S < 1 0.02 = 1. 18 S = 1. 2S+ 0 S1 if S 1 0.18

if S < 0.95 if 0.95 S < 1 if 1 S

www.guo.coursehost.com

c Yufeng Guo

109

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 0.23 1. 18 S = 0.18


0.23

P AH

if S < 0.95 if 0.95 S < 1 if 1 S

Profit

0.22

0.21

0.20

0.19

0.18 0.7 0.8 0.9 1.0 1.1 1.2

Copper Price

1.3

1.4

Short 0.95-strike put and long 1-strike call

www.guo.coursehost.com

c Yufeng Guo

110

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. Sell 0.975-strike put and buy 1.025-strike call The payo is max (0, 0.975 S) max (0, S 1.025) S < 0.975 0.975 S < 1.025 short 0.975-strike put (0.975 S) 0 long 1-strike call 0 0 Total (0.975 S) 0

S 1.025 0 (1.025 S) (1.025 S)

P AH = P BH + P Collar

F V (P ut P remium)F V (Call P remium) = (0.0265 0.0274) 1.06 = 0.001 S 0.975 if S < 0.975 0 if 0.975 S < 1.025 0.001 P Collar = S 1.025 if S 1.025 S 0.975 if S < 0.975 0 if 0.975 S < 1.025 0.001 = 1. 2 S + S 1.025 if S 1.025

if S < 0.975 0.224 S + 1. 199 if 0.975 S < 1.025 = 0.174 if 1. 025 S

www.guo.coursehost.com

c Yufeng Guo

111

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT if S < 0.975 0.224 S + 1. 199 if 0.975 S < 1.025 = 0.174 if 1. 025 S
0.22

P AH

Profit

0.21

0.20

0.19

0.18

0.7

0.8

0.9

1.0

1.1

1.2

Copper Price

1.3

1.4

Short 0.95-strike put and long 1-strike call

www.guo.coursehost.com

c Yufeng Guo

112

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT c. Sell 0.95-strike put and buy 0.95-strike call The payo is max (0, 0.95 S) + max (0, S 0.95) short 0.95-strike put long 0.95-strike call Total S < 0.95 (0.95 S) 0 S 0.95 S 0.95 0 S 0.95 S 0.95

F V (P ut P remium)F V (Call P remium) = (0.0178 0.0649) 1.06 = 0.05 P Collar = (S 0.95) 0.05 = S 1 P AH = P BH + P Collar = 1. 2 S + S 1 = 0.2

www.guo.coursehost.com

c Yufeng Guo

113

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT P AH = 0.2

Profit

1.2 1.0 0.8 0.6 0.4 0.2 0.0 0.7 -0.2 -0.4 -0.6 -0.8 0.8 0.9 1.0

Copper Price

1.1

1.2

Short 0.95-strike put and long 0.95-strike call

www.guo.coursehost.com

c Yufeng Guo

114

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.11. a. sell 0.975-strike call and buy two 1.034-strike calls The payo is 2 max (0, S 1.034) max (0, S 0.975) S < 0.975 0.975 S < 1.034 short 0.975-strike call 0 (S 0.975) long 1.034-strike calls 0 0 Total 0 (S 0.975) (S 0.975) + 2 (S 1.034) = S 1. 093 S 1.034 (S 0.975) 2 (S 1.034) S 1. 093

Initial net premium paid=2 (0.0243) 0.05 = 0.001 4 Future value: 0.001 4 (1.06) = 0.001 484 0.001 P P aylater

if S < 0.975 0 0.975 S if 0.975 S < 1.034 The payo= S 1. 093 if S 1.034

P aylater P AH = P BH + P if S < 0.975 0.001 0.976 S if 0.975 S < 1.034 = 1. 2 S + S 1. 092 if 1. 034 S

if S < 0.975 0.001 0.976 S if 0.975 S < 1.034 = S 1. 092 if 1. 034 S

if S < 0.975 0 0.975 S if 0.975 S < 1.034 + 0.001 = S 1. 093 if S 1.034

1. 201 S 2. 176 2S = 0.108

if S < 0.975 if 0.975 S < 1.034 if 1. 034 S

www.guo.coursehost.com

c Yufeng Guo

115

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 1. 201 S 2. 176 2S = 0.108


0.5 0.4 0.3 0.2 0.1 0.0 0.8 -0.1 -0.2 0.9 1.0 1.1 1.2

P AH

if S < 0.975 if 0.975 S < 1.034 if 1. 034 S

Profit

Hedged Profit

Copper Price

1.3

1.4

Un he

dge d

P ro fi t

www.guo.coursehost.com

c Yufeng Guo

116

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. sell two 1-strike calls and buy three 1.034-strike calls The payo is 2 max (0, S 1) + 3 max (0, S 1.034) S < 1 1 S < 1.034 sell two 1-strike calls 0 2 (S 1) buy three 1.034-strike calls 0 0 Total 0 2 (S 1) 2 (S 1) + 3 (S 1.034) = S 1. 102 S 1.034 2 (S 1) 3 (S 1.034) S 1. 102

Initial net premium paid=3 (0.0243) 2 (0.0376) = 0.002 3 Future value: 0.002 3 (1.06) = 0.002 438 0.002 4 P P aylater if S < 1 0 2 (S 1) if 1 S < 1.034 + 0.002 4 = S 1. 102 if S 1.034

if S < 1 0 2 (S 1) if 1 S < 1.034 The payo= S 1. 102 if S 1.034

P AH = P BH + P P aylater if S < 1 0 2 (S 1) if 1 S < 1.034 + 0.002 4 = 1. 2 S + S 1. 102 if S 1.034 1. 202 4 S 3. 202 4 3S = 0.100 4 if S < 1 if 1 S < 1.034 if 1. 034 S

www.guo.coursehost.com

c Yufeng Guo

117

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 1. 202 4 S 3. 202 4 3S = 0.100 4 if S < 1 if 1 S < 1.034 if 1. 034 S

P AH

Profit

0.5 0.4 0.3 0.2 0.1 0.0

Hedged Profit

0.8 -0.1 -0.2

0.9

1.0

1.1

1.2

Copper Price

1.3

1.4

Un he

dge d

P ro fi t

www.guo.coursehost.com

c Yufeng Guo

118

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.12. Wircos total prot per unit of wire produced: Revenue. S + 5, where S is the price of copper Copper cost is S Fixed cost is 3 Prot before hedging: P BH = S + 5 (S + 3 + 1.5) = 0.5 The prot is xed regardless of copper price. If Wirco buys a copper forward, this will introduce the copper price risk (i.e. Wircos prot will now depend on the copper price). Wirco buys a copper forward. The prot from the forward is S F0,T The prot after hedging is P AH = P BH + S F0,T = 0.5 + S F0,T If F0,T = 1 P AH = 0.5 + S 1 = S 0.5 Now you the prot depends on S. If S goes down, the prot goes down. Problem 4.13. The unhedged prot is P BH = 0.5. This doesnt depend on the copper price at T = 1. However, if Wirco uses any derivatives (call, put, forward, etc.), this will make the hedged prot as a function of the copper price at T = 1. Using any derivatives will make the hedged prot uctuate with the copper price, increasing the variability of the prot. Problem 4.14. The question "Did the rm earn $10 in prot (relative to accounting breakeven) or lose $30 in prot (relative to the prot that could be obtained by hedging?" portrays derivatives a way to make prot. However, most companies use derivatives to manage their risks, not to seek additional prot. If they have idle money, they would rather invest in their core business than buy call or put options to make money on stocks. This is all you need to know about this question. Problem 4.15. Pre-tax operating income Tax at 40% After tax income Price=$9 $1 1 (0.4) = 0.4 1 (0.4) = 0.6 Price=$11.20 $1.2 1.2 (0.4) = 0.48 1.2 0.48 = 0.72 Variable cost 1.5

Because losses are fully tax deductible, we pay 0.4 tax (i.e. IRS will send us a check of 0.4) Expected prot is: 0.5 (0.6 + 0.72) = 0.06 www.guo.coursehost.com c Yufeng Guo 119

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.16. a. Expected pre-tax prot: Firm A: 0.5 (1000 600) = 200 Firm B: 0.5 (300 + 100) = 200 b. Expected after-tax prot: Firm A Good State Bad State Pre-tax income 1000 600 Tax at 40% 1000 (0.4) = 400 600 (0.4) = 240 After tax income 1000 400 = 600 600 (240) = 360 Expected after-tax prot: 0.5 (600 360) = 120 Firm B Good State Bad State Pre-tax income 300 100 Tax at 40% 300 (0.4) = 120 100 (0.4) = 40 After tax income 300 120 = 180 100 40 = 60 Expected after-tax prot: 0.5 (180 + 60) = 120 Problem 4.17. a. Expected pre-tax prot: Firm A: 0.5 (1000 600) = 200 Firm B: 0.5 (300 + 100) = 200 b. Expected after-tax prot: Firm A Good State Bad State Pre-tax income 1000 600 Tax 1000 (0.4) = 400 0 After tax income 1000 400 = 600 600 Expected after-tax prot: 0.5 (600 600) = 0 Firm B Good State Bad State Pre-tax income 300 100 Tax at 40% 300 (0.4) = 120 100 (0.4) = 40 After tax income 300 120 = 180 100 40 = 60 Expected after-tax prot: 0.5 (180 + 60) = 120 c. This question is vague. Im not sure to whom A or B might pay. This is what I guess the author wants us to answer: www.guo.coursehost.com c Yufeng Guo 120

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT The expected cash ow Company A receives depends on the taw law. 120 if loss is tax deductible E P rof itA = 0 if loss is not tax deductible Suppose A is unsure about the IRSs tax policy (i.e. not sure whether the loss is deductible or not next year). Then the present value of the dierence of the tax law is 120/1.1 = 109. 09. So the eect of the tax law has a present value 109.09. Company B doesnt have any loss. Its after tax prot doesnt depend on whether a loss is tax deductible. So the eect of the tax law has a present value of zero. Problem 4.18. We are given: r = = 4.879% T =1

S0 = 420 F0,T = S0 e(r)T = 420 Call strike price KC = 440; put strike price KP = 400 First, nd the call and put premiums. Install the CD contained in the textbook Derivatives Markets in your computer. Open the spreadsheet titled "optbasic2." Enter: Inputs Stock Price 420 Exercise Price 440 Volatility 5.500% Risk-free interest rate 4.879% Time to Expiration (years) 1 Dividend Yield 4.879% You should get the call premium: C = 2.4944

Inputs Stock Price 420 Exercise Price 400 Volatility 5.500% Risk-free interest rate 4.879% Time to Expiration (years) 1 Dividend Yield 4.879% You should get the put premium: P = 2.2072 a. Buy 440-strike call and sell a 440-put Let S represent the gold price at the option expiration date T = 1. www.guo.coursehost.com c Yufeng Guo 121

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT The payo is: Buy 440-strike call Sell 400-strike put Total S < 400 0 (400 S) S 400 400 S < 440 0 0 0 S 440 S 440 0 S 440

The initial cost of the collar is: P remium = 2.4944 2.2072 = 0.287 2 F V (P remium) = 0.287 2e0.04879(1) = 0.30 So the prot from the collar is: S 400 if S < 400 0 if 400 S < 440 0.30 P Collar = S 440 if S 440 The prot before hedging: Auric sells each widget for $800 It has xed cost: $340 Input (gold) cost: S Prot before hedging: P BH = 800 (340 + S) = 460 S

S 400 if S < 400 0 if 400 S < 440 Payo= S 440 if S 440

www.guo.coursehost.com

c Yufeng Guo

122

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT So Aurics prot after hedging: P AH = P BH + P Collar S 400 if S < 400 59. 7 0 if 400 S < 440 0.30 = 459. 7 S = 460S+ S 440 if S 440 19. 7

if S < 400 if 400 S < 440 if 440 S

Profit

60

50

40

30

20 360 370 380 390 400 410 420 430 440 450 460 470 480 490 500

Gold Price

www.guo.coursehost.com

c Yufeng Guo

123

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT b. We need to nd C=P KC KP = 30 Using the spreadsheet "optbasic2," after trial-and-error, we nd that: KC = 435.52 KP = 405.52 C = 3.4264 P = 3.4234 CP Let KC and KP represent the strike price for the call and the put. Collar width 30 KC KP = 30 Let C and P represent the call and put premium calculated by the BlackScholes formula 0 When we buy the call, we pay C = C + 0.25 0 When we sell the put, we get P = P 0.25 0 0 Zero collar C = P C + 0.25 = P 0.25 C = P 0.5 So we need to nd C and P such C = P 0.5 KC KP = 30 This is all the concepts you need to know about this problem. Using the spreadsheet "optbasic2," after trial-and-error, we nd that: KP = 406.53 KC = 436.53 C = 3.1938 P = 3.6938 Problem 4.19. a. Sell 440-strike call and buy two K-strike calls such the net premium is zero. The 440-strike call premium is: C 440 = 2.4944 We need to nd K such that C 440 2C K = 0 2.4944 2C K = 0 C K = 2.4944/2 = 1. 247 2 We know that K > 440 (otherwise C K C 440 ) Using the spreadsheet "optbasic2," after trial-and-error, we nd that: K = 448.93 C K = 1.2469 1. 247 2 b. Prot before hedging: P BH = 800 (340 + S) = 460 S Zero cost collar Prot = Payo The payo is: S < 440 440 S < 448.93 sell 440-strike call 0 (S 440) buy two 448.93-strike calls 0 0 Total 0 440 S www.guo.coursehost.com c Yufeng Guo

S 448.93 (S 440) 2 (S 448.93) S 457. 86 124

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT (S 440) + 2 (S 448.93) = S 457. 86 P Collar

So Aurics prot after hedging: P AH = P BH + P Collar if S < 440 0 460 S if 440 S < 448.93 = 900 2S = 460S+ 440 S S 457. 86 if S 448.93 2. 14

if S < 440 0 440 S if 440 S < 448.93 = S 457. 86 if S 448.93

if S < 440 if 440 S < 448.93 if 448. 93 S

www.guo.coursehost.com

c Yufeng Guo

125

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT 460 S 900 2S = 2. 14


60 50 40 30 20 10 0 410 -10 -20 -30 -40 420 430 440 450 460 470 480

P AH

if S < 440 if 440 S < 448.93 if 448. 93 S

P BH = 460 S

Profit

Hedged profit Gold Price


490 500

Unhedged Profit

www.guo.coursehost.com

c Yufeng Guo

126

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT Problem 4.20. Ignore. Not on the FM syllabus. Problem 4.21. Ignore. Not on the FM syllabus. Problem 4.22. Ignore. Not on the FM syllabus. Problem 4.23. Ignore. Not on the FM syllabus. Problem 4.24. Ignore. Not on the FM syllabus. Problem 4.25. Ignore. Not on the FM syllabus.

www.guo.coursehost.com

c Yufeng Guo

127

CHAPTER 4. INTRODUCTION TO RISK MANAGEMENT

www.guo.coursehost.com

c Yufeng Guo

128

Chapter 5

Financial forwards and futures

Problem 5.1. Description Sell asset outright Sell asset through loan Short prepaid forward Short forward Get paid at time 0 T 0 T Deliver asset at time 0 0 T T payment S0 at t = 0 S0 erT at T S0 at t = 0 S0 erT at T

Problem 5.2.
P a. F0,T = S0 eT P V (Div) = 50e0(1) e0.06(3/12) + e0.06(6/12) + e0.06(9/12) + e0.06(12/12) = 46. 146 7 P b. F0,T = F0,T erT = 46. 146 7e0.06(1) = 49. 000 3

Problem 5.3.
P a. F0,T = S0 eT = 50e0.08(1) = 46. 155 8 P b. F0,T = F0,T erT = 46. 155 8e0.06(1) = 49. 009 9

Problem 5.4. 129

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES a. F0,T = S0 e(r)T = 35e(0.050)0.5 = 35. 886 0 b. 1 1 F0,T 35.5 = ln ln = 0.02837 T S0 0.5 35 35.5 = 35e(0.05)0.5 = 2. 163%

c. F0,T = S0 e(r)T

www.guo.coursehost.com

c Yufeng Guo

130

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.5. a. F0,T = S0 e(r)T = 1100e(0.050)9/12 = 1142. 033 2 b. As a buyer in a forward contract, we face the risk that the index may be worth zero at T (i.e. ST = 0), yet we still have to pay F0,T to buy it. This is how to hedge our risk: Transactions t=0 T long a forward (i.e. be a buyer in forward) 0 ST F0,T short sell an index S0 ST deposit S0 in savings account S0 S0 erT Total 0 S0 erT F0,T For this problem: Transactions buy a forward short sell an index deposit S0 in savings account Total After hedging, our prot is zero. c. As a seller in the forward contract, we face the risk that ST = . If ST = and we dont already have an index on hand for delivery at T , we have to pay ST = and buy an index from the open market. Well be bankrupt. This is how to hedge: Transactions t=0 T sell a forward (i.e. be a seller in forward) 0 F0,T ST buy an index S0 ST borrow S0 S0 S0 erT Total 0 F0,T S0 erT For this problem: Transactions sell a forward (i.e. be a seller in forward) buy an index borrow S0 Total t=0 0 1100 1100 0 T 1142. 03 ST ST 1100e(0.05)9/12 = 1142. 03 0 t=0 0 1100 1100 0 T ST 1142. 03 ST 1100e(0.05)9/12 = 1142. 03 0

www.guo.coursehost.com

c Yufeng Guo

131

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.6. a. F0,T = S0 e(r)T = 1100e(0.050.015)9/12 = 1129. 26 b. Transactions long a forward (i.e. be a buyer in forward) short sell eT index deposit S0 eT in savings account Total For this problem: Transactions buy a forward short sell eT index deposit S0 eT in savings Total t=0 0 S0 eT S0 eT 0 T ST F0,T ST S0 e(r)T S0 e(r)T F0,T T ST 1129. 26 ST 1087. 69e(0.05)9/12 = 1129. 26 0 T F0,T ST ST S0 e(r)T S0 e(r)T F0,T

t=0 0 1100e(0.015)9/12 = 1087. 69 1087. 69 0 t=0 0 S0 eT S0 eT 0

c. Transactions short a forward (i.e. be a seller in forward) buy eT index borrow S0 eT Total For this problem: Transactions short a forward buy eT index borrow S0 eT Total

t=0 0 1100e(0.015)9/12 = 1087. 69 1087. 69 0

T 1129. 26 ST ST 1087. 69e(0.05)9/12 = 1129. 26 0

www.guo.coursehost.com

c Yufeng Guo

132

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.7. F0,T = S0 erT = 1100e(0.05)0.5 = 1127. 85 a. The 6-month forward price in the market is 1135, which is greater than the fair forward price 1127. 85. So we have two identical forwards (one in the open market and one that can be synthetically built) selling at dierent prices. To arbitrage, always buy low and sell high. Transactions t=0 T = 0.5 sell expensive forward from market 0 1135 ST build cheap forward buy an index 1100 ST borrow 1100 1100 1100e(0.05)0.5 = 1127. 85 Total prot 0 1135 1127. 85 = 7. 15 We didnt pay anything at t = 0, but we have a prot 7. 15 at T = 0.5. b. The 6-month forward price in the market is 1115, which is cheaper than the fair forward price 1127. 85. So we have two identical forwards (one in the open market and one that can be synthetically built) selling at dierent prices. To arbitrage, always buy low and sell high. Transactions t=0 T = 0.5 buy cheap forward from market 0 ST 1115 build expensive forward for sale short sell an index 1100 ST lend 1100 1100 1100e(0.05)0.5 = 1127. 85 Total prot 0 1127. 85 1115 = 12. 85 We didnt pay anything at t = 0, but we have a prot 12. 85 at T = 0.5.

www.guo.coursehost.com

c Yufeng Guo

133

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.8. F0,T = S0 e(r)T = 1100e(0.050.02)0.5 = 1116. 62 a. The 6-month forward price in the market is 1120, which is greater than the fair forward price 1116. 62. So we have two identical forwards (one in the open market and one that can be synthetically built) selling at dierent prices. To arbitrage, always buy low and sell high. Transactions t=0 T = 0.5 sell expensive forward 0 1120 ST build cheap forward buy eT index 1100e(0.02)0.5 = 1089. 05 ST borrow S0 eT 1100e(0.02)0.5 = 1089. 05 1089. 05e(0.05)0.5 = 1116. 62 Total prot 0 1120 1116. 62 = 3. 38 We didnt pay anything at t = 0, but we have a prot 3. 38 at T = 0.5. b. The 6-month forward price in the market is 1110, which is cheaper than the fair forward price 1116. 62. So we have two identical forwards (one in the open market and one that can be synthetically built) selling at dierent prices. To arbitrage, always buy low and sell high. Transactions t=0 T = 0.5 buy cheap forward from market 0 ST 1110 build expensive forward for sale short sell eT index 1100e(0.02)0.5 = 1089. 05 ST lend S0 eT 1089. 05 1089. 05e(0.05)0.5 = 1116. 62 Total prot 0 1116. 62 1110 = 6. 62 We didnt pay anything at t = 0, but we have a prot 6. 62 at T = 0.5. Problem 5.9. This is a poorly designed problem, more amusing than useful for passing the exam. Dont waste any time on this. Skip.

www.guo.coursehost.com

c Yufeng Guo

134

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.10. a. F0,T = S0 e(r)T 1129.257 = 1100e(0.05)0.75 1129.257 e(0.05)0.75 = 1100 1 1129.257 0.05 = ln = 3. 5% 0.75 1100 = 1.5% b. If you believe that the true dividend yield is 0.5%, then the fair forward price is: F0,T = 1100e(0.050.005)0.75 = 1137. 759 The market forward price is 1129.257, which is cheaper than the fair price. To arbitrage, buy low and sell high. Transactions t=0 T = 0.5 buy cheap forward from market 0 ST 1129.257 build expensive forward for sale short sell eT index 1100e(0.005)0.75 = 1095. 883 ST lend S0 eT 1095. 883 1095. 883e(0.05)0.75 = 1137. 75 9 Total prot 0 1137. 75 9 1129.257 = 8. 502 c. If you believe that the true dividend yield is 3%, then the fair forward price is: F0,T = 1100e(0.050.03)0.75 = 1116. 624 The market forward price is 1129.257, which is higher than the fair price. To arbitrage, buy low and sell high. Transactions t=0 T = 0.5 sell expensive forward 0 1129.257 ST build cheap forward buy eT index 1100e(0.03)0.75 = 1075. 526 ST borrow S0 eT 1075. 526 1075. 526e(0.05)0.75 = 1116. 624 Total prot 0 1129.257 1116. 624 = 12. 633

www.guo.coursehost.com

c Yufeng Guo

135

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.11. a. One contract is worth 1200 points. Each point is worth $250. The notional value of 4 S&P futures is: 4 1200 250 = $1, 200 , 000 b. The value of the initial margin: $1, 200 , 000 0.1 = $120, 000 Problem 5.12. a. Notional value of 10 S&P futures: 10 950 250 = $2, 375 , 000 The initial margin: $2375 000 0.1 = $237, 500 b. The maintenance margin: 237, 500 (0.8) = 190, 000 At the end of Week 1, our initial margin grows to: 237500e0.06(1/52) = 237774. 20 Suppose the futures price at the end of Week 1 is X. The futures price at t = 0 is 950. After marking-to-market, we gain (X 950) points per contract. The notional gain of the 4 futures after marking-to-market is: (X 950) (10) (250) After marking-to-market, our margin account balance is 237774. 20 + (X 950) (10) (250) = 2500X 2137225. 8 We get a margin call if 2500X 2137225. 8 < 190000 X < 930. 890 32 For example, X = 930. 89 will lead to a margin call. Problem 5.13. a. Transactions buy forward lend S0 Total t=0 0 S0 S0 T ST F0,T = ST S0 erT S0 erT ST t=0 0 S0 + P V (Div) S0 + P V (Div) T ST F0,T = ST S0 erT + F V (Div) S0 erT F V (Div) ST

b. Transactions buy forward lend S0 P V (Div) Total c. Transactions buy forward lend S0 eT Total

t=0 0 S0 eT S0 eT

T ST F0,T = ST S0 e(r)T S0 e(r)T ST

www.guo.coursehost.com

c Yufeng Guo

136

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

Problem 5.14. If the forward price F0,T is too low, this is how to make some free money. 1. Buy low. At t = 0, enter a forward to buy one stock. Incur transaction cost k.
b 2. Sell high. At t = 0, sell one stock short and receive S0 k b b 3. The net cash ow after 1 and 2 is S0 2k. Lend S0 2k and receive rl T b at T S0 2k e

4. At T , pay F0,T and receive one stock. Return the stock to the broker. The net cash ow after 1 through 4 is zero. Your prot at T is: l b S0 2k er T F0,T Arbitrage is possible if: b l b l S0 2k er T F0,T > 0 F0,T < S0 2k er T To avoid arbitrage, weneed to have: b l F0,T F = S0 2k er T To avoidarbitrage, we need to have: b l b a S0 2k er T = F F0,T F + = (S0 + 2k) er T

Problem 5.15.
a b a. k = 0 and theres no bid-ask spread (so S0 = S0 = 800) So the non-arbitrage bound is: 800e(0.05)1 = F F0,T F + = 800e(0.055)1 841. 02 = F F0,T F + = 845. 23 Hence arbitrage is not protable if 841. 02 F0,T 845. 23 a b b. k = 1 and theres no bid-ask spread (so S0 = S0 = 800) Please note that you cant blindly copy the formula: b l b a S0 2k er T = F F0,T F + = (S0 + 2k) er T This is because the problem states that k is incurred for longing or shorting a forward and that k is not incurred for buying or selling an index. Given k is incurred only once, the non-arbitrage bound is: b l b a S0 k er T = F F0,T F + = (S0 + k) er T (800 1) e(0.05)1 = F F0,T F + = (800 + 1) e(0.055)1 839. 97 = F F0,T F + = 846. 29

c. Once again, you cant blindly use the formula l b b a S0 2k er T = F F0,T F + = (S0 + 2k) er T The problem states that k1 = 1 is incurred for longing or shorting a forward and k2 = 2.4 is incurred for buying or selling an index. The non-arbitrage formula becomes: www.guo.coursehost.com c Yufeng Guo 137

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

b l b a S0 k1 k2 er T = F F0,T F + = (S0 + k1 + k2 ) er T (800 1 2.4) e(0.05)1 = F F0,T F + = (800 + 1 + 2.4) e(0.055)1 837. 44 = F F0,T F + = 848. 82 d. Once again, you cant blindly use the formula b l b a S0 2k er T = F F0,T F + = (S0 + 2k) er T The problem states that k1 = 1 is incurred for longing or shorting a forward; k2 = 2.4 is incurred twice, for buying or selling an index, once at t = 0 and the other at T . The non-arbitrage formula becomes: l b b a S0 k1 k2 er T k2 = F F0,T F + = (S0 + k1 + k2 ) er T + k2 (800 1 2.4) e(0.05)1 2.4 = F F0,T F + = (800 + 1 + 2.4) e(0.055)1 + 2.4 837. 44 2.4 = F F0,T F + = 848. 82 + 2.4 835. 04 = F F0,T F + = 851. 22 e. The non-arbitrage higher bound can be calculated as follows: 1. At t = 0 sell a forward contract. Incur cost k1 = 1. 2. At t = 0 buy 1.003 index. This is why we need to buy 1.003 index. We pay 0.3% of the index value to the broker. So if we buy one index, this index becomes 1-0.3%=0.997 index after the fee. To have one index, we 1 1 need to have = 1 + 0.3% = 1.003 (remember we need 0.997 1 0.3% to deliver one index at T to the buyer in the forward). To verify, if we 1 1 index, this will become (1 0.3%) = 1 index after the have 0.997 0.997 1 fee is deducted. Notice we use the Taylor series 1 + x + x2 + ... 1x for a small x 3. At t = 0 borrow 1.003S0 + k1 = 1.003 (800) + 1. Repay this loan with b (1.003S0 + k1 ) er T at T 4. At T deliver the index to the buyer and receive F0,T . Pay the settlement fee 0.3%S0

Your initial cost for doing 1 through 4 is zero. Your prot at T is: b F0,T (1.003S0 + k1 ) er T 0.3%S0 To avoid arbitrage, we need to have b F0,T (1.003S0 + k1 ) er T 0.3%S0 0 b F0,T (1.003S0 + k1 ) er T + 0.3%S0 = (1.003 800 + 1) e(0.055)1 + 0.003 800 = 851. 22 The lower bound price can also be calculated as follows: www.guo.coursehost.com c Yufeng Guo 138

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

1. Buy low. At t = 0, enter a forward to buy 1.003 index (why 1.003 index will be explained later). Incur transaction cost k1 = 1. 2. Sell high. At t = 0, sell 0.997 index short. Receive 0.997 (800) 1. This is why we need to short sell 0.997 index. If we short sell one index, the broker charges us 0.3% of the index value and well owe the broker 1+0.3%=1.003 index. In order to owe the broker exactly one index, we need to borrow 1 1 0.003 = 0.997 index from the broker. 1.003 3. Lend 0.997 (800) 1 and receive (0.997 (800) 1) er
l

at T

4. At T , pay 1.003F0,T and receive 1.003 index. Pay settlement fee 0.3% (1.003). After the settlement fee, we have (1.003) (1 0.3%) 1 index left. We return this index to the broker. The net initial cash ow after 1 through 4 is zero. Your prot at T is: l (0.997 (800) 1) er T 1.003F0,T To avoid arbitrage, l (0.997 (800) 1) er T 1.003F0,T 0 l (0.997 (800) 1) er T (0.997 800 1) e(0.05)1 F0,T = = 834. 94 1.003 1.003 The non-arbitrage bound is: 834. 94 F0,T 851. 22 Make sure you understand part e, which provides a framework for nding the non-arbitrage bound for complex problems. Once you understand this framework, you dont need to memorize non-arbitrage bound formulas. Problem 5.16. Not on the syllabus. Ignore. Problem 5.17. Not on the syllabus. Ignore. Problem 5.18. Not on the syllabus. Ignore. Problem 5.19. Problem 5.20. a. b. r91 = (100 93.23) 1 1 91 = 1. 711 3% 100 4 90

$10 (1 + 0.017113) = $10. 171 13 (million) c Yufeng Guo 139

www.guo.coursehost.com

CHAPTER 5. FINANCIAL FORWARDS AND FUTURES

www.guo.coursehost.com

c Yufeng Guo

140

Chapter 8

Swaps

Problem 8.1. time t annual interest during [0, t] xed payment oating payments 0 1 6% R 22 2 6.5% R 23

PV xed payments=PV oating payments


22 1.06

23 1.0652

R 1.06

R 1.0652 ,

R = 22. 4831

Problem 8.2. a. time t annual interest during [0, t] xed payment oating payments 0 1 6% R 20 2 6.5% R 21 3 7% R 22

PV xed payments=PV oating payments


20 1.06

21 1.0652

22 1.073

R 1.06

R 1.0652

R 1.073 ,

R = 20. 952

b. We are now standing at t = 1


(t recommend that initially you dont memorize the complex formula R = P (0,ti )f0) i ) . P (0,ti Draw a cash ow diagram and set up the equation PV xed payments = PV oating payments. Once you are familiar with the concept, you can use the memorized formula. 1I

141

CHAPTER 8. SWAPS time t annual interest during [1, t] xed payment oating payments 1 2 6.5% R 21 3 7% R 22

PV xed payments=PV oating payments 21 22 R R 1.065 + 1.072 = 1.065 + 1.072 , R = 21. 482

Problem 8.3. The dealer pays xed and gets oating. His risk is that oils spot price may drop signicantly. For example, if the spot price at t = 2 is $18 per barrel (as opposed to the expected $21 per barrel) and at t = 3 is $19 per barrel (as opposed to the expected $22 per barrel), the dealer has overpaid the swap. This is because the xed swap rate R = 20. 952 is calculated under the assumption that the oil price is $21 per barrel at t = 2 and $22 per barrel at t = 3. To hedge his risk, the dealer can enter 3 separate forward contracts, agreeing at t = 0 to deliver oil to a buyer at $20 per barrel at t = 1, at $21 per barrel at t = 2 , and at $22 per barrel at t = 3. Next, lets verify that the PV of the dealers locked-in net cash ow is zero. time t annual interest during [0, t] xed payment oating payments net cash ow PV(net cash ows)= Problem 8.4. The xed payer overpaid 0.952 at t = 1. The implied interest rate in Year 2 2 (from t = 1 to t = 2) is 1.065 1 = 0.07 002 4. So the overpayment 0.952 at t = 1 1.06 will grow into 0.952 (1 + 0.07 002 4) = 1. 018 7 at t = 2. Then at t = 2, the xed payer underpays 0.048 and his net overpayment is 1. 018 7 0.048 = 0.970 7. 1.073 The implied interest rate in Year 3 (from t = 2 to t = 3) is 1.0652 1 = 0.0 8007 1. So the xed payers net overpayment 0.970 7 at t = 2 will grow into 0.970 7 (1 + 0.08007 1) = 1. 048 4, which exactly osets his underpayment 1. 048 at = 3. now the accumulative net payment after the 3rd payment is zero.
0.952 1.06

1 6% 20. 952 20 20. 952 20 = 0.952 +


1. 048 1.073

2 6.5% 20. 952 21 0.048

3 7% 20. 952 22 1. 048

0.048 1.0652

=0

www.guo.coursehost.com

c Yufeng Guo

142

CHAPTER 8. SWAPS Problem 8.5. 5 basis points=5%% = 0.5% = 0.0005 a. immediately after the swap contract is signed the interest rate rises 0.5% time t original annual interest during [0, t] updated annual interest during [0, t] xed payment oating payments 0 1 6% 6.5% R 20 2 6.5% 7% R 21 3 7% 7.5% R 22

20 21 22 R R R 1.065 + 1.072 + 1.0753 = 1.065 + 1.072 + 1.0753 , R = 20. 949 < 20. 952 The xed rate is worth20. 949, but the xedpayer pays 20. 952. His loss is: 20 21 22 20 21 22 1.06 + 1.0652 + 1.073 1.065 + 1.072 + 1.0753 = 0.510 63

b. immediately after the swap contract is signed the interest rate falls 0.5% time t 0 1 2 3 original annual interest during [0, t] 6% 6.5% 7% updated annual interest during [0, t] 5.5% 6% 6.5% xed payment R R R oating payments 20 21 22
20 1.055

21 1.062

22 1.0653

R 1.055

R 1.062

R 1.0653

R = 20. 955 > 20. 952

The xed rate is worth 20. 955, but the xed payer pays only 20. 952 The xed payers gain is:
20 1.055

21 1.062

22 1.0653

20 1.065

21 1.072

22 1.0753

= 1. 029 3

www.guo.coursehost.com

c Yufeng Guo

143

CHAPTER 8. SWAPS Problem 8.6. (1) calculate the per-barrel swap price for 4-quarter oil time t (quarter) 0 1 2 3 xed payment R R R oating payments 21 21.1 20.8 discounting factor 1.0151 1.0152 1.0153 swap 4 R 20.5 1.0154

P V of oating payments = P V of xed payments 21 1.0151 + 21.1 1.0152 + 20.8 1.0153 + 20.5 1.0154 = R 1.0151 + 1.0152 + 1.0153 + 1.0154 R = 20. 853 3 (2) calculate the per-barrel swap price for 8-quarter oil swap time t (quarter) 0 1 2 3 4 5 6 xed payment R R R R R R oating payments 21 21.1 20.8 20.5 20.2 20 7 R 19.9 8 R 19.8

The discounting factor at t is 1.015t (i.e. $1 at t is worth 1.015t at t = 0) P V of oating payments = P V of xed payments 21 1.0151 +21.1 1.0152 +20.8 1.0153 +20.5 1.0154 +20.2 1.0155 + 20 1.0156 + 19.9 1.0157 + 19.8 1.0158 = R 1.0151 + 1.0152 + 1.0153 + 1.0154 + 1.0155 + 1.0156 + 1.0157 + 1.0158 R = 20. 428 4 (3) calculate the total cost of prepaid 4-quarter and 8-quarter swaps cost of prepaid 4-quarter swap 21 1.0151 + 21.1 1.031 + 20.8 1.0451 + 20.5 1.061 = 80. 419 02 cost of prepaid 8-quarter swap 1 2 3 4 +20.2 1.0155 + 21 1.015 +21.1 1.015 +20.8 1.015 +20.5 1.015 20 1.0156 + 19.9 1.0157 + 19.8 1.0158 = 152. 925 604 Total cost: 80. 419 02 + 152. 925 6 = 233. 344 62

www.guo.coursehost.com

c Yufeng Guo

144

CHAPTER 8. SWAPS Problem 8.7. The calculation is tedious. Ill manually solve the swap rates for the rst 4 quarter but give you all the swaps. Final result quarter forward DiscFactor R 1 21 0.9852 21 2 21.1 0.9701 21.05 3 20.8 0.9546 20. 97 4 20.5 0.9388 20. 85 5 20.2 0.9231 20.73 6 20 0.9075 20.61 7 19.9 0.8919 20.51 8 19.8 0.8763 20.43

Ill manually solve for the rst 4 swap rates. quarter 1 2 forward price 21 21.1 xed payment R R zero coupon bond price2 0.9852 0.9701

3 20.8 R 0.9546

4 20.5 R 0.9388

(1) if theres only 1 swap occurring at t = 1 (quarter) PV xed=PV oat 21 (0.9852) = R (0.9852) R = 21 (2) if there are two swaps occurring at t = 1 and t = 2 PV xed=PV oat 21 (0.9852) + 21.1 (0.9701) = R (0.9852 + 0.9701) R = 21. 049 6 21+21.1 = 21. 05 2 (3) if there are 3 swaps occurring at t = 1 ,2,3 PV xed=PV oat 21 (0.9852) + 21.1 (0.9701) + 20.8 (0.9546) = R (0.9852 + 0.9701 + 0.9546) R = 20. 967 7 21+21.1+20.8 = 20. 966 67 3 (4)if there are 4 swaps occurring at t = 1 ,2,3,4 PV xed=PV oat 21 (0.9852)+21.1 (0.9701)+20.8 (0.9546)+20.5 (0.9388) = R (0.9852 + 0.9701 + 0.9546 + 0.9388) R = 20. 853 636 21+21.1+20.8+20.5 = 20. 853 4

coupon bond price is also the discounting factor. you run out of time in the exam, just take R as the average oating payments. This is often very close to the correct answer.
3 If

2 Zero

www.guo.coursehost.com

c Yufeng Guo

145

CHAPTER 8. SWAPS By the way, please note that in the textbook Table 8.9, the gas swap prices are not in line with the forward price and discounting factors. This is because the swap prices in Table 8.9 are stand-alone prices made up by the author of Derivatives Markets so he can set up problems for you to solve: ti (quarter) 1 2 3 4 5 6 7 8 R 2.25 2.4236 2.3503 2.2404 2.2326 2.2753 2.2583 2.2044 To avoid confusion, the author of Derivatives Markets should have used multiple separate tables instead of combining separate tables into one. Problem 8.8. quarter forward price xed payment zero coupon bond price 1 2 3 20.8 R 0.9546 4 20.5 R 0.9388 5 20.2 R 0.9231 6 20 R 0.9075

If you run out of time, then R = 20.8+20.5+20.2+20 = 20. 375 20.38 4 The precise calculation is: PV xed=PV oat 20.8 (0.9546)+20.5 (0.9388)+20.2 (0.9231)+20 (0.9075) = R (0.9546 + 0.9388 + 0.9231 + 0.9075) R = 20. 380 69 20.38

www.guo.coursehost.com

c Yufeng Guo

146

CHAPTER 8. SWAPS Problem 8.9. If the problem didnt give you R = 20.43, you can quickly estimate it as (21 + 21.1 + 20.8 + 20.5 + 20.2 + 20 + 19.9 + 19.8) /8 = 20. 412 5 Back to the problem. Please note that this problem implicitly assumes that the actual interest rates are equal to the expected interest rates implied in the zero-coupon bonds. If the actual interest rates turn out to be dierent than the rates implied by the zero-coupon bonds, then youll need to know the actual interest rates quarter-by-quarter to solve this problem. So for the sake of solving this problem, we assume that the interest rates implied by the zero-coupon bonds are the actual interest rates. quarter 1 2 3 4 5 6 7 fwd price 21 21.1 20.8 20.5 20.2 20 19.9 xed pay 20.43 20.43 20.43 20.43 20.43 20.43 20.43 xedfwd 0.57 0.67 0.37 0.07 0.23 0.43 0.53 disct factor 0.9852 0.9701 0.9546 0.9388 0.9231 0.9075 0.8919 Loan balance at t = 0 is 0 Loan balance at t = 1 is 0.57. The implicit interest rate from t = 1 to t = 2 is solved by 0.9852 0.9852 1+x = 0.9701. So 1 + x = 0.9701 . The 0.57 loan will grow into 0.57 0.9852 0.9701 = 0.579 at t = 2. The loan balance at t = 2 is 0.579 0.67 = 1. 249. 1. 249 will grow into 1. 249 0.9701 = 1. 269 at t = 3. 0.9546 The loan balance at t = 3 is1. 269 0.37 = 1. 639, which grows into 1. 639 0.9546 = 1. 667 at t = 4. 0.9388 The loan balance at t = 4 is 1. 667 0.07 = 1. 737 1. 737 grows into 1. 737 0.9388 = 1. 767 at t = 5. 0.9231 So the loan balance at t = 5 is 1. 767 + 0.23 = 1. 537 1. 537 grows into 1. 537 0.9231 = 1. 563 at t = 6 . 0.9075 The loan balance at t = 6 is 1. 563 + 0.43 = 1. 133 1. 133 grows into 1. 133 0.9075 = 1. 153 at t = 7. 0.8919 The loan balance at t = 7 is 1. 153 + 0.53 = 0.623 0.623 grows into 0.623 0.8919 = 0.634 at t = 8. 0.8763 So the loan balance at t = 8 is 0.634 + 0.63 = 0.004 0 quarter loan bal 0 0 1 0.57 2 1. 249 3 1. 639 4 1. 737 5 1. 537 6 1. 133 7 0.623 8 0

8 19.8 20.43 0.63 0.8763

www.guo.coursehost.com

c Yufeng Guo

147

CHAPTER 8. SWAPS You can also work backward from t = 8 to t = 0. You know that the loan balance at t = 8 is zero; overall the xed payer and the oating payer each have no gain and no loss if the expected yield curve turns out to the real yield curve. quarter fwd price xed pay xedfwd disct factor 1 21 20.43 0.57 0.9852 2 21.1 20.43 0.67 0.9701 3 20.8 20.43 0.37 0.9546 4 20.5 20.43 0.07 0.9388 5 20.2 20.43 0.23 0.9231 6 20 20.43 0.43 0.9075 7 19.9 20.43 0.53 0.8919 8 19.8 20.43 0.63 0.8763

Since the loan balance at t = 8 is zero and the xed payer overpays 0.6344 at t = 8, the loan balance at t = 7 must be 0.634 0.8919 = 0.623. 0.8763 Similarly, the loan balance at t = 7 must be (0.623 0.53) 133 .
0.9075 0.8919

= 1.

And the loan balance at t = 6 must be (1. 133 0.43) 0.9231 = 1. 537. 0.9075 So on and so forth. This method is less intuitive. However, if the problem asks you to only nd the loan balance at t = 7, this backward method is lot faster than the forward method.

4 I use 0.634 instead of 0.63 to show you that the backward method produces the same correct answer as the forward method. If you use 0.63, you wont be able to reproduce the answer calculated by the forward method due to rounding (because 0.63 is rounded from 0.634).

www.guo.coursehost.com

c Yufeng Guo

148

CHAPTER 8. SWAPS Problem 8.10. The oating payer delivers 2 barrels at even numbered quarters and 1 barrel at odd quarters. The cash ow diagram is: quarter fwd price xed pay disct factor 1 21 R 0.9852 2 21.1 (2) 2R 0.9701 3 20.8 R 0.9546 4 20.5 (2) 2R 0.9388 5 20.2 R 0.9231 6 20 (2) 2R 0.9075 7 19.9 R 0.8919 8 19.8 (2) 2R 0.8763

PV oat =PV xed 21 (0.9852) + 21.1 (2) (0.9701) + 20.8 (0.9546) + 20.5 (2) (0.9388) +20.2 (0.9231) + 20 (2) (0.9075) + 19.9 (0.8919) + 19.8 (2) (0.8763) = R (0.9852 + 2 0.9701 + 0.9546 + 2 0.9388) +R (0.9231 + 2 0.9075 + 0.8919 + 2 0.8763) R = 20. 409 94 Please note that the cash ow diagram is not: quarter 1 2 3 4 fwd price 21 21.1 (2) 20.8 20.5 (2) xed pay R R R R disct factor 0.9852 0.9701 0.9546 0.9388

5 20.2 R 0.9231

6 20 (2) R 0.9075

7 19.9 R 0.8919

8 19.8 (2) R 0.8763

www.guo.coursehost.com

c Yufeng Guo

149

CHAPTER 8. SWAPS Problem 8.11. The key formula is the textbook equation 8.13: R= Pn i=1 P (0, ti ) f0 (ti ) Pn i=1 P (0, ti )

From Table 8.9, we get: ti (quarter) 1 2 R 2.25 2.4236 P (0, ti ) 0.9852 0.9701 Notation:

3 2.3503 0.9546

4 2.2404 0.9388

5 2.2326 0.9231

6 2.2753 0.9075

7 2.2583 0.8919

8 2.2044 0.8763

P (0, ti ) is the present value at t = 0 of $1 at the ti . R is the swap rate. For example, for a 4-quarter swap, the swap rate is 2.2404 f0 (ti ) is the price of the forward contract signed at ti1 and expiring at ti The 1-quarter swap rate is P (0, t1 ) f0 (t1 ) R (1) = f0 (t1 ) = R (1) = 2.2500 P (0, ti ) The 2-quarter swap rate is: P (0, t1 ) f0 (t1 ) + P (0, t2 ) f0 (t2 ) R (2) = P (0, t1 ) + P (0, t2 ) 0.9852 (2.25) + 0.9701f0 (t2 ) 2.4236 = f0 (t2 ) = 2.5999 0.9852 + 0.9701 The 3-quarter swap rate is: P (0, t1 ) f0 (t1 ) + P (0, t2 ) f0 (t2 ) + P (0, t3 ) f0 (t3 ) R (3) = P (0, t1 ) + P (0, t2 ) + P (0, t3 ) 0.9852 (2.25) + 0.9701 (2.60) + 0.9546f0 (t3 ) 0.9546 = 0.9852 + 0.9701 + 0.9546 f0 (t3 ) = 2.2002 So on and ti R P (0, ti ) f0 (ti ) so forth. 1 2.25 0.9852 2.2500 The result is: 2 3 2.4236 2.3503 0.9701 0.9546 2.5999 2.2002 4 2.2404 0.9388 1.8998 5 2.2326 0.9231 2.2001 6 2.2753 0.9075 2.4998 7 2.2583 0.8919 2.1501 8 2.2044 0.8763 1.8002

www.guo.coursehost.com

c Yufeng Guo

150

CHAPTER 8. SWAPS Problem 8.12. ti R (8) f0 (ti ) P (0, ti ) i(ti1 , ti ) 1 2.2044 2.2500 0.9852 1.5022% 2 2.2044 2.5999 0.9701 1.5565% 3 2.2044 0.9546 0.9546 1.6237% 4 2.2044 0.9388 0.9388 1.6830%

ti 5 6 7 8 R (8) 2.2044 2.2044 2.2044 2.2044 f0 (ti ) 0.9231 0.9075 0.8919 0.8763 P (0, ti ) 0.9231 0.9075 0.8919 0.8763 i(ti1 , ti ) 1.7008% 1.7190% 1.7491% 1.7802% First, lets calculate the quarterly forward interest rate i(ti1 , ti ), which is the interest during[ti1 , ti ]. By the way, please note the dierence between f0 (ti ) and i(ti1 , ti ). f0 (ti ) is the price of a forward contract and i(ti1 , ti ) is the forward interest rate. The interest rate during the rst quarter is i(t0 , t1 ). This is the eective interest per quarter from t = 0 to t = 0.25 (year). Because P (0, t1 ) represents the present value of $1 at t = 0.25 1 P (0, t1 ) = 1 + i(t0 , t1 ) 1 1 0.9852 = i(t0 , t1 ) = 1 = 1. 5022% 1 + i(t0 , t1 ) 0.9852 The 2nd quarter interest rate i(t1 , t2 ) satises the following equation: 1 1 P (0, t1 ) P (0, t2 ) = = 1 + i(t0 , t1 ) 1 + i(t1 , t2 ) 1 + i(t1 , t2 ) 0.9852 0.9701 = i(t1 , t2 ) = 1. 5566% 1 + i(t1 , t2 ) Similarly, 1 1 1 P (0, t2 ) = 1 + i(t0 , t1 ) 1 + i(t1 , t2 ) 1 + i(t2 , t3 ) 1 + i(t2 , t3 ) 0.9701 0.9546 = i(t2 , t3 ) = 1.6237% 1 + i(t2 , t3 ) P (0, t3 ) = Keep doing this, you should be able to calculate all the forward interest rates.

www.guo.coursehost.com

c Yufeng Guo

151

CHAPTER 8. SWAPS Next, lets calculate the loan balance. ti 1 2 R (8) 2.2044 2.2044 f0 (ti ) 2.2500 2.5999 f0 (ti ) R (8) 0.0456 0.3955 Loan balance 0.0456 0.4418 i(ti1 , ti ) 1.5022% 1.5565%

3 2.2044 0.9546 0.0042 0.4444 1.6237%

4 2.2044 0.9388 0.3046 0.1470 1.6830%

ti R (8) f0 (ti ) f0 (ti ) R (8) Loan balance i(ti1 , ti )

5 2.2044 0.9231 0.0043 0.1451 1.7008%

6 2.2044 0.9075 0.2954 0.4430 1.7190%

7 2.2044 0.8919 0.0543 0.3963 1.7491%

8 2.2044 0.8763 0.4042 0.0009 1.7802%

At t = 0, the loan balance is zero. A swap is a fair deal and no money changes hands. At t = 1 (i.e. the end of the rst quarter), the oating payer lends 2.25 2.2044 = 0.045 6 to the xed payer. Had the oating payer signed a forward contract at t = 0 agreeing to deliver the oil at t = 1, he would have received 2.25 at t = 1. However, by entering into an 8-quarter swap, the oating payer receives only 2.2044 at the t = 1. So the oating payer lends 2.25 2.2044 = 0.045 6 to the xed payer. The 0.045 6 at t = 1 grows to 0.045 6 (1 + 0.015022) = 0.046 3 The total loan balance at t = 2 is 0.046 3 + 0.3955 = 0.441 8 The loan balance 0.441 8 at t = 2 grows into 0.441 8 (1 + 0.015565) = 0.448 7 at t = 3 The total loan balance at t = 3 is 0.448 7 0.0042 = 0.444 4 I used Excel to do the calculation. Due to rounding, I got 0.448 7 0.0042 = 0.444 4 instead of 0.444 5. So on and so forth. The nal loan balance at t = 8 is: 0.3963 (1 + 0.017491) 0.4042 = 0.000 9 0 The loan balance at the end of the swap t = 8 should be zero. We didnt get zero due to rounding.

www.guo.coursehost.com

c Yufeng Guo

152

CHAPTER 8. SWAPS Problem 8.13. ti P (0, ti ) i(ti1 , ti ) P (0, ti ) i(ti1 , ti ) R= P6


i=2

2 0.9701 1.5565% 0.0151

3 0.9546 1.6237% 0.0155

4 0.9388 1.6830% 0.0158

5 0.9231 1.7008% 0.0157

6 0.9075 1.7190% 0.0156

Total 4.6941 0.0777

P (0, ti ) r (ti1 , ti ) 0.0777 = = 1. 655 3% P6 4.6941 P (0, ti ) i=2

Problem 8.14. ti 1 2 3 4 Total P (0, ti ) 0.9852 0.9701 0.9546 0.9388 3.8487 i(ti1 , ti ) 1.5022% 1.5565% 1.6237% 1.6830% P (0, ti ) i(ti1 , ti ) 0.0148 0.0151 0.0155 0.0158 0.0612

Calculate the 4-quarter swap rate. R= P4


i=1

P (0, ti ) r (ti1 , ti ) 0.0612 = = 1. 5901% P4 3.8487 P (0, ti ) i=1

Calculate the 8-quarter swap rate. ti P (0, ti ) i(ti1 , ti ) P (0, ti ) i(ti1 , ti ) 1 0.9852 1.5022% 0.0148 2 0.9701 1.5565% 0.0151 3 0.9546 1.6237% 0.0155 4 0.9388 1.6830% 0.0158 5 0.9231 1.7008% 0.0157 6 0.9075 1.7190% 0.0156 7 0.8919 1.7491% 0.0156 8 0.8763 1.7802% 0.0156 Total 7.4475 0.1237 R= P8
i=1

P (0, ti ) r (ti1 , ti ) 0.1237 = = 1. 6610% P5 7.4475 P (0, ti ) i=1

Problem 8.15. Not on the FM syllabus. Skip. www.guo.coursehost.com c Yufeng Guo 153

CHAPTER 8. SWAPS Problem 8.16. Not on the FM syllabus. Skip. Problem 8.17. Not on the FM syllabus. Skip. Problem 8.18. Not on the FM syllabus. Skip.

www.guo.coursehost.com

c Yufeng Guo

154