Financial Engineering I, IEOR E4706, Fall 2003

Columbia University Instructor: Martin Haugh Brief Solutions to Final Examination Question 1 (a) Purchase 8 of the 5% bonds and sell 5 of the 8% bonds. The initial cost of this is 254, the coupon payments cancel one another, and the terminal value is 300. Therefore a 5year zero-coupon bond with face value 100 must be worth 254/3 = 84.6667. (b) The theoretical forward price, F , satises F = S/d(0, T ) = 93/.96 = 96.875 cents which is greater than the forward price quoted in the market. Therefore there is an arbitrage opportunity: at t = 0 purchase the forward contract, short sell copper in the spot market and invest the proceeds in 6 month T-Bills. (c) The forward value, F , is given by F = 430(1 + .08/4)2 + .5(1 + .08/4)2 + .5(1 + .08/4) = 448.4022.

(d) (1, 0, 0) is the only elementary security available. (e) If the bond were trading at par, then the yield-to-maturity would be exactly 8%. However, the bond is trading at less than par and therefore the yield-to-maturity is greater than 8%. (f ) The forward value, F , is given by F = 9100(1 + .12/2)2 500(1 + .12/2) 500 = 9194.76.

(g) Because the ABC Banking Corporation is selling the forward contract, there will be some credit risk associated with the position as there will be a chance that ABC will not be able to fulll its obligations one year from now. Bearing this credit risk requires compensation and therefore the forward price they quote will be a little bit less than the theoretical forward price. This assumes that ABC will be selling to a more creditworthy counterparty. If it were selling to a less creditworthy counterparty, then the quoted forward price would be a little bit higher than the theoretical forward price. (This question was somewhat tricky. Generally, speaking 3 to 5 marks were given if counterparty or default risk was mentioned. Marks were also given for other good reasons, e.g., liquidity risk.) (h) Yes. Since the next dividend payment is after the options expiration we know that 1

the American call option value equals the European call option value. We therefore have all the necessary information that is required to apply put-call parity and compute the European put-option price.

Question 2 (a) The risk-neutral probability, q , is given by q = (R d)/(u d) = (1.03 .9434)/(1.06 .9434) = 0.7427. The put only pays out at the bottom node at t = 3 and then the payout = 10.0381. The value then at the bottom node at t = 2 is max(94 88.9996, (1 q )10.0381/R) = 5.0004 and it is optimal to exercise the option at that node. Working backwards in the lattice we see that the value of the option at t = 0 is 0.3122. (b) The security that pays 1 if the terminal stock price is 94.3396 is worth 0.1350. The security that pays 1 if the terminal stock price is 83.9619 is worth 0.0156. (c) The payo of the call is 8.6604 when the terminal stock price is 94.3396, and 19.0381 when the terminal stock price is 83.9619. Part (b) and linear pricing then implies that the call option price is 8.6604 0.1350 + 19.0381 0.0156 = 1.4661. (d) At t = 1 it can be seen that call option with a value of 8.9124 should be chosen at the upper node. Similarly at the lower node at t = 1, the put option with a value of 2.748 should be chosen. Therefore, at t = 1, the chooser option is worth 8.9124 and 2.748 at the 2 possible nodes. We now discount this backwards using the risk-neutral probabilities to nd that the time t = 0 value of the option is 7.1124. (e) Let V (t) be the value of the chooser option at time t. Then V (1) = max(C (1), P (1)). By put-call-parity we then have V (1) = max(C (1), C (1) + 103/R S (1)) = C (1) + max(0, 103/R S (1)).
1 But this then implies that V (0) = C (0) + E R max(0, 103/R S (1)) which is the value of the original call option and a put option that expires at t = 1 with strike = 103/R.

(There was a typo in the question as it asked for a put option of a dierent expiration. Anybody who gave the solution above or appeared to have been close to it was given the full 3 marks.) Question 3 2 1 2 (1 ) = .3 .2 = .06. (N123 ) 1 (1 ) = 0 (a) 0 2

(b) We use the formula qk = k S2 (k )/

m l=1

l S2 (l ) and nd q = [0.1016 0.4570 0.4414].

0 (c) The forward price, F , is given by S1 /d(0, 2). The discount factor, d(0, 2), is the date t = 0 value of $1 at date t = 2. There are many ways to compute this. We can do so using 2 the state prices, 0 . In particular, we have d(0, 2) = .3(.2 + .3 + .4346) + .3(.3 + .3 + .3524) + .3524(.25 + .4 + .3209) = 0.9082.

Therefore we have F = 2.2173/.9082 = 2.4414. (d) At each of the three date t = 1 nodes do the following: nd the portfolio that replicates X at those nodes. This requires solving a 3 3 system of linear equations at each node. Since the model is complete each system will have a unique solution. Once the replicating portfolio at each of the three date t = 1 nodes is found, compute their costs, C123 , C456 and C789 , say. Finally at date t = 0 nd the replicating portfolio for the security with payo at date t = 1 given by [C123 C456 C789 ]. You now have a self-nancing trading strategy with terminal value, X . i.e. a replicating portfolio for X . (e) Let = [0 1 2 ]T represent the amount of the three securities purchased at node N456 . The optimal upper bound is found by solving the following linear program: min T S subject to A X and 0 0 where X = [x1 x2 x3 ]T , S = [1.05 1.9571 2.2048]T and 1.1025 2 3 A = 1.1025 1 2 . 1.1025 3 2
2 (f ) First compute the date t = 0 state prices, 0 (i ), for each of the nine terminal states. Divide these state prices by their probabilities and then rank these values from cheapest to highest. If W0 is suciently large you should purchase units of the cheapest elementary security. If there is enough cash remaining, you then purchase units of the next cheapest elementary security. You continue in this way until you cannot aord to purchase units of any of the other elementary securities.

Actually, this is only approximately optimal. (It is in optimal in the limit as the number of states goes to innity and their associated probabilities go to zero.) To nd the true optimal solution it is not necessary to solve a knapsack problem. It was not necessary to do this to obtain full marks.