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Corporate Finance
Tutorial 6: Derivatives
Suggested Solutions
Solutions to Exercises on Derivation Assets: Properties and Pricing
A1.
a)
Fk = So (1 + r)k
3
F3 = $12.50(1.06 )
= $14.89
5
F5 = $12.50(1.06 )
= $16.73
b)
A2.
Short a 3-year forward contract and buy Robotronics stocks at spot. Hold
until maturity of forward contract for delivery.
0.64 = $1
rd = 6%
rf = 4%
5
&1.06 #
F5 = 0.64 $
! = 0.7040
%1.04 "
&1.06 #
F10 = 0.64 $
!
%1.04 "
10
= 0.7743
Corporate Finance
A3.
a)
a=
KH " KL
SH " SL
a=
$30 " $0
= 0.5
$150 " $90
b=
SL KH " SH KL
(1+ rf )(SL "S H )
b=
We can buy 0.5 unit of stock & short 40.91 units of the risk-free asset.
Corporate Finance
b)
a=
KH " KL
SH " SL
a=
$0 " $10
= "0.1667
$150 " $90
b=
SL KH " SH KL
(1+ rf )(SL "S H )
b=
We can short 0.167 unit of stock & buy 22.73 units of the risk-free asset.
Corporate Finance
A4.
S = $17.50
X = $15
! = 15%
r = 7%
d1 =
# 17.50 &
ln% "0.07(5) (
$ 5e
'
(0.15)
(0.15)
0.5042 0.3354
+
= 1.5033 + 0.1677
0.3354
2
= 1.6710
d1 =
d2 = d1 ! T
= 1.6710 0.15 5
= 1.3356
c = $17.50 N(1.6710) [$15e-0.07(5)] N(1.3356)
N(1.6710) = N(1.67) + (0.10)[N(1.68) N(1.67)]
= 0.9525 + (0.10)(0.9535 0.9525)
= 0.9526
N(1.3356) = N(1.33) + (0.56)[N(1.34) N(1.33)]
= 0.9082 + (0.56)(0.9099 0.9082)
= 0.9092
c = ($17.5 x 0.9526) ($15e 0.35 x 0.9092)
= $16.67 $9.61
= $7.06
S + p = c + Xe rT
p = $7.06 + $15e-(0.07)(5) $17.50
= $0.13
If r increases to 10%
d1 = 1.9503 + 0.1677 = 2.118
d2 = 2.118 (0.15) 5 = 2.118 0.335 = 1.783
N(d1) = 0.9830
N(d2) = 0.9625
c = ($17.50 x 0.9830) [$15e (0.10)(5) x 0.9625]
= $17.20 $ 8.76 = $8.44
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(b)
=1
CALL
SH = 130
So
(100)
X = 100
SL = 90
Equation 1 2
KH = 30
KL = 0
Equation 1
Equation 2
Equation 1
Equation 2
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(c)
(d)
=> => c
p
Although extremely good outcomes (i.e. underlying asset price very high) are
rewarded highly, extremely bad outcomes are not penalized due to the kink
in the option payoff profile. This would imply that an increase in likelihood
of extreme outcomes should increase option prices as large payoffs are
increased in likelihood. From the put-call parity equation above, if call price
increases, while all other things being equal, p price should also increase to
maintain the equilibrium.
Corporate Finance
Positions
Now *
Maturity *
Long forward
Sk Fk
Fk (1 + r) -k
-Fk
Borrow PV of Fk
Long underlying
asset
* Represent cash flows for the two strategies.
- S0
Sk
Under no-arbitrage strategy, two investment portfolios with the same outcome
should have the same value.
Value (Portfolio A) = Value (Portfolio B)
0
= Fk (1+ r)-k - S0
Fk
= S0 (1+ r)k
Hence, that is the k-period forward price.
Corporate Finance
S0 + P = C + XerT
The implication of the put-call parity is that given the respective options and an
underlying asset, a risk-free position can be created from the relationship.
Xe-rT= P C + S0
This relationship can be shown in the following position diagram:
Payoff
Long Stock
+S
Rf
Investment
ST
Long PUT
+P
Short CALL - C
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Part (b)
Assume S = current spot price of the stock index
r = risk free interest rate
y = dividend yield
k = period of the future contract
Under no-arbitrage strategy, two investment strategies with the same outcomes should
have the same value. Consider the following two portfolios:
Portfolio A
Portfolio B
:
:
At maturity, the pay-off profiles for the two investment strategies are as follows:
Strategy
Portfolio A
Portfolio B
Positions
Long future contract
Borrow PV of Fk
Long underlying asset
Now *
Maturity *
Sk Fk
Fk (1 + r - y) k
Fk
- S0
Sk
As the theoretical price of the futures is greater than the actual futures price, one
should buy the futures, sell the stock index and lend the difference of the cashflows at time 0 at the risk free rate. The arbitrage profit would be the difference
between the actual and the theoretical futures price.
Corporate Finance
If there is a rise in the interest rate, the theoretical futures price will rise
according to the pricing equation above. However, a rise in interest might also
suggest a weaker than expected economy or a potential rise in inflation. As such,
spot price might fall which will reduce the price of the futures. If markets are
informationally efficient, the pricing relationship between spot and futures will
maintain.
Part (c)
Let u = upside change
d = downside change
Hence,
T
(.20 ) 1 / 2
(1 + u ) = e
(1 d ) = e
=e
=e
= 1.1519
(.20 ) 1 / 2
= 0.8681
u = 0.1519
d = 0.1319
Given,
= 10 :
= 10 (1.1519)
= 11.519
= 10 (0.8681)
= 8.681
Therefore,
K
K
= 11.519 - 8 = 3.519
= 8.681 - 8 = 0.681
q=
r+d
0.075 + 0.1319
=
= 0.7290
u + d 0.1519 + 0.1319
Hence,
C=
q K H + (1 q) K L
1+ r
0.729(3.519) + (1 0.729)(0.681)
1 + 0.075
= 2.558
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Corporate Finance
Delta Ratio
K
S
H
H
KL
SL
3.519 0.681
11.519 8.681
2.838
=1
2.838
11
Corporate Finance
C = S 0 N (d1 ) Xe rT N (d 2 )
where
S 0
ln rT
Xe T
d1 =
+
2
T
d 2 = d1 T
Hence,
d1
d2
In (
5____)
4/1.15 _____ + 0.2 H1___
0.2 1
1.9150
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Corporate Finance
(b)
There are five determinants which would influence the price of a call
option in the above model:
(i)
Price of the underlying asset: The higher the underlying asset price
implies the option gives the holder a claim on a more valuable
asset, hence call price increases.
(ii)
(iii)
(iv)
(v)
All the above determinants have positive relationships with value of call option
except for exercise price which has an inverse relationship.
(c)
stock
Assume that:
p
Upper bound for an European put option is p Xert, given that the put
option cannot be exercised until maturity. Using PV argument, the value
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Corporate Finance
of a European put should be less than or equal to the present value of the
exercise price. At maturity, the maximum value of European put will be X,
the exercise price.
Lower bound of a European put option:
p > max [0, XerT S]
Under no-arbitrage strategy, two investments with the same outcomes
ought to have the same prices. Consider the following two portfolios:
Portfolio A
Portfolio B
At maturity of the put option, the pay-offs for the two investment
portfolios are as follows:
Investments
Position Now
Portfolio A,
VA
Portfolio B,
VB
At Maturity
ST > X
ST < X
p+S
ST
XerT
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