Question 3.9.

The strategy of buying a call (or put) and selling a call (or put) at a higher strike is called call (put) bull spread. In order to draw the profit diagrams, we need to find the future value of the cost of entering in the bull spread positions.We have: Cost of call bull spread: _$120.405 $93.809_ 1.02 = $27.13 Cost of put bull spread: _$51.777 $74.201_ 1.02 = $22.87 The payoff diagram shows that the payoffs to the put bull spread are uniformly less than the payoffs to the call bull spread. There is a difference, because the put bull spread has a negative initial cost, i.e., we are receiving money if we enter into it. The difference is exactly $50, the value of the difference between the two strike prices. It is equivalent as well to the value of the difference of the future values of the initial premia. Yet, the higher initial cost for the call bull spread is exactly offset by the higher payoff so that the profits of both strategies are the same. It is easy to show this with equation (3.1), the put-call-parity.

Payoff-Diagram:

Profit diagram:

Question 3.15. a) Profit diagram of the 1:2 950-, 1050-strike ratio call spread (the future value of the initial cost of which is calculated as: _$120.405 2 $71.802_ 1.02 = $23.66):

b) Profit diagram of the 2:3 950-, 1050-strike ratio call spread (the future value of the initial cost of which is calculated as: _2 $120.405 3 $71.802_ 1.02 = $25.91.

c) We saw that in part a), we were receiving money from our position, and in part b), we had to pay a net option premium to establish the position. This suggests that the true ratio n/m lies between1:2 and 2:3. Indeed, we can calculate the ratio n/m as:

n $120.405 m $71.802 = 0
n $120.405 = m $71.802 n/m = $71.802/$120.405 n/m = 0.596 which is approximately 3:5.

Question 4.5. XYZ will buy collars, which means that they buy the put leg and sell the call leg. We have to compute for each case the net option premium position, and find its future value.We have for a) _$0.0178 $0.0376_ 1.062 = $0.021 b) _$0.0265 $0.0274_ 1.062 = $0.001 c) _$0.0665 $0.0194_ 1.062 = $0.050

Question 5.7. We need to find the fair value of the forward price first. We plug the continuously compounded interest rate and the time to expiration in years into the valuation formula and notice that the time to expiration is 6 months, or 0.5 years. We have:

a) If we observe a forward price of 1135, we know that the forward is too expensive, relative to the fair value we determined. Therefore, we will sell the forward at 1135, and create a synthetic forward for 1,127.85, make a sure profit of $7.15. As we sell the real forward, we engage in cash and carry arbitrage:

This position requires no initial investment, has no index price risk, and has a strictly positive payoff.We have exploited the mispricing with a pure arbitrage strategy. b) If we observe a forward price of 1,115, we know that the forward is too cheap, relative to the fair value we have determined. Therefore, we will buy the forward at 1,115, and create a synthetic short forward for 1,127.85, make a sure profit of $12.85. As we buy the real forward, we engage in a reverse cash and carry arbitrage:

This position requires no initial investment, has no index price risk, and has a strictly positive payoff. We have exploited the mispricing with a pure arbitrage strategy.

Question 7.3.

Question 7.7. a) We are looking for r0 (1, 3). We will use equation (7.3) of the main text, and the known one-year and three-year zero-coupon bond prices. We have to solve the following equation:

b) Lets calculate the zero-coupon bond price from year 1 to 2 and from year 1 to 3, they are:

Now, we have the relevant implied forward zero-coupon prices and can find the coupon of the par 2-year coupon bond issued at time 1 according to formula (7.6).

Question 7.13. First, let us calculate the value of the 3-year par coupon bond after we have held it for 2 years. After two years, the bond still entitles us to receive one coupon and the repayment of the principal. We have to discount those payments, which we receive at t = 3, with the implied forward rate from year two to three. This determines the value of the 3-year par coupon bond after 2 years. We have:

Furthermore, after one year, we received a coupon of 6.95485 dollars, which we reinvested at the prevailing interest rate, the implied forward rate from year one to year two, 1.0700237, and we receive a coupon of 6.95485 at the end of year two. The value of the coupons at the end of year two is:

Therefore, our two-year gross return is:

Finally, we annualize this return by taking its square root. This yields an annualized gross return of 1.065, which was to be shown.

Question 8.5. Since the dealer is paying fixed and receiving floating, she generates the cash-flows depicted in column 2. Suppose that the dealer enters into three short forward positions, one contract for each year of the active swap. Her payoffs are depicted in columns 3, and the aggregate net position is summarized in column 4.

We need to discount the net positions to year zero, taking into account the uniform shift of the term structure. We have:

The present value of the net cash flow is negative: The dealer never recovers from the increased interest rate he faces on the overpayment of the first swap payment.

The present value of the net cash flow is positive. The dealer makes money, because he gets a favorable interest rate on the loan he needs to take to finance the first overpayment. The dealer could have tried to hedge his exposure with a forward rate agreement or any other derivative protecting against interest rate risk.

Question 9.7. a) We make use of the version of the put-call-parity that can be applied to currency options. We have:

b) The observed option price is too high. Therefore, we sell the put option and synthetically create a long put option, perfectly offsetting the risks involved. We have:

We have thus demonstrated the arbitrage opportunity. c) We can use formula (9.7.) to determine the value of the corresponding Yen-denominated at-the-money put, and then use put-call-parity to figure out the price of the Yen-denominated at the-money call option.

Now, we can use put-call-parity, carefully handling the interest rates (since we are now making transactions in Yen, the $-interest rate is the foreign rate):

We have used the direct relationship between the yen-denominated dollar put and our answer to a) and the put-call-parity to find the answer.

Question 9.15. We demonstrate that these prices permit an arbitrage. We buy the cheap option, the longer lived one-and-a-half year call, and sell the expensive one, the one-year option. Let us consider the two possible scenarios. First, let us assume that St < 105.127. Then, we have the following table:

Clearly, there is no arbitrage opportunity. However, we will need to check the other possibility as well, namely that St 105.127. This yields the following no-arbitrage table:

We have thus shown that in all states of the world, there exist an initial positive payoff and nonnegative payoffs in the future. We have demonstrated the arbitrage opportunity.