Philipp Illeditsch

Fall 2010
Financial Derivatives (206/717)
Sections 401, 402, 403
The Wharton School, University of Pennsylvania

Solutions to Final Exam

Exam statistics

All FNCE 206 FNCE 717

Mean 132.57 135.95 124.69
St. Deviation 29.88 30.33 27.56
Median 136 138.5 128.5
Max 188 188 169
25th percentile 116.75 120.25 104.5
75th percentile 155 157 146.5

Regrade policy

I am happy to consider any regrade requests.

The request must be made to me, and not to any of my TAs.

You must return your exam to me together with a written statement of your
specic concern.

You must submit your request by 5pm on Tuesday, January 18.

I will look at the whole exam, and not just the concern you raise. Your score
can go down as well as up.

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Solution to Question 1

(a) There are no dividends payed during the life of the forward contract and thus the
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forward price is F0,1mth = 150e 12 0.05 = $150.63.

(b) The strike price of the at-the-money call is K = 150. There is one dividend
payment before the option matures and thus the current stock price adjusted for the
dividends payed during the lifetime of the option is
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S0 P V (D2mth ) = 150 5e5% 12 = 145.04.

Plugging into the formulas for d1 and d2 and replacing S0 with S0 P V (D2mth ) leads
to
   0.32

ln 145.04
150
+ 0.05 + 2
3/12
d1 =  = 0.06577
0.3 3/12

d2 = d1 0.3 3/12 = 0.21577.

The price of a European at the money call with three months to maturity is

C0 = 145.04 N(0.06577) 148.14 N(0.21577) = 7.30

Solution to Question 2

a) The one year forward price that precludes any arbitrage is

F0,1yr = S0 e(r) = 1200e(3%2%) = 1212.06.

The two year forward price that precludes any arbitrage is

F0,2yr = S0 e(r)2 = 1200e(3%2%)2 = 1224.24

Hence, the no arbitrage price of a swap with payments in one year and two years is

F0,1yr e3% + F0,2yr e3%2 2329.185735

X0 = = = 1218.06.
e3% + e3%2 1.91221

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b) To nd the value of the swap in six months we need to determine the amount of
money we need to pay/receive in order to exit this swap agreement in six months.
To exit the swap agrement we just take an osetting long position in 10 swap agree-
ments. In this case the combined cash ows are
0 6mth 1yr 2yr
short 10 swaps at date 0 0 0 $(S1 X0 ) 10 $(S2 X0 ) 10
long 10 swaps in 6mth 0 0 $(S1 X6mth ) 10 $(S2 X6mth ) 10
total 0 0 $(X0 X6mth ) 10 $(X0 X6mth ) 10

Hence, the value of the swap in six months is

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V6mth = $10(X0 X6mth )e3% 12 + $10(X0 X6mth )e3% 12 = $2070.84.

[ Derivation of the new swap price X6mth :

The 6mth forward price that precludes any arbitrage is
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F6mth,1yr = S6mth e(r) 12 = 1100e(3%2%) 12 = 1105.51

The 18mth forward price that precludes any arbitrage is

18 18
F6mth,2yr = S6mth e(r) 12 = 1100e(3%2%) 12 = 1116.62

Hence, the new no arbitrage price of a swap with payments in one year and two years
is

6 18
F6mth,1yr e3% 12 + F6mth,2yr e3% 12
X6mth = 6 18 = 1110.99.
e3% 12 + e3% 12

Solution to Question 3
erh d
a) The risk neutral or pricing probability is q = ud
= 0.49.
The stock price is 100u2 = 156.25 after two up moves, 100ud = 100 after an up and
down (down and up) move, and 100d2 = 64 after two down moves.
The value of a European and American put with strike price K = 135 is max(135

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156.25, 0) = 0 after two stock up moves, max(135 100, 0) = 35 after a stock up and
down (down and up) move, and max(135 64, 0) = 71 after two stock down moves.
Hence, the value of the European put is:

 
PE = er q 2 0 + 2q(1 q) 35 + (1 q)2 71 = 34.53.

To determine the value of a American put we have to work backwards through the
tree and check in each node wether it is optimal to exercise the put or not:

up node (the stock price is 125): the value of immediately exercising is 135
125 = 10 and the continuation value is erh (q 0 + (1 q) 35) = 17.49. Hence,
the value of the American put in this node is 17.49.

down node (the stock price is 80): the value of immediately exercising is 135
80 = 55 and the continuation value is erh (q 35 + (1 q) 71) = 52.29. Hence,
the value of the American put in this node is 55.

date 0 (the stock price is 100): the value of immediately exercising is 135100 =
35 and the continuation value is erh (q 17.49 + (1 q) 55 = 35.88. Hence,
the value of the American put today is 35.88.

Hence, the early exercise premium of this put is PA PE = 35.88 34.53 = 1.36.
b) FALSE: The early exercise premium decreases with an increase in dividends be-
cause an investor who is holding a put does not have to pay dividends whereas by
exercising you are eectively short the underlying and therefore responsible for any
dividend payments during the remaining life of the option.

Solution to Question 4

(a) The continuously compounded interest rate payed on Japanese Yen (the asset)
can be interpreted as the dividend yield and thus the 6mth forward price is

6 $  6
F0,6mth = S0 e 12 (r0,6mth r0,6mth ) = 0.0125e 12 1.5% = 0.012594.

Hence, you need to pay $12, 594.10 for 1M Japanese Yen.

(b) FALSE. It is never optimal to exercise a call on a non dividend paying stock early
and thus European call options on Japanese yen have the same value as American
call options on Japanese yen if the interest rate on Yen is zero. Hence, the bank wont
incur any losses if they sell American call options at the same price as European call
options as long as the interest rate on Yen is zero.

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Solution to Question 5
The cash ows of this structured note from the banks perspective are

today 1.5yr
structured note 2
3
X 1
3
X S1.5

The interest rate is zero and hence the bank is eectively short a forward contract on
the Russell 2000 that matures in 1.5 years, i.e.

today 1.5yr
structured note 0 X S1.5

The fair value for this structured note is thus

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X = S0 e 2 = 747.24.

(b) The unhedged cash ow for the bank after issuing 10, 000 notes is

today 1.5yr
Unhedged cash ow 0 (X S1.5 ) 10000

There is no futures contract that matures in 1.5 years and hence we need to trade
in the futures contract that matures in one year, then roll over into a new one year
contract that we need to close out after 0.5 years.
To gure out how many contracts we need to long we use backward induction. Note
that the interest rate is zero on the margin account and thus there is no dierence
between the cash ows of forward and futures contracts.
Suppose in one year you long N1 futures that you close out after 0.5 years. The
combined cash ows are
1yr 1.5yr
Unhedged cash ow 0 10000(X S1.5 )
long N1 futures 0 N1 (F1.5,2 F1,2 )100
and exit in 0.5 years

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We know that F1.5,2 = S1.5 e 2 and hence the total hedged cash ow is
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N1 (F1.5,2 F1,2 )100 + 10000(X S1.5 ) = 10000X 100N1 F1,2 + 100S1.5(N1 e 2 100)
 
 

known at date 1 unknown at date 1

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To cancel the unknown cash ow we need to choose N1 = 100e 2 = 101 and thus the

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hedged cash ow is

1yr 1.5yr
hedged cash ow 0 10000X 10100F1,2

The interest rate is zero and thus

1yr 1.5yr
hedged cash ow 10000X 10100F1,2 0

We know that F1,2 = S1 e and thus we can hedge this cash ow by entering into
N0 = 101e = 99 today. Specifcally,

today 1yr
Unhedged cash ow 0 10000X 10100F1,2
long N0 = 99 futures 0 99(S1 F0,1 )100
total 10000X 9900F0,1 .

This cash ow is known at date zero.

To summarize, to hedge the 10,000 issued structured notes the bank needs to

long 99 futures today and

long 101 futures in one year.

Solution to Question 6
Lets check rst whether the call option is under priced relative to the put and the
forward contract.
Suppose the call is under priced. In this case we would (i) buy the call, (ii) sell the
put, and short futures:
today in 6mth
buy call 11.01 max(S6mth 88, 0)
sell put 8.82 max(88 S6mth , 0)
short futures 0 90 S6mth
total 2.19 2
We are eectively investing at a negative interest rate and hence there is no arbitrage.
Lets check whether the call option is overpriced relative to the put and the forward
contract.
Suppose the call is overpriced. In this case we would (i) sell the call, (ii) buy the put,
and long futures:

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 today in 6mth
sell call 10.77 max(S6mth 88, 0)
buy put 9.18 max(88 S6mth , 0)
long futures 0 S1 90
total 1.59 2
We are eectively borrowing at an interest rate of r = ln(2/1.59) = 4.58% which is
larger than the 1% borrowing rate and thus there is no arbitrage.
Hence, all prices preclude any arbitrage opportunities.

Solution to Question 7

a) FALSE: A put option is a portfolio consisting of a short position in the underlying

and cash and hence if the risk premium of the underlying is positive, then the risk
premium of the put option is negative.
b) TRUE: A call option is a portfolio consisting of a long position in the underlying
and a short position in cash and thus the risk premium of any call is positive. You
take on more risk (more leverage) with an out-of-the money call, then with an in-the-
money call and hence the risk premium of an out-of-the money call exceeds the risk
premium of an in-the-money call.
c) TRUE: Every delta neutral portfolio is insensitive to changes in the stock price
and thus the risk premium of a delta neutral Strangle is zero.

Solution to Question 8

a) The net premium that you receive in December from writing 2 calls with strike
$600 and buying one call with strike $570 is

2 $19 $35.55 = $2.45.

b) Let SJan denote the price of Google stock on January 15.

If SJan > $600, then all calls are exercised and your cash ow in January is

SJan $570 2 (SJan $600) = $630 SJan .

If $570 < SJan $600, then only the call you bought is exercised and your cash ow
in January is
SJan $570.
If SJan $570, then neither option is exercised and your cash ow in January is 0.

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