The yields of riskless zero-coupon bonds are shown below: 1 – 3.15%, 2 – 3.70%, 3 – 4.

10% •(20 points) The stock of company X currently costs $100. In one year, the stock will either move up 10%
3Y 8% coupon bond trading with YTM 3.5% at 80/1.035 + 80/1.035^2 etc. should be trading at zero coupon yields or down 8%, with equal likelihood. Similarly, in year 2, the stock will either move up 10% or down 8%, with
Arbitrage opp: equal likelihood. The risk-free annual rate is 2%. What is the price of a European call on company X stock
with a strike price of $95 and a maturity of two years?

Bonds Find Value of Call at T=1 in up scenario.

121a + 1.02b = 26
101.2a + 1.02b = 6.2
A = 1, B=-93.14
Stocks A and B have standard deviations of 20% and 10%, respectively. Their correlations with the market P1U = 110*1-93.14 = $16.86
portfolio are 0.6 and 0.3. The market portfolio has a standard deviation of 15%. Find Value of Call at T=1 in down scenario.
a)(10 points) What are the betas of A and B? 101.2a + 1.02b = 6.2
Solution: 84.64a + 1.02b = 0
BetaA = cov (rA, rM) / var (rM) = corr(rA, rM) std(rA) std (rM) / var (rM) A = 0.37, B=-31.07
= corr(rA, rM) std(rA) /std (rM) = 0.6 x 20% / 15% = 0.8 P1D = 92*0.37-31.07 = $3.38
BetaB = cov (rB, rM) / var (rM) = corr(rB, rM) std(rB) std (rM) / var (rM) Find Value of Call at T=0
•corr(rB, rM) std(rB) /std (rM) = 0.3 x 10% / 15% = 0.2 110a + 1.02b = 16.86
(10 points) The risk-free rate of return is 2%, and the expected rates of return of A and B are respectively
Call Option
92a + 1.02b = 3.38
6.8% and 3.2%. In a graph of betas (horizontal axis) against expected returns (vertical axis), plot the A = 0.75, B=-64.27
security market line (SML) and find the expected return of the market portfolio. P0 = 100*0.75-64.27= $10.66
The market risk premium is the slope of the line:
rM - rf = (rA – rB) / (BetaA - BetaB) = (6.8% - 3.2%) / (0.8-0.2) = 6% A knock-out option is one that becomes worthless if the price of the underlying instrument ever goes above
Hence, by CAPM: the knock-out price K. Assume the call from Part 1 of this question has a knock-out price of $120. How do
rf = rA - BetaA (rM - rf ) = 2%
Stocks the payoffs of the call in two years change from the plain vanilla call?
rM = 2% + 6% = 8% Answer: Now, in the UP, UP scenario, the call becomes worthless (because the stock price goes above
$120). So the payouts look like this:
You manage a pension fund and your liabilities consist of two payments as follows:
What is the price of the knock-out call option at time = 0? Answer:
Your assets are equal to $100 million and the term structure of interest rates is flat at 5.0%.
Find Value of Call at T=1 in up scenario.
(10 points) Use duration to determine what happens to the present value of your liabilities when interest
121a + 1.02b = 0
rates increase by 0.20%?
101.2a + 1.02b = 6.2
Answer:
Time (years) Payment A = -0.31, B=37.15
PV of liabilities = 64.13
10 $40 million P1U = 110*-0.31+37.15 = $2.70
Using the duration formula we get: D = 16.17
Find Value of Call at T=1 in down scenario.
Using the formula that links D with MD we get: MD = 15.40 20 $105 million 101.2a + 1.02b = 6.2
ΔΒ = - ΜD*B* y = -1.98M
84.64a + 1.02b = 0
(10 points) Suppose that you invest your $100m of assets in 1-year Treasury bills (1 year zero coupon bonds) and in
A = 0.37, B=-37.01
a Treasury bond with a modified duration (MD) of 20. (Recall that MD = D /(1+y), where D denotes duration and y
P1D = 92*0.37-37.01 = $3.38
denotes the yield). How would you allocate your assets to avoid interest rate risk and a duration mismatch between
Find Value of Call at T=0
assets and liabilities?
110a + 1.02b = 2.70 KO Call Option
MD of 1-year t-bill = 0.95
92a + 1.02b = 3.38
MDA*PVA = MDL*PVL Duration A = -0.04, B=6.69
x*0.95*100 + (1-x)*20*100 = 15.40*64.13 => x=0.5314
P0 = 100*-0.04+6.69 = $2.94
53.14% in 1-year t-bill and 1-53.14% in bond
A new investment, Sloan Startups, becomes available with expected returns of 16%, standard deviation of returns of
25%, and a market beta of 1.8. This risk-free rate is 3% and the market risk premium is 8%. Standard deviation of
Suppose we have a 3-year Treasury bond with a face value of $100, a coupon rate of 2.5%, and a yield to
returns on the market portfolio is 12%.
maturity of 4.0%. The coupons are paid in annual installments. There are also zero-coupon bonds traded
(10 points) Is the expected return of Sloan Startups above, below, or equal to the CAPM prediction for its
with yields given in the table below.
expected return?
•(10 points) Is the price of the 3-year Treasury bond consistent with the prices of the Treasury zero-coupon
Answer: Below. According to the CAPM: 3% + 1.8*8% = 17.4%
bonds?
Bonds M Yield (10 points) For the CAPM to hold, would the price of Sloan Startups have to increase or decrease? What impact
Solution:
would this have on Sloan Startups expected future return? Answer: Price would have to decrease, increasing expected
(10 points) The price of Treasury note using its yield to maturity is: 1 2.9% return until it reaches 17.4%
PTn = 2.5 /(1 + 0.04) + 2.5 / (1 + 0.04)2 + 102.5 / (1 + 0.04)3 = $95.84. 2 3.5% (10 points) Assuming Sloan Startups’ expected return remains 16%, find the expected return and standard deviation
The price of the same cash flow replicated by the zero-coupon is: 3 5.0%
2 3 for a portfolio with 25% weight in Sloan Startups and 75% weight in the market portfolio.
PS = 2.5 / (1 + 0.029) + 2.5 / (1 + 0.035) + 102.5/ (1 + 0.050) = $93.31.
Expected Return: 25% * 16% + 75% * (3% + 6%) = 11.5%
•(15 points) If the prices were not consistent, provide an arbitrage strategy to benefit from this CAPM
Standard Deviation: square root of [(25%^2 * 25%^2) + (75%^2 * 12%^2) +
inconsistency. What precise positions would you take? Show your calculations and reasoning.
2*25%*75%*(1.8*12%^2)] = 14.7%
Solution:
(10 points) What is the idiosyncratic volatility of SloanStartups? What should be a fair compensation for bearing
(15 points) The 3-year Treasury note is overpriced in the market. Selling the overpriced asset and buying
this volatility according to the CAPM?
the underpriced asset makes a profit. A short position in one unit of the T-bond gives $95.84 today.
Idiosyncratic volatility = 25%^2 – 1.8^2*12%^2 = 0.01584. We can express it in percentage terms
Replicating the cash flow of the Treasury bond using zero coupon costs $93.31 today. Shorting the
(standard deviation) by taking square root of 0.01584, which gives us 12.6%.
Treasury bond and buying the zero-coupon bonds (in the amount of 2.5, 2.5, and 102.5) leads to a profit of
Out of 25% total standard deviation of returns on SloanStartups, 12.6% is idiosyncratic. According to the
$2.53. By scaling the positions one can obtain any amount of profit today, without any cost in the future.
CAPM, investors would not require compensation for bearing idiosyncratic risk.
 Firm ABC just announced some earnings of $2.50/share. The management also announced an aggressive Your friend Chris has just been accepted at MIT Sloan and asks you for some financial assistance in obtaining his
growth plan: starting from today (end of period 0) and until the end of year 1, it will reinvest all earnings into MBA. He would like to borrow $70,000 in each of the two years of the program (the first payout would be right
the company. After year 1, the company will start paying out 50% of its earnings as dividends, and is now, and the second would be one year from now). At the end of the second year, Chris is confident that he will
expected to maintain this policy forever (so, the first dividend payout will take place at the end of period 2). receive a signing bonus of at least $25,000 which he will turn over to you. Starting at the end of the third year, Chris
Last year’s return on equity (ROE) was 12%. Assume that the market is expecting a ROE of 20% during thinks he can afford to pay you 10% of his salary for the first 5 years that he is working (he would make these 5
the growth phase (so, for period 1) and an ROE of 12% thereafter (once the new dividend policy kicks in). payments at the end of each year). He expects his salary to rise at a rate of 5% per year. You have access to a bank
Also, assume a constant discount rate of 12%. account that yields 4% interest annually. What must Chris' starting salary be in order for you to be willing to make
What should be ABC’s stock price today? Stock him this loan?
The price is the PV of the expected future dividends. The stock price should be $25.0 Annuity
S = 252.012 K or $252,012 per year
NOW = end of period 0
0 1 2
Stock Alpha-beta is currently trading at $95. In one year, the stock price will either move up to $110, or
ROE 12% 20% 12%
down to $80, with equal likelihood. The risk-free annual rate is 5%.
Earnings 2.5 4.666666667 3.36
•(10 points) What should a European call on stock Alpha-beta with strike price $100 and one year
BV bop 20.83333333 23.33333333 28
maturity be priced at?
BV eop 23.33333333 28 29.68
Answer:
Payout ratio 0 0 50%
Set up the equation system and solve to the right
Dividend 0 0 1.68
Constant growth rate (ROE x b) 6.00%
(10 points) What should a European put with strike Option
price $100 and one year maturity be priced at? (down)
Discount rate 12%
Value of constant growth perpetuity from year 3 onwards 29.68
Value of dividends + perpetuity at T=2 31.36 Suppose you see the European call option currently trading for $5.
PV of future dividends 0 25 Define an arbitrage strategy using 100 call options which yields an
25 immediate profit today. List the assets used, whether you buy or sell
You can invest in the following 3 assets: them, and the quantity of each (does not need to be round numbers;
Asset E[r] Std Dev Corr A B C fractions may be traded). You do not need to state the amount of profit
yielded today. (answer to the left)
A 15% 25% A 1 .75 .25
Mr. Efficient holds a portfolio that lies on the Capital Market Line (CML). The expected return of his portfolio is
B 20% 10% B .75 1 .5 16.5% and its Sharpe ratio is 0.9.
(5 points) Assume Mr. Efficient’s portfolio has an expected standard deviation of 15%. What is the risk-free rate?
Answer: The Sharpe ratio of Mr. Efficient’s portfolio is 0.9, so → (Rp – Rf) / σp = 0.9 → Rp – Rf = 0.9 *15% → Rp –
C 25% 20% C .25 .5 1 Rf = 13.5% → Rf = 3%.
(5 points) Another portfolio has an expected return of 11% and a standard deviation of 10%. Could this be the
Find the portfolio return and standard deviation for the following 3 portfolios: tangency portfolio? Why or why not?
wA wB wC Answer: The tangency portfolio must have the same Sharpe ratio as Mr. E’s portfolio, since they both lie on the
Portfolio X: E[r] = .25*15% + .75 * 20% = 18.75%
Portfolio X .25 .75 0 CML. The Sharpe ratio of the given portfolio is (11%-3%)/10%, which is LESS than 0.9. That portfolio is therefore
Portfolio Y .5 0 .5 inefficient (lies below the CML) and cannot be the tangency portfolio.
Portfolio (10 points) Assume that the tangency portfolio has indeed a standard deviation of 10%. What is the weight of the
Portfolio Z .25 .25 .5
tangency portfolio in Mr. Efficient’s portfolio? What is the weight of the risk-free asset?
Std dev x = √(. 25)2 ∗ (. 25)2 + (. 75)2 ∗ (. 1)2 + 2 ∗ .25 ∗ .75 ∗ (. 75 ∗ .25 ∗ .1) = .1287 = 12.87% Answer: The tangency portfolio has a Sharpe ratio of 0.9, so we can calculate its expected return: Portfolio
Portfolio Y: E[r] = .5*15% + .5*25% = 20% ( Rp – Rf ) / σp = 0.9 → Rp – Rf = 0.9 * 10% → Rp = 12%.
Mr. E’s portfolio is a combination of the tangency portfolio and the risk-free asset (since it lies on the CML). If w1
= √(. 5)2 ∗ (. 25)2 + (. 5)2 ∗ (. 2)2 + 2 ∗ .5 ∗ .5 ∗ (. 25 ∗ .25 ∗ .2) = .1785 = 17.85% is the weight of the tangency portfolio, then the weight of the risk-free asset must be (1-w1), and Mr. E’s exp. return
Portfolio Z: E[r] = .25 * 15% + .25 * 20% + .5*25% = 21.25% (16.5%) is equal to w1 * 12% + (1-w1) * 3%. Solving the equation, we get:
√(. 25)2 ∗ (. 25)2 + (. 25)2 ∗ (. 1)2 + (. 5)2 ∗ (. 2)2 + 2 ∗ .25 ∗ .25 ∗ (. 75 ∗ .25 ∗ .1) + 2 ∗ .25 ∗ .5 ∗ (. 25 ∗ .25 w1 = 150% and w2 = - 50%
∗ .2) + 2 ∗ .25 ∗ .5 ∗ (. 5 ∗ .1 ∗ .2) = .15 = 15%
The yield curve for zero-coupon US treasuries is as follows:
Suppose an investor has a utility function defined by: = U = A+ .5 ∗ E [ r ] − 2 ∗ sigma
Maturity (years) Yield (%)
Of these three, which portfolio would he or she choose? Why?
Utility Portfolio X:= + .5 ∗ 18.75 − 2 ∗ 12.87 = − 16.365 1 1.75%
Utility Portfolio Y:= + .5 ∗ 20 − 2 ∗ 17.85 = − 25.7 2 2.00%
Utility Portfolio Z:= + .5 ∗ 21.25 − 2 ∗ 15 = − 19.375 3 2.25%
Of only those 3 portfolios, the investor would prefer Portfolio X because their utility is highest (because they 4 2.35%
weight the increased risk more heavily than the increased return) (a) (15 points) According to the expectations hypothesis, what do markets expect the oneyear
Can the investor use the three assets to construct a better portfolio than the portfolios X, Y, or Z? Why or why not? yield-to-maturity to be one year from now? Answer above
(You do not need to calculate the actual portfolio weights to answer this question.) (15 points) According to the expectations hypothesis, what is the YTM
Answer: yes, because adding more assets that are not perfectly correlated can give you an equal return with less risk expected return of the two-year zero coupon bond over the next year?
Easy way: All bonds have same expected return, so 1.75% (15 points)
The risk-free rate for the next year is 2%. Everyone agrees that, for the next year, there are two potential investments What is the price today of a US treasury bond with face value $1000
with the following market betas and expected returns. that pays 2.0% annual coupons and matures in 3 years, assuming there
Investment 𝛽 𝐸(𝑟) is no arbitrage? $993 (15) What is the return for the coupon bond in
Stock A 1.4 12%
CAPM
part (c) over the next year if the yield curve one year from now is the
Stock B 0.8 ? same as the yield curve today (e.g. one year from now, zero coupon
If the CAPM is true, what must the expected return be for Stock B? Read answer right to left bonds with one year to maturity will have a 1.75% YTM 2.72%
 Consistent with their motto “a healthy body, a healthy mind,” the Coop Bookstore is contemplating
The beta of Fuzzy Wuzzy Toys Inc., an all-equity-financed corporation, is 1.5. If the expected risk premium of the
expanding their product line to include frozen health food. This will be a 5 -year project ending 12/31/2019,
market is 6 percent, and the Treasury bill rate is 1 percent, what is the company's cost of capital? Be sure to state all
after which time the Coop will move to another location. The Coop will need to install freezers for $50,000,
which the Coop will pay for today (12/31/2014; t=0). These will be operational and stocked with food on assumptions explicitly Assuming that the CAPM holds (frictionless markets, mean-variance optimizers, etc.), the cost
January 1, 2015. The Coop forecasts that no investment in working capital is needed. The value of the of capital is Rf + β(Market Risk Premium) = 1% + 1.5×6% = 10%
freezers will be depreciated over the course of 5 years on a straight-line basis from $50,000 to $20,000,
The current price of a non-dividend paying stock is $800 and the risk-free interest rate is 5%. A one-year European
which is their salvage value. At the end of the project, the freezers will be sold for their salvage value. For
call on the stock with a strike price of $815 costs $75 and a put with the same strike price and maturity costs $45.
the duration of the project, the Coop anticipates annual project revenues and expenses of $25,000 and
(15 points) Explain how to use the call and put options and the stock to construct a risk-free payoff. What’s the payoff
$8,000, respectively (assume the Coop only accepts cash and all the cash flows occur at the end of each
year). The corporate income tax rate is 35% and the project’s cost of capital is 15%. Assume that the at maturity? Go long one put and one stock and short one call. This gives a risk-free payoff of $815 at maturity.
capital gains on asset dispositions (i.e., when freezers are sold) are not taxed. (35 points) Calculate the
Is there an arbitrage opportunity? If so, please describe specifically how you could profit from the arbitrage
cash flows for years 0-5, then compute the net present value. DCF opportunity.Solution: There is an arbitrage. Put-call parity suggests that P0 + S0 = C0 + K / (1 + r)
Year 0 1 2 3 4 5
P0 + S0 - C0 = K /(1 + r)

implying the project earns less than 0.

$5,000 NPV acknowledges value destruction,
Coop not invest in the project. The project’s negative
the Coop embark on this expansion? I recommend the
(a) should be different from this]. Do you recommend
to be negative $5,000 [hint: the NPV answer in part
(5 points) Suppose you computed the project’s NPV
Revenue $25,000.0 $25,000.0 $25,000.0 $25,000.0 $25,000.0 Plugging in the prices, we have Options Arbitrage
Expense ($8,000.0) ($8,000.0) ($8,000.0) ($8,000.0) ($8,000.0) P0 + S0 - C0 = 45 + 800 – 75 = $770 < 815/1.05 = K/(1 + r)
Dep Exp ($6,000.0) ($6,000.0) ($6,000.0) ($6,000.0) ($6,000.0) So put-call parity fails. To construct an arbitrage, we should buy low and sell high JJ
Op Inc (pre-‐tax) $11,000.0 $11,000.0 $11,000.0 $11,000.0 $11,000.0 Specifically, at time 0, we should: 1. Borrow $770 at 5% 2. Long 1 stock 3. Long 1 put 4. Short 1
Taxes @ 35% ($3,850.0) ($3,850.0) ($3,850.0) ($3,850.0) ($3,850.0) call
Op Inc (after-‐tax) $7,150.0 $7,150.0 $7,150.0 $7,150.0 $7,150.0
Company ABC expects earnings of $2 per share next year. Its return on equity (ROE) is 15% and its payout ratio is
Add: Non-‐Cash DepExp $6,000.0 $6,000.0 $6,000.0 $6,000.0 $6,000.0 60%. The company's current book value per share is $100. Assume that the cost of capital is 10%.
Add: Sale of Freezers $20,000.0
(15 points) What is the stock price of company ABC?
Cash flow ($50,000.0) $13,150.0 $13,150.0 $13,150.0 $13,150.0 $33,150.0
Solution: The growth rate g of the company can be computed from: g = (ROE) x (1 - p) = 15% x 40% = 6%.
Disc Factor at r=15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972 The dividend next year is D1 = 2 x 60% = $1.2. Then, from the Gordon growth formula:
PV CF ($50,000.0) $11,434.8 $9,943.3 $8,646.3 $7,518.6 $16,481.4 V = D1 / (r - g) = $1.2 / (10% - 6%) = $1.2 / 4% = $30.
NPV $4,024.4 (15 points) How much of stock ABC's value is attributable to the present value of its growth opportunities (PVGO)?
Solution: The PVGO is defined by the difference between the price of the stock and the value of one share if there is
Dep Exp: $6,000.0 no growth in any subsequent period. In this simple case, the value of one share without growth (p = 100%) is E 1/r.
Beg $50,000.0 Therefore,PVGO= V - E1/r = $30 - $2 / 0.1 = $10.
RUL 5years
NiceCraft is a local furniture manufacturer and it plans to expand its business by selling its products to
Salvage $20,000.0
customers who live further away. NiceCraft faces a tax rate of 34% and a cost of capital of 10%. With local
Stock $25 today -> 1mo: $32 and $19. Risk-free bonds face value of $100 and a price today customers only, its expected pre-tax profit is $1 million per year forever. The company plans to distribute all
of $99.90. Find the no-arbitrage price of a call option expiring in one month strike $27. Left profits to shareholders. What is the current market value of NiceCraft?
If the call option trades at the no-arbitrage price you found in (a), what is its average return After-tax profit per year is (1 – 0.34) * 1 = 0.66 million. The perpetuity formula gives the market value: 0.66 / 10% =
over the next month? 7.99 Sell 1000 call options arbitrage – use a and b? Down 6.6 million. NiceCraft can build an outlet to increase sales to far away customers. The building cost is $1.5 million.
Option The expected pre-tax profit from increased sales is another $1 million per year forever. NiceCraft's new outlet could be
depreciated linearly to $0 over 3 years. Should NiceCraft carry out this expansion? Explain. We should consider the
incremental cash flows. The PV of the tax shield is:
0.34 (1.5/3) / (1 + 10%) + 0.34 (1.5/3) / (1 + 10%) 2 + 0.34 (1.5/3) / (1 + 10%)3 = 0.423 million. Tax
After graduating from MIT and securing a lucrative job, you are assessing an all-equity financed U.S. stock named The PV of incremental after-tax profit is: (1 - 0.34) * 1 / 10% = 6. 6 million
IronWorks for possible investment. You have determined the amount and timing of the cash flows for the business. The NPV of incremental CFs is therefore: 6.6 + 0. 423 – 1. 5 = 5.52 million > 0 The project should be carried out.
You recall from Finance Theory that all you need now is to discount the cash flows by an appropriate discount rate.
The expected return on the stock market is 9%, the current long-term corporate bond rate is 5%, and the long-term The current price of the stock “Risky World” (RW) is $100. In the next two periods, it follows the binomial
U.S. Treasury rate is 3%. A colleague tells you that the required expected return on IronWorks is 15%. What is the process: 100 -> 150/90 -> 225/135/135/81. The risk-free interest rate is zero. An investment bank offers you an
beta of IronWorks? Market Premium = (expected return on the stock market) – (risk free rate) = 9% - 3% = 6% From insurance contract for each $100 dollar invested in the stock. The insurance pays nothing if you make money on
CAPM: Required Return = rf + β(Market Premium) Rearranging: β = (Req. Rtn – rf ) / (Market Premium) your stock investment over the two periods, and it pays the loss if you lose money. For example, if the stock
Therefore, IronWorks β = (15% – 3% ) / (6%) = 2.0 Beta
value increases to $225, you receive nothing while if the stock value drops to $81, you receive 100-81 = $19.
(10 points) Suppose you are uncertain of your calculation, so you ignore part (a). You decide to check online and Describe the payoff of this insurance policy at the end of two periods. What is the value of this insurance policy?
find IronWorks actually has a beta of 2.5. You are worried because this differs from the beta implied by your In the second period, the payoff of the insurance contract in the “uu”, “ud”, “du”, “dd” nodes are (0; 0; 0; 19)
colleague’s statement of expected return. What is the required return given this beta of 2.5 you found online? respectively. Let’s go back to period 1. In the “up” node, the insurance is worth zero. In the “down” node, the
Market Premium = (expected return on the stock market) – (risk free rate) = 9% - 3% = 6% From CAPM: Required insurance has a positive value. Replicate its payoff with a shares of the stock, and b dollars invested in bonds:
Return = rf + β(Market Premium) Therefore, IronWorks Required Return = 3% + 2.5(6%) = 18% 135a + b = 0
(5 points) Just to add more uncertainty to your analysis, your investment advisor at a large bank tells you that the 81a + b = 19 Options
required expected return for IronWorks is actually closer to 25% (Wow! What an elusive calculation…), which he Therefore, a = -19/54 = - 0.3519 and b =19x135/54= 47.5. The value of the contract is there:
determined using some factor model (perhaps the Fama-French model…). You sit back and try to recall the models Vd = a x S + b = -19/54 x 90 + 47.5 = 15.83.
from the Finance Theory lectures. Briefly discuss the main difference between the CAPM and some factor and why Let’s now go back to period 0. The insurance is worth Vu = 0 in the “up” node and Vd = 15.83 in the “down" node.
your expected return may differ from the investment advisor’s expected return Replicate its payoff with a shares of stock and b in the bond:
The CAPM is a theoretical single factor model derived under some assumptions. The Fama-French model is a multi- 150a + b = 0
factor empirical model consisting of three factors: (1) market factor, (2) size factor [R SMB], and 90a + b = 15.83
(3) value factor [RHML]. The two models may lead to different expected returns if the IronWorks’ returns comove Therefore, a = -0.2638 and b = -150a = 39.575. The value of this insurance contract is:
significantly with the value and size factors. V = a x S + b = - 0.2638x100 + 39.575 = 13.195.
 OPTIONS
• Call: right to buy an asset for a given price Black-Scholes: volatility increases the value of a call option
• Put: right to sell an asset for a given price
• European: Can only exercise on expiration date
• American: Exercise on or before expiration date
• Call payoff is never negative (just don’t exercise)
• Checking Arbitrage Opportunities/Put-Call Parity
• P0+S0=K1+rT+C0

Put-Call Parity
- Synthetically replicating a risk-free return (Euro)
1.First check and see if put-call parity holds, if not something is off (potential arbitrage)
If the put-call parity is violated, you can construct an arbitrage strategy to take 2.Figure out the left side of equation if greater than right, there’s an arbitrage so borrow and you
advantage of it. Note that the put-call parity requires the put and call to have get the difference between the left and right
the same maturity and strike price. The put-call parity relation relies on the
absence of arbitrage, but it does not rely on any particular model, such as the Options True/False:
binomial model or Black-Scholes model. • Selling a call option and a put option on the same stock with the same strike price is essentially making a
bet against price fluctuation. True. If prices do not move very far, then the premiums from selling the
options will leave the seller better off. However, if prices move dramatically, the buyer of the call option
Binomial option pricing model: Suppose that the underlying asset (say a stock) price is S0 ,and can move up to Su or Sd in the next period. We or the put option will profit at the expense of the seller.
saw how to price a call option with the strike price of K or a put option with strike K, using the replication method. Take a call option for
example. It works as follows. Suppose that you buy a shares and put b dollars in the bank account (earning risk-free rate r). You want a and b
such that the portfolio value is equal to the option payoff on the maturity date. That is, The risk-free interest rate is 5%.
Solve a and b from the above equation. By no arbitrage, the call option value today is equal Assume that there is no arbitrage
to the market value of its replicating portfolio, aS0 + b. The procedure for calculating the put and that investors can borrow
option value is similar. and lend at the risk-free rate.
What is the price of an American
call option at date 0 on a share of
WKLS with a strike price of $90
per share that expires on date 2?
Please specify the strategy with
which an investor can replicate
the option with a combination of
the underlying asset and
borrowing or lending
Solution: Begin in year 2. The payoffs from the put option are Puu = 30, Pud = 0 Pdu
=10 and Pdd = 0.
STEP 1 To calculate Cu, construct the replicating portfolio in year 1: buy a shares and
invest b dollars at the risk free rate so that the value of the replicating portfolio in
year 2 coincides with the value of the call option

Because ($100-$90)= $10 < $17.86, early exercise in the upper node in year 1 is not
optimal. Hence, Cu = $17.86

STEP 2 Next, consider the lower node in year 1. Construct the replicating portfolio in
year 1 whose value in year2 coincides with the value of the option:
Note: payoffs for calls are stock – strike The value of the replicating portfolio
Payoff c= max(s-k, 0) Payoff p= max(k-s, 0) is aSd + b = 0.1666 × 50 – 6.3492 =
Ex: for Cuu is Suu -k
$1.98

Ø Option values increase with the volatility of the underlying Early exercise in the lower node is not optimal because the option is out of the
Today's price of three traded call options on the stock BackBay.com, all expiring A stock price is currently $50. It is money. Hence, Cd=$1.98
asset (more chances of a positive payoff). known that at the end of two months it
in one month, are as follows:
Ø The equity of a firm can be viewed as a call option on the will be either $53 or $48. The 2-month
firm’s asset, with a strike price equal to the debt face value. You are considering buying a spread consisting of the following positions: STEP 3. To calculate C0, construct the replicating portfolio in year 0: buy a shares
•Buy 1 call at strike price of $50 risk-free interest rate, not annualized, and invest b dollars at the risk free rate so that the value of the replicating portfolio
Ø Real options. Many business decisions can be viewed as
•Sell (write) 2 calls at strike price of $60 is 1.68%. What is the value of a two- in year 1 coincides with the value of the options in year 1:
options to purchase or dispose of assets. A common form of
real options is a sequence of projects, the NPV of a later •Buy 1 call at strike price of $70. month European call option with a 100 × a + 1.05 × b = 17.86 a = 0.3176⇒50 × a + 1.05 × b = 1.98 b = -13.2381aS0 + b =
project depends on the outcome of earlier projects. We saw strike price of $49? 0.3176*75 - 13.2381 = 10.58
Assume the one-month interest rate is 0%. Answer:
how to calculate the NPV of a project, after taking into S0=$50
account the strategic option to start a second, follow-up 1.What is the dollar investment required to establish the spread? Su=$53 Again, the value of the American option today is the max. between what you get
project. Sd=$48 from exercising it immediately and what you get from postponing the exercise
B0=$1 decision:P0 = max {K − S0, aS0 + b}= max {75 − 90, 10.58}= $10.58 The strategy with
Bu=$1.0168 Subtracting the second equation from the which an investor can replicate the option with a combination of the underlying
Bd=$1.0168
first we get 5a=4, and so a=0.8,b=−37.77. asset and borrowing or lending is as follows. In period 0, buy 0.3176 shares of stock
2.For what stock prices on the maturity date will you be making an overall C0=?
Cu=$4 Buy 0.8 share of stock and sell $37.77 and borrow $13.2381 at a5% interest rate. In period 1, if the stock goes up to $100,
profit? Cd=$0 worth of risk-free bonds. Payoff of this adjust the portfolio to have 0.75 shares of stock and a bank loan of $57.1428; if the
There will be a positive profit for stock prices at portfolio is identical to that of the call. PV stock goes down to $50, adjust to have 0.1666 shares of stock and a bank loan of
option maturity between $53.00 and $67.00 of the call must equal the current cost of $6.3492.
this “replicating portfolio" which
is ($50)(0.8)−$37.77=$2.23