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This document provides an exam for a derivatives and risk management course. It consists of 5 problems: 1) Calculating stock option prices using Black-Scholes and binomial models and describing hedging strategies. 2) Deriving the pricing function for an exotic derivative using risk-neutral valuation and the Black-Scholes PDE. 3) Defining delta and gamma, and using options to delta- and gamma-neutralize an OTC portfolio. 4) Interpreting parameters in a short rate model and deriving the volatility of a zero-coupon bond price. 5) Indicating whether risk/return statements are true or false.

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120 views3 pages

Oldexam

This document provides an exam for a derivatives and risk management course. It consists of 5 problems: 1) Calculating stock option prices using Black-Scholes and binomial models and describing hedging strategies. 2) Deriving the pricing function for an exotic derivative using risk-neutral valuation and the Black-Scholes PDE. 3) Defining delta and gamma, and using options to delta- and gamma-neutralize an OTC portfolio. 4) Interpreting parameters in a short rate model and deriving the volatility of a zero-coupon bond price. 5) Indicating whether risk/return statements are true or false.

Uploaded by

benchmarking3
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Exam: Derivatives & Risk Management

Elective Master Course in Finance, Fall 2009

Derivatives & Risk Management Written Open Book Examination: January 6, 2010, 09.00-13.00 Aarhus University M. Hinnerich

Arguments should be complete and careful. The exam consists of ve problems. The maximum total score on the exam is 100 points. Should you need cumulative probabilities from the standard normal distribution you can nd them in Hulls book on pages 800-801. Good Luck! 1. Stock Options (Max 25 points) Consider a stock with a current value of 10 kr. The volatility of the stock is 20% per annum and the expected rate of return is 8% per annum. The continuously compounded risk free interest rate is 5% per annum. Consider a European call option with one year left to maturity and a strike price of 9 kr that is written on the stock. (a) Compute the option price assuming that the stock evolves as in the Black-Scholes model. (b) Compute the option price using a two step CRR binomial tree for the development of the stock price. Hint: In a CRR tree u = e t and d = 1/u. (c) What do you think the price of the option would be if you instead used a ve hundred step CRR binomial tree for the development of the stock price? Why? (d) Create a portfolio by investing 8.56 kr into the money market account, buy one call option and short sell one stock. Draw a payo diagram of the portfolio. What is this strategy called? (e) Assume now that you can also trade in two other European call options written on the stock, both with one year left to maturity. One option has a strike price of 10 kr and the other has a strike price of 11 kr. Create a portfolio consisting of one long position in the option with a strike price of 9 kr, one long position in the option with a strike price of 11 kr, and two short positions in the option with a strike price of 10 kr. Draw a payo diagram of the portfolio. What is this strategy called?

2. The Black-Scholes Model (Max 20 points) Take the Black-Scholes model with one risk free asset B and one non-dividend paying stock S as given such that under the risk neutral measure Q dSt = rSt dt + St dWtQ dBt = rBt dt where the parameters r and are positive constants and WtQ is a Wiener process. Consider a derivative with maturity date T and payo function (ST ) = 1 ST
2

(a) Use risk-neutral valuation to show that the theoretical price at time t of the derivative is given by 2 e3( r)(T t) f (t, St ) = . St2 1

Exam: Derivatives & Risk Management

Elective Master Course in Finance, Fall 2009

(b) Conrm that the pricing function provided in exercise (a) satises the Black-Scholes partial dierential equation, including the boundary condition. (c) Calculate the exact composition at time t of the replicating portfolio of the derivative.

3. Greeks & Hedging (Max 20 points) Assume that you are the manager of an OTC portfolio. The portfolio is worth 12 million kr, has a delta of -318 490 and a gamma of 1243. The following traded options, written on a market index, are available: Type Price call 89.23 put 3.61 Delta Gamma 0.632 0.0023 -0.049 0.0006

(a) Provide the denition of delta and gamma and explain what happens with the call price if the market index decreases by 1 unit. (b) Show how to delta-neutralize the OTC-portfolio using (i) only the traded call, (ii) only the traded put. (c) How many of the traded calls and puts should you buy or sell to simultaneously deltaand gamma- neutralize the OTC-portfolio?

4. A Short Rate Model (Max 20 points) Assume that the dynamics of the short rate under the risk-neutral probability measure Q is given by: drt = (k art )dt + dWtQ where a, k and are positive constants and WtQ is a Wiener process. (a) Interpret the parameters a, k and in words. A zero coupon bond that pays out 1 kr at maturity date T has a price at time t, which is given by P (t, T ) = eA(t,T )B(t,T )rt , where A(t, T ) and B(t, T ) are known functions of t and T . In particular B(t, T ) = 1 ea(T t) . a

The dynamics of the bond price under the risk-neutral measure Q can be written as dP (t, T ) = m(t, T )P (t, T )dt + s(t, T )P (t, T )dWtQ (b) Use the Ito formula to show that s(t, T ) = You do not need to derive m(t, T ). 2 1 ea(T t) a

Exam: Derivatives & Risk Management

Elective Master Course in Finance, Fall 2009

(c) What does the result in (b) tell you about the relation between the stochastic movements in the short rate and in the zero coupon bond? (d) Can you estimate a and k from historical data? Motivate your answer.

5. True or False (Max 15 points) For each statement below, please indicate if true or false. Each correct answer yields 3 points. No calculations or motivations are needed for this question. (a) If the implied volatilities are high for deep in- and out-of-the-money calls and low for at-the-money calls, it means that at-the-money-straddles will be overpriced in the BlackScholes model. (b) Suppose that two companies A and B both wish to borrow 100 million kr for 3 years and have been oered the rates shown in the table below. Company Fixed Floating A 3% 6-month LIBOR B 4% 6-month LIBOR+0.5% Assume that company A wants to borrow at a xed interest rate and company B wants to borrow at a oating interest rate linked to the 6-month LIBOR. Due to comparative advantages, both companies can lower their borrowing cost if they do not only take up loans but also enter into an interest rate swap with each other. (c) If the one day 95% Value-at-Risk of a portfolio is 10 million kr, then the probability that the portfolio loss tomorrow will be at most 10 million kr is 5 %. (d) The price of a defaultable zero coupon bond with maturity date T is always smaller than or equal to the price of a corresponding non-defaultable zero coupon bond with maturity date S < T . (e) Let St be the price process of non-dividend paying stock at time t and let Bt be the price process of the risk free money market account. Assume that under the real world probability measure P : dSt = St dt + St dWt , S0 = 10kr dBt = rBt dt, B0 = 1kr where r = 3% and = 30%, while is only known to lie in the interval [5%, 15%]. 2 Consider the square-derivative which at maturity date T = 3 years pays out X = ST kr. Given that the market is free of arbitrage, we have enough information to calculate the unique price of the square derivative.

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