HKUST FINA3203 Spring 2022

School of Business Yicheng Zhu

Midterm Exam Solutions

1 (20 points) Short Questions

(Please briefly explain your answers.)

(i) (5 points) The spot exchange rate between Euros and USD is 1.19 USD per EUR. The
annualized continuously-compounded risk-free interest rates in Euro zone and U.S are
both 0.5%. The three-month forward exchange rate is 1.196 USD per EUR. What is
the implied annualized continuously-compounded convenience yield for USD?

Answer:
(3 points) The forward exchange rate between USD and EUR must satisfy
$
e(rc +c)(T −t)
F (t, T ) = Mt rEU R (T −t) .
ec

(2 points) As a result, the annualized continuously-compounded convenience yield for

USD must satisfy  
1 F (t, T )
c= ln − rc$ + rcEU R
T −t Mt
 
1 1.196
= × ln
1/4 1.19
= 2.01%.

(ii) (5 points) The Hong Kong Monetary Authority promised that the exchange rate be-
tween HKD and USD is fixed at 7.8 HKD per USD. The annualized continuously com-
pounded interest rates US is 1%. What must the interest rate (annualized, continuously-
compounded) be in Hong Kong if HKMA allows for free exchange between the two
currencies?

Answer:
(3 point) The HKMA promised that the exchange rate between HKD and USD is fixed
at 7.8 HKD per USD. As a result, the forward exchange rate must be 7.8 HKD per
USD as well if free exchange between the two currencies is allowed.

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 (1 points) The forward and spot rates must satisfy
HKD
e(rc )(T −t)
F (t, T ) = Mt rU SD (T −t) .
ec
(1 point) As F (t, T ) = Mt , it must be that
rcHKD = rcU SD = 1%.

(iii) (5 points) Explain why investors who want to get exposure to realized volatility
prefers to trade volatility swap instead of strategies involving other assets.

Answer:
Swap contracts provide direct exposure to realized volatility as they use the realized
volatility as underlying. For other assets, since they rely on indirect exposure, there is
chance that
(iv) (5 points) Consider two forward contracts on the same non-dividend-paying financial
asset underlying but different maturities, 6 month and 1 year, respectively. If the
forward prices are the same for the contracts, what is the implication in terms of the
forward interest rate?

Answer:
(2 points) The 6-month and 1-year forward prices satisfy
F (t, t + 1/2) = ST erc,t,t+1/2 ×1/2
F (t, t + 1) = ST erc,t,t+1 ×1 .
(2 point) As F (t, t + 1/2) = F (t, t + 1), it must be that
erc,t,t+1/2 ×1/2 = erc,t,t+1 ×1 .
(1 point) We know the 6-month to 1-year forward rate F (t, t + 1/2, t + 1) satisfy
erc,t,t+1 ×1 = erc,t,t+1/2 ×1/2 eF (t,t+1/2,t+1)×1/2 .
As a result the forward rate from 6 month to 1 year ahead must be 0.

2 (25 points) Commodity Forwards

The spot price of Brent Crude oil is currently 50 USD per barrel. The cost of storing one
barrel of oil for one year is $3, paid when storage starts. The annually-compounded risk-free
rate is 2% per annum. The forward price of Brent Crude oil with 1-year maturity is 55 USD
per barrel.
(i) (8 points) (8 points) What should be the no-arbitrage price of 1-year forward? Is the
market forward price higher or lower than the price implied by absence of arbitrage?

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 Answer: The forward price is given by

F (t, t + 1) = erc (St + Λ) = e0.02×1 (50 + 3) = $54.07 (1)

The market price is $55, thus the market price is higher than the price implied by
absence of arbitrage.
Grading policy: Correct formula for forward price (5 points); Correct forward price (1
point); Correct answer for “over pricing” (2 points).

(ii) (17 points) Design a trading strategy in order to take advantage of the arbitrage op-
portunity. Lay out in detail what assets you need in your portfolio and the cash flow
of your strategy. What is your arbitrage profit? Profit realized either now or 1 year
later should suffice.

Answer: The market forward price is too high. As a result, we short the forward contract
and hedge the risk exposure by the replication portfolio.

Positions Cash flows at t Cash flows at t + 1

Short forward 0 F (St , t, t + 1) − St+1
Long one barrel of oil −St ST
Storage costs −Λ 0
Short bonds St + Λ −erc (St + Λ)
Total 0 F (St , t, t + 1) − erc (St + Λ)

Plug in the numbers, we obtain

(Profit at t + 1) = F (St , t, t + 1) − erc (St + Λ) = $55 − $54.07 = $0.93 (2)

Grading policy: Correct answer (1 point); Clearly show the replicating approach (16
points). It is fine to not write down the whole payoff table, but you have to clearly explain
each position and the corresponding value/payoff.

3 (35 points) Swaps of Stocks

The spot price of stock ABC is traded at $50 per share. Stock ABC pays a constant dividend
yield of 5% per annum, continuously-compounded.
The 1, 2, 3 year zero-coupon bonds with face value $1000 trade at $990.05, $975.31 and
$961.75, respectively.

(i) (6 points) What are the annualized continuously-compounded risk-free rates for 1 year,
2 year and 3 year deposits?

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 Answer: The annual continuously-compounded risk-free rates are
1
rt,t+1 = − ln(990.05/1000) = 1% (3)
1−0
1
rt,t+2 =− ln(975.31/1000) = 1.25% (4)
2−0
1
rt,t+3 =− ln(961.75/1000) = 1.30% (5)
3−0

Grading policy: Use the right formula (5 points). If students forget to convert the
interest rates to “annualized” interest rates, -1 point; Correct answer (1 point).
(ii) (6 points) What are the 1-year, 2-year and 3-year forward prices for one share of ABC?

Answer: The 1-year forward price is given by

F (t, t + 1) = St e(rt,t+1 −d)×1 = 50 × e(1%−5%)×1 = 48.04. (6)

The 1-year forward price is given by

F (t, t + 2) = St e(rt,t+2 −d)×2 = 50 × e(1.25%−5%)×2 = 46.39. (7)

The 3-year forward price is given by

F (t, t + 3) = St e(rt,t+3 −d)×3 = 50 × e(1.3%−5%)×2 = 44.75. (8)

Grading policy: 1 point for each formula; 1 point for each forward price correctly
calculated.
(iii) (8 points) What is the swap price for ABC for a swap contract with maturity 3 years
and one settlement after 1 year, 2 years and 3 years, respectively?

Answer: The Swap price is given by

F (t, t + 1) × Z(t, t + 1) + F (t, t + 2) × Z(t, t + 2) + F (t, t + 3) × Z(t, t + 3)
K=
Z(t, t + 1) + Z(t, t + 2) + Z(t, t + 3)
= 46.40.

Grading policy: Use the right formula (4 points). Calculate the answer correctly (4
points).
(iv) (15 points) Suppose after 1 year, after the first settlement, the spot price of stock
ABC is $52, and 1 and 2 year zero coupon bonds with face value $1000 cost $990.05
and $975.31, respectively. How much can an investor with a long position of the swap
in (iii) get right after the first settlement if he or she tries to close the contract in the
market? Give the answer as a present value and clearly write down your derivation.

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Answer: Obviously, the time t + 1 1-year and 2-year annualized risk free rates are 1%
and 1.25%, continuously-compounded, respectively. In addition, the original swap contract
now becomes a 2-year swap contract.
The time t + 1 1-year and 2-year forward prices are:

F (t + 1, t + 2) = St+1 e(rt+1,t+2 −d)×1 = 52 × e(1%−5%)×1 = 49.96

F (t + 1, t + 3) = St+1 e(rt+1,t+3 −d)×1 = 52 × e(1.25%−5%)×2 = 48.24

The corresponding 2-year swap price is given by

F (t + 1, t + 2) × Z(t + 1, t + 2) + F (t + 1, t + 3) × Z(t + 1, t + 3)
Kt+1 =
Z(t + 1, t + 2) + Z(t + 1, t + 3)
= 49.11.

The value of the contract is now

(Kt+1 − K)(Z(t + 1, t + 2) + Z(t + 1, t + 3))

= 5.31

Grading policy: Correct calculation of the new swap rate (5 points). Correct calculation
of the contract value (10 points). Students also get full marks if they take other routes and
get correct answer.

4 (20 points) Forward Pricing

Consider an asset whose spot price at t is unavailable (i.e., St is unknown). The asset does
not yield any dividends. Financial analysts estimate that the value of the asset after a year
(i.e., at t + 1) can take two values: with 20% probability, the asset value is 50; and with
80% probability, the asset value is 40. Based on the capital asset pricing model (CAPM),
financial analysts also estimate that the expected return of the asset is 5% (annualized and
annually-compounded). The annually-compounded risk-free rate is 2% per annum.

(i) (5 points) What is Et [St+1 ], the time-t expectation of the payoff of the asset at t + 1?

Answer: The expected payoff is

Et [St+1 ] = 0.2 × 50 + 0.8 × 40 = 42. (9)

(ii) (5 points) What is the present value of the asset at t?

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 Answer: The present value is

Et [St+1 ] 42
P Vt (St + 1) = = = 40. (10)
1 + 5% 1.05

(iii) (10 points) Suppose there is a forward market for the asset. What is the theoretical
forward price at time t for maturity t + 1?

Answer: We use the general pricing formula:

F (t, t + 1) = P Vt (St + 1) × (1 + ra ) = 40 × (1 + 2%) = 40.8. (11)