FINANCIAL MODELLING AND

D E R I VAT I V E S
TUTORIAL WEEK 6

1
QUESTION 0
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

2
QUESTION 1
• Financial literacy: Suppose you had $100 in a savings account and the interest
rate was 2% per year. After five years, how much do you think you would have in
the account if you left the money to grow?
A. More than $102
B. Exactly $102
C. Less than $102
D. Impossible to say

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QUESTION 1
• 100 ∗ 1.025 > 102
• The correct answer is: A

4
QUESTION 2
• Financial literacy: Imagine that the interest rate on your savings account was 1%
per year and inflation was 2% per year. After one year, how much would you be
able to buy with the money in this account?
A. More than today
B. Exactly the same
C. Less than today
D. Impossible to say

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QUESTION 2
• If prices increase faster than the value of your savings, you’ll be able to buy less
as time goes on
• The correct answer is: C

6
QUESTION 3
• Financial literacy: Buying a single company's stock usually provides a safer return
than a stock mutual fund.
A. True
B. False
C. Impossible to say

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QUESTION 3
• Combining assets in a portfolio typically reduces the risk because of diversification
• The correct answer is: B

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QUESTION 4
• Which of the following statements is FALSE?
A. In the Black-Scholes model, we need to know the probability of each possible future
stock price to calculate the option price
B. The expected return of a typical stock includes a positive risk premium because
investors are risk-averse.
C. The Black-Scholes formula works for any set of investor risk preferences, including risk-
neutral investors
D. If all market participants were risk neutral, then all financial assets (including options)
would have the same cost of capital – the risk-free rate of interest

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QUESTION 4
• In both the Binomial and Black-Scholes Pricing Models, we do not need to know
the probability of each possible future stock price to calculate the option price.
• “Only five inputs are needed for the Black-Scholes formula: 1) Stock price at
the beginning, 2) strike price, 3) exercise date, 4) risk-free rate and 5)
volatility of the stock.” (Lecture 9, slide 7)
• The correct answer is: A

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QUESTION 5
• Just Say Knope Motivational Books’s stock has a volatility of 25% and a current stock
price of $40 per share. Just Say Knope pays no dividends. The risk-free interest rate is
4%, compounded annually. In the Black-Scholes valuation for a one-year, at-the-money
call option on Just Say Knope stock, 𝑑1 (used for 𝑁(𝑑1 )) is:
A. 0.03
B. 0.13
C. 0.20
D. 0.28

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QUESTION 5
• At-the-money means that S = 𝐾 = 40
𝑆 40
ln 𝑃𝑉 𝐾 𝜎 𝑇 ln 40/1.04 0.25 1
• 𝑑1 = + = + = 0.282
𝜎 𝑇 2 0.25 1 2

• The correct answer is: D

12
QUESTION 6
• Same share: Just Say Knope Motivational Books’s stock has a volatility of 25% and a
current stock price of $40 per share. Just Say Knope pays no dividends. The risk-free
interest rate is 4%, compounded annually. In the Black-Scholes valuation for a one-year,
at-the-money call option on Just Say Knope stock, 𝑑2 (used for 𝑁(𝑑2 )) is (𝑑1 = 0.28):

A. 0.03

B. 0.13

C. 0.20

D. 0.29

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QUESTION 6
• 𝑑2 = 𝑑1 − 𝜎 𝑇
• 𝑑2 = 0.282 − 0.25 1 = 0.032
• The correct answer is: A

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QUESTION 7
• The cumulative standard normal distribution value [N(d1)] for z-values of 0.28 and
0.03 is:
A. z = 0.28: 0.3859; z = 0.03: 0.4840
B. z = 0.28: 0.4841; z = 0.03: 0.3040
C. z = 0.28: 0.5500; z = 0.03: 1.7500
D. z = 0.28: 0.6103; z = 0.03: 0.5120

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QUESTION 7
• 𝑁 𝑑1 = 𝑁 0.28 = 0.6103
• 𝑁 𝑑2 = 𝑁 0.03 = 0.5120
• Note that you could also use Excel
[=norm.dist(0.285,0,1,TRUE)], which gives slightly
more accurate numbers. At the exam, however, you
must be able to use the statistical tables.
• The correct answer is: D

16
QUESTION 8
• Same share: Just Say Knope Motivational Book’s stock has a volatility of 25% and a
current stock price of $40 per share. Just Say Knope pays no dividends. The risk-free
interest rate is 4%. The Black-Scholes valuation for a one-year, at-the-money call option
on Just Say Knope stock is closest to [N(d1)=0.6103; N(d2)=0.5120]:
A. $1.45
B. $3.15
C. $4.72
D. $9.50

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QUESTION 8
• 𝑐 = 𝑆 ∙ 𝑁 𝑑1 − 𝑃𝑉 𝐾 ∙ 𝑁 𝑑2
• 𝑐 = 40 ∙ 0.6103 − 40/1.04 ∙ 0.5120 = $4.72
• The correct answer is: C

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E VA L U AT I O N
• The evaluation of our course is now open (link on Canvas)

• Please take a minute or two to fill it in.

• Please do so now

19
QUESTION 9
• Which of the following statements is FALSE?
A. Because real options allow a decision maker to choose the most attractive alternative
after new information has been learned, the presence of real options adds value to an
investment opportunity
B. To make an investment decision correctly, the value of embedded real options must be
included in the decision-making process
C. A key distinction between a real option and a financial option is that real options, and
the underlying assets on which they are based, are often traded in competitive markets
D. We can compute the value of the real option by comparing the expected profit without
the real option to the value with the option

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QUESTION 9
• A key distinction between a real option and a financial option is that real options,
and the underlying assets on which they are based, are often traded in
competitive markets – This is FALSE
• The correct answer is: C
• Explanation: A key distinction between a real option and a financial option is that
real options, and the underlying assets on which they are based, are not traded in
competitive markets.

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QUESTION 10
• Which of the following statements is FALSE?
A. Real options imply that sometimes you will choose not to invest in a positive-NPV project
because waiting gives a higher NPV
B. You invest today only when the NPV of investing today exceeds the value of the option
of waiting, which from option pricing theory we know to be always positive
C. When you do not have the option to wait, it is optimal to invest in any positive-NPV
project
D. When you have the option of deciding when to invest, it is usually optimal to invest only
when the NPV is positive but close to zero

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QUESTION 10
• When you have the option of deciding when to invest, it is usually optimal to invest
only when the NPV is positive but close to zero – This is FALSE
• The correct answer is: D
• Explanation: When you have the option of deciding when to invest, it is usually
optimal to invest only when the NPV is substantially positive.

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QUESTION 11
• Taggart Transcontinental's stock has a volatility of 30% and a current stock price of $50
per share. Taggart is expected to pay $5 in dividends in half a year. The risk-free
interest rate is 4%, compounded semi-annually. Use the Black-Scholes model to value a
one-year, at-the-money call option on Taggart stock. In this calculation 𝑁(𝑑1 ) is:
A. 0.48
B. 0.61
C. 0.72
D. 0.86

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QUESTION 11
• At-the-money means that 𝐾 = 50
5
• 𝑃𝑉 𝐷𝑖𝑣 = 0.04 = 4.90
1+
2

• 𝑆 𝑥 = 𝑆 − 𝑃𝑉 𝐷𝑖𝑣 = 50 − 4.90 = 45.10

• 𝑁 𝑑1 = 0.475
• The correct answer is: A

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QUESTION 12
• Taggart Transcontinental's stock has a volatility of 30% and a current stock price of $50
per share. Taggart is expected to pay $5 in dividends in half a year. The risk-free
interest rate is 4%, compounded biannually. Use the Black-Scholes model to value a one-
year, at-the-money call option on Taggart stock. 𝑁 𝑑1 = 0.475, 𝑁 𝑑2 = 0.359. The
value of the call option is:
A. $3.50
B. $4.20
C. $5.83
D. $6.53

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QUESTION 12
• At-the-money means that 𝐾 = 50
5
• 𝑃𝑉 𝐷𝑖𝑣 = 0.04 = 4.90
1+
2

• 𝑆 𝑥 = 𝑆 − 𝑃𝑉 𝐷𝑖𝑣 = 50 − 4.90 = 45.10

• The correct answer is: B

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QUESTION 13
• Kinston Industries has come up with a new mountain bike prototype The pilot production and test marketing phase
will last for one year and cost $500,000. If the test-marketing phase is successful (50% chance), then Kinston
Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows
of $400,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the
prototype mountain bike to an overseas competitor for $300,000
• If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual
after-tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston's cost of capital is 10%.
• The NPV of the Kinston Industries Mountain Bike Project is closest to:
A. -$45k
B. $91k
C. $455k
D. $590k

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QUESTION 13
• If marketing successful:
400𝑘
• Build plant: 𝑁𝑃𝑉 = −3𝑚𝑙𝑛 + = $1𝑚𝑙𝑛
0.1

• If marketing unsuccessful:
200𝑘
• Build plant: 𝑁𝑃𝑉 = −3𝑚𝑙𝑛 + = −$1𝑚𝑙𝑛
0.1
• Don’t build (sell prototype): 𝑁𝑃𝑉 = $300𝑘
0.5∗$1𝑚𝑙𝑛+0.5∗$300𝑘
• 𝑁𝑃𝑉 = − 500𝑘 = $90909
1.1

• The correct answer is: B

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QUESTION 14
• Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead
and build their manufacturing plant immediately by investing $3 million immediately. Assuming that the
probability of high or low demand is still 50%, the NPV of the Kinston Industries Mountain Bike Project is
closest to:
• If successful: annual after-tax cash flows of $400,000 in perpetuity. If not successful $200,000 in
perpetuity.
• Kinston's cost of capital is 10%.
A. -$45k
B. $0
C. $91k
D. $590k

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QUESTION 14
400𝑘 200𝑘
• 𝑁𝑃𝑉 = 0.5 ∗ + 0.5 ∗ − 3𝑚𝑙𝑛 = 0
0.1 0.1

• The correct answer is: B

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QUESTION 15
Kinston:
• NPV from pilot production and test marketing: $90909
• NPV from starting production immediately: $0
• What is the value of the option to do pilot production and test marketing?
A. -$90909
B. $0
C. $90909
D. Impossible to say
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QUESTION 15
Kinston:
• Value option: $90909 – 0 = $90909
• The correct answer is: C

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QUESTION 16
Alexander Arms is considering investing in a new munition type, the Iron Fist, that it plans to
sell to the government. This investment will generate a cash flow of $20mln for 10 years.
The discount rate for this investment is 12%. In one year, there is the possibility that the
government commits to Iron Fist purchases for a longer period, which makes the project less
risky and the discount rate then drops to 8%. If this doesn’t happen, the discount rate
becomes 15% What is the value of the project today, and in one year?
A. Today: $107 mln. In one year: $125 mln or $95 mln
B. Today: $107 mln. In one year: $134 mln or $100 mln
C. Today: $113 mln. In one year: $125 mln or $95 mln
D. Today: $113 mln. In one year: $134 mln or $100 mln
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QUESTION 16
𝐶1 1
𝑉0 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 1− 𝑡
𝑟 1+𝑟
Value project today:
20 1
𝑉0 = 1− 10
= 113.00
0.12 1.12
Value project in one year:
20 1
𝑉1 = 1− = 124.94
0.08 1.089
20 1
𝑉1 = 1− = 95.43
0.15 1.159
The correct answer is: C 35
QUESTION 17
Iron Fist Alexander project: Worth $113mln today, and either $124.94mln or
$95.43 mln next year. Now suppose you have the option to wait with producing until
next year. Suppose the investment into the project is $120mln. If the risk-free rate is
5%, what is the net present value of the project?
A. -$7.00 mln
B. $1.01 mln
C. $1.97 mln
D. $3.70 mln

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QUESTION 17
Essentially this boils down to the following real option: V1,u = 124.94
NPV1,u = $5
(since you only invest if the riskiness is low)
V0=113
So, either use risk-neutral probabilities or replicating portfolio
Risk-neutral probabilities: V1,d = $95.43
NPV1,d = $0
113 ∗ 1.05 = 𝜌125 + 1 − 𝜌 95 → 𝜌 = 78.7%
4.94 ∗ 0.787 + 0 ∗ (1 − 0.787)
= $3.70𝑚𝑙𝑛
1.05
The correct answer is: D
Note that the option to wait makes this project have positive NPV. If you had to invest
immediately, the NPV would be 113-120<0
37
QUESTION 18
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

38
QUIZZES
• Don’t forget to take the quiz on Thursday
• 7:00 – 21:00
• Correct answers are shown after 22:00
• Use a decimal point and a comma as thousands separator
• For example: 12,345.67

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