UNIVERSITY OF CAPE TOWN

DEPARTMENT OF FINANCE & TAX

FTX3045S FINANCE IIB

CLASS TEST 2 – 13 OCTOBER 2021

75 MARKS 100 MINUTES

PLEASE READ THE FOLLOWING INSTRUCTIONS CAREFULLY
1. Please do not turn this page over until instructed to do so.
2. Please fill in your personal details on the attendance slip and leave this on your desk
with your student card.
3. Ensure that your name and student number appears on the cover pages of ALL
answer booklets.
4. All cell phones must be switched off for the duration of your examination and
placed with your other possessions out of sight underneath your chair.
5. The duration of this examination paper as indicated includes reading time.
6. The paper comprises of two sections. Section A has multiple choice questions and
Section B has written questions. You must answer all questions.
7. No questions will be answered by the invigilators during the test. Make whatever
assumptions you deem appropriate and clearly state these in your answer.
8. For your written questions, please ensure that you show all workings. No marks
will be awarded unless all workings have been shown.
9. There is no negative marking for the Multiple Choice Questions.
10. For questions requiring Black-Scholes, round up your d1 and d2 to two decimal
places, e.g. 0,0233 should be 0,02 while 0,026 should be 0,03.
This test paper consists of 8 pages, including the cover page, formula sheet and the
cumulative normal distribution table.

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SECTION A: MULTIPLE CHOICE QUESTIONS 20 MARKS

No negative marking (each question is for 4 marks)

1. The price of a four-month BHP Billiton Plc call option with an exercise
price of R260 is R25. The current price of BHP Billiton Plc is R285. The price
of BHP Billiton Plc at expiration is R290. What is the payoff to the call
holder at expiration? (Each contract is for 100 shares of BHP Billiton Plc
stock).
A. R500
B. R1000
C. R3000
D. R1500
E. None of the above

2. The price of a six-month Compagnie Financière Richemont SA put option

with a strike price of R80 is R11. The current price of Compagnie
Financière Richemont SA is R90. The price of Compagnie Financière
Richemont SA at expiration is R70. What is the profit (loss) per share to
the put writer at expiration?
A. Profit per share of R10
B. Loss per share of R1
C. Profit per share of R1
D. Loss per share of R9
E. None of the above

3. The exercise price of a six-month European call option is R48. The risk-
free rate if 3% and the standard deviation is 26%. The current stock price
is R44,46. The stock does not pay dividends. The Black-Scholes Hedge
Ratio (delta) for the put is closest to?
A. -0.24
B. 0,4052

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 C. 0,76
D. -0,5948
E. None of the above

4. Which one of the following statements regarding the value of a call option
is false?
A. A longer time to expiration increases the value of a call option.
B. A higher dividend payout policy decreases the value of a call option.
C. As the volatility of the underlying stock price decreases, the value
of the call option increases.
D. As the interest rate increases, the value of the call option increases.
E. As the exercise price increases, the value of the call option
decreases.

5. Suppose an investor expects a moderate rise in the price of Bamboo Ltd

stock over the next 2 months. She decides to take out a bullish spread
position. She buys one call option contract on Bamboo Ltd stock expiring
in December 2021 with a strike price of R75. The premium quoted for this
call option contract is R8.50. She also writes one call option contract on
Bamboo Ltd stock expiring in December 2021 with a strike price of R80.
The premium quoted on this call option contract is R6. At expiration the
price of share of Bamboo Ltd stock is R79. What is the profit of this bullish
spread at expiration? (Assume each contract is 100 shares of Bamboo Ltd
stock)

A. R150
B. R400
C. R750
D. R250
E. None of the above

End of Section A

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START SECTION B ON A FRESH PAGE

SECTION B: (CONSISTS OF 4 WRITTEN QUESTIONS) 55 MARKS

Question 1 (20 marks)

Consider a call option with an exercise price of R70 whose current price is R68.
Suppose there are two sub-periods of 6-months each and in each sub-period the
stock price can either increase by 25% (u=1,25), or it can decrease by 18%
(d=0,82). Also suppose that the risk-free rate per 6-month sub-period is 5%.
Using the Binomial Option Pricing Model and the Hedge Ratio, H, calculate the
value of the call option (C)?

Question 2 (13 marks)

a) The current stock price of African Rainbow Minerals Ltd is R170. The stock
does not pay dividends. The instantaneous risk-free rate is 6%. The
instantaneous standard deviation of African Rainbow Minerals Ltd is 18%.
You wish to purchase a call option on the stock with an exercise price of
R150 and an expiration date 5 months from now.

Using the Black-Scholes Option Pricing Model, calculate the call option
price?

(8 marks)

b) Using Put-Call Parity, what would the corresponding put option price be?
(5 marks)

Question 3 (10 marks)

Assume that the current stock price of Mondi Ltd is R130 and that the stock does
not pay a dividend. Further assume that the risk-free interest rate is 7% per
annum compounded annually. In addition, assume that a 3-month European put

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option on Mondi Ltd’s stock is currently selling for R15. Assume also that the
exercise price is R140. Further assume that a 3-month European call option on
the same underlying stock with the same maturity and strike price is currently
selling at R20.

Given the information above, assess if Put-Call Parity has been violated and if an
arbitrage opportunity exists? If yes, show you can take advantage of this
mispricing (i.e., what trades to undergo). Also calculate the arbitrage profit that
you can expect to earn.

Question 4 (12 marks)

You are a portfolio manager who makes use of option strategies to meet the
investment objectives of your clients while reducing their risk exposures where
possible. You are provided with the following table:

Underlying Current Price Strike Price Call Price Put Price

Asset (So) (X) (C) (P)
Stock A R120 R100 R10 R7
Stock B R150 R140 R20 R13
Stock C R90 R75 R8 R6

a) One of your clients would like to invest in Stock A. However, she is worried
about its price falling drastically. Which option strategy would you advise
she take out so that she is offered some insurance against stock price
declines? Your answer must include a brief explanation on how this option
strategy is composed.
(2 marks)

b) What is the cost of establishing the strategy you recommended in a)?

(2 marks)

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 c) Another client believes that there will be a significant price change in
Stock B but is uncertain about the direction of the change. What option
strategy would you advise they take out so that they can do well
regardless of whether Stock B makes an extreme upward or downward
movement? Your answer must include a brief explanation on how this
option strategy is composed.

(2 marks)

d) What is the maximum loss on the strategy you recommended in c)?

(2 marks)

e) Suppose one of your clients is writing a call option naked (writing a call
option without an offsetting stock position). They are worried that if the
call is in the money they will have to buy it at a high ST and sell it to the
call option holder at the lower strike price, X. What option strategy could
they have taken out to avoid this? Your answer must include a brief
explanation on how this option strategy is composed.
(2 marks)

f) What would be the cost of establishing the strategy you recommended in

e? You can use the pricing information provided for Stock C.
(2 marks)

End of Section B

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