Professor: Subject: Session:

Lorenzo Bretscher Derivatives Spring 2021

Final Exam

Please, read this carefully:

• Time available to solve the exam: 2 hours.

• Additional time granted to upload your solutions: 10 minutes.

• This exam contains in total 9 pages (including the cover sheet) and 3 parts (multiple choice questions,
short questions, and long questions). The total number of points is 100. Points for problems are
awarded for correct answers and clear reasoning. Correct answers obtained through logically false
arguments or no arguments at all will not be awarded full points.

• If you feel that you need to make additional assumptions, please do so and state your
assumptions clearly.d

• Please, upload your solution on MoodleExam as a single pdf file.

• Please, check that the your solutions contain the following information:

– course title and exam date,

– your full name,

– your student ID number,

– signed statement of originality:

I, the undersigned, do hereby confirm that my solutions are original, e.g., I have not used solu-
tions obtained from any other source, including the internet or another person, and I have not
communicated with any other person during the exam.
Part I: Multiple Choice Questions (26 Points)

1. (26 points) Multiple Choice Questions

(1) (2 points) An American call option on a non-dividend-paying stock has the same price as its Eu-
ropean counterpart? The real interest rate is positive.

A. Yes
B. No
C. More information is necessary.

(2) (2 points) Which of the following decreases the cost/price of an American put option?

A. Increase in strike price

B. Increase in current stock price
C. Increase in time to expiration
D. Increase in volatility

(3) (2 points) A firm has debt and equity outstanding. Hence, the total value of the firm equals the
sum of the debt and equity values. Moreover, equity holders have limited liability. Which one of
the following statements is true?
A. Equity is a straddle on firm’s value
B. Debt is a call on firm’s value
C. Equity is a call on firm’s value
D. Debt is risk free
E. Equity return volatility is constant

(4) (2 points) A convertible bond is worth more compared to a non-convertible bond from the same
issuer and identical face value, coupon rates, maturity, and seniority.

A. Always true
B. True only if put-call parity holds
C. Always false
D. True only if the term structure of interest rates is upward sloping
E. True only if the term structure of interest rates is downward sloping

Page 2
(5) (2 points) In a one-period trinomial tree, the stock price can take three possible values in one year
from now: Su > Sm > Sd . The stock price equals Su (Sm and Sd ) with a risk-neutral probability
of qu (qm and qd ). Further, the one year risk-free rate equals 1%. The price of a one year European
put option with strike price K such that Sd < K < Sm , is given by:

qd (K−Sm )
A. 1.01
qu (K−Su )
B. 1.01
qd (Sd −K)
C. 1.01
qd (K−Sd )
D. 1.01 - correct
qu (K−Sd )
E. 1.01

(6) (4 points) Consider a one-period model. At day 0, it is known that there are 2 possible states at
day 1. Two securities are freely traded. The first security has the day 1 payoff vector X1 = (10; 8),
while the second security has the day 1 payoff vector X2 = (20; 12). The day 0 price of the first
security is 6.7, while the day 0 price of the second security is 12.8. What is the day 0 price of the
risk-free bond, which pays 1 in each state at day 1?

A. 0.90
B. 0.91
C. 0.70
D. 3.50
E. 5.30

(7) (2 points) The assumptions for the Black-Scholes model hold. Suppose you have a one year Euro-
pean call option on a stock. There are no dividends. The risk-free interest rate is 0%. The stock
price is $100 and the option is at the money. The standard deviation of stock returns is 10% p.a.
The price of the call is closest to

A. 10
B. 8
C. 4
D. 5
E. 6

(8) (2 points) Which of the following represents the Delta of a European call on a non-dividend paying
stock with a strike of 50 USD, when the volatility is 30% per annum and the risk-free rate is 3%?

Page 3
 A
(9) (2 points) Which of the following statements is most likely to be true?

A. the risk-neutral probabilities of bad aggregate states are higher than the corresponding physical
probabilities and interest rates are always lower in bad aggregate states
B. the risk-neutral probabilities of good aggregate states are higher than the corresponding physical
probabilities
C. the risk-neutral probabilities of bad aggregate states are higher than the corresponding physical
probabilities and interest rates are always higher in bad aggregate states
D. the risk-neutral probabilities of bad aggregate states are higher than the corre-
sponding physical probabilities
E. the risk-neutral probabilities of bad aggregate states are lower than the corresponding physical
probabilities

(10) (2 points) Consider the following binomial model for a stock price

S(i, j) denotes the value of a non-dividend paying stock in node (i, j). Denote the value of an

Page 4
 American-style option on the stock in node (i, j) by V (i, j) and the early exercise payoff in node
(i, j) via P (i, j). q denotes the risk-neutral probability of moving up in the tree. The one-period
zero coupon discount factor is e−r∆t . Only some of the following equations are true:

1. V (i, j) = e−r∆t [qV (i, j + 1) + (1 − q)V (i + 1, j + 1)]

! "
2. V (i, j) = max P (i, j), e−r∆t [qV (i, j + 1) + (1 − q)V (i + 1, j + 1)]
3. S(i, j) = e−r∆t [qS(i, j + 1) + (1 − q)S(i + 1, j + 1)]
! "
4. V (i; j) = max P (i, j), e−r∆t [qV (i + 1, j + 1) + (1 − q)V (i + 1, j + 1)]
5. S(i, j) = e−r∆t [qS(i + 1, j + 1) + (1 − q)S(i + 1, j + 1)]

Which of the following statements is true if there is no arbitrage:

A. 2 & 5 are true
B. 2 & 3 are true
C. 1 & 5 are true
D. 1, 2 & 5 are true
E. 1, 3 & 4 are true

(11) (2 points) What is the date-t delta of the European derivative whose payoffs are as follows: ST − K
when ST > K and K − ST when ST < K?
A. 2N (d1 )
B. 2N (d1 ) − 1 - correct
C. 2N ′ (d1 )
D. 0
E. N (d1 ) + N (−d1 )

(12) (2 points) On the expiration date of a futures contract, the price of the contract
A. always equals the purchase price of the contract
B. always equals the average price over the life of the contract
C. always equals the price of the underlying asset
D. always equals the average of the purchase price and the price of underlying asset
E. cannot be determined

Page 5
 Part II: Short Questions (20 Points)

2. (20 points) Short Questions

(a) (14 points) In recent years, many companies have started writing put options on their own stocks.
This is also true in the case of the company ABC. The firm’s total asset value equals $100,000.
Moreover, its capital structure is composed of 2000 common shares outstanding and 1000 2-year
European put options written by the company.At maturity, the holder of each put option has the
right to sell a share of ABC to the company for $50 each. Assume, that before selling the share to
ABC, the put option holders will be able to buy the ABC share in the open market at the current
market price. Further, in the following two years, ABC’s asset valuation will evolve according to a
binomial tree. That is, the asset value will either increase or decrease by 20%. Finally, the risk-free
interest rate (simple, annualized) is 10% and ABC will not pay any dividend.

What is the current market value of one put option?

Solution:
r−d
The parameters: u = 1.2, d = 0.8, r = 1.1, p = u−d = 0.75. Construct the binomial tree of asset
value: 100000, (120000,80000), (144000,96000,64000). The stock market rationally expects the put-
144,000
holders to exercise at nodes ud and dd, but not at node uu. So each stock is worth: Suu = 2,000 =
96,000−50,000 64,000−50,000
72Sud = 2,000−1,000 = 46Sdd = 2,000−1,000 = 14 Stock tree: 48.4505, (59.5455, 34.5455), (72, 46, 14)
total put value = 100, 000 − 48.4505 ∗ 2000 = 3099.09 So each put is worth $3.099 and each stock
is worth $48.4505.

458.107J

Page 6
(b) (6 points) The following one-period binomial stock price model was used to calculate the price of
a one-year 10-strike call option on the stock.

12
↗
10
↘
8

You are given:

• The period is one year.

• The true probability of an up-move is 0.75.
• The stock pays no dividends.
• The price of the one-year 10-strike call is $1.13.

Upon review, the analyst realizes that there was an error in the model construction and that Sd,
the value of the stock on a down-move, should have been 6 rather than 8. The true probability of
an up-move does not change in the new model, and all other assumptions were correct.

What is the actual price of the call option?

Solution:
The time t = 0 price of the call option is
# $
er − 0.8 1 − 0.8e−r
C0 = e−r [q × Cu + (1 − q) × Cd ] = e−r × 2 + (1 − q) × 0 =
1.2 − 0.8 0.2
1−0.8e−r
Setting 0.2 = 1.13 we get e−r = 0.9675 (or a c.c. rate r = 3.3%)

If Sd = 6,then d = 0.6, and

# $
−r er − 0.6 1 − 0.6 × 0.9675
C0 = e × 2 + (1 − q) × 0 = = 1.398
1.2 − 0.6 0.3

Page 7
 Part III: Long Questions (54 Points)

3. (34 points) You are working on a structured products desk. A salesperson would like you to quote a
price on a product called “straddle”, where the underlying is the S&P 500 Index. Denote the day t level
of the S&P 500 Index by St . The straddle pays FT USD at the expiry date T , where:
%
&
'1000 × max(ST − K, 0) ST ≥ K
FT = 0 ST = K
&
(
1000 × max(K − ST , 0) ST < K

Assume the evolution of the S&P 500 under the risk-neutral probability measure Q is given by

dSt
St = (r − q)dt + σdZtQ

where r is the risk-free rate, q is the dividend yield, σ is the volatility per unit time of returns on the
S&P 500, and Z Q is a standard Brownian motion under Q.

The current level of the S&P 500 Index is 2’114 and the dividend yield is 2% per annum. The implied
volatility for a 3 month European at-the-money put on the S&P 500 Index is 16% per annum and the
risk-free rate is 2.96% per annum.

(a) (4 points) Find the Black-Scholes price of the straddle with K = 2’114, which expires in 3 months
from now.
Solution:
Straddle is just a put plus a call.
r−q
√ √
d1 = σ T − t + 12 σ T − t
0.0096
) )
= 0.16 3/12 + 12 0.16 3/12 = 0.03 + 0.04 = 0.07
d2 = 0.03 − 0.04 = −0.01
Thus,
N (−d2 ) = 0.5 + 0.004
N (d2 ) = 0.5 − 0.004
N (−d1 ) = 0.5 − 0.0279
N (d1 ) = 0.5 + 0.0279
Find put price and call price:
pt = e−r(T −t) XN (−d2,t ) − St e−q(T −t) N (−d1,t )
= 2114[e−0.0296∗0.25 0.504 − e−0.02∗0.25 0.4721] = 64.56
ct = −e−r(T −t) XN (d2,t ) + St e−q(T −t) N (d1,t )
= 2114[e−0.02∗0.25 0.5279 − e−0.0296∗0.25 0.496] = 69.60
Straddle price in USD (don’t forget to multiply by 1000 USD):
(69.60 + 64.56) ∗ 1000 = 134160
(To the nearest 1000 USD, have 134000 USD [Some allowance made for rounding error.])

Page 8
(b) (4 points) If you were to delta hedge the straddle, what would your initial trade be?
Solution: Most people will ignore the effects of the dividend yield, so shall I until the
end.
Put delta is −N (−d1 ) and call delta is N (d1 ). Therefore straddle delta is:
N (d1 ) − N (−d1 ) = 0.5 + 0.0279 − (0.5 − 0.0279) = 0.0558
Option seller is short the straddle and so her delta is -0.0558.
If 1 unit of the index at 2114 is worth 2114 USD, need to buy 1000 ∗ 0.0558 = 55.8 units of the
index to delta hedge the short position in the straddle.
In actual fact, the delta of the call will be e−q(T −t) N (d1 ) and for the put −e−q(T −t) N (−d1 ) so
multiply the above answer by e−q(T −t) = 0.9950 to do it right.

(c) (4 points) After delta-hedging, what would the Gamma of your portfolio be?
Solution: Buying the index does not change the option seller’s gamma. So we first
need to find the gamma of the straddle. The gamma of a put and a call are the same,
both given by:
∂N (d1 ) ∂d1
= ′ √1 N ′ (d1 )
∂S ∂S N (d1 ) = Sσ T −t

The gamma of a call/put is therefore:

2
1 √ √1 ∗ e−0.5∗0.07 = 0.002353
2114∗0.16∗ 3/12 2π
The straddle gamma is 2 ∗ 0.002353 = 0.004706.
The gamma of the option seller’s position is therefore −1000 ∗ 0.004706 = −4.706.
Multiply the above answer by e−q(T −t) to capture the effect of the dividend yield (most students
will not realize this, so no marks subtracted for missing it).

(d) (10 points) If the market suddenly crash by -10%, what trade would you carry out to delta-hedge
the sale of the straddle? Please solve this question with the gamma above.
Solution: Before the crash, the option seller’s portfolio has zero delta, because the negative delta
of the short straddle has been neutralized via a purchase of the index. After the crash, the straddle’s
delta becomes hugely negative, since the straddle derives most of it’s value from the put, which is
now ITM. This means that the option seller’s portfolio will have a large positive delta after the
crash. The option seller will need to sell some of the underlying index after the crash on order to
make her portfolio delta neutral. The question is how much.
We can can use the portfolio’s gamma to estimate by how much the portfolio delta will increase by
d∆ = ΓdS = −0.004706 ∗ −211.4 = 0.99
Multiplying by 1000 gives 990. So the option seller would need to sell approximately 990 units of
the index after the crash (if 1 unit of the index at x is worth x US).
Multiply the above answer by e−q(T −t) to capture the effect of the dividend yield (If students do
not realize this, no marks are subtracted for missing it)

Page 9
(e) (6 points) Are there any shortcomings of the Black-Scholes model, which you would worry about
before quoting a price to the salesperson?
Solution: The Black-Scholes model does not allow for jumps in the underlying stock
price, so it ignores crash risk. The model also ignores the possibility of a random
change in volatility. Liquidity risk is also ignored. So are transaction costs such as
bid-ask spreads.

(f) (6 points) To overcome some of the shortcomings of the Black-Scholes model, you consider the new
model
√
dSt
St = (r − q)dt + vt dZtQ
√ Q
dvt = k(θ − vt )dt + # vt dZv,t
dZtQ dZv,t
Q
= ρdt
Comment on whether this model is preferred to the Black-Scholes model.
Solutions: The new model still ignores crash risk (and liquidity risk, and transaction
costs). [Only the stochastic vol is fine.]

Page 10
4. (20 points) Consider the following specs for futures contracts on Ethanol traded on the Chicago Mer-
cantile Exchange (CME):

Kane Inc., a gasoline producer, will require 145,000 gallons (gal) of ethanol in April 2021. The price for
April 2021 delivery is 1.54 $/gal. While the spot price today (January 2021) is 1.52 $/gal, Kane prefers
to trade futures instead of incurring costs of storing ethanol to hedge its price. For logistic reasons, Kane
will not have the ethanol delivered through the futures contract, but will close its futures position on
the April 2021 spot market and buy ethanol at the spot price.

(a) (8 points) How many contracts should Kane buy or sell to minimize its exposure to ethanol price?
What is the effective cost of purchasing ethanol if Kane 2021 price would be 1.52 $/gal, with and
without the hedge you propose? What if Kane 2021 price would be 1.45 $/gal instead?
Solution:
Futures contracts are sold on the Chicago Mercantile Exchange (CME) and are for the delivery of
29,000 gal. of ethanol. The company can hedge the ethanol price perfectly by entering a long hedge
for N = 5 contracts. Denote as pAP R the spot price of ethanol in April 2021. The effective cost of
purchasing is:
purchase costs profits from futures
* +, - *. +, -/
145000 · pAP R − 5 · 29000 · (pAP R − 1.54) = 223, 300$

which is invariant with respect to April 2015 spot price.

Assignment of partial credit: [2 pts] for the number of contracts, [8 pts] for recognizing the the cost
of purchasing does not depend on pAP R

(b) (12 points) Kane has mandated a market research company to study the possible scenarios for
the ethanol market in April 2021. After reading their report, Kane’s management believes in the
following scenario:
April Ethanol
Strong Weak
Probability pS pW
Spot Price 1.67 1.42
where pS and pW are the probability the firm attaches to the strong and weak market conditions
and the management is trying to evaluate. The company needs to decide how much of the 145,000
gal. requirement to purchase on the spot market in April 2021, and how much with the April 2021

Page 11
futures. Suppose the firm is risk neutral. What is your recommendation based on the values of pS
and pW ?
Solution
Denote as N the number of futures contracts to be purchased. The expected purchasing cost in
April 2021 is
0 3
purchase costs profits from futures
1 * +, - * +, - 4
pS · 21.67 · 145000 − N · 29000 · (1.67 − 1.54)5 +

0 3
purchase costs profits from futures
1 * +, - * +, - 4
pW · 21.42 · 145000 − N · 29000 · (1.42 − 1.54)5

The coefficient on N is negative (i.e. buying more contracts decreases costs) if

−29000 · [pS · (1.67 − 1.54) + (1 − pS ) · (1.42 − 1.54)] < 0

which implies
expected spot price futures price
* +, - *+,-
pS · 1.67 + (1 − pS ) · 1.42 > 1.54

Intuitively, when the expected spot price is higher than the futures prices, increasing N reduces
costs and Kane expects to be better off with hedging. Solving for pS yields:

pS > 0.48

Therefore, if the management is confident that the strong market will happen with a probability
greater than 0.6 they should hedge by buying N = 5 contracts, otherwise they should buy ethanol
on the spot market in April 2021.
Assignment of partial credit: [3 pts] for computing the expected purchasing cost, [8 pts] for solving
for either pS or pW ,[3 pts] for giving the right recommendation.

Page 12
Lorenzo Bretscher Derivatives Spring 2021

Midterm
Date: 15/04/2021, 2pm - 16/04/2021, 2pm

1
Lorenzo Bretscher Derivatives Spring 2021

1. GreenGas is a company based in Pekin, Illinois, that employs ethanol in its production process,
and needs to purchase 290,000 gallons of it in three months. The three-month futures price
of ethanol contracts traded on CBOT is 1.55 $/gallon, and the spot price of ethanol is 1.5
$/gallon. The contract size is 290,000 gallons. The three-month interest rate is 0.25%. Ethanol
is stored in steel fuel tanks, and the convenience yield of holding ethanol in the next three
months is negligible.

a) CoolTanks is a company that rents storage services for business clients operating in
Illinois. CoolTanks uses proprietary and patented technologically advanced probes and
pumps that guarantee a higher storage efficiency than traditional technologies. Currently,
CoolTanks can store each gallon of ethanol at a annualized and continuously compounded
cost s = 5% of the current spot price. How much could CoolTanks charge GreenGas at
most for storing 290,000 gallons of Ethanol for three months?
b) Suppose CoolTanks has a 2.9 mln gallons idle capacity for the next three months. Can
CoolTanks make arbitrage profits in the market? If this is the case, what is the sequence
of transactions that CoolTanks can implement to do so? How much could CoolTanks
potentially gain three months from now?

2
Lorenzo Bretscher Derivatives Spring 2021

2. The investment fund Rusty Bear enters a short position to sell 10,000 shares of Microsoft for
50$ per share. The initial margin is 80% of the initial stock price and the maintenance margin
is 70% of the current stock price. Rusty Bear trades by putting the minimum amount of cash
on the margin account to satisfy the initial requirement.

a) What is the maximum possible profit the position Rusty Bear can get at maturity? What
is the maximum possible loss? Suppose that if the price falls below 20$, Rusty Bear will
be squeezed out and be forced to liquidate its position. What are the maximum profit
and loss in this case?
b) What is the minimum security price pM that will lead to a margin call? Would you
receive a margin call if the price is greater than pM ? Would your answer to the last
question change in the case of a long position in the very same stock?
c) What is the value of pM if the initial amount of cash in the account would be 500,000$
instead?
d) On the first two weeks the price of the futures goes down by 10%, and Rusty Bear
interprets this as a bearish sign for Microsoft and is willing to strengthen its position.
The requirements to short a contract are now a 75% maintenance margin, and a 85%
initial margin. What is the minimum amount of cash Rusty Bear needs to add to its
account to short additional 5,000 shares?

3
Lorenzo Bretscher Derivatives Spring 2021

3. Consider a portfolio composed of two options on the same underlying asset:

• Long a European call option with a strike price of K

• Short a European put option with a strike price of K

Both options mature at date T .

(a) What is the payoff of this portfolio at date T , graphically and algebraically (as a function
of the price of the underlying asset at time T )?
(b) How would you price this portfolio?

4
Lorenzo Bretscher Derivatives Spring 2021

4. You go long a one-year-long forward contract on a non-dividend-paying stock when the stock
price is $50 and the continuously compounded risk-free interest rate is 5%.

(a) What is the forward price? What is the value of the forward contract?
(b) Six months after entering into the forward contract, the price of the stock is $55 and the
interest rate is still 5%. What would the new market forward price if you wanted to enter
into the same arrangement now (so that the forward trade would expire in 6 months)?
(c) What is the current value of your long position?
[Hint: It may help to think how you could put on a trade to lock in the current value for
sure.]

5
Lorenzo Bretscher Derivatives Spring 2021

5. Suppose that the following binomial tree describes the price evolution of a non-dividend-paying
stock which currently trades at $16.

36
↗
24
↗ ↘
16 18
↘ ↗
12
↘
9

The (continuously-compounded, annualized) interest rate is 10%. The time interval between
each stage is h = 6 months (ie, six months from today the price will be either 24 or 12; six
months later, it will be either 36, 18, or 9).

Consider the following European-style “chooser” option: in six months’ time, you will get to
choose whether the option is a call or a put. In either case, the chooser has strike 18, and
expires in a further six months’ time.

(a) What is the value of this asset today, and what is its initial delta?
(b) If the strike is 26, what is the value of the chooser today, and what is its initial delta?
(c) If the chooser is American-style with strike 26, what is its price initially?

6
HEC Lausanne

Take-Home Exam
Session/year : Spring 2020 MIDTERM
Title of the course : Derivatives 2020
Lecturer : Dimitris Karyampas
Deadline of submission : 29.04.2020, 23:59
The total number of questions : 6

To be completed :
Last and first name :

Student number :

Procedures :
Documentation : Open book.
Calculator : Any type

This exam contains 6 problems. The total number of

points is 100. Points for problems are awarded for cor-
rectness of the answer and the clarity of the reasoning
as well as the steps leading to the answer. Correct an-
Instructions : swers arrived at through false logic will not be awarded
full points. If you feel that you need to make additional
assumptions, please do so and state your assumptions
clearly. The questions are in no particular order, so do
not assume that the last question is more difficult than
the first one.
Pen : Pens (ink) only are authorized.

Reserved for grading

Participation Course work Exam Final grade

Grade: Grade: Grade: /100 Grade: /6

1
HEC Lausanne

Question 1 (20 Points): Multiple Choice Questions and Short-Answer Ques-

tions

Q1.1: Which of the following would decrease the cost/price of an American put option?
A. Increase in strike price
B. Increase in current stock price
C. Increase in time to expiration
D. Increase in volatility
E. Increase in the option’s delta

Q1.2: Which of the following statements is true? (You can assume a discrete time.)
A. A European call can be replicated by a long position in the stock and a short position
in a risk-free bond
B. A European call can be replicated by a short position in the stock and a short position
in a risk-free bond
C. A European call can be replicated by a long position in the stock and a long position
in a risk-free bond
D. A European call cannot be replicated perfectly
E. A European call can be replicated perfectly at initiation but not thereafter.

Q1.3: Assuming that a firm’s value consists of equity value and debt value and equity
holders have limited liability (allowing bankruptcy), which one of the following statements
is true?
A. Equity is a straddle on firm’s value
B. Debt is a call on firm’s value
C. Equity is a call on firm’s value
D. Debt is risk free
E. Equity return volatility is constant

Q1.4: Using your intuition developed from the class, judge the following statement: A
convertible bond is worth more than a non-convertible bond with identical face value,
coupon rates, maturity, and seniority, with both issued by the same company.

A. Always true
B. True only if put-call parity holds
C. Always false

2
HEC Lausanne

D. True only if the term structure of interest rates is upward sloping

E. True only if the term structure of interest rates is downward sloping

Q1.5: The current spot price of the a non-dividend-paying firm is S0 , the current futures
price is F0 and the expected price of the stock in one month is S1 . Risk-free rate is positive.
The futures contract has one-month maturity. Then
A. F0 > S1
B. F0 < S0
C. S0 < S1
D. A, B, and C are all wrong.
E. A, B, and C are all correct.

Q1.6: Assume that the price of a call option expiring in 3 months equals c at time t0 =
today. The strike price (K) of the call equals today’s spot price of the underlying (S).
What is the price of a put option with same strike price and maturity if the interest rate
(zero) curve is flat at 0%?

Q1.7: What are the main di↵erence between the so-called “standardized” and “OTC”
contract trading? Give two examples for each.

Q1.8: What is the underlying logic/intuition in interest rate parity? What does it mean
when it holds and does not hold? If all assumptions for it are valid, why would you expect
it to always hold or why would you not to expect so?
Explain each of the three sub-questions with at most 2 sentences concisely in your
own words (Answers that have more than 2 sentences for each question mark will not be
marked.).

Q1.9: Are a long position in a put and a short position in a call the same? Elaborate
why.

Q1.10: Which position has more downside exposure: a short position in a call or a short
position in a put option? That is, in the worst case, in which of these two positions would
your losses be greater? Indicate what are the maximum loss values on each position.

Q1.11: Can you replicate the payo↵ of a forward contract with options? If yes, elaborate
how.

Q1.12: Would an American call option on a non-dividend-paying stock has the same price
as its European counterpart? If yes, elaborate why?

3
HEC Lausanne

Question 2 (15 Points): Essay-type Question

Global equities and emerging market currencies ended the week with heavy losses as a
simmering undercurrent of risk aversion finally boiled over, largely triggered by mounting
concerns about China and heightened by Argentina’s peso woes.

The growing sense of nervousness in the markets fueled gains for havens such as the yen,
gold, and longer-dated US and German government bonds. However, short-dated Treasury
bills came under pressure from fresh concerns about the US debt ceiling, traders said.

In New York, the S&P 500 equity index dived 2.1 per cent on Friday, leaving it 2.6 per cent
lower over the holiday-shortened week - its worst weekly performance since June 2012.

Tellingly, the CBOE Vix volatility index, which gauges the cost of US equity portfolio
protection and is often called Wall Street’s fear gauge, soared nearly 30 per cent on Friday
to its highest since mid-October.

In light of the above news report, your line manager has become worried about how
your quantitative analysts (quants) use models to price risk. He has asked you for a
qualitative and intuitive explanation of how the financial risks related to events
such as those mentioned in the above article are priced across linear and non-linear
products.

(Please write down your answers legibly and concisely in one A4-page. For the
answers beyond one page, only the first one A4-page answer will be marked,
and the rest will be ignored. If applicable, you are welcome to utilize the
intuition and knowledge acquired by other finance courses.)

4
HEC Lausanne

Question 3 (15 Points): Forward and Futures Prices

Firm W will pay a dividend of $0.1 a quarter from now. The firm’s dividends will grow
at 0.5% per quarter. Its stock is currently traded at $20 per share. The risk-free rate (all
are annualized) yield curve are given:

Rate Maturity
0.25% 3 months
0.30% 6 months
0.45% 9 months
0.75% 12 months

a) No arbitrage holds. Dividends in the following one year are paid just before the contract
expires. What is the price of a forward contract on the stock with one-year maturity?
b) Another firm G’s stock is traded at $15 per share. The firm pays quarterly dividends
and keeps a constant dividend yield of 1% per year, a di↵erent policy from Firm W. A
hedge fund is asking a broker for a 1-year long forward contract on a portfolio of 4,000
shares of W and 6,000 shares of G. The broker quotes a contract price of 1,650 cents per
share, where the contract size is 10,000 shares. Is there an arbitrage opportunity for
the fund to exploit? (Hint: you might try to think from an angle of a whole portfolio
as one asset and try to flexibly use some taught equations.)
c) Another hedge fund has just entered a short position of 100,000 shares of W at the
current market price (e.g. via selling borrowed stocks). The fund has an investment
horizon of one year, but after ascertaining new information about W’s reorganization
the fund manager is now unsure about the share price. He is convinced that W will
unexpectedly stop paying dividends before next year due to current liquidity shortfalls.
The fund is negotiating a long position in a forward contract on W’s 100,000 shares
with a bank which does not share the manager’s concerns. The fund manager always
re-invests dividend payments and proceeds from short sales at the risk-free rate with
continuous compounding.
- Suppose you suggest the manager to go long the forward contract.
Assume the manager’s forecast is right, and W will stop paying dividends in four
months from now. What is the performance of your strategy if W’s price decreases
by 1.5%? What is the performance of your strategy if W’s price increases by 1.5%
instead?
- What is the profit of the strategy if dividends do not change instead?
(Hints: 1. If the borrowed stock pays a dividend, the short seller is responsible for
paying the dividend to the person or firm making the loan. 2. In calculations, be
aware what is the present time and whether you need PV(D) - the present value of the
dividend- or else.)

5
HEC Lausanne

Question 4 (15 Points): Interest Rate Hedging

The following table reports the term structure of assets (e.g. loans) and liabilities (e.g.
deposits) of a bank

Maturity (months) Assets ($mln) Liabilities ($mln)

3 50 328.71
6 60
9 100
12 140

The annualized continuously compounded yield-to-maturity (YTM) of the bank’s assets

and liabilities are respectively 12% and 10%. Three-month T-Bill futures contracts of size
$1 million are available on the market. Their underlying asset is a three-month Treasury
Bill (zero coupon) with $100 face value, and the futures are priced at $87.933 with a
contract size of $10,000.

a) Compute the present value of the bank’s assets and liabilities (with continuous com-
pounding).
b) Define duration gap as the di↵erence of the durations of the bank’s assets and liabilities.
Compute its duration gap. How much will the bank approximately earn (or lose) if its
interest rates increase from 12% and 10% to 13% and 11%?
c) Propose a strategy that employs the futures contracts described above to allow the
bank to hedge interest rate risk arising from its duration gap. How many futures
contracts should the bank either buy or sell?

(Hint: You should be able to use slide 32 of the Lecture 4 to address all three sub-
questions. For students who want to refresh their memory on the concept of duration, I
suggest you revise the first two lectures of Investment course. The duration in Derivatives
class and this question is the so-called ’Modified Duration’ and the ’weighted average
maturity of all claimed cash flows’.)

6
HEC Lausanne

Question 5 (17 Points): Options 1 - Vanilla

a) Assuming no arbitrage and no market frictions, derive Put-Call parity. Does it hold
with American options?
b) Show the put-call parity at maturity graphically.
c) A speculator believes that the level of the S&P500 index is highly likely to be close
to or at 2,800 in one month from today. She wants to only use European options of
the same maturity to form a strategy to lock profits based on her belief. She wants to
gain a profit when the index is within the range of 2,700-2,900 after one month, and
to gain the maximum potential profit if the index is exactly equal to 2,800. She wants
a strategy that has constantly same zero or negative payo↵ (the price of the strategy)
for all other possible outcomes of the S&P500 index level.
As her advisor, recommend a suitable option strategy to her. Clearly specify the
features of the options involved. Plot the supposed payo↵ at maturity of this strategy.
Clearly specify the coordinates of intersection and inflection points and the slopes of
lines. For values unknown, you may use letters and symbols to represent them.
d) You own a put option on Ford stock with a strike price of $10. The option will expire
in exactly six months time.
(a) If the stock is trading at $8 in six months, what will be the payo↵ of the put?
(b) If the stock is trading at $23 in six months, what will be the payo↵ of the put?
(c) Draw a payo↵ diagram showing the value of the put at expiration as a function
of the stock price at expiration.
e) You are reading the news. The current stock price of F-Net is $20 per share and the
one year risk-free interest rate is 8%. A one year put on F-Net with a strike price of
$18 quotes at $3.31 (bid) - $3.33 (ask), while the identical call quotes at $6.98 - $7. Is
there an arbitrage opportunity? If yes, how would you exploit it?

7
HEC Lausanne

Question 6 (18 Points): Options 2 - Exotic Options

a) Price a “down-and-in” call option with final payo↵ as follows:

P ayof f (T ) = [max(ST K, 0); ⌧H  T ], (1)

where the event ⌧H is described as:

⌧H = inf {t > 0 : St < H}, (2)

and H being the barrier level, K the strike price, St the underlying price and T the
maturity. In other words, the payo↵ equals that of a standard call option as long as
the spot price St is below (at least once) the barrier level H, otherwise 0.
You know that the price of a standard call option on same underlying with same
strike level and maturity worths $12.15 and the equivalent “down-and-out” call option
worths $12.09. Note that a “down-and-out” option is a standard call option if event
⌧H = inf {t > 0 : St H} occurs, otherwise 0.
b) Draw a relationship between C(t) the price of a standard call option, Ccdi (t) the price
of a “down-and-in” call option and Ccdo (t) the price of a “down-and-out” call option.
Show graphically the following three scenarios and calculate the value of each option’s
final payo↵. Based on the final payo↵ derive your relationship for C(t), Ccdi (t), Ccdo (t).
• A scenario for St starting at 100 and not cross the barrier level (H) of 70 until
maturity T .
• A scenario for St starting at 100 and crossing the barrier level of 70 at T /3. Final
value for ST is above strike price K = 100.
• A scenario for St starting at 100 and crossing the barrier level of 70 at T /2. Final
value for ST is below H.
c) Can you derive a similar relationship for “up-and-out” and “up-and-in” call options
with standard vanilla call options? Elaborate your answer.
d) Price the following “knock-in, knock-out” option having a payo↵ at T equal to:
• 0, if H1 = 140 was not hit at any time between today and T ,
• 2 ⇥ max(ST 120, 0), if H1 was hit but H2 = 160 is not hit in (t0 , T ),
• max(ST 120, 0), if H2 is hit.
The following table provides “up-and-out” call option prices for di↵erent barrier levels,
K = 120 and same maturity T as the option we want to price above.

Barrier level Price

140 0.3986
150 1.0607
160 1.8897
170 2.7140
180 3.4286
1 5.3686

8
MIDTERM
CORR 2020
Question 2

Risk is inherent to financial markets, indeed even the safest of assets are volatile in some way.
Nowadays, there is even contracts on the volatility of the market (and even on the volatility of the
volatility of the market). Therefore, risk is everywhere, and we need to account for it.

In order to model and price risk, we first need to understand that there is no “Free-lunch” in the
markets, indeed theoretically, there is no such things as “cheap” or “expensive” everything is priced at
his fair value and the price of an asset does account for it’s risk.

There are many ways to express the risk of a product: the volatility, the semi-variance, the maximum
drawdown, the expected shortfall, … in the end they all capture some part of the risk of an asset.

Across linear product, one can say that the bigger these measures of risk are, the lower the price at a
given level of expected return. Indeed, I want to be compensated for the risk that I take. Therefore,
financial risks as the one that the just happened are normal and they are incorporated in the prices
and the strategies.

Across non-linear product, such as options, the logic is different. Indeed, volatility can be interesting
and can be positively priced. The question you need to ask yourself is: “Will my product have a bigger
chance to be worth more, if the volatility increases? “. This typically the case for a standard plain vanilla
Call where you would have more chance to be on the right side of the strike price if there is more
volatility.

On the other hand, with more exotic options, the results can be different. Let’s consider a “Down-and-
out” call. Clearly if the volatility increases, you would get more chance to be on the right side of the
strike price, but you would also have more chance to breach the barrier and therefore, loose the right
to exercise the option. In this case, it more complicated to have an answer about whether risk has a
positive influence or not but with some more involved math, we can do it.

Considering the news report, we can see that almost all the market is down and therefore, almost all
“long” products are losing money, but they will get higher, at least for linear products. This kind of
movement are proof of strong pairwise correlation between assets which is something that’s
important to consider to price the risk correctly.

Therefore, the interesting way to tackle this precise case is to ask ourselves, do I survive with such
strong events? Indeed, if I’m investing over a long horizon, losing money today is not important since
market should in the end go up again. This is where some measure as the maximum drawdown can be
interesting to look at. On the other hand, if I’m investing in a more short-term horizon, I should hedge
myself again such moves and this is where derivatives can be very useful.
HEC Lausanne

Take-Home Exam
Session/year : Spring 2020

Title of the course : Derivatives

Lecturer : Dimitris Karyampas
Deadline of submission : 10.06.2020, 23:59
The total number of questions : 4

To be completed :
Last and first name :

Student number :

Procedures :
Documentation : Open book.
Calculator : Any type

This exam contains 4 problems. The total number of

points is 100. Points for problems are awarded for cor-
rectness of the answer and the clarity of the reasoning
as well as the steps leading to the answer. Correct an-
Instructions : swers arrived at through false logic will not be awarded
full points. If you feel that you need to make additional
assumptions, please do so and state your assumptions
clearly. The questions are in no particular order, so do
not assume that the last question is more difficult than
the first one.
Pen : Pens (ink) only are authorized.

Reserved for grading

Participation Course work Exam Final grade

Grade: Grade: Grade: /100 Grade: /6

1
HEC Lausanne

Question 1 (18 Points): Multiple Choice Questions

Q1.1: In a one-period trinomial tree, the stock price can take three possible values in one
year from now: Su > Sm > Sd . The risk-neutral probability of the stock price being Su
is qu and the risk-neutral probability of the stock price being Sm is qm . The one year
risk-free rate is 1%. The price of a one year European put option with strike price K s.t.
Sd < K < Sm , is given by:
qd (K Sm )
A. 1.01

qu (K Su )
B. 1.01
qd (Sd K)
C. 1.01

qd (K Sd )
D. 1.01
qu (K Sd )
E. 1.01

Q1.2:Which of the following statements about the Black-Scholes model is false?

A. Stock market crashes (huge price jumps) are allowed
B. The risk-free rate is constant
C. The volatility of stock returns in constant
D. Expected stock returns can be allowed to change over time
E. It is assumed that there is no-arbitrage

Q1.3: Consider a one-period model. At day 0, it is known that there are 2 possible states
at day 1. Two securities are freely traded. The first security has the day 1 payo↵ vector
X1 = (10; 8), while the second security has the day 1 payo↵ vector X2 = (20; 12). The
day 0 price of the first security is 8.1, while the day 0 price of the second security is 14.4.
What is the day 0 price of the risk-free bond, which pays 1 in each state at day 1?
A. 0.90
B. 0.91
C. 0.88
D. 0.89
E. 0.92

Q1.4: The assumptions for the Black-Scholes model hold. Suppose you have a one year
European call option on a stock. There are no dividends. The risk-free interest rate is
0%. The stock price is $100 and the option is at the money. The standard deviation of
stock returns is 10% p.a. The price of the call is closest to

A. 10

2
HEC Lausanne

B. 8
C. 4
D. 5
E. 6

Q1.5: The day t Gamma (= @@S ) of the above European call option is
A. N (d1 )
N 0 (d1 )
B. S(t)
p
T t

C. N 0 (d1 )
D. N 0 (d2 )
N 0 (d1 )
E. S(T )
p
T t

Q1.6: Which of the following represents the Delta of a European call on a non-dividend
paying stock with a strike of 50 USD, when the volatility is 30% per annum and the
risk-free rate is 3%?

Q1.7: Which of the following statements is most likely to be true?

A. the risk-neutral probabilities of bad aggregate states are higher than the corresponding
physical probabilities and interest rates are always lower in bad aggregate states
B. the risk-neutral probabilities of good aggregate states are higher than the correspond-
ing physical probabilities
C. the risk-neutral probabilities of bad aggregate states are higher than the corresponding
physical probabilities and interest rates are always higher in bad aggregate states

3
HEC Lausanne

D. the risk-neutral probabilities of bad aggregate states are higher than the corresponding
physical probabilities
E. the risk-neutral probabilities of bad aggregate states are lower than the corresponding
physical probabilities

Q1.8: Consider the binomial model for stock prices.

S(i, j) denotes the value of a non-dividend paying stock in node (i, j). Denote the value
of an American-style option on the stock in node (i, j) by V (i, j) and the early exercise
payo↵ in node (i, j) via P (i, j). The one-period zero coupon discount factor is e r t . Only
some of the following equations are true:
r t
1. V (i, j) = e [qV (i, j + 1) + (1 q)V (i + 1, j + 1)]
⇣ ⌘
r t
2. V (i, j) = max P (i, j), e [qV (i, j + 1) + (1 q)V (i + 1, j + 1)]
r t
3. S(i, j) = e [qS(i, j + 1) + (1 q)S(i + 1, j + 1)]
⇣ ⌘
4. V (i; j) = max P (i, j), e r t [qV (i + 1, j + 1) + (1 q)V (i + 1, j + 1)]
r t
5. S(i, j) = e [qS(i + 1, j + 1) + (1 q)S(i + 1, j + 1)]
Which of the following statements is true if there is no arbitrage:
A. 2 & 5 are true
B. 2 & 3 are true
C. 1 & 5 are true
D. 1, 2 & 5 are true
E. 1, 3 & 4 are true

Q1.9: The value of a European put option on a non - dividend paying stock is given by:
r(T t)
p(t) = e KN ( d2 ) S(t)N ( d1 )
S(t) 1 2 )(T
ln( K )+(r t)
d1 = p 2
p
T t
d2 = d1 T t

4
HEC Lausanne

What would be the day t price of a digital option which pays out H dollars when the
European put option is in the money?
r(T t)
A. e HN ( d2 )
r(T t)
B. e HN (d2 )
rT
C. e HN (d2 )
r(T t)
D. e HN (d1 )
r(T t)
E. e HN ( d1 )

5
HEC Lausanne

Question 2 (20 Points):

The current price of Natasha Corporation stock is $10. In each of the next two years, this
stock price can either go up by $3 or go down by $2. Each of these two states happens
with probability 50% in all years. The stock pays no dividends. The one-year risk-free
interest rate is 3% and will remain constant.
a) Using the Binomial Model, calculate the price of a two-year American put option on
Natasha stock with a strike price of $11 (Hint: Using the risk neutral probability
approach will be faster, and for this question there is no need to apply continuous
compounding).
b) Does the put-call parity hold with the American put you calculated?

6
HEC Lausanne

Question 3 (44 Points):

You are working on a structured products desk. A salesperson would like you to quote a
price on a product called “straddle”, where the underlying is the S&P 500 Index. Denote
the day t level of the S&P 500 Index by St . The straddle pays FT USD at the expiry date
T , where:
8
>
<1000 ⇥ max(ST K, 0) ST K
FT = 0 ST = K
>
:1000 ⇥ max(K S , 0) S < K
T T

Assume the evolution of the S&P 500 under the risk-neutral probability measure Q is
given by
dSt
St
= (r q)dt + dZtQ

where r is the risk-free rate, q is the dividend yield, is the volatility per unit time of
returns on the S&P 500, and Z Q is a standard Brownian motion under Q. The day t
price of a European put option on the S&P 500 with a strike of X and expiry date of T
is given by
r(T t) q(T t)
pt = e XN ( d2,t ) St e N ( d1,t )
S
ln( Xt )+(r q+ 12 2 )(T t)
d1,t = p
Tp t
d2,t = d1,t T t
1 2
N 0 (x) = p1 e 2
x
2⇡

The current level of the S&P 500 Index is 2’114 and the dividend yield is 2% per annum.
The implied volatility for a 3 month European at-the-money put on the S&P 500 Index
is 16% per annum and the risk-free rate is 2.96% per annum.

a) Find the Black-Scholes price of the straddle with K = 2’114, which expires in 3 months
from now. [6 marks]
b) If you were to delta hedge the straddle, what would your initial trade be? [6 marks]
c) After delta-hedging, what would the Gamma of your portfolio be? [6 marks]
d) If the market suddenly crash by -10%, what trade would you carry out to delta-hedge
the sale of the straddle? [6 marks]
e) Are there any shortcomings of the Black-Scholes model, which you would worry about
before quoting a price to the salesperson? [4 marks]
f) To overcome some of the shortcomings of the Black-Scholes model, you consider the
new model
p
dSt
St
= (r q)dt + vt dZtQ
p Q
dvt = k(✓ vt )dt + ✏ vt dZv,t
dZtQ dZv,t
Q
= ⇢dt

7
HEC Lausanne

Among your answers for (e), which shortcomings of the Black-Scholes model are you
able to overcome/alleviate with the new model? [4 marks]
g) What would you expect the sign of ⇢ to be? Provide a one sentence explanation. [2
marks]
h) Prove that
EtQ [vt+u ] = e ku
vt + (1 e ku
)✓ (1)

You may use the following facts

dvs +R kvs ds = e ks d[eks vs ],

t+u p
EtQ [ t eks vs dZv,sQ
]=0

[6 marks]
i) Give a two-sentence intuitive interpretation of Equation (1). [4 marks]

8
HEC Lausanne

Question 4 (18 Points):

On 15th Feb 2012, you collected the following data on put options written on the S&P500
Index, which mature on 30th March 2012. You may assume the time till expiry is therefore
1.5 months i.e. ( 1.5
12
) years.

put price, p(t) 0.65 0.75 1 2 3 4 4.35 5.2 8 11 14.7 21.5

K 900 950 1’000 1’050 1’100 1’125 1’150 1’175 1’225 1’250 1’275 1’300

On 15th Feb 2012 the S&P 500 Index was at 1’350.50. The continuously compounded
risk-free interest rate was 2% per annum.

Fitting a quintic to the data in the above table gives the following relationship
P 0
p(K) = 5n=0 an ( K B1 125 )n
where B = 129.7, a5 = 0.6434, a4 = 1.9516, a3 = 1.1968, a2 = 0.4584, a1 = 3.3564,
a0 = 3.7766.
The figure below shows the fit of the above function: the circles are the put prices from
the table and the curved line is the fitted values from the quintic fit.

The following questions help you to calculate the risk-neutral probability of the index
falling below 1’125 on 30th March 2012 using the above put price data.

a) The day t Black-Scholes price of a European style put option (with strike K, expiration
date T) on the S&P 500 is p(t) = e r(T t) KN ( d2 ) e q(T t) S(t)N ( d1 ), where q is
the dividend yield (annualized), r is the continuously compounded (annualized) risk-
free rate, S(t) is the date t level of the the index. d1 and d2 are given by

S(t)
ln( )+(r q+ 12 2 )(T t)
d1 = K p
pT t
d2 = d1 T t

9
HEC Lausanne

2
and N 0 (x) = p1 e 0.5x .
2⇡
@p(t)
Derive an expression for @K
in terms of r, T t, d2 , and the cumulative normal
distribution function.
b) Hence calculate the risk-neutral probability of the index being below 1’125 on the 30th
March 2012.
c) What will happen to the risk-neutral probability of the index being below 1’125 on
30th March 2012 if implied volatilities for S&P500 put options with strikes greater than
1’125 shift upwards. Provide a qualitative answer.

10
HEC Lausanne

Take-Home Exam
Session/year : Spring 2020

Title of the course : Derivatives

Lecturer : Dimitris Karyampas
Deadline of submission : 10.06.2020, 23:59
The total number of questions : 4

To be completed :
Last and first name : Hany Wanis

Student number : 164 341 93

Procedures :
Documentation : Open book.
Calculator : Any type

This exam contains 4 problems. The total number of

points is 100. Points for problems are awarded for cor-
rectness of the answer and the clarity of the reasoning
as well as the steps leading to the answer. Correct an-
Instructions : swers arrived at through false logic will not be awarded
full points. If you feel that you need to make additional
assumptions, please do so and state your assumptions
clearly. The questions are in no particular order, so do
not assume that the last question is more difficult than
the first one.
Pen : Pens (ink) only are authorized.

Reserved for grading

Participation Course work Exam Final grade

Grade: Grade: Grade: /100 Grade: /6

1
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

MIDTERM EXAM
November 6th, 2014

DO NOT OPEN THE EXAM UNTIL YOU ARE TOLD TO DO SO!

The following rules apply (please read very carefully):

 Duration: 1 hour and 30 minutes.

 The exam is composed of three questions with three parts (a, b, c), for a total of 100 points.

 Materials: the exam is closed book and closed notes, a non-programmable calculator is au-
thorized. A formula sheet is attached at the end of the exam.

 To get full credits, all your answers must be precisely justiÖed and clearly handwritten. All
acronyms and mathematical symbols used in your answers must be deÖned precisely.

 If you strongly believe the information provided is not su¢cient to answer precisely, make
additional assumptions and state them explicitly.

 Please deliver only the exam sheets (no other paper). Do not forget to put your name and
signature on the Örst page. Please have your ID ready for identity checking.

 At the beginning of the exam (when you are told to start working on it), and before handing
in your paper, it is your responsibility to check that the exam is complete (5 two-sided paper
sheets).

STUDENTíS FULL NAME: ___________________________

I understand and accept all the exam and grading rules as described here, in the course Syllabus,
and on the course website.

Lausanne, November 6th, 2014

SIGNATURE: ____________________
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

This page is intentionally left blank

Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

1. Exotic Heaven is a US Örm that sells its products in the Kingdom of Tonga, and will need to
receive payments denominated in Tonga Paíanga (TAP). The 3-month forward USD TAP
exchange
USD
rate is 0:6 TAP , and the 3-month USD risk-free rate 2.50%, and the 3-month TAP risk-free
rate is 12%. All rates are annualized and continuously compounded.

TAP
a) What must the spot USD
exchange rate if there is no arbitrage?
Solution. Consider the position of a TAP investor who is investing in the United States
at the riskfree rate rU S = 0:025. The USD
TAP
forward price F0 is such that
U S r T AP )T
F0 = S0  e(r

USD
where S0 is the TAP
spot exchange rate, rT AP = 0:12, and T = 0:25. Hence:

T AP r U S )T USD
S0 = F0  e(r = 0:6  e(0:120:025)0:25 = 0:6144
TAP
TAP
Hence, the no-arbitrage spot USD
exchange rate S0 is

1 1 TAP
S0 = = = 1:6276
S0 0:6144 USD

b) Suppose that the TAP

USD
spot exchange rate is 1:6. Describe exactly what transactions
Exotic Shark, a US-based trader, would implement to generate an arbitrage proÖt using
the contract described above. How much would be the arbitrage proÖt in USD in three
months if Exotic Shark can borrow at most 1,000 TAP in the Kingdom of Tonga today?
1 1 USD
Solution. With S0 = S0
= 1:6
= 0:625 TAP
the forward no-arbitrage exchange FN A rate
should be
1 US T AP 1 USD
FN A = 
 e(r r )T =  e(0:0250:12)0:25 = 0:6103
S0 1:6 TAP
US T AP
Since F0 < FN A = S0  e(r r )T , it means that F0  erT AP T < S0  erU S T . Hence,
from Exotic Sharkís perspective, borrowing TAP from the foreign bank, changing TAP
into USD on the spot, and investing at the 2:5% rate in the US is more convenient than
investing 1000 TAP in the Kingdom of Tonga at a rate or 12%, and selling TAP for USD
at maturity using the extant forward contract. Thus, a short position in the futures
contracts today allows to receive TAP for USD and repay the loan for a relatively high
price (F0 ) in three months.

1
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

Thus, the following trading strategy allows Exotic Shark to take advantage of the arbi-
trage opportunity, with a "free lunch" of 10:65 USD in three months.

c) After Exotic Sharks trades, the forward price converges to its no arbitrage value of
F0 = 0:6103 USDTAP
. Then, suppose Exotic Heaven enters a long position in the three-
month contract above to hedge FOREX receivables to receive USD at F0 for an amount
of 1 mln TAP. At maturity the spot exchange rate is S3 = 0:65 USD
TAP
, but after their client
delays the promised payment and gets a three-month extension, Exotic Heaven would
like to roll over the contract and enter another three-month forward contract. What is
Exotic Heavenís loss three months from now due to the change in the "intermediate"
exchange rate S3 ? Using only the forward contract described above, propose a way for
Exotic Heaven to hedge completely currency risk related to variations in S3 . Verify
that the Önal playo§ in six months with your proposed solution does not depend on S3 .
Assume trading commissions, margin requirements, and transaction costs are negligible,
and that there are no arbitrage opportunities in the market.
Hint: recall that, under the assumptions, the cost of entering a new forward contract is
zero independent of the amount invested.
3
Solution. Denote the amount of account receivables as R = 1 mln TAP, as T1 = 12 the
6
intermediate maturity (3 months), and as T2 = 12 the Önal maturity (6 months). After
three months, Exotic Heavenís proÖt from the forward position is:
USD
R  (F0  S3 ) = 1 mln TAP  (0:6103  0:65) = 39; 700 USD
TAP
that is a loss of 39; 700 USD. The no-arbitrage forward price F3 of the new contract the
companies could roll over would be
U S r T AP )(T T ) USD
F3 = S3  e(r 2 1
= 0:65  e(0:0250:12)0:25 = 0:6347
TAP
To understand how to hedge rollover risk related to F3 ; consider the Önal payo§ from the
forward position at T2 if Exotic Heaven rolls over the contract for the same amount R
and reinvests the intermediate USD proÖts or borrows to Önance the intermediate USD
losses at the US rate:
U S (T T )
R  (F0  S3 )  er 2 1
+ R  (F3  S6 )

2
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

U S r T AP )(T T )
where S6 is the spot rate at maturity. Using F3 = S3  e(r 2 1
the Önal proÖt
becomes
U S (T T ) US T AP
R  (F0  S3 )  er +h R  (S3  e(r r )(T2 T1 )  S6i) =
2 1

US T AP US
= R  (F0  S6 ) + R  S3 e(r r )(T2 T1 )  er (T2 T1 )

To make this amount independent of S3 , Exotic Heaven could roll over the contract by
entering a forward contract at T1 for a di§erent amount R1 :Then the payo§ at T2 would
be: US
R  (F0  S3 )  er (T2 T1 ) + R1  (F3  S6 ) =
US US T AP
= R  (F0  S3 )  er (Th2 T1 ) + R1  (S3  e(r r )(T2 T1 )  S6 )i =
U S r T AP )(T T ) U S (T T )
= R  (F0  S6 ) + S3 R1  e(r 2 1
 R  er 2 1

T AP
which is independent of S3 for R1 = R  er (T2 T1 ) . Therefore, Exotic Heaven can
perfectly hedge rollover risk simply by entering the new contract in three months for an
amount
T AP
R  er (T2 T1 ) = 1 mln T AP  e0:12(0:25) = 1; 030; 455 TAP

3
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

2. The following table reports the term structure of assets (e.g. loans) and liabilities (e.g. de-
posits) of RiskyBank
Maturity (months) Assets (mln $) Liabilities (mln $)
3 25:00
6 30:00 171:70
9 50:00
12 70:00

The annualized continuously compounded yield-to-maturity (YTM) of RiskyBankís assets and

liabilities are respectively 6% and 5%. Three-month T-Bill futures contracts of size 0:85 mln
$ are available on the market. Their underlying asset is a three-month Treasury Bill, and
the futures are priced at 94:536$ per 1 mln $ of face value. All rates are annualized and
continuously compounded.

a) DeÖne RiskyBankís duration gap as the di§erence of the durations of RiskyBankís assets
and liabilities. Compute RiskyBankís duration gap. How much will RiskyBank approxi-
mately earn (or lose) if the YTM of RiskyBankís asset and liabilities respectively increase
from 6% to 7%, and from 5% to 6%?
Solution. First, to compute the durations of RiskyBankís assets and liabilities, one must
compute the present values P V (A) and P V (L) of the bankís assets and liabilities. We
have:
3 6 9 12
P V (A) = 25e0:06 12 + 30e0:06 12 + 50e0:06 12 + 70e0:06 12 = 167:46 mln $

and
6
P V (L) = 171:70  e0:05 12 = 167:46 mln $
Then, the duration DA of RiskyBankís assets is given by
3 6
25  e0:06 12 30  e0:06: 12
DA = 0:25  + 0:5  +
167:46 167:46
9 12
50  e0:06 12 70  e0:06 12
+0:75  +1
167:46 167:46
= 0:734 years

The duration DL of RiskyBankís liabilities is given by

6
171:70  e0:05 12
DL = 0:5  = 0:5 years
167:46
The duration gap DG is therefore positive and equal to

DG = DA  DL = 0:734  0:5 = 0:234 years

4
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

Approximately:
P V (A)
= DA  YA
P V (A)
and
P V (L)
= DL  YL
P V (L)
where P V (A) and P V (L) denote the change in value of RiskyBankís assets and
liabilities respectively, and YA and YL denote the changes in the yields on RiskyBankís
assets and liabilities. Hence, if interest rates increase to 7% and 6%, we have

P V (A) = 167:46  0:734  0:01 = 1:229 mln $

and
P V (L) = 167:46  0:5  0:01 = 0:837 mln $
Therefore, RiskyBankís values of assets would decrease by 1:229 mln $, while the value
of liabilities only by 0:837 mln $, with a loss of 1:229  0:837 = 0:392 mln $.
b) Propose a strategy that employs the futures contracts described above to allow Risky-
Bank to hedge interest rate risk arising from its duration gap. How many futures con-
tracts should RiskyBank either buy or sell?
Solution. SafeBank can use the T-Bill futures to reduce the value on the assets to the
one of liabilities, hence eliminating its duration gap. The number of futures contracts N
to sell to reduce the SafeBankís asset duration to DL = 0:50 is:
P V (A)  (DA  DL ) P V (A)  DG
N= =
F  DF F  DF
mln $
where F = 0:85 mln $ 94:536
1 mln $
= 80:356 mln $ is the value of one futures contract, and
DF = 0:25 years is the duration of the asset underlying the contract (the zero-coupon
T-Bill). Thus:
167:46  0:234
N= ' 2 contracts
80:356  0:25
c) DeÖne third-order duration for a Öxed-income Önancial instrument that generates cash
áows CFt in period t = 1; :::T; with a market price P and a yield-to-maturity Y T M as:

X
T  
3 CFt  eY T M t
D3  t 
t=1
P

Prove that:
P 1 1
' D  Y T M +  C  (Y T M )2   D3  (Y T M )3 (1)
P 2 6

5
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

where P is a change in the Önancial instrument price, D is its duration, C is its

convexity, and Y T M is a change in its yield to maturity.
Using the approximation in (1) and knowing that the convexities of RiskyBankís assets
and liabilities are CA = 0:60821 years2 and CL = 0:25 years2 , and the third-order du-
rations of RiskyBankís assets and liabilities are D3A = 0:53878 years3 and D3L = 0:125
years3 , how much will RiskyBank approximately earn (or lose) if the YTM of RiskyBankís
asset and liabilities respectively increase from 6% to 10%, and from 5% to 6%? Compare
the results with the approximations in (1) and with the Örst-order approximation
P
' D  Y T M
P
Hint: recall Taylorís expansion for a generic function f () around a point x given a
change x around x:
X
1
f (n) (x)
f (x + x) = f + f = (x)n
n=0
n!

where f (n) (x) is the n-th order partial derivative of f in the point x:
Solution. Consider the asset price P; that is
X
T
P = CFt  eY T M t
t=1

Taking a third-order Taylorís approximation of the price for a change in its yield Y T M
we obtain:
@P 1 @2P 2 1 @3P
P + P ' P + Y T M + 2
(Y T M ) + 3
(Y T M )3 (2)
@Y T M 2 @Y T M 6 @Y T M
where
@P X T
= t  CFt  eY T M t = P  D (3)
@Y T M t=1

@2P X T
= t2  CFt  eY T M t = P  C (4)
@Y T M 2 t=1

@3P X T
=  t3  CFt  eY T M t = P  D3 (5)
@Y T M 3 t=1

Plugging (3), (4), and (5) into (2) yields

P 1 1
' D  Y T M +  C  (Y T M )2   D3  (Y T M )3
P 2 6

6
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

and completes the proof.

Using the same notation of point a), the third-order approximation yields:

P V (A) 1 1
= DA  YA +  C  (YA )2   D3  (YA )3
P V (A) 2 6

and
P V (L) 1 1
= DL  YL +  C  (YL )2   D3  (YL )3
P V (L) 2 6
so that
 
1 2 1 3
P V (A) = 167:46 0:734  0:04 +  0:60821  0:04   0:53878  0:04 = 4:836 mln $
2 6

and
 
1 1
P V (L) = 167:46  0:5  0:01 +  0:25  0:012   0:125  0:013 = 0:835 mln $
2 6

with a loss of 4:836 0:835 = 4:00 mln $.

The Örst-order approximation instead yields:

P V (A)
= DA  YA
P V (A)

and
P V (L)
= DL  YL
P V (L)
so that
P V (A) = 167:46  0:734  0:04 = 4:917 mln $

and
P V (L) = 167:46  0:5  0:01 = 0:837 mln $

with a loss of 4:917  0:837 = 4:08 mln $. Therefore, the Örst-order approximation seems
to be very close to the third-order in this case.

7
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

3. Consider an interest rate swap issued 4 months ago and with 14 months of residual life for a
notional amount of 2 mln $. The swap áoating rate is the 6-month USD LIBOR. The Öxed
rate is 3% with semi-annual compounding. Cash áows are swapped every 6 months, so that
next payments are exchanged 2 months from now. The realized 6-month USD LIBOR rates
for the last six months are reported below:

The current term structure of interest rates is as follows:

Unless stated otherwise, all interest rates provided are annualized and continuously com-
pounded.

a) Compute the semi-annually compounded forward rate f8;14 used for the payments of
the forward rate agreement (FRA) that has a maturity of 14 months and is part of a
replicating portfolio for the swap.
Solution. The semi-annually compounded forward rate f8;14 for the payments of the FRA
is: 14 8
!
1 0:008 12 0:006 12
 14  8
f8;14 = 2  e2 12 12 1 = 1:0695%

b) Compute the no-arbitrage value of the swap contract for the Öxed-rate payer using an
appropriate replicating portfolio with a bond and a áoater.
Solution. From the Öxed-rate payerís perspective, an appropriate replicating portfolio is
long on a áoater with value PFBLO and short on a Öxed-rate bond with value PFBIX . The
face value of both bonds equals the notional amount. Hence, the value of the swap PFSWIX
can be computed as:
PFSW B B
IX = PF LO  PF IX

The price of the áoater is

 
B 0:0055076 2
PF LO = 1 +  2 mln $  e0:003 12 = 2; 004; 505 $
2

where 0:55076% is the six-month rate on which the next coupon is based with semiannual
compounding, in that  0:0055 
2  e 2  1 = 0:55076%

8
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

The price of the Öxed-rate bond is

0:032 mln $ 2 0:032 mln $ 8
PFBIX = 2
 e0:003 12 + 2
 e0:006 12 +
 0:03
 14
+ 1+ 2
 2 mln $  e0:008 12 = 2; 071; 007 $

Thus:
PFSW
IX = 2; 004; 505  2; 071; 007 = 66; 502 $

c) A nonparallel shift in the yield curve that causes all zero rates for maturities greater
than 3 months to change, while the others remain unchanged. Due to the shift, the value
of the swap contract above for the áoating-rate payer becomes 70; 000 $, the duration
of the áoater at point a) is 0:4 years, and the yield-to-maturity (YTM) of the Öxed-
coupon bond in point a) becomes 0:65%. Consider an inverse áoater, a bond with the
same characteristics of a áoater, except that the coupons are indexed to a Öxed value
of x% minus the áoating rate (instead of simply the áoating rate as in the áoater).
Compute i) the no-arbitrage price and ii) the duration of the inverse áoater with the
same speciÖcations of the áoater at point a) and x = 6%, where x is annualized and
expressed with semi-annual compounding. Is the duration of the inverse áoater either
higher, lower, or equal to its maturity?
Hint: compute the sum of cash áows from a áoater and an inverse áoater at each point
in time and its present value, and using the available information express its price and
duration as a function of Öxed coupon bonds, and ultimately of the price of the swap at
point a) after the shift.
Solution. The cash áows of a portfolio of long on a áoater and a reverse áoater produces
identical cash áows of two Öxed coupon bonds whose coupon rates sum to x = 6%. The
price of the portfolio is therefore:
 
ft1;t x ft1;t
X T
2
+ 2
 2
F 2F
B B;x%
PF LO + PIN V =   t +  T = (6)
t=1 1 + r2t 1 + r2T
X
T x
F 2F B;c% B;xc%
2
=  
rt t
+ T = PF IX + PF IX
rT
t=1 1+ 2 1+ 2

B;x% B;c%
where PIN V denotes the price of an inverse áoater with the Öxed rate x, PF IX denotes
the price of a coupon bond with coupon rate c < x, and PFB;xc%
IX denotes the price of
a coupon bond with coupon rate x  c. Recall now that the price of the swap at point
a) for the áoating-rate payer can be expressed as a di§erence between the price of a
Öxed-coupon bond and of a áoater, that is:

PFSW B B
LO = PF IX;3%  PF LO

9
Prof. Roberto Steri Derivatives I - MScF - Midterm Exam Fall 2014

where PFBIX;3% denotes the price of the Öxed-coupon bond and emphasizes the coupon
rate of 3%. Since the two-month zero rate is unchanged after the shift, the price of the
áoater is the same of point a), that is:
 
B 0:0055076 2
PF LO = 1 +  2 mln $  e0:003 12 = 2; 004; 505$
2

Then, from the new swap price, one can compute PFBIX;3% as

PFBIX;3% = PFSW B
LO + PF LO = 2; 004; 505$ + 70; 000$ = 2; 074; 505$

Hence, using (6) with x = 6% and c = 3%, that is by decomposing the sum of a áoater
and of a reverse áoater in two equal 3% coupon bonds, we obtain
B;6%
PIN V = 2  PFBIX;3%  PFBLO =
= 2  2; 074; 505$  2; 004; 505$ = 2; 144; 505$

The duration of the Öxed-coupon bond at point a) after the shift, given its YTM (0:65%),
is:
2 8
2 0:032000000
2
 e0:0065 12 8 0:032000000
2
 e0:0065 12
DF IX =  +  +
12  2074505
 12 2074505
14
14 1 + 0:032
 2000000  e0:0065 12
+  =
12 2074505
= 1:1451 years

B;6%
Hence, denoting as DF LO = 0:4; the duration of the inverse áoater DIN V can be obtained
B;3%
from the duration DF IX of a replicating portfolio of two bonds, that is:
B;6% B;6%
DF LO  PFBLO + DIN V  PIN V
B;6%
= DFB;3%
IX
PFBLO + PIN V

Plugging available inputs we obtain:

B;6%
0:4  2004505 + DIN V  2144505
= 1:1451
2004505 + 2144505
B;6%
Solving for DIN V yields
B;6%
DIN V = 1:8416

which is longer than its maturity of 14 months (1:166 7 years).

10