HKUST FINA3203 Spring 2021

School of Business Yicheng Zhu

Midterm Exam (L3 & L4)

Monday, March 22, 2021

1 (20 points) Short Questions

(Please briefly explain your answers. Answers without derivation will get zero points.)

(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?
Solution. The convenience yield c satisfies
∗
Ft (St , T ) = St e−rc (T −t) × e(rc +c)(T −t) ,

where Ft (St , T ) is the forward exchange rate, St is the spot rate, rc is the annualized
risk-free interest rate for domestic currency (USD), and rc∗ is the annualized risk-free
interest rate for foreign currency. Both interest rates are continuously-compounded.
As a result, the convenience yield for the USD should be
 
1 Ft (St , T )
c= log + rc∗ − rc
T −t St
 
1 1.196
= log + 0.5% − 0.5%
1/4 1.19
= 2.0117%.

(It is acceptable that you present the formula for convenience yield directly.)

(ii) (5 points) True or False? From put-call parity, with the same underlying, strike price
and maturity, the price of a European put option is always higher than the price of a
European call option. Write down the corresponding equation and explain your answer.
Solution. False.
The put-call parity is given by

pt − ct = Ke−rc (T −t) − Ft (St , T )e−rc (T −t) .

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 This implies that the difference between the put and call prices is determined by the
difference between the strike and forward prices of the underlying asset. When the
strike is higher than the forward price, the put price is greater than the call price;
when the strike is lower than the forward price, the call price is greater.
Intuitively, if the strike price is very low (e.g. 0), the probability and payoff of the put
option are both very low, and the put price should be very low compared to call price.
If the strike price is very high, put is very likely to be exercised, and the price of the
put option should be higher.
(It is also acceptable that you present the put-call parity using the stock price directly,
as long as you can argue accordingly.)

(iii) (5 points) What derivatives do you need to generate a box spread? Specify in detail
1) what kind of derivatives and 2) what the corresponding strike prices are so that the
investor can borrow via a box spread. Briefly explain why investors want to deposit
through a box spread instead of purchasing a risk-free Treasury bond.
Solution. In order to create a box spread and borrow from the call market, the investor
needs to

(a) Buy a call option with strike K2 ;

(b) Short a put option with strike K2 ;
(c) Buy a put option with strike K1 ;
(d) Short a call option with strike K1 .

The options should all be European, with the same underlying asset and maturity. The
payoff of the position is
K1 − K2 ,
which is the cash flow for a borrowing contract.
The investors, however, prefer to deposit via box spread as US tax code treats the
interest gain from box spread as capital gain, and capital losses are deductible for such
type of profit, while profits from deposit via Treasury holding is not considered as
capital gain. As a result, deposit via box spread can save tax expenses when there is
capital losses.

(iv) (5 points) Explain why investors who want to get exposure to realized volatility
prefers to trade volatility swap instead of option straddles.
Solution. Volatility swap provides direct exposure as its underlying is realized volatil-
ity itself. The payoff of straddles, however, depends on the terminal values of the
underlying asset, and can only provide indirect exposure. As a result, the profit from
investment in volatility swaps is ‘safer’ for volatility strategies, and investors prefer to
invest in volatility swaps if they want to get exposed to asset volatility.

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 2 (25 points) Forward Contract
The spot price of stock ABC is traded at $50 per share at time t. ABC has already announced
that it would make a single dividend payment of $5 per share 1 month later, or at time
t + 1/12. There are no other dividend payments between now and 3 month later, or from t
to t + 1/4.
The market risk-free interest rate for a 1-month deposit is 4% per annum. The risk-
free interest rate for a 3-month deposit is also 4% per annum. Both rates are continuously
compounded.

(i) (4 points) What is the time-t present value of the dividend payment 1 month later,
P V (D)?
Solution. The dividend payment is fixed and risk-free, and as a result the cash flow
can be discounted with risk-free rates.
The present value of the dividend is then given by

P V (D) = D × e−rc ×1/12

= 5 × e−4%/12
= 4.98.

(ii) (7 points) What is the three-month forward price for stock ABC (i.e., with maturity
t + 1/4), by absence of arbitrage?
Solution. The three-month forward price for the stock is given by

Ft (St , T ) = (St − P V (D)) × erc ×1/4

= (50 − 4.98) × e4%/4
= 45.47.

(iii) (14 points) Suppose at time t that forward price of stock ABC with maturity 3 months
is traded at $50 per share. Is there an arbitrage opportunity? Describe a strategy
including 1) the composition of your portfolio with 1 unit of the forward contract and
2) corresponding cash flow to explain how you would take advantage of the opportunity,
if any. What is the time-t present value of your arbitrage profit?
Solution. The market forward price is higher than the price implied by absence of
arbitrage. As a result, we want to take a short position with the forward contract.
The portfolio is given by

(a) A short position of the forward contract with market forward price.

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 (b) Short zero coupon bonds with maturity 3 months and face value $50.
(c) Short zero coupon bonds with maturity 1 month and face value $5.
(d) Long 1 stock ABC.
The cash flow is given by
ˆ At time t, the investor get
0 + 50e−rc ×1/4 + 5e−rc ×1/12 − 50 = 4.49.
ˆ At time t+/12, or one month later, the investor get $5 from the dividend payment,
but also need to pay $5 for the short position of bond from (c). The net cash flow
is
0.
ˆ At time t + 1/4, or three months later, the investor gets $50 due to the short
position of the forward contract, and loses the 1 stock he holds. In addition, he
needs to pay $50 for the short position of bond from (b). The net cash flow is
50 − 50 = 0.
The strategy has 0 cash flow in the future, but positive cash flow at time t, and by
definition is an arbitrage. The time-t present value of the profit is simply the cash flow
at time t, $4.49.

3 (25 points) Futures

On the morning of January 1st, Bob took a long position on one contract of January 3rd oil
futures at a futures price of $100 per barrel. The initial margin is $20 and the maintenance
margin is $15. That is, in order to long 1 unit of the future contract, Bob needed to deposit
$20 the margin account, and will receive a margin call if your balance in your margin account
is below $15. For simplicity, assume that the interest rate on margin accounts is zero. The
contract size is one barrel of oil. The initial balance of Bob’s margin account is $20, the
same as the initial margin.
(i) (5 points) At the end of January 1st, the oil futures price closed at $110. What is
Bob’s profit/loss (P/L) on January 1st? What is the balance in the margin account
after including the P/L on January 1st?
Solution. The P/L on January 1st is given by
110 − 100 = 10.
The balance in the margin account is then
20 + 10 = 30.

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 (ii) (5 points) At the end of January 2nd, the oil futures price closed at $90. What is Bob’s
P/L on January 2nd? What is the balance in the margin account after including the
P/L on January 2nd? Would this trigger a margin call? If the margin call is triggered,
what is the minimum amount of money that needs to be added to the margin account
to maintain the futures position?
Solution. The P/L on January 2nd is given by

90 − 110 = −20,

or a loss of $20. The balance in the margin account is

30 − 20 = 10.

Since 10 < 15, the maintenance margin, this triggers a margin call. The minimum
amount of money that is needed is the difference between the initial margin and current
balance. As a result,
20 − 10 = 10
is needed.

(iii) (5 points) Suppose Bob maintained the futures position by just adding the minimum
amount of money that you solve in the previous question. On January 3rd, the oil
futures price closed at $95, which is also the price corresponding to the maturity date.
What is Bob’s P/L on January 3rd? What is the balance in the margin account after
including the P/L on January 3rd?
Solution. The P/L on January 3rd is given by

95 − 90 = 5.

The balance in the margin account is

20 + 5 = 25.

(iv) (5 points) Suppose oil futures use physical settlement. This means that Bob needs to
pay the futures price $95 on the maturity date (i.e., at the end of January 3rd) to
buy one barrel of oil. However, when Bob initially entered the long futures position
on January 1st, the futures price was $100 per barrel, which implies that Bob agreed
to buy one barrel of oil by paying $100 on January 3rd. Explain why the price that
Bob paid on the maturity date (i.e., $95) is different from the initial futures price (i.e.,
$100)? In other words, why Bob paid $5 dollar less on the maturity date?
Solution. For future contracts, the P/L is realized via daily settlement. In other
words, the P/L has already been paid to the investor, while for forward contracts, the
P/L is only realized on the maturity day.

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 Bob paid $5 dollars less on the maturity date (January 3rd) because he already paid
$5 before the maturity date due to mark to market. To see this, we can sum up the
P/L of January 1st, 2nd, and 3rd, to obtain

TotalP/L = $10 − $20 + $5 = −$5,

which means that Bob already paid $5 before the maturity date. Thus the total pay-
ment made by Bob is

$5
|{z} + $95
|{z} = $100,
payment before the maturity date payment on the maturity date

which is exactly the same as the future price, $100, at the point when Bob entered the
long futures position.

(v) (5 points) Do we know the oil spot price on January 3rd, when the market closes?
Provide explanations for your answer.
Solution. The spot price should be equal to the future price, $95. This is due to the
convergence property of the future price.

4 (30 points) Forward Rate Agreements

Today’s time is denoted by t. Suppose you are scheduled to receive $ 1 million after 6 months
(at time t + 0.5), and want to deposit it for another 6 months (from time t + 0.5 to t + 1).
You want to enter a Forward Rate Agreement (FRA) to lock the interest rate for your
deposit. The spot annualized continuously-compounded risk-free interest rates for 3, 6, 9
and 12 month deposits are 2%, 2.3%, 2.5% and 2.6%, respectively.

(i) (5 points) Do you want to enter a long or short position of the FRA? Provide an
intuitive explanation for your choice.
Solution. The investor wants to lock the interest rate for a deposit contract, via FRA,
and as a result want to pay the floating leg (which is funded from the interest payment
of the deposit) and received the fixed leg.

(ii) (5 points) To achieve the a perfect hedge, what is the notional amount of your FRA
position?
Solution. $1 million.

(iii) (10 points) Calculate the annualized continuously-compounded forward rate for the
period from 6 months to 12 months. What is the corresponding FRA rate for the fixed
leg of FRA? Be sure you choose the correct frequency for compounding.

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 Solution. The annualized continuously-compounded forward rate is given by
1
Ft (t + 0.5, t + 1) (2.6% ∗ 1 − 2.3% ∗ 0.5) = 2.9%.
0.5

The corresponding FRA rate is given by

FRA
rt+0.5,t+1 = 2 × (eFt (t+0.5,t+1)×0.5 − 1) = 2.92%.

(iv) (10 points) Suppose after six month (i.e., at t + 0.5), the spot annualized simple risk-
free rate for 6-month deposits is 2%. Describe in detail the cash flows from your FRA
position. You need to present 1) when the cash flow occurs and 2) the sizes of the cash
flows. Net cash flow suffices, but you need to make clear whether your cash flow is
positive or negative.
Solution. The investor receives the fixed FRA rate 2.92% and pays the spot rate 2%,
and as a result receives net cash flow.
The settlement cash flow happens at t + 0.5, and the size of the payment is given by
simple


FRA
rt+0.5,t+1 − rt+0.5,t+1 × 0.5
simple × Notional Principle
1 + rt+0.5,t+1 × 0.5
(2.92% − 2%) × 0.5
= × 1 million
1 + 2% × 0.5
=4.6 thousand.

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