Name: Sidra

Roll No.: MBBEM-22-04

Assignment: Financial Derivatives

Problem 7.5
A currency swap has a remaining life of 15 months. It involves exchanging interest at
10% on £20 million for interest at 6% on $30 million once a year. The term structure
of interest rates in both the United Kingdom and the United States is currently flat,
and if the swap were negotiated today the interest rates exchanged would be 4% in
dollars and 7% in sterling. All interest rates are quoted with annual compounding. The
current exchange rate (dollars per pound sterling) is 1.8500. What is the value of the
swap to the party paying sterling? What is the value of the swap to the party paying
dollars?
Solution:
The swap involves exchanging the sterling interest of 20x0.10 or £2 million for the
dollar interest of 30 x 0.06 = $1.8 million. The principal amounts are also exchanged
at the end of the life of the swap. The value of the sterling bond underlying the swap
is
2/(11.07)^1/4 +22/(1.0757)^5/4 = 22.182 million pounds

The value of the dollar bond underlying the swap is

1.8/(1.04)^1/4+31.8/(1.04)^5/4 = 532.061 million

The value of the swap to the party paying sterling is therefore

32.061-(22.182×1.85) = -S8.976 million

The value of the swap to the party paying dollars is +$8.976 million. The results can
also be obtained by viewing the swap as a portfolio of forward contracts. The
continuously compounded interest rates in sterling and dollars are 6.766% per annum
and 3.922% per annum. The 3-month and 15-month forward exchange rates are 1.85
e^(0.0392-0.06766)*0.25= 1.8369 and 1.85e^(0.03922-0.06766)x1.25 = 1.7854. The
values of the two forward contracts corresponding to the exchange of interest for the
party paying sterling are therefore

(1.8-2×1.8369)e^- 0.039224*0.25 = -$1.855 million and

(1.8-2×1.7854)e ^03922x1.25 = -$1.686 million

The value of the forward contract corresponding to the exchange of principals is

(30-20×1.7854)e^- 0.03922x1.25 = -$5.435 million

The total value of the swap is -S1.855 - $1.686 - S5.435 = -$8.976 million.

Problem 9.12.
A trader buys a call option with a strike price of $45 and a put option with a strike
price of $40. Both options have the same maturity. The call costs $3 and the put costs
$4. Draw a diagram showing the variation of the trader's profit with the asset price.
Solution:
Figure S9.6 shows the variation of the trader's position with the asset price. We can
divide the alternative asset prices into three ranges:
a) When the asset price less than $40, the put option provides a payoff of 40 - Sr, and
the call option provides no payoff. The options cost $7 and so the total profit is 33-Sr,
b) When the asset price is between $40 and $45, neither option provides a payoff.
There is a net loss of $7
c) When the asset price greater than $45, the call option provides a payoff of Sr, - 45
and the put option provides no payoff. Taking into account the $7 cost of the options,
the total profit is Sr,-52.
The trader makes a profit (ignoring the time value of money) if the stock price is less
$33 or greater than $52. This type of trading strategy is known as a strangle and is
discussed in Chapter 11.
Problem 10.22:
A European call option and put option on a stock both have a strike price of $20 and
an expiration date in 3 months. Both sell for $3. The risk-free interest rate is 10% per
annum, the current stock price is $19, and a $1 dividend is expected in 1 month.
Identify the arbitrage opportunity open to a trader.?
Solution:
If the call is worth $3, put call parity shows that the put should be worth
3 + 20e^ 0.1*3/12 + e^0.1*1/12 - 19 = 4.5
This is greater than $3. The put is therefore undervalued relative to the call. The
correct arbitrage strategy is to buy the put, buy the stock, and short the call. This costs
$19. If the stock price in 3 months is greater than $20, the call is exercised. If it is less
than $20, the put is exercised. In either case, the arbitrageur sells the stock for $20 and
collects the $1 divided in 1 month. The present value of the gain to the arbitrageur is
-3 - 19 + 3 + 20e^ 0.1*3/12 + e ^0.1*1/12 = 1.5
Problem 11.4.
Call options on a stock are available with strike prices of $15, $17 1/2, and $20 and
expiration dates in three months. Their prices are $4, $2, and $1/2, respectively.
Explain how the options can be used to create a butterfly spread. Construct a table
showing how profit varies with stock price for the butterfly spread.?
Solution:
An investor can create a butterfly spread by buying call options with strike prices of
$15 and $20 and selling two call options with strike prices of $17½. The initial
investment is 4+1/2-2x2=$1/2. The following table shows the variation of profit with
the final stock price:

Problem 15.3.

Explain why employee stock options on a non-dividend-paying stock are frequently

exercised before the end of their lives whereas an exchange-traded call option on such
a stock is never exercised early.?
Solution:
It is always better for the option holder to sell a call option on a non-dividend -paying
stock rather than exercise it. Employee stock options cannot be sold and so the only
way an employee can monetize the option is to exercise the option and sell the stock.

Problem 16.5.

Explain how corporations can use range forward contracts to hedge their foreign
exchange risk when they are due to receive a certain amount of the foreign currency
in the future.?
Solution:
A range forward contract allows a corporation to ensure that the exchange rate
applicable to a transaction will not be worse that one exchange rate and will not be
better than another exchange rate. In this case, a corporation would buy a put with the
lower exchange rate and sell a call with the higher exchange rate.

Problem 17.7.

Calculate the value of a five-month European put futures option when the futures
price is $19, the strike price is 820, the risk-free interest rate is 12% per annum, and
the volatility of the futures price is 20% per annum.?
Solution:

In this case Fo =19, K = 20, r = 0.12, ϭ= 0.20, and T = 0.4167. The value

of the European put futures option is

20N(-d2)e ^-0.12x0.4167 - 19N(-d1)e^-0.12x0.4167

where

d1 = ln(19/20) + 0.04/2)0.4167/0.2√0.4167 =-0.33327

d2 = d1 -0.2√0.4167 =-0.4618

This is

e^-0.12x0.4167[20N(0.4618) -19N(0.3327)]

=e ^0.12*0..4167 (20×0.6778-19×0.6303)

= 1.50 or $1.50.
8. Use stratified sampling with 100 trials to improve the estimate of z

in Business Snapshot 20.1 and Table 20.1.

9. Suppose that the daily volatilities of asset A and asset B calculated at the close of trading
yesterday are 1.6% and 2.5%, respectively. The prices of the assets at close of trading
yesterday were $20 and $40 and the estimate of the coefficient of correlation between the
returns on the two assets was 0.25. The parameter & used in the EWMA model is 0.95. (a)
Calculate the current estimate of the covariance between the assets. (b) On the assumption that
the prices of the assets at close of trading today are $20.5 and $40.5, update the correlation
estimate.
10. How does a five-year nth-to-default credit default swap work? Consider a hasket of 100
reference entities where each reference entity has a probability of defaulting in each year of 1%.
As the default correlation between the reference entities increases what would you expect to
happen to the value of the swap when a) kappa = 1 and b) n = 25 Explain your answer.