Assignment 2 - 2013

Useful information: this assignment should be handed in no later than at 8:15 on Tuesday October 1st, either before the lecture or at my o ce (M 338). Please write your names and student numbers on each page of your solution sheets. You are suppose to form teams of 2 or 3 students, unless you have special permission to deviate from this rule. Exercise 1: An investor receives $2200 in one year in return for an investment of $2000 now. Calculate the percentage return per annum with: 1. Annual compounding 2. Semiannual compounding 3. Monthly compounding 4. Continuous compounding

Exercise 2: A one-year long forward contract on a non-dividend paying stock is entered into when the stock price is $40 and the risk-free rate of interest is 10% per annum with continuous compounding. 1. What are the forward price and the initial value of the forward contract? 2. Six months later the price of the stock is $45 and the risk-free rate is 10% per annum with continuous compounding. What are the forward price and the value of the forward contract

Exercise 3: Suppose that F1 and F2 are two forward contracts on the same consumption commodity with times to maturity t1 and t2 > t1 . Argue that F2 F1 er(t2
t1 )

where r is the constant interest rate

with continuous compounding. Throughout we assume that there are no storage costs 1

Hint: consider a strategy where you are long a forward with expiry at t2 and short a forward contract with expiry at t1 . You are also allowed to borrow money in the bank!

Exercise 4: Suppose that the Treasury bond futures price is 101-12. Which of the following bonds is cheapest to deliver: Bond 1 2 3 4 Price 125-05 142-15 115-31 144-02 CF 1.2131 1.3792 1.1149 1.4026

Exercise 5: It is July 30, 2002. The cheapest-to-deliver bond in a September 2002 Treasury bond futures contract is a 13% coupon bond, and delivery is expected to be made on September 30, 2002. Coupon payments on the bond are made on February 4 and August 4 each year. The term structure is at, and the rate of interest with semi-annual compounding is 12% per annum. The conversion factor for the bond is 1.5. The current quoted bond price is $110. Calculate the quoted futures price for the contract.

Exercise 6: Companies A and B have been oered the following rates per annum with continuous compounding on a $20 million ve-year loan. Fixed Rate Company A Company B 12.0% 13.4% Floating rate LIBOR+0.1% LIBOR+0.6%

Company A requires a oating loan while company B requires a xed-rate loan. Design a swap that will give an intermediary bank 0.1% per annum of the notional, and that will appear equally attractive to both companies. 2

Exercise 7: A $100 million interest rate swap has a remaining life of 10 months. Under the terms of the swap, six-month LIBOR is exchanged for 12% per annum (compounded semiannually). The average of the bid-oer rate being exchange for six-month LIBOR in swaps of all maturities is currently 10% per annum with continuous compounding. The six-month LIBOR rate was 9.6% per annum two months ago. What is the current value of the swap to the party paying oating. What is the value to the party paying xed?

Exercise 8: A currency swap has a remaining life of 15 months. It involves exchanging interest at 14% on 20 million for interest at 10% on $30 million once a year. The term structure of interest rates in both the UK and the US is at, and if the swap were negotiated today the interest rates exchanged would be 8% in dollars and 11% in sterling. All interest rates are quoted with annual compounding. The current exchange rate (dollar per pound sterling) is 1.65. What is the value of the swap to the party paying sterling? What is the value of the swap to the party paying dollars?

Exercise 9: Explain carefully the dierence between writing a put option and buying a call option.

Exercise 10: Prove equations 10.8 and 10.9 on page 229 in the Hull book

Exercise 11: The price of an European call that expires in six months and has a strike price of $30 is $2. The underlying stock price is $29 and a dividend of $0.5 is expected in two months and again in ve months. The term structure is at, with all risk-free rates being 10%. What is the price of a European put option that expires in six months and has a strike price of $30?

Exercise 12: Prove equation 10.7 on page 224 of the Hull book. 3

Exercise 13: Use the put-call parity to relate the initial investment for a bull spread created using calls to the initial investment for a bull spread created using puts.

Exercise 14: Use the put-call parity to show that the cost of a butter y spread created from European puts is identical to the cost of a butter y spread created from European calls