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1) Chapter 20 Question 12

a)

Scenario Price at Expiry < Strike Price Strike Price < Price at Expiry
Value of Stock Price at Expiry + Dividend Price at Expiry + Dividend
Value of Put Strike Price - Price at Expiry 0
Total value Strike Price + Dividend Price at Expiry + Dividend

b)

Scenario Price at Expiry < Strike Price Strike Price < Price at Expiry
Value of Zero Coupon Bond Strike Price (X) + Dividend (D) Strike Price (X) + Dividend (D)
Value of Call 0 Price at Expiry - Strike Price
Total value Strike Price (X) + Dividend (D) Price at Expiry + Dividend

We can see that the value of the Zero coupon bond + the call option = value of stock + put option

c)

Put call parity condition; P = C – So + PV(X) + PV dividends

Cost of establishing the stock-plus-put portfolio = S 0 + P


Cost of establishing the call-plus-ZCB portfolio = C + PV (X + D)

S0 + P = C + PV (X + D)
P = C – So + PV(X) + PV(D)

2) Chapter 20 Question 13
a)

Position   St < X1<X2<X3 X1 < St < X2<X3 X1< X2 < St < X3 X1< X2 < X3 < St
12.5 < 15 < 20 < 15 < 17.5 < 20 < 15 < 20 < 22.5< 15 < 20 < 25 <
Example   25 25 25 27.5
           
Long call (X1)   0 St-X1 St-X1 St-X1
Short 2 calls
(X2)   0 0 -2 (St-X2) -2 (St-X2)
Long call (X3)   0 0 0 St-X3
           
Total   0 St-X1 2X2 - X1 - St X2-X1 + X2-X3 = 0
X1 X2 X3 St ->

b)

    St<X1<X2 X1<St<X2 X1< X2 < St


Buy call
(X2)   0 0 St-X2
Buy Put
(X1)   X1-St 0 0
Total   X1-St   St-X2

X1 X2 St->

3) Chapter 20 Question 14

    St<X1<X2 X1<St<X2 X1< X2 < St


Buy call
(X2)   0 0 St-X2
Sell Call
(X1)   0 -(St-X1) -(St-X1)
Total   0 X1-St X1-X2

X1 X2 St->
4) Chapter 20 CFA Question 1
Strangle strategies are used when investors expect a big price movement, but is unsure of
the direction of the movement.

The two types of strangle strategies are :

Long Strangle = Long Call (at higher strike price) and Long Put (at lower strike price)
Short Strangle = Short Call (at higher strike price) and Short Put (at lower strike price)

a) Donna could recommend the long strangle strategy. An investor who goes long a
strangle expects that the price of the underlying asset (TRT materials) will either move
substantially below the exercise price on the put or above the exercise price on the call.
b)
i. The maximum possible loss per share is $9.00, which is the total cost of the two
options (5+4)
ii. The maximum possible gain is theoretically unlimited if the stockprice moves outside
the breakeven range of prices. This specially holds true if the stock price rises. If the
stock price falls, the gain is limited to the value of the put when the stock value is zero
iii. Breakeven on upside = 60+9 = $69. Breakeven on downside = 55-9 = $46

5) Chapter 20 CFA Question 2


a) Equity index linked note: This instrument usually pays little or no coupon interest during
the term of the note. At maturity, however, the investor receives the original issue price
and an additional amount, which depends on where the equity index is at, relative to a
predetermined level.

b) Commodity linked bear bond: The commodity linked bear bond allows an investor to
participate in a decline in a commodity’s price. In exchange for a lower than market
coupon, investors receive a redemption value that exceeds the purchase price if the
commodity price has declined by the maturity date.

6) Chapter 20 CFA Question 3


a) Conversion value of a convertible bond is the value of the security if it is converted:
Conversion value = market price of stock * conversion ratio = 40*22 = $880
b) Market conversion price is the price that an investor effectively pays for the common stock if
the convertible bond is purchased:
Market conversion price = Market price of the convertible bond / conversion ratio = 1050/22
= $47.72

7) Chapter 20 CFA Question 4


a)
i. Current market conversion price = market price of convertible bond / conversion
ratio = 980/25 = $39.20
ii. Expected 1 year return for convertible bond = [(end of year price + coupon)/current
price] -1 = [(1125+40)/980] -1 = 18.88%
iii. Expected 1 year return for common equity = [(end of year price + dividend)/current
price] -1 = [(45+0)/35] -1 = 28.57%
b) The two components of a convertible bond’s value are the straight bond value, which is
the convertible bond’s value as a bond and the option value, which is the value
associated with the potential conversion ratio
i. The straight bond value should stay the same and the option value should increase.
ii. The straight bond value should decrease and the option value should increase. (The
option value increases as call option values increase as interest rates increase).

8) Chapter 20 CFA Question 5


a) ii. Profit =$13.50;
Long call option leg - Strike Price = $25, Premium paid = $4
Short Call option leg - Strike Price = $40, Premium received = $2.50
Maturity price = 50
Net result = -4+2.5+(50-25)+(-50+40) = $13.50

b) i. $38.00 and $3.50


Short put option leg - Strike Price = $40, Premium received = $2
Maximum amount payable =40-2=38

Short call option leg - Strike Price = $40, Premium received = $3.5
Maximum amount received = premium = $3.50

9) Chapter 22 Question 12
According to the parity relation, the proper price for December futures is:
FDec = FJun (1+rf)^6/12 = 846.30*1.05^0.5 = $867.20
The actual December price is lower than the calculated one. One can go long in the
December contract and short the June contract

10) Chapter 22 Question 13


a) The quoted futures price for a single stock would be 120*1.06 = $127.20
b) Stock price falls to 120*0.97 = $116.4
Futures price falls to 116.4*1.06 = $123.384
Loss = (127.2-123.384)*1000 = $3,816
c) Return = -3,816/12,000 = -31.8%

11) Chapter 22 Question 14


a) Initial futures price = 1300 [1 + (0.005-0.002)]^12 = $1,347.58
In one month, futures price = 1320 [1 + (0.005-0.002)]^11 = $1,364.22
Mark to market proceeds = (1,364.22 - 1,347.58)* 250 = $4,160
b) HPR = 4,160/13,000 = 32%

12) Chapter 22 CFA Question 1

a) Commodity spot price = $120


Futures price for commodity expiring in 1 year = $125
Interest rate for 1 year = 8%; Calculated future price = 120*1.08 = $129.6

An arbitrage opportunity does exist. Joan can make use of a ‘reverse cash and
carry’. Joan can sell the asset short, use the proceeds to lend at the prevailing
interest rate, and then buy the asset for future delivery. At the future date, she
can collect the proceeds of the loan with interest, accept delivery of the asset
and cover the short position in the commodity.

b)

Action Cash flows now Cash flows after one year


Sell the Asset Short 120 -125
Buy commodity futures expiring in one year 0 0
Invest money for 1 year @ 8% -120 129.6
Net cash flow 0 4.6
Assuming no transaction costs or margin requirements for the futures.

13) Chapter 22 CFA Question 2


a) The call option is a less risky alternative for the company at a relatively lower cost. If the
Swiss franc rises (above the strike price), the company can buy francs at the
predetermined strike price of the call to service its debt, capping its risk to currency
fluctuations. On the other hand, if the franc falls, the firm’s loss is limited to the
premium paid on the call option.

In futures and forwards, the dollar cost of financing is locked in regardless of the future
movements of the franc. The firm may face an issue with regard to mark to market in
the case of futures. It may face demands of large margin requirements if the currency
movements are large.

b) The call option may seem simple and more rewarding (ability to profit from a declining
franc), but there is a cost associated with it (the premium). This may be recommended
for firms with adequate financial expertise in currency speculation.
For firms without specialised knowledge, forwards or futures contracts may be
preferred, where the future costs of repaying the debt can be locked in.

14) Chapter 22 CFA Question 4


a) The investor should sell the bond forward contract to protect the value of the bond
against rising interest rates during the holding period. (As the investor is long in the
asset, the hedge requires a short position)
b) Value of forward contact on expiration date = Spot price of asset on expiration date –
forward price of asset;
= 978.40 – 1,024.70 = $-46.30
(The negative value is for a long holder. For a short holder, the amount would be a gain)
c) Value of combined portfolio = 978.40+46.30 = $1,024.70
Change = 1,024.70-1000 = $24.70

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