FINS 3635 - Options, Futures, and Risk Management Techniques: Mock Final Solution

May 31, 2012

1) (a) At maturity, the shareholders get whatever is left of the assets after paying out the bondholders claims. If theres nothing left, they can abandon the rm and receive nothing but they dont have to meet the rms liabilities. Therefore, the payo to the equity holders is max (VT (X1 + X2 ), 0) . This is the payo from a European call option over the assets VT with term T and exercise price X1 + X2 . At maturity, the payo received by the senior debt holders is the face value of the debt provided the rms assets are sucient to pay this amount. Otherwise the payo is whatever the rms assets are. Therefore, the payo to the senior debt holders is X1 max (X1 VT , 0) , by considering the 2 cases: VT < X1 and VT > X1 . At maturity, the junior debtholders get paid the face value of the debt if the assets are sucient to pay it. There are 3 cases to consider: X1 + X2 < VT X1 < VT < X1 + X2 VT < X1 The payo suggests was X2 + max (X1 VT , 0) max (X1 + X2 VT , 0) . Hence, it follows that the payo on the junior debt is equivalent to long a default-free ZCB with face value X2 , long a put option with exercise price X1 and short a put option with exercise price X1 + X2 . (b) Straightforward application of risk-neutral valuation. Value(equity) Value(senior debt) Value(junior debt) = VE = C = VSD = X1 erT P1 = VJD = X2 erT + P1 P2 payo = X2 payo = VT X1 payo = 0

where C is a European call option and P1 and P2 are European put options over the value of the assets (V ) of the rm. (c) Value of senior debt is given as VSD = X1 erT P1 = 80.34 1.29 = 79.05. 1

2) (a) Consider the early exercise time T1 . At time T1 , if the option isnt exercised early the value of the Bermudan option is V (S), the value of a European option that matures at time = T2 T1 relative to time T1 , where S is the value of the stock at that time and is the time remaining till maturity. The early exercise value at time T1 is E(S) = max(S X, 0). The value of the Bermudan option at time T1 is thus max(V (S), E(S)). Note that If S X then, via put-call parity, we get C = (S X) + P + X(1 er ). It follows that C (S X) so it is not optimal to exercise early at time T1 . (b) Consider the situation as at time T1 , the early exercise date. In the case S X it is clear that the value of the put option exceeds the early exercise value (which would be zero). If S X then via put-call parity, we get C P = S Xer . P (X S) = C X(1 er ). Solving P (X S) is equivalent to solving C(S) = X(1 er ). The RHS is positive and constant and the left hand side is an increasing function of S, so we know that a solution exists. For values of S below this critical value the put is worth exercising early. This is true for any option pricing model where C is an increasing function of S and where C approaches innity as S does. (c) The equation that determine the critical value of S where it becomes worthwhile to exercise early will apply regardless of the option pricing model used, provided that model has certain reasonable features. However, dierent models may have dierent critical values S due to dierent functions f (S).

3) (a) Just consider the payo diagram of a portfolio comprising of a long position in one option wihh strike price of X1 , and a long position in another option with strike price X3 and short position in two options with strike price X2 . We consider the payo from this portfolio under three dierent share price scenarios at the maturity of the option (ST ). (b) Payo diagram. The delta of the spread is negative when the share price is below the strike price of the underlying call and put option. Delta increases with the share price and is positive when the share price is above the strike price. Gamma is always positive. Gamma increases and peaks around the strike price then decreases. Theta remains negative. The delta of the spread is negative when the share price is below the strike price of the underlying call and put option. Delta increases with the share price and is positive when the share price is above the strike price. Gamma is always positive. Gamma increases and peaks around the strike price then decreases. Theta remains negative. The combined portfolio hedges an investor against movements away from the central stock price; i.e. the investor is rewarded for any volatility in the stock price, with greater rewards for large volatility movements. This may be useful where the investor believes volatility of the share price is underpriced in the option market.

4) (a) The models assume a dierent process for the stock price. The Black-Scholes model assumes continuous stock price, where the Binomial is discrete. While the Black-Scholes is the limiting case for the Binomial, where there are only a few periods, the result would be dierent. (b) The payo of a call option is max(S K, 0). Therefore, the value of a call option will increase with increases in share price - either the actual payout increases with the share price, or the option becomes more likely to payout. When the option is well in the money, the change in option value will tend towards the full change in share price i.e. the delta will equal to one. This will be the maximum possible delta for an option that relates to a single share. A component of the value of the options relates to uncertainty around future stock price movements. This value is always positive, but will reduce over time as the time to expiry and hence uncertainty, reduces. Therefore, the value of the option will reduce over time and theta is negative. 0 S KerT

(c)

5) (a) Simple graph. (b) For 10 AW S 90, the payo from 5 turbines will be R = 250 AW S K + 5000. and 0 otherwise. If AW S > 90. In this case, the revenue will be nil. Therefore, in order to hedge this we need cash-or-nothing call options with strike price for AWS of 90. The payo needs to be $10, 000, or 10 contracts. If 10 < AW S < 90. The required payo is (20 AW S) 250. This is equal to the payo from buying 50 contracts of a put option with a strike price for AWS of 20. if AW S < 10. In this case, the revenue will be nil. However, the options in (ii) will be (20 AW S) 250. Therefore, the required hedging will be: 50 short put options with strike price for AWS of 10 and 8 cash-ornothing put options with a strike price for AWS of 10. In summary, to hedge against revenue from falling below $10, 000 per day, you would need to purchase the following options 1 : 50 long put option with a strike for AWS of 20. 50 short put option with a strike for AWS of 10. 8 cash-or-nothing put option with AWS strike level below 10. 10 cash-or-nothing call option with strike AWS of 90.

There may exist other possible strategies.