Selected & Annotated FRM 2010 Questions: Valuation & Risk Models: Hull, Chapters 11,13 & 17

Valuation & Risk Models: Hull, Chapters 11,13 & 17
Selected & Annotated FRM 2010 Questions
By David Harper, CFA FRM CIPM

www.bionicturtle.com
Table of Contents
Hull Chapter 11 .......................................................................................... 2
Hull Chapter 13 ........................................................................................ 11
Hull Chapter 17 ........................................................................................ 24
FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 1
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Hull Chapter 11
Hull.11.01:
A stock price is currently $40. It is know that at the end of 1 month it will
be either $42 or $38. The risk-free interest rate is 8% per annum with
continuous compounding. What is the value of a 1-month European call
option with a strike price of $39?
Answer:
Click here for spreadsheet
Consider a portfolio consisting of:

-1: call option
+: shares
If the stock price rises to $42, the portfolio is worth 42 3. If the stock price falls to $38, it is
worth 38. These are the same when
42 3 = 38
or = 0.75. The value of the portfolio in one month is 28.5 for both stock prices. Its value today
must be present value of 28.5, 28.5e^-0.08x0.08333 = 28.31. This means that
-f + 40 = 28.31
where f is the call price. Because = 0.75, call price is 40 x 0.75 28.31 = $1.69. As an alternative
approach, we can calculate the probability, p, of an up movement in a risk-neutral world. This
must satisfy:
42p + 38(l p) + 40e^0.08x0.08333
so that
4p = 40e^0.08x0.08333 38
or p = 0.5669. The value of the option is then its expected payoff discounted at the risk-free rate:
[3 x 0.5669 + 0 x 0.4331]e^-0.08x0.08333 = 1.69
or $1.69. This agrees with the previous calculation.
Hull.11.02:
Explain the no-arbitrage and risk-neutral valuation approaches to valuing
a European option using a one-step binomial tree.
Answer:
In the no-arbitrage approach, we set up a riskless portfolio consisting of a position in the option
and a position in the stock. By setting the return on the portfolio equal to the risk-free option
and a position in the stock. By setting the return on the portfolio equal to the risk-free interest
rate, we are able to value the option. When we use risk-neutral valuation, we first choose
probabilities for the branches of the tree so that the expected return on the stock equals the riskfree interest rate. We then value the option by calculating its expected payoff and discounting
this expected payoff at the risk-free interest rate.
Hull.11.03:
11.03 What is meant by the delta of a stock option?
11.03b. Please express delta as a derivative.
11.03c.
What are the units of option delta

For the following questions, assume stock price = $10, strike price = $10, volatility =
20%, riskfree rate = 4%, and term = 1.0 year.
11.03d. What is the delta of call option?

11.03e. What is the delta of a put option with same terms as above?
11.03f.
If an investor has sold (written) 1,000 call options, what trade achieves a delta-neutral
hedge?
11.03g. What are the limitations of this delta-neutral hedge?

11.03h. Does this delta-neutral hedge have negative or positive gamma? Is the position long or
short volatility?
11.03i.
What is the gamma of the underlying stock?
Answer:
11.03. The delta of a stock option measures the sensitivity of the option price to the price of the
stock option to the change in the price of the underlying stock.
11.03b. Please express delta as a derivative.
D(call)/d(Stock); i.e., (instantaneous) rate of the change of the option price with respect to the
price of the underlying stock
11.03c. What are the units of option delta?
Unitless as both option price and stock price are in the same dollar units; so they cancel.
For the following questions, assume stock price = $10, strike price = $10, volatility = 20%,
riskfree rate = 4%, and term = 1.0 year.
11.03d. What is the delta of call option?
d1 = (LN(10/10) + (4% + 20%^2/2)*1) / (20%*SQRT(1)) = 0.30
N(d1) = delta = 0.6179
and for ATM call option, we expect delta ~ 0.5 to 0.6, so this looks right
11.03e. What is the delta of a put option with same terms as above?
delta of European put option on non-dividend stock = N(d1) 1 = -0.382
11.03f. If an investor has sold (written) 1,000 call options, what trade achieves a delta-neutral
hedge?
1,000 options * 0.62 percentage delta = 620 position delta
such that investors needs a LONG POSITION in 620 shares
since 620 shares * 1.0 delta/share = + 620 position delta for shares
11.03g. What are the limitations of this delta-neutral hedge?
It only holds for a short period of time and for small movements in the underlying; when the
underlying moves, the delta changes.
11.03h. Does this delta-neutral hedge have negative or positive gamma? Is the position long or
short volatility?
The short options have negative gamma; the delta hedge (short options and long shares) is short
volatility.
11.03i. What is the gamma of the underlying stock?
The gamma is the 1st derivative of the delta. As the delta of a share is constant at 1.0, the gamma
of the share is zero. (ergo, the long share position above does not change the negative gamma of
the short option position)
Hull.11.04:
A stock price is currently $50. It is known that at the end of 6 months it
will be either $45 or $55. The risk-free interest rate is 10% per annum
with continuous compounding. What is the value of a 6-month European
put option with a strike price of $50?
Answer:
Consider a portfolio consisting of:

-1 : put option
+ : shares
If the stock price rises to $55, this is worth 55. If the stock price falls to $45, the portfolio is
worth 45 5 = 55 or = -0.50. The value of the portfolio in one month is -27.5 for both stock
prices. Its value today must be the present value of -27.5, or -27.5e^-0.1x0.5 = 26.16. This means
that -f + 50 = -26.16
where f is the put price. Because = -0.50, the put price is $1.16. As an alternative approach we
can calculate the probability, p, of an up movement in a risk-neutral world. This must satisfy:
55p + 45(1 p) = 50e^0.1x0.5, so that
10p = 50e^0.1x0.5 45
or p = 0.7564. The value of the option is then its expected payoff discounted at the risk-free rate:
[0 x 0.7564 + 5 x 0.2436][EXP(-0.1x0.5)] = 1.16 or $1.16. This agrees with the previous
calculation.
Hull.11.05:
A stock price is currently $100. Over each of the next two 6-months it is
expected to go up by 10% or down by 10%. The risk-free interest rate is
8% per annum with continuous compounding. Keeping this in mind:
a) What is the value of a 1-year European call option with a strike price of $100?
b) What is the value of a 1-year European put option with a strike price of $100? Also,
verify that the European call and European put prices satisfy put-call parity.
Answer:
a. What is the value of a 1-year European call option with a strike price of $100?
In this case u = 1.10, d = 0.90, = 0.5, and r = 0.08, so that

p = [EXP(0.08*0.5) - 0.90] / [1.10 - 0.90] = 0.7041
The tree for stock price movements is shown in Figure S11.1. We can work back from the end of
the tree to the beginning, as indicated in the diagram, to give the value of the option as $9.61.
The option value can also be calculated directly from equation (11.10):
[0.704^2 x 21 + 2 x 0.704 x 0.2959 x 0 + 0.2959^2 x 0][EXP(-2x0.08x0.5) = $9.61
b. What is the value of a 1-year European put option with a strike price of $100?
b. Figure S11.2 shows how we can value the put option using the same tree as in Problem 11.5.
The value of the option is $1.92. The option value can also be calculated directly from equation
(11.10):
[EXP(-2x0.08x0.5)][0.7041^2 x 0 + 2 x 0.7041 xx 0.2959 x 1 + 0.2959^2 x 19] = $1.92
or $1.92. The stock price plus the put price is 100 + 1.92 = $101.92. These are the same, verifying
that put-call parity holds.
Hull.11.12 & 13:

11.12: A stock price is currently $50. Over each of the next two 3-month
periods, it is expected to go up by 6% or down by 5%. The risk-free
interest rate is 5% per annum with continuous compounding. What is the
value of a 6-month European call option with strike price of $51?
11.12b. Ignore the assumption that the stock price will go down by 5%. Instead, assuming the
stock price will go up by 6%, find the implied volatility and the down movement (d) that match
volatility to with up (u) and down (d).
11.13 For the situation above, what is the value of a 6-month European put option with a strike
price of $51? Verify that the European call and European put satisfy put-call parity. If the put
option were American, would it ever be optimal to exercise it early at any of the nodes on the
tree?
11.13b. Doesnt Hull say that it is suboptimal to exercise an American option early? How can
early exercise, as above, be optimal?
Answers:
11.12. Option Price = $1.635
11.12b. If u=1.06, then implied volatility = LN(1.06)/SQRT(0.25) = 11.65%. To match volatility,

down(d) = 1/1.06 = 0.943. In this case, option value = $1.7784
11.13. Option Price = $1.376. Put-call parity says: Stock price + put = $51.36 should equal
Call price + *discounted* strike price = $51.376!
11.13b. Hull says it is never optimal to early exercise an American option. But a put option
should always be exercised early if it is sufficiently deep in the money.
Hull.11.15:
Calculate u, d, and p when a binomial tree is constructed to value an
option on a foreign currency. The tree step size is 1 month, the domestic
interest rate is 5% per annum. The foreign interest rate is 8% per annum,
and the volatility is 12% per annum.
Answer:
In this case
a = EXP(0.05-0.08)*(1/12) = 0.9975
u = EXP(0.12*SQRT(1/12)) = 1.0352
d = l/u = 0.9660
p = (0.09975 0.9660)/(1.0352 0.9660) = 0.4553
Hull Chapter 13
Hull.13.01:
What does the Black-Scholes stock option pricing model assume about the
probability distribution of the stock price in one year? What does it
assume about the continuously compounded rate of return on the stock
during the year?
13.01b. If u = 1.1, solve for both an arithmetic down (d) and a geometric down (d)
13.01c.
Under what conditions should the binomial OPM approximate (or, converge to) the
Black-Scholes-Merton OPM?
13.01d. Which OPM relies on the assets (stocks) expected return?

13.01e. Which OPM utilizes risk-neutral valuation; i.e., the option value produced in the riskfree world, where the riskless rate is the expected return, is valid in the real (risky)
world?
13.01f.
In theory, which is better suited to pricing an employee/executive stock option (ESO)?
Answer:
13.01 The Black-Scholes option pricing model assumes that the probability distribution of the
stock price in 1 year (or at any other future time) is lognormal. It assumes that the continuously
compounded rate of return on the stock during the year is normally distributed.
13.01b.
Arithmetic down = 0.9; i.e., +10% up and -10% down
Geometric down = 1/1.1 = 0.9091
Note: the binomial in Hull which matches volatility with up and down assumes geometric
13.01c. There are basically two conditions:
First, as the binomial is infinitely flexible, its distributional assumption must approximate the
Brownian motion (GBM) assumed in the Black-Scholes; it must be a Cox-Ross-and Rubenstein
(CRR) tree.
Second, as the binomial is discrete while the Black-Scholes is continuous, the number of steps
must be increased.
In brief, as the number of steps in the discrete CRR increase, the binomial converges to the
Black-Scholes Merton.
13.01d. Neither!
13.01e. Both! (note: riskless rate is an input)
13.01f. In theory, which is better suited to pricing an employee/executive stock option (ESO)?
Probably the binomial because it lends itself to the exotic features of an ESOs. In particular, the
vesting and forfeiture restrictions (e.g.., an ESO is almost American-style but typically cannot be
exercised in the first 3 to 4 years) that can be easily simulated in the binomial (and which, while
possible in the analytical BSM, are more difficult).
Hull.13.04:
13.04 Calculate the price of a 3-month European put option on a nondividend-paying stock with a strike price of $50 when the current stock
price is $50, the risk-free interest rate is 10% per annum, and the
volatility is 30% per annum.
13.04b. Compare this price given by a two-step binomial tree?
Answer:
In this case S0 = 50, K = 50, r = 0.1, sigma = 0.3, T = 0.25, and

d1 = (ln(50/50) + (0.1 + 0.09/2)*0.25)/[0.3*SQRT(.25)] = 0.2417
d2 = d1 0.3 * SQRT (0.25)= 0.0917
The European put price is
50* N(-0.0917)* EXP(-0.1*0.25) 50*N(-0.2417) = $2.37
13.04. Binomial two-step put price = $2.04
Hull.13.05:
Assume a 3-month European put option on a stock with a strike price of
$50 when the current stock price is $50, the risk-free interest rate is 10%
per annum, and the volatility is 30% per annum (i.e., same assumptions as
Hull. 13.04).
13.05.
If a dividend of $1.50 is expected in 2 months, what is the price of a put option?
13.05b. If the dividend yield is 2%, what is the put price according to Black-Scholes?
13.05c.
If the dividend yield is 2%, what is the put price according to a two-step binomial?
13.05d. Briefly summarize the directional impact of dividends on both a European call option
and put option.
Answer:
13.05 In this case we must subtract the present value of the dividend from the stock price before
using Black-Scholes. Hence the appropriate value of S0 is
S0 = 50 1.50 [EXP(-0.1667x0.1)] = 48.52
As before K = 50, r = 0.1, sigma (volatility) = 0.3, and T = 0.25. In this case
d1 = [LN(48.52/50) + (0.1 + 0.09/2)0.25]/[0.3 *SQRT(0.25)] = 0.0414
d2 = d1 0.3*SQRT(0.25) = -0.1086
The European put price is: 50*N(0.1086)*EXP(-0.1*0.25) 48.52*N(-0.0414)
= 50 x 0.5432{EXP(-0.1x0.25)] 48.52 x 0.4835 = $3.03
13.05b. If the dividend yield is 2%, what is the put price according to Black-Scholes?
Put price = $2.478
13.05c. If the dividend yield is 2%, what is the put price according to a two-step binomial
The only difference here is that a = EXP(riskless rate dividend yield)*Time step.
Put price = $2.14
13.05d. Briefly summarize the directional impact of dividends on both a European call option and
put option.
As the dividend effectively decreases the value of the stock price in the models, an increase in
dividend yield has the same directional impact as a decrease in the stock price: An increase in
dividend lowers the value of a call and increases the value of a put.
Here is a way to remember that a dividend effectively lowers the stock price:
Consider that total return = capital appreciation + dividend income;
For a given total return, higher dividend income implies lower capital appreciation.
(i.e., the option holder forgoes the dividend)
Hull.13.06:
What is implied volatility? How can it be calculated?
13.06b.
Assume stock price on a non-dividend paying stock = $10, strike price = $10, riskless
rate = 5%, and term = 1 year. What is the implied volatility if the price of a European
call option is $1.00?
13.06c.
Under what conditions should the implied volatility of a European put option equal
the answer above for the European put?
13.06d.
Assume the option exhibits a volatility smile. What does this imply about the actual
distribution of the underlying stock in comparison to the theoretical assumption
underlying Black-Scholes?
13.06e.
According to Hull, implied volatility for equity options tends to be skewed; i.e.,
volatility is highest for low strike prices, and then implied volatility decreases as the
strike price increases. If this is true, yet we use the Black-Scholes-Merton to price
options, what is the implication of our error for both (i) deep out-of-the-money
options and (ii) deep in-the-money options?
13.06f.
Use the Merton model to posit a theory for why equity options should exhibit a smile.
Answer:
Click here for spreadsheet http://sheet.zoho.com/public/btzoho/hull-13-06
13.06 The implied volatility is the volatility that makes the Black-Scholes price of an option equal
to its market price. It is calculated using an iterative procedure.
13.06b. A volatility of 18.8% will produce a model price of approximately $1.00 for the European
call option. (This will not be asked on the exam, as there is no analytical solution).
13.06c. If the strike price and the maturity date are the same, per put-call parity, the implied
volatility of the call must equal the implied volatility of the put.
13.06d. The theoretical assumption underlying BSM is that the asset price exhibits a lognormal
distribution (i.e., log returns are normally distributed). A volatility smile suggest at least one tail
will be heavy-tailed; i.e., if the smile is really a smile and not a skew/smirk, then both tails are
heavy vis--vis the lognormal.
13.06e. At low strike prices (i.e., deep inthe-money call, deep out-of-the-money put), actual
price is higher than model price (our model underestimates price as the implied volatility is
higher than our input).
At high strike prices (i.e., deep outthe-money call, deep in-of-the-money put), actual price is
lower than model price (our model overestimates price as the implied volatility is lower than
our input)
13.06f. In Merton, equity is like a call option on firm assets with strike price a function of debt.
As equity declines (i.e., the distance to default is lower), leverage increases, and the equity is
riskier which manifest as higher volatility. As equity increase, leverage decreases and the equity
is less risky which manifests as lower volatility.
Hull.13.07:
Hull.13.07. A stock price is currently $40. Assume that the expected
return from the stock is 15% and that its volatility is 25%. What is the
probability distribution for the rate of return (with continuous
compounding) earned over a 2-year period?
At the end of the 2-year period:
13.07b.
What is the median stock price?
13.07c.
What is the mean (expected) stock price?
13.07d.
What is the 95% confidence interval for the stock?
13.07e.
What is the 95% confidence value at risk (VaR)?
Answer:
13.07 In this case mu = 0.15, and sigma= 0.25. From equation (Hull 13.7) the probability
distribution for the rate of return over a 2-year period with continuous compounding is:
(0.15 [0.25^2/2], [0.25/2])
i.e.,
(0.11875, 0.1768)
The expected value of the return is 11.875% per annum and the standard deviation is 17.68%
per annum.
13.07b. Median = $40*EXP((15%-25%^2/2)*2) = $50.72
13.07c. Mean = $40*EXP(15%*2)=$53.99
The price distribution is lognormal (log returns are normal), which is positively skewed: the
mean is greater than the median!
13.07d. See XLS, the interval is two-tailed. Deviate is 1.96.
Interval = {$25.37, $101.43}
13.07e. VaR is one-tailed! Deviate is 1.645. Lower bound (95% VaR) = $28.36
Hull.13.08:
A stock price follows geometric Brownian motion with an expected return
of 16% per annum and a volatility of 35% per annum. The current price is
$38.
13.08a. What is the probability that a European call option on the stock with an exercise price
of $40 and a maturity date in 6 months will be exercised?
13.08b. What is the probability that a European put option on the stock with the same exercise
price and maturity will be exercised?
13.08c.
What is the 95% confidence interval for the stock price in six months?
13.08d. What is the 95% absolute value at risk (VaR) at the end of six months?
13.08e. What is the 95% relative value at risk (VaR) at the end of six months
Answer:
Click here for spreadsheet: http://sheet.zoho.com/public/btzoho/hull-13-08-2
13.08a. The required probability is the probability of the stock price being above $40 in six
months time. Suppose that the stock price in six months is S(t)
LN(St) ~ (LN38 + (0.16 0.35^2)*0.5, 0.35 *SQRT(.5)); i.e., LN(St) ~ (3.687, 0.247)
Since ln40 = 3.689, the required probability is: 1 N([3.689 3.687]/0.247) = l N(0.008)
From normal distribution N(0.008) = 0.5032 so that the required probability is 0.4968. In
general the required probability is N (d2).
13.08.b. In this case the required probability is the probability of the stock price being less than
$40 in six months time. It is l 0.4968 = 0.5032
13.08.c. 95% confidence interval = {$24.58, 64.85}
13.08.d. 95% absolute VaR = $38 - $26.57 = $11.43
13.08.e. 95% relative VaR = $39.92 - $26.57 = $13.35
Hull.13.13:
What is the price of a. European call option on a non-dividend-paying
stock when the stock price is $52, the strike price is $50, the risk-free
interest rate is 12% per annum, the volatility is 30% per annum, and the
time to maturity is 3 months?
Answer:
Spreadsheet: http://sheet.zoho.com/public/btzoho/hull-13-13
Hull.13.14:
What is the price of a European put option on a non-dividend-paying
stock when the stock price is $69, the strike price is $70, the risk-free
interest rate is 5% per annum, the volatility is 35% per annum, and the
time to maturity is 6 months?
Answer:
Spreadsheet: http://sheet.zoho.com/public/btzoho/hull-13-14
Hull.13.15:
Consider an American call option on a stock. The stock price is $70, the
time to maturity is 8 months, the risk-free rate of interest is 10% per
annum, the exercise price is $65, and the volatility is 32%. A dividend of
$1 is expected after 3 months and again after 6 months. Show that it can
never be optimal to exercise the option on either of the two dividend
dates.
Answer:
It is not optimal to exercise if: Dn <= K*[1-EXP(-rate(T-tn))]

In this case D1 and D2 = $1.00,
And K @ t2 = $1.07 and K @ t1 = $1.60
Hull Chapter 17
Hull.17.02:
What does it mean to assert that the delta of a call option is 0.7? How can
a short position in 1,000 options be made delta neutral when the delta of
each option is 0.7?
Answer:
A delta of 0.7 means that, when the price of the stock increases by a small amount, the price of
the option increases by 70% of this amount. Similarly, when the price of the stock decreases by a
small amount, the price of the option decreases by 70% of this amount. A short position in 1,000
options has a delta of -700 and can be made delta neutral with the purchase of 700 shares.
Hull.17.03:
Calculate the delta of an at-the-money 6-month European call option on a
non-dividend-paying stock when the risk-free interest rate is 10% per
annum and the stock price volatility is 25% per annum.
17.03b. What is the delta of a put with the same features (i.e., ATM, sigma = 25%, term = 0.5
years, Riskfree rate = 10%)?
17.03c.
Holding everything else constant, what happens to delta as the stock price increases?
As stock price decreases?
17.03d. Holding everything else constant, what happens to delta (naturally) as time to maturity
decreases?
17.03e. What is the meaning of, and what do we call, the first derivative of delta (with respect
to stock price)? Where is this value likely highest?
Answer:
17.03 In this case S0 = K, r = 0.1, sigma = 0.25, and T = 0.5. Also,

d1 = [ln(S0/K) + (0.1 + 0.25^2/2)*0.5]/[0.25*SQRT(0.5)] = 0.3712.
The delta of the option is N(d1) or 0.64.
17.03b. Delta of put = N(d1) 1. In this case, 0.6448 1 = - 0.3552
17.03c. As stock price increase, delta of increases and converges to (is asymptotic to) 1.0; i.e., a
deeply-in-the-money call option has a delta nearer to 1.0 as a $1 stock price increase translates
mostly into the option value. As the stock price decreases, delta decreases and converges toward
zero.
17.03d. For an at the money (ATM) call option, delta is increasing with time
17.03e. Gamma is the first derivative of delta; i.e., gamma is the second partial derivative of the
option with respect to stock (asset) price. Gamma will tend to be highest at the money
Hull.17.04:
What does it mean to assert that the theta of an option position is -0.1
when time is measure in years? If a trader feels that neither a stock price
nor its implied volatility will change, what type of option position is
appropriate?
Answer:
A theta of -0.1 means that if t years pass with no change in either the stock price or its volatility,
the value of the option declines by 0.1t. If a trader feels that neither the stock price nor its
implied volatility will change, he or she should write an option with as high a theta as possible.
Relatively short-life at-the-money options have the highest theta.
Hull.17.05:
What is meant by the gamma of an option position? What are the risks in
the situation where the gamma of a position is large and negative and the
delta is zero?
Answer:
The gamma of an option position is the rate of change of the delta of the position with respect to
the asset price. For example, a gamma of 0.1 would indicate that when the asset price increases
by a certain small amount delta increases by 0.1 of this amount. When the gamma of an option
writers position is large and negative and the delta is zero, the option writer will lose significant
amounts of money if there is a large movement (either an increase or a decrease) in the asset
price.
Hull.17.06:
The procedure for creating an option position synthetically is the
reverse of the procedure for hedging the option position. Explain this
statement.
Answer:
To hedge an option position it is necessary to create the opposite option position synthetically.
For example, to hedge a long position in a put it is necessary to create a short position in a put
synthetically. It follows that the procedure for creating an option position synthetically is the
reverse of the procedure for hedging the option position.
Hull.17.07:
Why did portfolio insurance not work well on October 19, 1987?
Answer:
Portfolio insurance involves creating a put option synthetically. It assumes that as soon as a
portfolios value declines by a small amount the portfolio managers position is rebalanced by
either (a) selling part of the portfolio, or (b) selling index futures. On October 19, 1987, the
market declined so quickly that the sort of rebalancing anticipated in portfolio insurance
schemes could not be accomplished.
Hull.17.08:
The Black-Scholes price of an out-of-the-money call option with an
exercise price of $40 is $4. A trader who has written the option plans to
use a stop-loss strategy. The traders plan is to buy at $40.10 and to sell
at the $39.90. Estimate the expected number of times the stock will be
bought or sold.
Answer:
The strategy costs the trader $0.20 each time the stock is bought and sold. The total expected
cost of the strategy, in present value terms, must be $4. This means that the expected number of
times the stock will be bought and sold is approximately 20. The expected number of times it
will be bought is approximately 20 and the expected number of times it will be sold is also
approximately 20. The buy and sell transactions can take place at any time during the life of the
option. The above numbers are therefore only approximately correct because of the effects of
discounting. Also they assume a risk-neutral world.
Hull.17.09:
Suppose that a stock price is currently $20 and that a call option with an
exercise price of $25 is created synthetically using a continually changing
position in the stock. Consider the following two scenarios:
a) Stock price increases steadily from $20 to $35 during the life of the option.
b) Stock price oscillates wildly, ending up at $35.
Which scenario would make the synthetically created option more expensive? Explain your
answer.
Answer:
The holding of the stock at any given time must be N(d1). Hence the stock is bought just after the
price has risen and sold just after the price has fallen. (This is the buy high sell low strategy
referred to in the text.) In the first scenario the stock is continually bought. In second scenario
the stock is bought, sold, bought again, etc. the final holding is the same in both scenarios. The
buy, sell, buy, sellsituation clearly leads to higher costs than the buy, buy, buysituation. This
problem emphasizes one disadvantage of creating options synthetically. Whereas the cost of an
option that is purchased is known up front and depends on the forecasted volatility the cost of
an option that is created synthetically is not known up front and depend on the volatility actually
encountered.
Hull.17.12 & 13:

17.12: A company uses delta hedging to hedge a portfolio of long
positions in put and call options on a currency. Which of the following
would give the most favorable result?
a) A virtually constant spot rate
b) Wild movements in the spot rate
Explain your answer.
17.13. Repeat this problem for a financial institution with a portfolio of short positions in put
and call options on a currency.
Answer:
17.12. A long position in either a put or a call option has a positive gamma. From Figure 15.8,
when gamma is positive the hedger gains from a large change in the stock price and loses from a
small change in the stock price. Hence the hedger will fare better in case (b).
17.13. A short position in either a put or a call option has a negative gamma. From Figure 15.8,
when gamma is negative the hedger gains from a small change in the stock price and loses from
a large change in the stock price. Hence the hedger will fare better in case (a).
It is maybe easier to follow Carol Alexanders terminology:
An options percentage gamma is always positive; e.g., gamma = 0.06 for either a call or a put
If we are long 1,000 call options, then the position gamma = 1,000 * 0.06 = 60
If we are short 1,000 call options, then the position gamma = -1,000 * 0.06 = -60
In summary: position Greek = Quantity * percentage Greek
...viewed this way, we can interpret a negative Gamma as a negative position Gamma owing to a
short position, where the percentage Gamma is always positive.
Hull.17.14:
A financial institution has just sold 1,000 7-month European call options
on the Japanese yen. Suppose that the spot exchange rate is 0.80 cent
per yen, the exercise price is 0.81 cent per yen, the risk-free interest
rate in the United States is 8% per annum, the risk-free interest rate in
Japan is 5% per annum, and the volatility of the yen is 15% per annum.
Calculate the delta, gamma, vega, theta, and rho of the financial
institutions position. Interpret each number.
Answer:
Click here for spreadsheet:
http://sheet.zoho.com/public/btzoho/hull-15-14
Delta = 0.5249
Gamma = 4.206
Vega = 0.2355
Theta = -.0399
Rho = 0.2231
Delta: when the spot price increase by a small amount, the value of an option to buy one yen
increases by 0.525 times that amount.
Gamma: when the spot price increases by a small amount (measured in cents), the delta
increases by 4.2 times that amount. The gamma of a long position is always positive.
Vega: when the volatility increases by a small amount, the options value increases by 0.2355
times that amount.
Theta: when a small amount of time passes (measured in years), the options value decreases by
0.0399 times that amount. Please note the intuition of a necessarily negative theta. As time
maturity decreases, the time value of the option almost always must decrease.
Rho: when the interest rate increases by a small amount, the options value increases by 0.2231
times that amount.
Hull.17.16:
Note: this is advanced. An FRM candidate can skip this question without worry, unless you
seek reinforcement of the foundation - David
Hull.17.16. A fund manager has a well-diversified portfolio that mirrors

the performance of the S&P 500 and is worth $360 million. The value of
the S&P 500 is 1,200, and the portfolio manager would like to buy
insurance against a reduction of more than 5% in the value of the
portfolio over the next 6 months. The risk-free interest rate is 6% per
annum. The dividend yield on both the portfolio and the S&P 500 is 3%,
and the volatility of the index is 30% per annum.
a) If the fund manager buys traded European put options, how much would the insurance
cost?
b) Explain carefully alternative strategies open to the fund manager involving traded
European call options, and show that they lead to the same result.
c) If the fund manager decides. to provide insurance by keeping part of the portfolio in riskfree securities, what should the initial position be?
d) If the fund manager decides to provide insurance by using 9-month index futures, what
should the initial position be?
Answer:
Click here for spreadsheet @
http://sheet.zoho.com/public/btzoho/hull-15-16
a) Value of one put = $63.40 such that total insurance cost = 300,000 * 63.40 = $19.02
million
b) From put-call parity, a put can be replicated with:
p = c S0*EXP(-qT) + K*EXP(-rT)
Applied here, the fund manager should:
1) Sell 360*EXP(-3%*0.5) = $354.64 million in stock; i.e., S0*EXP(-qT)
2) Buy call options on 300,000 times the S&P500; with exercise price of 1140 and
maturity in six months
3) Invest the remaining cash at risk free interest rate; i.e., K*EXP(-rT)
c) Delta of one put = -0.3327 such that 33.27% of portfolio ($119.77 million) should be sold
d) Delta of nine-month futures contract = EXP((r-q)*T) = EXP(3%*.75) = 1.023
The spot short position required = 119.77 MM / 1200 = 99,808 times the index.
Therefore, a short position in 390 future contracts is required: 99,808/ (1.023*250) =
390
Hull.17.21:
17.21. Does a forward contract on a stock index have the same delta as
the corresponding futures contract? Explain you answer.
17.21b.
What two or three words summarize the primary reason for the difference in delta
between a forward and futures contract?
17.21.c. Does this difference apply to forward rate agreements (FRAs) and Eurodollar futures
contracts also?
Answer:
17.21. The value of a forward contract on the asset is S0*EXP(-qT) K*EXP(-rT). When there is a
small change, S, in S0 the value of the forward contract changes by EXP(-qT)* S. The delta of
the forward contract is therefore EXP(-qT).
The futures price is S0*EXP((r-q)*T). When there is a small change, S, in S0 the futures price
change by S*EXP((r-q)*T). Given the daily settlement procedures in futures contracts, this is
also the immediate change in the wealth of the holder of the of the futures contract. The delta of
the futures contract is therefore EXP((r-q)*T). The deltas of a futures and forward contract are
not the same. The delta of the futures is greater than the delta of the corresponding forward by a
factor of EXP(rT).
Please note that in regard to non-dividend-paying stock:
Delta of forward = 1.0
Delta of futures contract = EXP(rT)
17.21b. Daily settlement or margin account
17.21c. Yes, this is why Hull shows the convexity adjustment. The futures rate is larger than the
corresponding forward rate:
Forward rate (FRA) = Futures rate 0.5*variance of interest rate change*T1*T2
the futures contract implies additional cash flow volatility (i.e., margin calls or excess margin
cash) which, as compensation, requires a higher rate.

Selected & Annotated FRM 2010 Questions: Valuation & Risk Models: Hull, Chapters 11,13 & 17

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Selected & Annotated FRM 2010 Questions: Valuation & Risk Models: Hull, Chapters 11,13 & 17

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Valuation & Risk Models: Hull, Chapters 11,13 & 17

Selected & Annotated FRM 2010 Questions

By David Harper, CFA FRM CIPM

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 1

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 2

Consider a portfolio consisting of:

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 3

What are the units of option delta

11.03d. What is the delta of call option?

11.03g. What are the limitations of this delta-neutral hedge?

What is the gamma of the underlying stock?

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 4

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 5

Consider a portfolio consisting of:

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 6

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 7

In this case u = 1.10, d = 0.90, = 0.5, and r = 0.08, so that

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 8

Hull.11.12 & 13:

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 9

11.12b. If u=1.06, then implied volatility = LN(1.06)/SQRT(0.25) = 11.65%. To match volatility,

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 10

13.01d. Which OPM relies on the assets (stocks) expected return?

In theory, which is better suited to pricing an employee/executive stock option (ESO)?

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 11

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 12

In this case S0 = 50, K = 50, r = 0.1, sigma = 0.3, T = 0.25, and

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 13

13.04. Binomial two-step put price = $2.04

If a dividend of $1.50 is expected in 2 months, what is the price of a put option?

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 14

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 15

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 16

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 17

What is the median stock price?

What is the mean (expected) stock price?

What is the 95% confidence interval for the stock?

What is the 95% confidence value at risk (VaR)?

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 18

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 19

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 20

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 21

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 22

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 23

It is not optimal to exercise if: Dn <= K*[1-EXP(-rate(T-tn))]

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 24

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 25

17.03 In this case S0 = K, r = 0.1, sigma = 0.25, and T = 0.5. Also,

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 26

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 27

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 28

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 29

Hull.17.12 & 13:

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 30

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 31

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 32

Hull.17.16. A fund manager has a well-diversified portfolio that mirrors

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 33

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 34

FRM 2010 VALUATION & RISK: HULL, CHAPTERS 11,13 & 17 35

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