FIN 413

Midterm 2 VERSION

lettron A

kl

14 November 2OL3

part 1: Multiple Choice: CTRCLE the letter corresponding to the best answer in the list of choices'
(1 point each, total of 10 Points)

1.

Which of the following is NOT true?

a.
b.
6)
Y
2.

Options can be valued based on the assumption that investors are risk neutral
ln risk-neutralvaluation the expected return on all investment assets is set equalto the risk-free
rate
Risk-neutral valuation assumes that investors are risk neutral
l, risk-neutralvaluation the risk-free rate is used to discount expected cash flows

Which of the following is a definition of volatility?

a. The variance of the return, measured with continuous compounding, in one year
b. The standard deviation of the stock price in one year
c. The variance of the stock price in one year
of the return, measured with continuous compounding, in one year
e)fhe standard deviation

3. The current price of a non-dividend-paying stock is S30. Over the next six months it is expected to

rise to 536 or fall to S26. Assume the risk-free rate is zero. An investor sells call options with a strike
price of S32. Which of the following hedges the position?

a.
b.
c.

}\{. :
=
Sr^- SA Bt-4

A= S^-QJ

Short 0.4 shares for each call option sold

Buy 0.6 shares for each call option sold
Short 0.6 shares for each call option sold
0.4 shares for each call option sold

o.rl

@ tr,
4.

Which of the following is NOT true in a risk-neutral world?

a.
b.
c.

@
5.

The expected return on a call option is independent of its strike price

The expected return on a stock is the risk-free rate
The discount rate used for the expected payoff on an option is the risk-free rate
lnvestors expect higher returns to compensate for higher risk

A stock price is currently S23. A reverse (i.e., short) butterfly spread is created from options with
strike prices of S20, S25, and S:0. Wfrictr of the following is true?
The gain when the stock price is greater than S30 is less than the gain when the stock price is

a.

less than S20

f[.) fne gain when the stock price is greater than S30 is the same as the gain when the stock price is
- l"r, than S2o
c. The gain when the stock price is greater than S30 is greater than the gain when the stock price is
d.

less than S20

lt is incorrect to assume that there is always a gain when the stock price is greater than S30 or
less than S20

3 of 9

FIN 413

6.

Midterm 2 VERSION

14 November2Ot3

A company can invest funds for five years at LIBOR minus 30 basis points. The five-year swap rate is
3%. What fixed rate of interest can the company earn by using the swap?

a.
b.

3.3%

tL-'3] +3-L

'

3.0o/o

a'4

@2ru
d.

7.

2.4%

A company enters into an interest rate swap where it is receiving fixed and paying LIBOR. When

interest rates increase, which of the following is true?

a.
@
c.
8.

The value of the swap to the company increases

rfre value of the swap to the company decreases
The value of the swap can either increase or decrease

Which of the following creates a bear spread?

a. Buy a low strike price call and sell a high strike price call
b. Buy a low strike price call and sell a high strike price put
price calland sell a low strike price call
@ try a high strike price
put and sell a high strike price call
d. Buy a low strike
9.

The risk-free rate is 5% and the expected return on a non-dividend-paying stock is !2%. Which of the
following is a way of valuing a derivative?

a.

Assume that the expected growth rate for the stock price is 17% and discount the expected

b.

Assuming that the expected growth rate for the stock price is 5% and discounting the expected

payoff att2%
payoff al

c.

t2o/o

Assuming that the expected growth rate for the stock price is L2% and discounting the expected
payoff at 5%
Assuming that the expected growth rate for the stock price is 5% and discounting the expected
payoff at 5%

10. Which of the following

a.

c.
d.

is

true for an interest rate swap?

forward rate agreement underlying a swap is worth close to zero when the swap is first
entered into
n swap is usually worth LGte zero when it is first negotiated
Comparative advantage is a valid reason for entering into the swap
a and b are true.
Each

4of9

FIN 413

14 November 2073

Midterm 2 VERSION 2

Part 2: Answer the following in the space provided. Question value shown at end of each question.

1.

at S25. Riskless bonds with a face value of 51 and time to maturity of one year
currently trade at SO.SS. (i.e. the present value of a dollar coming in one year is SO.SS1.

XYZ stock trades

a)

Compute the lower bound price of a one-year European put option with a strike price of S30.
No dividends are expected before the expiration of the option. [7 marks]

p.r&-S:
b)

3ot.S-a6

3.5o

Suppose the put in part a) is trading at 52.50. Construct a riskless arbitrage portfolio and detail
the profit of this portfolio for all possible outcomes at the option's expiration date. [3 marks]

?*\ lcrte \ro [ov.r b^1 rt, b"l s\ocK , tottord .#

'Ib{o1 : o\ pt b.5)t @ B,at sl*k- L a )
(o il** 3',1.60

l-{\ \

1r

Q^.As

'

fI Sr{ io,Oafar.,,* ?*\, se\\

s+ocK Sc 30

oE1 bk [qrr

1,f 3r z 3o ,

,.1,so

-.q-5
RA\ I

e\t\cs uo'llnksS
'\,^f
@ set 6tock- ""\ 3r
O ?.\ b"ck \.q\ "3o
'flo,

P..R\
5 of 9

(zte5)
\-oS

Sr
t2s.qs)

. s\ -z<

^r

z I.o5

FIN 413

Midterm 2 VERSION

14 November 2OL3

2. You observe discount factors that were computed from today's swap curve, where fixed interest
rates are exchanged against one-year LIBOR. The discount factors are given below. Use them to
answer the following questions.

Term in years

Discount Factor
0.9615
0.9070
0.8396

2
3

a)

Given these discount factors, what is the current 3-year fixed swap rate? [2 points]

Co^np*<

3 \c I^r co*ton

; c L.quts +

\00

q01O

<31bf,

\0o

('(3%)

c= W:5.qa3p
b)

receiver

Suppose you are the payer on an existing swap that has 3 years remaining. The floating rate was

just reset. You are receiving 6.25% each year in exchange for one-year LIBOR. lf the notional
value of the swap is S10 million, what amount of money would you need to pay or be paid today
to terminate this swap? Be clear about whether you, as the receiver, would be paying or
receiving this sum to terminate the swap. [2 points]

\.*t=
\lsr,

tJcr.- \)S,o.* {**+ = toO

b)5[qUrst .\o* r. $3qb\ + t,D[.(39{)

c) You approach

a swap counterparty with a proposal. You want receive LIBOR every year for the
years
next 3
on a notional principal balance of S10 million. ln exchange for this, you want to
make two equal fixed payments, one of which would occur in one year and the other of which

would occur in three years. How much must the fixed payment be in year one and year three for
the swap counterparty to agree to do this? [2 points]

U^\"e

Uq\'( Qt*'\"q \tq

-\-\
qn uN^s\^^\
d

fix.J br =
{

-l\r3 i3

1o ryrtN=

: [o rnr'A

\t \*., U{ r+ B s\\\ '' S*eJ \

it t ^l \.\ .r.,A \r 3)

I [.1ArS + . (sab) + \ovnil\t ta\b)

x=

+1q0,666.<t

\r,\\ \e

6of9

p,\ $ \ q..A 3

FIN 413

3.
This is
useless info.

Midterm 2 VERSION

L4 November 20L3

You value derivatives on a particular underlying asset using a 2-step binomial process. The current

price of the underlying asset is SZS. The asset does not pay dividends. The annual volatility of the
underlying asset's returns is 30%. The risk-free interest rate is 4.5% per annum, compounded

continuously. You believe there is a75% chance that the underlying asset's price will move up over
any time step.
You may use the following sketch of a binomial tree to assist in answering the following questions:

L.\,^= erpto rtE\=

L.t d=
0:

t:

fti**
.'{W
=.

enpCousr '25)-

\"\-

= 0.5

(.Trl
The real probabilities DO
NOT MATTER. If you are
doing valuations using risk
neutral probability method,
you must compute the risk
neutral prob

"

,
a)

l<'54
o

Compute the current fair value of a 6-month American call option with a strike price of S25.

[z points] Arnr."

..t= E^.o cq\\ \rf

non

c: gt L$.+u\ erpL-.etS*.s) :

drrl s\oct\
'1St<'tq)erpG'ousr'<)

: a.\"1

b)

Compute the current fair value of a 6-month European put option with a strike price of S25.

lt point]

[ee f -c- FnXJ ?= c+ kerpL-.r):.

a.lU

* ,6tJQt-.n*s r.{) - }5

tr \.63
c)

Would your answer to part b) be different if you were valuing an American put? State yes or no
and indicate why, but you are not required to compute the price of the American put. [2 point]

Checb

fI

ilo.\u.s

q\ ,.de c-

't

6r,co, erpG.arsx25')(,t)Ltor>5- K.sa)

= 3.1+

ecrc,*f ot f,ocAeq-Li+ N,^t,.") Iofd \.t e6-z\.sz: 3.\() v,*lte'li'Dq

w\t i: u\o.,e ... f.*", 2<t<.re 6,r\ .HX"t
be
^,^ror\d
d.R.trJ.

FIN 413

4.

Midterm 2 VERSION

l-4 November 2013

The following option strategy is known as a 2:l- put ratio spread:

you buy one put option (premium = $2)with strike price K2 and you write two put options (premium
same expiration date'
of s1 per option) with strike K1 where Kr < Kz. The options have the
level the underlying
on the grid below, sketch the profit diagram for this strategy. ldentify what
points]
asset,s price must be at expiration to achieve maximum profit. [3

fth,,

?"Rt

u[a,r

5.

o\c[\trud,

S,, = K,

of the
What strike price must you choose to ensure that the value of a European call and the value
pays a
corresponding European put are equal? Consider the case of the underlying asset that
continuous yield of q. state your answer in terms of other derivative securities we have considered
this term. [2 Points]

qseets
dtrt
ts
\ie\a\
F.\
p + 6erp t yr) : ct Kt'?L- rr)
LF ?=c + Serptil) : K.tCrr)

sh,c+ w\K
?-e

!a = S.n Ltfg\rl

X^";i,ffi U;

b. de\rn.i + $rr,troru
J\*s, r,.t\e,r shke Qnte \s q.=e\s frnatA itrta 8r dc\'ve,t1
..^\ tlc.\r,.e -= !t,* Uc.\ut
e+ r$N.r\o".
THE END
.

8of9