Homework Set 2 (Due on Nov.

11)
Read Chapter 2, 3, 5 and 7, and Chapter 23.1 to 23.2. 1. A company enters a short futures contract to sell 5,000 bushels of wheat for 450 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account? 2. A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. The stock price is $50, and the risk-free rate of interest is 8% per anum with continuous compounding for all maturities. An investor has just taken a short position in a 6-month forward contract on the stock. (a). What are the forward price and the initial value of the forward contract? (b). Three months later, the price of the stock is $48 and the risk-free rate of interest is still 8% per annum. What are the value of the short position in the above forward contract? 3. A bank oers a corporate client a choice between borrowing cash at 11% per annum and borrowing gold at 2% per annum. (If gold is borrowed, interest must be repaid in gold. Thus, 100 ounces borrowed today would require 102 ounces to be repaid in 1 year.) The risk-free interest rate is 9.25% per annum, and storage costs are 0.5% per annum. Discuss whether the rate of interest on the gold loan is too high or too low in relation to the rate of interest on the cash loan. The interest rates on the two loans are expressed with annual compounding. The risk-free interest rate and storage costs are expressed with continuous compounding. 4. Under the terms of an interest rate swap, a nancial institution has agreed to pay 10% per annum and to receive 3-month LIBOR in return on a notional principal of $100 million with payments being exchanged every 3 months. The swap has a remaining life of 14 months and the last payment exchange was one month ago. The 3-month LIBOR rate 1 month ago was 11.8% per annum. The current LIBOR rates are given by Months 2 5 8 11 14 LIBOR (%) 10 12 12.3 12.5 13

All rates are compounded continuously. What is the value of the swap? 5. (Dicult, Optional) Suppose that a forward contract on an asset is written at time 0 and there are M periods until delivery. Suppose that the carrying charge in period k is qSk , where Sk is the spot price of the asset at the end of period k. Show that the forward price should be M 1 F = erM S. 1q Assume that S is the current asset price and the interest rate is r per period. The carrying costs are paid at the end of each period. (Hint: Consider a portfolio that pays all carrying costs by selling a fraction of the asset as required.) 6. Suppose that: (a) The yield on a 5-year risk free bond is 7%. (b) The yield on a 5-year corporate bond issued by company X is 9.5%. (c) A 5-year CDS providing insurance against company X defaulting costs 150 basis points (1.5%) per year. What arbitrage opportunity is there in this situation?