A project costing $100 will produce perpetual net cash flows that have an annual volatility of 35% with no expected growth. If the project existed, net cash flows today would be $8. The project beta is 0.5, the effective annual risk-free rate is 5%, and the effective annual risk premium on the market is 8%. What is the static NPV of the project? What would you pay to acquire the rights to this project if investment rights lasted only 3 years? What would you pay to acquire perpetual investment rights?
> Using the assumptions of Example 16.4, and the stock price derived in Example 16.5 suppose you were to perform a “naive” valuation of the convertible as a risk free bond plus 50 call options on the stock. How does the
> Using the information in Table 15.5, suppose we have a bond that pays one barrel of oil in 2 years. a. Suppose the bond pays a fractional barrel of oil as an interest payment after 1 year and after 2 years, in addition to the one barrel after 2 years. Wh
> Problem 12.11 showed how to compute approximate Greek measures for an option. Use this technique to compute delta for the gap option in Figure 14.3, for stock prices ranging from $90 to $110 and for times to expiration of 1 week, 3 months, and 1 year. Ho
> Using the information in the previous problem, compute the prices of a. An Asian arithmetic average strike call. b. An Asian geometric average strike call. Previous Problem Suppose that S = $100, K = $100, r = 0.08, σ = 0.30, δ = 0, and T = 1. Construct
> Consider a put for which T = 0.5 and K = $45. Compute the Greeks and verify that equation (13.9) is zero. Market-maker profit: C(S,))h
> Consider a bull spread where you buy a 40-strike call and sell a 45-strike call. Suppose σ = 0.30, r = 0.08, δ = 0, and T = 0.5. a. Suppose S = $40. What are delta, gamma, vega, theta, and rho? b. Suppose S = $45. What are delta, gamma, vega, theta, and
> We sawin Section 10.1 that the undiscounted risk-neutral expected stock price equals the forward price. We will verify this using the binomial tree in Figure 11.4. a. Using S = $100, r = 0.08, and δ = 0, what are the 4-month, 8-month, and 1-
> Let S = $40, K = $40, r = 8% (continuously compounded), σ = 30%, δ = 0, T =0.5 year, and n = 2. a. Construct the binomial tree for the stock. What are u and d? b. Show that the call price is $4.110. c. Compute the prices of American and European puts.
> In the following, suppose that neither stock pays a dividend. a. Suppose you have a call option that permits you to receive one share of Apple by giving up one share of AOL. In what circumstance might you early exercise this call? b. Suppose you have a p
> Using the zero-coupon bond yields in Table 8.9, what is the fixed rate in a 4-quarter interest rate swap? What is the fixed rate in an 8-quarter interest rate swap? TABLE 8.9 Quarter 2 3 4 5 7 8 20.5 Oil forward price Gas swap price Zero-coupon bond
> As in the previous problem, consider holding a 3-year bond for 2 years. Now suppose that interest rates can change, but that at time 0 the rates in Table 7.1 prevail. What transactions could you undertake using forward rate agreements to guarantee that y
> Verify that when there are transaction costs, the lower no-arbitrage bound is given by equation (5.12). Fa < F = (S% - 2k)eT (5.12) %3|
> Golddiggers has zero net income if it sells gold for a price of $380. However, by shorting a forward contract it is possible to guarantee a profit of $40/oz. Suppose a manager decides not to hedge and the gold price in 1 year is $390/oz. Did the firm ear
> Suppose the stock price is $40 and the effective annual interest rate is 8%. Draw payoff and profit diagrams for the following options: a. 35-strike put with a premium of $1.53. b. 40-strike put with a premium of $3.26. c. 45-strike put with a premium of
> Suppose you enter into a put ratio spread where you buy a 45-strike put and sell two 40-strike puts. If you delta-hedge this position, what investment is required? What is your overnight profit if the stock tomorrow is $39? What if the stock is $40.50?
> Pick a derivatives exchange such as CME Group, Eurex, or the Chicago Board Options Exchange. Go to that exchange’s website and try to determine the following: a. What products the exchange trades. b. The trading volume in the various products. c. The not
> Using Monte Carlo simulation, reproduce Tables 27.10 and 27.11. Produce a similar table assuming a default correlation of 25%. TABLE 27.10 Pricing of Nth to default bonds. Assumes the bonds owned as assets have uncorrelated defaults. Probability Pay
> Using the same assumptions as in Problem 26.12, compute the 10-day 95% VaR for a claim that pays $3m each year in years 7–10. Problem 26.12 Suppose the 7-year zero-coupon bond has a yield of 6% and yield volatility of 10% and the 10-year zero-coupon bon
> What volatilities were used to construct each tree? (You computed zero-coupon bond prices in the previous problem; now you have to compute the year-1 yield volatility for 1-, 2-, 3-, and 4-year bonds.) Can you unambiguously say that rates in one tree are
> For this problem, use the implied volatilities for the options expiring in January 2005, computed in the preceding problem. Compare the implied volatilities for calls and puts. Where is the difference largest? Why does this occur?
> For the lookback call: a. What is the value of a lookback call as St approaches zero? Verify that the formula gives you the same answer. b. Verify that at maturity the value of the call is ST − ST .
> The box on page 282 discusses the following result: If the strike price of a European put is set to equal the forward price for the stock, the put premium increases with maturity. a. How is this result related to Warren Buffett’s critique of put-pricing,
> You are offered the opportunity to receive for free the payoff [Q(T ) − F0,T (Q)]× max [0, S(T ) − K] (Note that this payoff can be negative.) Should you accept the offer?
> Suppose that S and Q follow equations (20.36) and (20.37). Derive the value of a claim paying S(T )aQ(T )b by each of the following methods: a. Compute the expected value of the claim and discounting at an appropriate rate. (Hint: The expected return on
> Consider Pr(St
> Let S = $120, K = $100, σ = 30%, r = 0, and δ = 0.08. a. Compute the Black-Scholes call price for 1 year to maturity and for a variety of very long times to maturity. What happens to the price as T →∞? b. Set r = 0.001. Repeat (a). Now what happens? What
> A project has certain cash flows today of $1, growing at 5% per year for 10 years, after which the cash flow is constant. The risk-free rate is 5%. The project costs $20 and cash flows begin 1 year after the project is started. When should you invest and
> Consider the hedging example using gap options, in particular the assumptions and prices in Table 14.4. a. Implement the gap pricing formula. Reproduce the numbers in Table 14.4. b. Consider the option withK1= $0.8 andK2 = $1. If volatility were zero, wh
> Repeat the previous problem for n = 50. What is the risk-neutral probability that S1< $80? S1> $120? Previous Problem Let S = $100, σ = 0.30, r = 0.08, t = 1, and δ = 0. Using equation (11.12) to compute the probability of reaching a terminal node and Su
> Repeat the previous problem assuming that the stock pays a continuous dividend of 8% per year (continuously compounded). Calculate the prices of the American and European puts and calls. Which options are early-exercised? Previous Problem Let S = $100,
> Suppose the interest rate is 0% and the stock of XYZ has a positive dividend yield. Is there any circumstance in which you would early-exercise an American XYZ call? Is there any circumstance in which you would early-exercise an American XYZ put? Explain
> What is the fixed rate in a 5-quarter interest rate swap with the first settlement in quarter 2?
> Using the information in Table 7.1, suppose you buy a 3-year par coupon bond and hold it for 2 years, after which time you sell it. Assume that interest rates are certain not to change and that you reinvest the coupon received in year 1 at the 1-year rat
> Verify that going long a forward contract and lending the present value of the forward price creates a payoff of one share of stock when a. The stock pays no dividends. b. The stock pays discrete dividends. c. The stock pays continuous dividends.
> What happens to the variability of Wirco’s profit if Wirco undertakes any strategy (buying calls, selling puts, collars, etc.) to lock in the price of copper next year? You can use your answer to the previous question to illustrate your response.
> Suppose the stock price is $40 and the effective annual interest rate is 8%. a. Draw on a single graph payoff and profit diagrams for the following options: (i) 35-strike call with a premium of $9.12. (ii) 40-strike call with a premium of $6.22. (iii) 45
> Consider a one-period binomial model with h = 1, where S = $100, r = 0.08, σ = 30%, and δ = 0. Compute American put option prices for K = $100, $110, $120, and $130. a. At which strike(s) does early exercise occur? b. Use put-call parity to explain why e
> Suppose the S&R index is 800, the continuously compounded risk-free rate is 5%, and the dividend yield is 0%. A 1-year 815-strike European call costs $75 and a 1- year 815-strike European put costs $45. Consider the strategy of buying the stock, selling
> Suppose your bank’s loan officer tells you that if you take out a mortgage (i.e., you borrow money to buy a house), you will be permitted to borrow no more than 80% of the value of the house. Describe this transaction using the terminology of short-sales
> Repeat the previous problem, only assuming that defaults are perfectly correlated. Repeat the previous problem, Suppose that in Figure 27.6 the tranches have promised payments of $160 (senior), $50 (mezzanine), and $90 (subordinated). Reproduce the tabl
> Suppose the 7-year zero-coupon bond has a yield of 6% and yield volatility of 10% and the 10-year zero-coupon bond has a yield of 6.5% and yield volatility of 9.5%. The correlation between the 7-year and 10-year yields is 0.96. What are 95% and 99% 10-da
> What are the 1-, 2-, 3-, 4-, and 5-year zero-coupon bond prices implied by the two trees?
> In this problem you will compute January 12 2004 bid and ask volatilities (using the Black-Scholes implied volatility function) for 1-year IBM options expiring the following January. Note that IBM pays a dividend in March, June, September, and December.
> Covered call writers often plan to buy back the written call if the stock price drops sufficiently. The logic is that the written call at that point has little “upside,” and, if the stock recovers, the position could s
> What is the value of a claim paying Q(T )−1S(T )? Check your answer using Proposition 20.4. (20.4)
> Suppose that S1 follows equation (20.26) with δ = 0. Consider an asset that follows the process dS2 = α2S2 dt − σ2S2 dZ Show that (α1 − r)/σ1=âˆ
> Let h = 1/52. Simulate both the continuously compounded actual return and the actual stock price, St+h. What are the mean, standard deviation, skewness, and kurtosis of both the continuously compounded return on the stock and the stock price? Use the sam
> Let KT= S0erT. Compute Pr(ST
> Obtain at least 5 years’ worth of daily or weekly stock price data for a stock of your choice. 1. Compute annual volatility using all the data. 2. Compute annual volatility for each calendar year in your data. How does volatility vary over time? 3. Compu
> Suppose a firm has 20 shares of equity, a 10-year zero-coupon debt with a maturity value of $200, and warrants for 8 shares with a strike price of $25. What is the value of the debt, the share price, and the price of the warrant?
> Make the same assumptions as in the previous problem. a. What is the price of a standard European put with 2 years to expiration? b. Suppose you have a compound call giving you the right to pay $2 1 year from today to buy the option in (a). For what stoc
> Let S = $100, σ = 0.30, r = 0.08, t = 1, and δ = 0. Using equation (11.12) to compute the probability of reaching a terminal node and Suidn−i to compute the price at that node, plot the risk-neutral distribution of year-1 stock prices as in Figures 11.7
> Let S = $100, K = $95, r = 8% (continuously compounded), σ = 30%, δ = 0, T = 1 year, and n = 3. a. Verify that the binomial option price for an American call option is $18.283. Verify that there is never early exercise; hence, a European call would have
> In each case identify the arbitrage and demonstrate how you would make money by creating a table showing your payoff. a. Consider two European options on the same stock with the same time to expiration. The 90-strike call costs $10 and the 95-strike call
> Using the zero-coupon bond prices and natural gas swap prices in Table 8.9, what is the implicit loan amount in each quarter in an 8-quarter natural gas swap? TABLE 8.9 Quarter 2 3 4 5 7 8 20.5 Oil forward price Gas swap price Zero-coupon bond price
> Suppose you are the counterparty for a lender who enters into an FRA to hedge the lending rate on $10m for a 90-day loan commencing on day 270. What positions in zero-coupon bonds would you use to hedge the risk on the FRA?
> Suppose the S&P 500 index is currently 950 and the initial margin is 10%. You wish to enter into 10 S&P 500 futures contracts. a. What is the notional value of your position? What is the margin? b. Suppose you earn a continuously compounded rate of 6% on
> Suppose that Wirco does nothing to manage the risk of copper price changes. What is its profit 1 year from now, per pound of copper? Suppose that Wirco buys copper forward at $1. What is its profit 1 year from now?
> Consider the 3-year swap in the previous example. Suppose you are the fixed-rate payer in the swap. How much have you overpaid relative to the forward price after the first swap settlement? What is the cumulative overpayment after the second swap settlem
> For each entry in Table 2.5, explain the circumstances in which the maximum gain or loss occurs. TABLE 2.5 Maximum possible profit and loss at maturity for long and short forwards and purchased and written calls and puts. FV(premium) denotes the fut
> Suppose that you go to a bank and borrow $100. You promise to repay the loan in 90 days for $102. Explain this transaction using the terminology of short-sales.
> Suppose that in Figure 27.6 the tranches have promised payments of $160 (senior), $50 (mezzanine), and $90 (subordinated). Reproduce the table for this case, assuming zero default correlation. dA - (α- δ)dt+ σdZ Α (27.6)
> Suppose you write a 1-year cash-or-nothing put with a strike of $50 and a 1-year cash-or-nothing call with a strike of $215, both on stock A. a. What is the 1-year 99% VaR for each option separately? b. What is the 1-year 99% VaR for the two written opti
> Verify that the 1-year forward rate 3 years hence in Figure 25.5 is 14.0134%. For the next four problems, here are two BDT interest rate trees with effective annual interest rates at each node. Tree #1 0.08000 0.07676 0.08170 0.07943 0.07552 0.10362
> Suppose the stock price is $50, but that we plan to buy 100 shares if and when the stock reaches $45. Suppose further that σ = 0.3, r = 0.08, T − t = 1, and δ = 0. This is a noncancellable limit order. a. What transaction could you undertake to offset th
> Suppose there are 1-, 2-, and 3-year zero-coupon bonds, with prices given by P1, P2, and P3. The implied forward interest rate from year 1 to 2 is r0(1, 2) = P1/P2 − 1, and from year 2 to 3 is r0(2, 3) = P2/P3 − 1. Denote the rates as r(1) and r(2). Supp
> What is the value of a claim paying ? Check your answer using Proposition 20.4. (20.4)
> Suppose that the processes for S1 and S2 are given by these two equations: Note that the diffusions dZ1 and dZ2 are different. In this problem we want to find the expected return on Q, αQ, where Q follows the process Show that, to avoid arbitrage,
> Assume S0 = $100, r = 0.05, σ = 0.25, δ = 0, and T = 1. Use Monte Carlo valuation to compute the price of a claim that pays $1 if ST > $100, and 0 otherwise. (This is called a cash-or-nothing call and will be further discussed in Chapter 23. The actual
> Compute estimated profit in 1 year if XYZ sells a call option with a strike of $0.95, $1.00, or $1.05. Draw a graph of profit in each case.
> Let t = 1. What is E (St |St < $98)? What is E (St |St < $120)? How do both expectations change when you vary t from 0.05 to 5? Let σ = 0.1. Does either answer change? How?
> Verify the binomial calculations in Figure 17.3. FIGURE 17.3 YEAR O YEAR 1 YEAR 2 Value of the investment $307.74 option for the project in Figure 17.2. $147.31 $55.80 $50 $15.64
> A firm has outstanding a bond with a 5-year maturity and maturity value of $50, convertible into 10 shares. There are also 20 shares outstanding. What is the price of the warrant? The share price? Suppose you were to compute the value of the convertible
> Suppose S = $40, K = $40, σ = 0.30, r = 0.08, and δ = 0. a. What is the price of a standard European call with 2 years to expiration? b. Suppose you have a compound call giving you the right to pay $2 1 year from today to buy the option in part (a). For
> In the absence of an explicit formula, we can estimate the change in the option price due to a change in an input—such as σ—by computing the following for a small value of ε: a. What is the log
> Repeat the previous problem, except that for each strike price, compute the expected return on the option for times to expiration of 3 months, 6 months, 1 year, and 2 years. What effect does time to maturity have on the option’s expected return? Previou
> Suppose S0 = $100, K = $50, r = 7.696% (continuously compounded), δ = 0, and T = 1. a. Suppose that for h = 1, we have u = 1.2 and d = 1.05. What is the binomial option price for a call option that lives one period? Is there any problem with having d >1?
> Suppose call and put prices are given by Find the convexity violations. What spread would you use to effect arbitrage? Demonstrate that the spread position is an arbitrage. Strike 80 100 105 Call premium Put premium 22 4 21 24.80
> Using the zero-coupon bond prices and natural gas swap prices in Table 8.9, what are gas forward prices for each of the 8 quarters? TABLE 8.9 Quarter 2 3 4 5 7 8 20.5 Oil forward price Gas swap price Zero-coupon bond price 0.9852 0.9701 0.9546 0.938
> What is the rate on a synthetic FRA for a 180-day loan commencing on day 180? Suppose you are the counterparty for a borrower who uses the FRA to hedge the interest rate on a $10m loan. What positions in zero-coupon bonds would you use to hedge the risk
> a. Suppose you enter into a long 6-month forward position at a forward price of $50. What is the payoff in 6 months for prices of $40, $45, $50, $55, and $60? b. Suppose you buy a 6-month call option with a strike price of $50. What is the payoff in 6 mo
> Suppose the S&P 500 index futures price is currently 1200. You wish to purchase four futures contracts on margin. a. What is the notional value of your position? b. Assuming a 10% initial margin, what is the value of the initial margin?
> Compute estimated profit in 1 year if Telco buys paylater calls as follows (the net premium may not be exactly zero): a. Sell one 0.975-strike call and buy two 1.034-strike calls. b. Sell two 1.00-strike calls and buy three 1.034-strike calls. Draw a gra
> For Figure 2.8, verify the following: a. The S&R index price at which the put option diagram intersects the x-axis is $924.32. b. The S&R index price at which the put option and forward contract have the same profit is $1095.68. FIGURE 2.8
> Short interest is a measure of the aggregate short positions on a stock. Check an online brokerage or other financial service for the short interest on several stocks of your choice. Can you guess which stocks have high short interest and which have low?
> Consider two firms, one with an FF rating and one with an FFF rating. What is the probability that after 4 years each will have retained its rating? What is the probability that each will have moved to one of the other two ratings? For the next two probl
> Compute the 95% 10-day tail VaR for the position in Problem 26.8. Problem 26.8. Compute the 95% 10-day VaR for a written strangle (sell an out-of-the-money call and an out-of-the-money put) on 100,000 shares of stock A. Assume the options have strikes o
> Verify that the price of the 12% interest rate cap in Figure 25.6 is $3.909. FIGURE 25.6 Year 0 Year 1 Year 2 Year 3 $6.689 Tree showing the payoff to a 12% interest rate cap on a $100 3-year loan, assuming that interest rates evolve $6.799 accordin
> Suppose an option knocks in at H1> S, and knocks out at H2 >H1. Suppose that K H1, it is not possible to hit H2 without hitting H1): What is the value of this option? if Hj not hit Payoff = max (0, ST – K) if Hj hit and H2 not hit if Hj hit and
> Repeat the previous problem assuming that δ1= 0.05 and δ2 = 0.12. Verify that both procedures give a price of approximately $15.850. Previous Problem Suppose that S1 and S2 are correlated, non-dividend-paying assets that follow geometric Brownian motion
> Suppose that a derivative claim makes continuous payments at the rate. Show that the Black-Scholes equation becomes For the following four problems, assume that S follows equation (21.5) and Q follows equation (21.35). Suppose S0 = $50, Q0 = $90, T = 2,
> ABC stock has a bid price of $40.95 and an ask price of $41.05. Assume there is a $20 brokerage commission. a. What amount will you pay to buy 100 shares? b. What amount will you receive for selling 100 shares? c. Suppose you buy 100 shares, then immedia
> The formula for an infinitely lived call is given in equation (12.18). Suppose that S follows equation (20.20), with α replaced by r, and that E∗(dV ) = rV dt. Use Itˆo’s Lemma to verify that t
> Consider a project that in one year pays $50 if the economy performs well (the stock market goes up) and that pays $100 if the economy performs badly (the stock market goes down). The probability of the economy performing well is 60%, the effective annua
> Examine the prices of up-and-out puts with strikes of $0.9 and $1.0 in Table 14.3. With barriers of $1 and $1.05, the 0.90-strike up-and-outs appear to have the same premium as the ordinary put. However, with a strike of 1.0 and the same barriers, the up
> “Time decay is greatest for an option close to expiration.” Use the spreadsheet functions to evaluate this statement. Consider both the dollar change in the option value and the percentage change in the option value, and examine both in-the-money and out
> Let S = $100, σ = 30%, r = 0.08, t = 1, and δ = 0. Suppose the true expected return on the stock is 15%. Set n = 10. Compute European put prices, ∆, and B for strikes of $70, $80, $90, $100, $110, $120, and $130. For each strike, compute the expected ret
> Let S = $100, K = $95, σ = 30%, r = 8%, T = 1, and δ = 0. Let u = 1.3, d = 0.8, and n = 2. Construct the binomial tree for an American put option. At each node provide the premium, ∆, and B.
> Suppose call and put prices are given by Find the convexity violations. What spread would you use to effect arbitrage? Demonstrate that the spread position is an arbitrage. Strike 50 55 60 Call premium 18 14 9.50 Put premium 7 10.75 14.45
> What is the rate on a synthetic FRA for a 90-day loan commencing on day 90? A 180-day loan commencing on day 90? A 270-day loan commencing on day 90?
