QUESTION 1 (TOTAL 50 marks)

a) What are options? Discuss their rationales fully.

(5 marks)

Students should define and discuss options and their uses (speculation and hedging). (3 marks) Numerical examples are required (additional 2 marks).

b) Write down and explain intuitively the Black-Scholes European call option pricing formula. Discuss how call prices it delivers change with each of the inputs to the calculation. (5 marks) Write down the Black Scholes model of option pricing. They should explain why BS is a better model as compared to Binomial option pricing model and elaborate on the theoretical underpinnings. The determinants of option prices, with respect to BS formula should discussed fully, viz Spot price, Strike price, volatility, time and rate of interest. (equal mark per determinants and correct explanations)

c) Consider a stock of CVN, with a price of $50 and a standard deviation of 0.3. The current risk free rate of interest is 10%. A European call and put on this stock have an exercise price of $55 and expire in three month. Calculate the call option and the put option price C=$1.61057 n(d1)=0.3469 P=$5.25262 Supose that you own 3,000 shares of CBC, a subsidiary of CVN Corporation, and that you plan to go on Christmas shopping in New York City. To finance your shopping trip, you wish to sell your 3,000 shares of CBC in one week. However you donot want the value of your investment in CBC t0 fall below its current level. Construct a DELTA neutral hedge using the put option written on CVN. Be sure to describe the composition of your hedged portfolio. (6 marks) Need to hild -1/DELTAput put options per 100 shares of stock. The DELTA of the put opitions is -0.6531= 0.3469-1.hence the hedge ratio is 1.5312, put options per 100 shares. Since we have 3000 shares, must purchase 3000/100 x 1.5312 with a strike price of $55. Rounded to 46 options contracts purchased ( 7 marks)

d) An investor has just obtained the following quotes for European options on a stock worth $30 when the three month risk free interest rate is 10% per annum. Both options have a strike price of $30 and expire in three months European Call: $3 European Put : $ 1.75 i) Given the information above, determine whether the prices conform to the put call parity rule (3 marks) $1.75 not equal to 2.259 i) profits If there is a violation, suggest a trading strategy that will generate riskless arbitrage (7 marks)

The synthetic put costs $2.259 and the exchamge traded put is trading at 1.75. To capture the potential profits from the arbitrate opportunity we must simultaneously sell the synethetic put and purchase the traded put. Selling the synthetic put requires one to sell the call for 3 purchase the stock for 30 and sell the present value of 30 of the risk free bond, 29.5, resulting in a cash inflow if 2.26.

e) Consider a call and a put option on the same underlying stock. The call has an exercise price of $100 and costs $20. The put has an exercise price of $90 and costs $12. Graph a short position in a strangle based on these two options. What is the worst outcome from selling the strangle? At what stock price or prices does the strangle have a zero profit? ( 7 marks + 3 marks) The worst outcomes occur when the stock price is very low or very high. First the strangle loses $1 for each dollar the stock price falls below $58. With a zero stock price the strangle loses $58. If the stock price is too high, the strangle also loses money. Because the stock could theoretically go the infinity, the potential loss on the strangle is unbounded. For stock prices of $58 or $132, the strangle gives exactly a zero profit

f) Suppose that your good friend Wayne has retired. With his free time necessary to follow the market closely, Wayne has established large option positions as a stock investor. He tells you that his portfolio has a positive THETA. Give an intuitive explanation of what this means. Wayne is a also a big soccer fan, and is heading to Qatar to watch the World Cup for a month. He believes that there is not sufficient liquidity in the market to close out his open positions, and he is going to leave the positions open while he is in Qatar. Explain what will happen to the value of Wayne portfolio while he is in Qatar. (7 marks)

Theta measures the change in the value of the option because if changes in the time until expiration. As time passes ,generally value of option decreases (time decay). Since Wayne has constructed a portfolio with a +ve Theta (formally theta is the neagative of the first derivative of the option pricing model with respect to changes in the time until expiration), the passage of time should increase the value of his portfolio. Thus he should, cetirus paribus, return from his vacation to find that the value of his portfolio has increased.

SECTION B

QUESTION 3 (25 marks) a) As the semester starts, Felipe is making arrangements for University of California (UoC) Summer program to be run in London. This is a program in which UoC faculty teach courses to UoC students at St Hugh college in London. Room and board is 1500 per participant to be paid May 15th. The enrollment is capped at 42 people and UoC always operates at the cap. In the past, the summer program has been burned by adverse movements in exchange rates. This happens because UoC has borne the exchange rate risk between the dollar denominated room and board rate quoted to the students and the British pounds rate paid to St Hugh college. Felipe wonders if there is some way UoC could pass this risk off to someone else. i) Does UoC face translation or transaction risk? Please discuss fully Transaction riskto explain carefully ii) What could UoC do to reduce this exchange risk? (4 marks) (3 marks)

There are several ways. I) UoC could negotiate a room and board contract in $ Using forwards and futures (transferring the risk to a third party, student should discuss further. iii) Felipe asks a finance professor for advice. The professor pulls up the following $/ quotes on the 62500 futures contract: Delivery $/ SEP (this year) 1.6152 DEC(this year) 1.6074 MAR( next year) 1.6002 JUN (next year) 1.5936 What strategy might the professor recommend to reduce UoC exchange rate exposure.

(5 marks)

The prof might suggest buying pounds using the June futures. The amount of exposure UoC has is equal to the enrollment in the programme times the pound denominated room and board rate. The exposure will be 63000 To hedge this, UoC should buy one June british futures contract at $1.5936 per iv) May 15th arrives, the following situation is realized: number of participants Dollar room and board rate $/ exchange rate June Futures contract 42 $2400 $1.65 $1.6451 per

Compute UoC gains and losses in the cash market and the futures market. Was the hedging strategy successful? (5 marks) Cash market: Opportunity loss= -$3553 Profit in the futures market=$ 3219 Net loss = -$334

b) A manager has heard that transaction exposure can equally be managed externally by a derivative referred to forward hedge or internally by a money market hedge. He is very confused about these. Explain to him how these two hedging strategies differ and make an evaluation of both methods for him.

Using numerical example explain hedging through a forward market (+ its characteristics) and alternatively through a money market hedge (3 + 5 marks). d) What are the determinants of the forward rate in the context of exchange rates. The current annual US interest rate is 8% while its UK counterpart is 6%. The price of one pound sterling in the spot exchange rate market is $ 1.84. Price a one 7 month forward contract for the dollarsterling exchange rate. (3 marks)