FN426/452: Financial Derivatives

Semester 1/2010
Instructor: Satjaporn Tungsong

Solution to Problem Set #1

1. Suppose you want to sell a share of stock that has price Bt 100 at time 0. At time 0 you
agree to a price, which is paid either today or at time T. The share is delivered either at
time 0 or T. The interest rate is r. Fill in the following table:
Receive payment

Deliver Security

Payment

at Time

at Time

Received (Bt)

1. Outright purchase

100 at time 0

2. Fully leverage purchase

100erT at T

3. Prepaid forward contract

?*erT

Description

4. Forward contract

2. A 50-Baht stock pays 1-Baht dividend every 3 months, with the first dividend coming
3 months from today. The continuously compounded risk-free rate is 6%.
a. What is the price of a prepaid forward contract that expires 1 year from today,
immediately after the fourth-quarter dividend?

0.25

0.5

0.75

F0,1 = 50*e0.06*1 -1 -1*e0.06*0.25 -1*e0.06*0.5 -1*e0.06*0.75 = Bt 49.0002

FP0,1 = 49.0002*e-0.06*1 = Bt 46.1467
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b. What is the price of a forward contract that expires at the same time?
F0,1 = 50*e0.06*1 -1 -1*e0.06*0.25 -1*e0.06*0.5 -1*e0.06*0.75 = Bt 49.0002
3. A 50-Baht stock pays an 8% continuous dividend. The continuously compounded
risk-free rate is 6%.
a. What is the price of a prepaid forward contract that expires 1 year from today?
FP0,1 = 50*e-0.08*1 = Bt 46.1558
b. What is the price of a forward contract that expires at the same time?
F0,T = S0 * e (r-)T
F0,1 = 50*e(0.06-0.08)*1 = Bt 49.0099
4. Suppose the stock price is BHT 35 and the continuously compounded interest rate is
5%.
a. What is the 6-month forward price, assuming dividends are zero?
Bt 35.886
b. If the 6-month forward price is BHT 35.50, what is the annualized continuous
dividend yield?
F0,T = S0 * e (r-)T
35.50 = 35* e (0.05-)*0.5
= 0.0216 = 2.16%

5. Suppose you are a market-maker in S&R index forward contracts. The S&R index
spot price is 1100, the risk-free rate is 5%, and the dividend yield on the index is 0.
a. What is the no-arbitrage forward price for delivery in 9 months?
1142.02
b. Suppose a customer wishes to enter a short index futures position. If you take
the opposite position, demonstrate how you would hedge your resulting long
position using the index and borrowing or lending.
Description
Long forward, resulting from

Today
0

In 9 months
ST - F0,T
2

customer purchase
Sell short the index

S0

Lend + S0, the proceeds from

- S0

- ST
S0*erT

short-selling
Total

S0*erT- F0,T

With the numbers given in the problem:

Description

Today

Long forward, resulting from

In 9 months
ST - 1,142.02

customer purchase
Sell short the index

1,100

- ST

Lend + S0, the proceeds from

- 1,100

1,100*e0.5*0.75

short-selling

=1,142.02

Total

We have perfect hedge.

c. Suppose a customer wishes to enter a long index futures position. If you take
the opposite position, demonstrate how you would hedge your resulting short
position using the index and borrowing or lending.

6. The S&R index spot price is 1100, the risk-free rate is 5%, and the continuous
dividend yield on the index is 2%.
a. Suppose you observe a 6-month forward price of 1120. What arbitrage would
you undertake?
The forward price implied from cost-of-carry model is
F0,0.5 = S0*e(r-)T = 1,101.652
Thus, the forward in the market is too expensive. To make arbitrage
profit, you sell the forward at 1,120 and borrow S0*e-T =1,100*e0.02*0.5 =
1,101.101 to buy a fraction of the index in the spot market.

Transaction

Cash flows
Time 0

Time T
3

Borrow S0*e-T

1,101.101

-1,101.101* e(0.05-0.02)*0.5
= -1,117.75

Buy stock

-1,101.101

ST

Short forward

1,120- ST

Total

2.25

b. Suppose you observe a 6-month forward price of 1100. What arbitrage would
you undertake?

7. Suppose the SET50 index futures price is currently 500. You wish to purchase 10
futures contracts on margin.
a. What is the notional value of your position?
= 500*1000*10 = Bt 5,000,000
b. Assuming a 10% initial margin, what is the value of the initial margin?
= 0.1* 5,000,000 = Bt 500,000
c. Suppose you earn a continuously compounded rate of 6% on your margin
balance, your position is marked to market weekly, and the maintenance
margin is 80% of the initial margin. What is the greatest SET50 index futures
price 1 week from today at which you receive a margin call?
You earn interest on Bt 500,000 in the first week
Your balance at the end of the first week is
500,000*e(0.06*7/52) + (gain or loss on futures price*1000*10)
= 504,054.81 + *1000*10*(S1-500)
You will receive a margin call if your balance falls below
0.8*500,000 = 400,000
Thus, 400,000 = 504,054.81 + *1000*10*(S1-500)
S1 = 489.59

8. Suppose the SET50 index is 800, and that the dividend yield is 0. You are an
arbitrageur with a continuously compounded borrowing rate of 5.5% and a
continuously compounded lending rate of 5%.
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a. Suppose there are no transaction fees, show that a cash-and-carry arbitrage is

not profitable if the forward price is less than 845.23
Suppose the forward contract will mature in 1 year. The theoretical
forward price is F0,T = S0*e rT
Highest possible forward price = 800*e0.055*1 = 845.2325
Lowest possible forward price = 800*e0.05*1 = 841.0169
Cash-and-carry arbitrage refers to an arbitrage transaction in which you
buy the underlying asset using the proceeds from the sale of forward (buy spot,
sell forward). Cash-and-carry is profitable when the actual forward price is
above the theoretical forward price. Therefore, the actual forward price has to
be higher than 845.2325 to make a cash-and-carry profit.

b. Suppose there are no transaction fees, show that a reverse cash-and-carry

arbitrage is not profitable if the forward price is greater than 841.02.
Reverse cash-and-carry arbitrage refers to an arbitrage transaction in
which you sell the underlying asset and use the proceeds to buy the forward (sell
spot, buy forward). Reverse cash-and-carry is profitable when the actual
forward price is below the theoretical forward price. Therefore, the actual
forward price has to be lower than 841.0169 to make a reverse cash-and-carry
profit.

9. (Bonus) Suppose the SET50 currently has a level of 875. The continuously
compounded return on a 1-year T-bill is 4.75%. You wish to hedge an $800,000
portfolio that has a beta of 1.0 and a correlation of 1.0 with the SET50.
a. What is a 1-year futures price for the SET50 assuming no dividends?
917.57
b. How many SET50 futures contract should you short to hedge your portfolio?
What return do you expect on the hedged portfolio?

Short 3.65714 contracts to hedge your portfolio. The return you can
expect is the risk-free rate. Because if you perfectly hedge the position
and your portfolio is now a risk-less investment.

1. (Bonus) Synthetic Replication

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.
Solution already given in class
11. zero-coupon bonds 1.1 1.2

11.1

Days to Maturity

Zero-Coupon Bond
Price

90

0.99009

180

0.97943

270

0.96525

360

0.95238

synthetic FRA loan 90 90

: synthetic FRA loan zero-coupon bonds t+s

zero-coupon bonds t

r0(t, t+s)
r0(90, 180)
r0(90, 270)
r0(90, 360)

11.2

synthetic FRA loan 180 180

11.3

() FRA

10 270
90 hedge

To hedge, you go long on the FRA and buy/sell zero coupon bonds as shown
below:

12. 100 60 150

Implied forward rate ( FRA) 150

2.5% 2.2% 2.8%
12.1

60 2.8% FRA

60 FRA 210
7

 60

210

12.2

60 2.2% FRA

60 FRA 210
60
= (0.022-0.025)/(1+0.022) * 100,000,000 = -$293,542.07

210
= (0.022-0.025) * 100,000,000 = -$300,000

13. T-bill 90 face value $1,000,000 (discount

yield) T-bill 8.75% T-bill
Price = Face*[1 - DR*(t/360)]
= $1,000,000*(1-0.0875*(90/360))
= $978,125.00
14. price index T-bill 88.70 (discount yield) T-bill

T-bill futures price index 88.70 price index

88.90
DR

= [Face - P]/[Face*(360/t)]
= (100-88.7)/(100*(360/90))
= 2.825% per 90 days or 11.3% per year

88.70 88.90 (88.90-88.70)/88.70 = 0.2255%

15. June T-bill futures index value 92.80 September T-bill futures index value

93.00 implied interest rate

92.80/93 1 = -0.22%
16. Suppose you observe the following zero-coupon bond prices per $1 of maturity payment:
0.96154 (1-year), 0.91573 (2-year), 0.87630 (3-year), 0.87630 (4-year), 0.77611 (5year). For each maturity year compute the zero-coupon bond yields (effective annual
and continuously compounded), the par coupon rate, and the 1-year implied forward
rate.

17. Using the information in question 16, find the price of a 5-year coupon bond that has a
par payment of $1,000.00 and annual coupon payments of $60.00.

zero-coupon bond
$1,037.2528

18. Suppose that in order to hedge interest rate risk on your borrowing, you enter into an
FRA that will guarantee a 6% effective annual interest rate for 1 year on $500,000.00.
On the day you borrow the $500,000.00, the actual interst rate is 5%. Determine the
dollar settlement of the FRA:
18.1 If settlement occurs on the date the loan is initiated
18.2 If settlement occurs on the date the loan is repaid
Solution:

19. What is the yield to maturity of the 10-year zero coupon bond with a face value of $100
and current price $69.20205?
P0
$69.20205
-r
r
r

=
=
=
=
=

Face*e-rT
100*e(-r*10)
(1/10)ln(69.20205/100)
-(1/10)ln(69.20205/100)
3.6814%

20. Suppose that oil forward prices for 1 year, 2 years, and 3 years are $20, $21, and $22.
The 1-year effective annual interest rate is 6%, the 2-year interest rate is 6.5%, and the 3year interest rate is 7%.
20.1

What is the 3-year swap price?

The present value of the cost per 3 barrels based on the forward price is:

The swap price per barrel is:

10

20.2

What is the price of a 2-year swap beginning in one year? (That is, the first
swap settlement will be in 2 years and the second in 3 years.)
The present value of the cost per 2 barrels based on the forward price is:

The swap price per barrel is:

21. Consider the same 3-year oil swap in question 20. Suppose a dealer is paying the fixed
price and receive floating. What position in oil forward contracts will hedge oil price
risk in this position? Verify that the present value of the lock-in net ash flows is zero.
Solution:

22. Consider the same 3-year swap in question 20. Suppose you are a dealer who is paying
the fixed oil price and receive the floating price. Suppose that you enter into the swap
and immediately thereafter all interest rates rise 50 basis points but oil forward prices are
unchanged. What happens to the value of your swap position? What if interest rates fall
50 basis points? What hedging instrument would have protected you against interest rate
risk in this position?

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Solution:

23-30
Quarter

Oil forward
price

21

21.1

20.8

20.5

20.2

20

19.9

19.8

Gas swap
price

2.25

2.42

2.35

2.24

2.23

2.28

2.26

2.20

Zero-coupon
bond price

.9852

.9701

.9546

.9388

.9231

.9075

.8919

.8763

Eurodenominated
zero-coupon
bond price

.9913

.9825

.9735

.9643

.9551

.9459

.9367

.9274

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Euro forward
price ($/)

.9056

.9115

.9178

.9244

.9312

.9381

.9452

.9524

$/ 0.9
23. Suppose the effective quarterly interest rate is 1.5%, what are the per-barrel swap prices
for 4-quarter and 8-quarter oil swaps? What is the total cost of prepaid 4- and 8-quarter
swaps?
Solution:

13

24. Construct the set of swap prices for oil for 1 through 8 quarters.

25. What is the swap price of a 4-quarter oil swap with the first settlement occurring in the
third quarter?
Solution:

26. Using the zero-coupon bond prices and oil forward prices in the table provided above,
what is the price of an 8-period swap for which two barrels of oil are delivered in evennumbered quarters and one barrel of oil in odd-numbered quarters?
Solution:

27. Using the zero-coupon bond prices and oil forward prices in the table provided above,
what are the gas forward prices for each of the 8 quarters?

14

Solution:

28. What is the fixed rate in a 5-quarter interest rate swap with the first settlement in quarter
2?
Solution:

29. What is the fixed rate in a 4-quarter interest rate swap? What is the fixed rate in an 8quarter interest rate swap?

15

Solution:

30. What are the euro-denominated fixed rates for 4- and 8-quarter swaps?
Solution:

16