FINA0301/FINA2322

Fall, 2016

Homework Questions 3: Due dateThursday, Nov. 17, 2016

Name:

Instructions:
Read the questions carefully, write all your steps where necessary.
You dont have to computer-type the solution. However, the hand-written version has
to be reader-friendly.
Hard copies of the solutions must be dropped in the TAs box by 6PM on the due
date. No later submission will be accepted.
You may work in groups of four or less, and only one solution set will be turned in
by each group. The grade on the problems turned by the group will be given to each
member of the group.
Please write clearly which subclass you are from: A, B or C.
1. A lender plans to invest $100m for 150 days, 60 days from today. (That is, if
today is day 0, the loan will be initiated on day 60 and will mature on day 210.)
The implied forward rate over 150 days, and hence the rate on 150-day FRA, is
2.5%. The actual interest rate over that period could be either 2.2% or 2.8%.
(a) If the interest rate on day 60 is 2.8%, how much
if the FRA is settled on day 60? How much if it
(b) If the interest rate on day 60 is 2.2%, how much
if the FRA is settled on day 60? How much if it

will the lender have to pay

is settled on day 210?
will the lender have to pay
is settled on day 210?

2. 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 6.0%, the 2-year interest rate is
6.5%, and the 3-year interest rate is 7.0%.
(a) What is the 3-year swap price?
(b) What is the price of a 2-year swap beginning in 1 year? (That is, the first
swap settlement will be in 2 years and the second in 3 years.)
3. 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 index, selling the 815-strike call, and buying the 815-strike put.
(a) What is the rate of return on this position held until the expiration of options?
(b) What is the arbitrage implied by your answer to part (a)?
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FINA0301/FINA2322

Fall, 2016

(c) What difference between the call and put prices would eliminate arbitrage?
(d) What difference between the call and put prices eliminates arbitrage for
strike prices of $780, $800, $820, and $840?
4. Suppose the dollar-denominated interest rate is 5%, the yen-denominated interest
rate is 1% (both rates are continuously compounding), the spot exchange rate is
0.009 $/U, and the price of a dollar-denominated European call to buy one yen
with 1 year to expiration and a strike price of $0.009 is $0.0006.
(a) What is the dollar-denominated European yen put price such that there is
no arbitrage opportunity?
(b) Suppose that a dollar-denominated European yen put with a strike of $0.009
has a premium of $0.0004. Demonstrate the arbitrage.
(c) Now suppose that you are in Tokyo, trading options that are denominated
in yen rather than dollars. If the price of a dollar-denominated at-themoney yen call in the United States is $0.0006, what is the price of a yendenominated at-the-money dollar call (an option giving the right to buy one
dollar, denominated in yen) in Tokyo? What is the relationship of this answer to your answer to part (a)? What is the price of the at-the-money
dollar put?
5. Suppose call and put prices are given by:
Strike
50 55
Call premium 16 10
Put premium 7 14
What no-arbitrage property is violated? What spread position would you use to
effect arbitrage? Demonstrate that spread position is an arbitrage.
6. Suppose call and put prices are given by:
Strike
80 100 105
Call premium 22
9
5
Put premium 4
21 24.80
Find the convexity violations by computing the change in premium per dollar
change in the strike price. What spread would you use to effect arbitrage? (Hint:
In this problem, consider buying one 80-strike option, selling five 100-strike options, and buying four 105-strike options.) Demonstrate that the spread position
is an arbitrage.