Derivatives I

Assignment 2

Winter 2015/16

1. Forward Contract
Assume that the current (t = 0) stock price equals 40 and the stock pays no dividends. The
risk-free interest rate equals 10% p.a. (continuous compounding). Consider a forward contract
on this stock that expires in one year (t = 1).

(a) Determine the forward price and the forward value at time t = 0.
(b) During the next six months the stock price rises to 45. Determine the forward price and
the forward value in six months, i.e. at time t = 0.5.

2. Forward and Futures Contracts

Consider a forward and a futures contract, each maturing in three months. Assume that interest
rates are deterministic, so that the forward price and the futures price coincide. The stock price
development for the next three months is given in the table below. The risk-free interest rate
equals 6% p.a. (continuous compounding).
Determine the prices and values of both contracts over the next three months. For simplicity,
assume that the futures contract settles at the end of each month only.

t [months] 0 1 2 3
stock price 70.00 92.00 85.00 80.00
forward price
payments to long
payments to short
forward value (long)
futures price
payments to long
payments to short
futures value (long)

3. Binomial Model Plain Vanilla Call

Consider a one-period binomial model with parameters u = 1.2 and d = 0.8. The current stock
price equals S0 = 100 and the risk-free interest rate equals 5% p.a. (discrete compounding). Find
the price of a call option with strike K = 100 that matures in one year. Use the two different
approaches discussed in the lecture, i.e. pricing via replicating portfolio and risk-neutral pricing.

4. Binomial Model Call on Squared Stock Price

Assume that the current stock price equals 25 and that it is known that it will equal either
23 or 27 in two months. The risk-free interest rate equals 10% p.a. (continuous compounding).
Use a one-period binomial model to price a derivative maturing in two months whose payoff is
given by the squared stock price, i.e. ST2 ,

(a) via replication

(b) via risk-neutral valuation.

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5. Risky Debt
Consider a company with a single investment project. The project requires an initial investment
of 100$ and the risk-free rate of interest is 10% p.a. (discrete compounding).

C1u = 150
0.5
C0 = 100
0.5
C1d = 80

The payments to debt- and shareholders depend on the nominal interest rate (which depends
on the risk of default), i.e., the payment to debtholders is

min (1 + rN ) N, C1i


and the payment to shareholders is the residual

C1i min (1 + rN ) N, C1i



where rN is the nominal interest rate and N is the notional principal.

(a) Interpret the claims on debt and equity from an option pricing perspective.
(b) Determine the nominal interest rate (use N = 80). Assume that the current price of debt
is equal to N .
(c) Calculate the expected return on debt.