Dr Zoe Tsesmelidakis

Problem Set 2
Financial Risk Management

Note: Remember to label all important elements in your graphs, particularly the axes,
unambiguously.

Homework Exercises

I. CAPM and Investment Decisions

Solution:

(a) The Security Market Line (SML) is characterized through two securities that lie on
that line. Market beta is always M = 1, but the market return has to be inferred.
One possibility is to start by determining the slope of the SML given the the two
A
securities: Slope=Risk premium= BB A
= 0.160.08
1.20.4
= 10%.
Given the CAPM equation
i = rf + (M rf )i
we now have
i = rf + 0.1i
and can plug in the details (coordinates) of one of the securities (here we use A) to
obtain the intercept of the SML (i.e., the risk-free rate):
0.08 = rf + 0.1 0.4 rf = 0.04
Given a risk premium M rf = 0.1, the market return must be m = 0.14.

(b) SML: i = rf + (M rf )i = 0.04 + 0.1i

r
CML: i = rf + MM f i = 0.04 + 34 i

(c) Start with the beta formula:

cov(rA , rM )
A =
var(rM )
r
0.00225 0.00225
0.4 = 2
M = = 0.075
M 0.4

(d) Sketch:

1
 SML

B

M E

C
D
A

(e) Stock D:
D = 0.04 + 0.1 (0.2) = 0.02
Dividend Discount Model: 100 = 4/r r = 0.04
Since 0.04 (the actual return) > 0.02 (the fair return), stock D is underpriced. You can
check this by re-calculating the stock price using the DDM to obtain 4/0.02 = 200.
Arbitrageurs would buy underpriced stock D. As its price increases, its return de-
creases until it reaches the SML, the state of equilibrium.
Stock E:
D = 0.04 + 0.1 (1.6) = 0.20
Dividend Discount Model: 21 = 2(1.05)/(r 0.05) r = 0.15
Since 0.15 (the actual return) < 0.20 (the fair return), stock D is overpriced. You can
check this by re-calculating the stock price using the DDM to obtain 2(1.05)/(0.2
0.05) = 14.
Arbitrageurs would sell overpriced stock E. As its price decreases, its return increases
until it is on the SML.

II. CAPM and Cost of Capital Modigliani-Miller Revisited

Solution:

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(a) The asset (unlevered) beta is the weighted average of equity and debt betas:

E D
A = E + D
E+D E + D |{z}
=0
 
D
A = 1 E
E+D
T esco(F ood) : A = 0.56
Samsung(Electronics) : A = 1.28
BASF (Chemistry) : A = 0.72

(b) Conglos unlevered beta:

AConglo = 0.5 0.56 + 0.3 1.28 + 0.2 0.72 = 0.808

Conglos levered beta:

E + D Conglo 10
EConglo = A = 0.808 = 1.346
E 6

(c) Conglos equity cost of capital:

rE = 0.07 + (0.15 0.07)E = 17.768%

(d) (i) Calculation using WACC formula:

E D
rA = rE + rD
E+D E+D
rA = 0.6 0.17768 + 0.4 0.07 = 13.46%

(ii) Calculation using unlevered beta:

rE (0) = rA = rf + (M rf )A
| {z }
MM1
rA = 0.07 + 0.08 0.808 = 13.46%

Intuition: This calculation yields the cost of equity of an all-equity financed

firm. According to the first Modigliani-Miller proposition, this must be equal
to the total cost of capital of a levered company.

III. Hedging with Futures

Solution:

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(a)

F0 = P0 erT = 800 e0.051 = 841

(b) The company is looking for a short position of (1,000/100=) 10 Futures contracts. It
has to be a short position so as to ensure that low revenues (in the bad state of the
world) are offset with positive payoffs of the same magnitude from futures position.
This is the payoff graph for a short futures on one ounce of gold:

Payoffs (per ounce)

Combined position
841

Long gold

Short forward

F0=841 Gold price

(c) Table:

Sale revenue Short futures payoff Total proceeds

1000,000 (1, 000 841) 1000 = 159, 000 841,000
700,000 (841 700) 1000 = 141, 000 841,000

In t1 , without the hedge, the company will have revenues of either $700,000 or
$1000,000. With the hedge, it will have a certain revenue of $841,000.
The company is earning the risk-free rate: ln(841, 000/800, 000) = 5%

IV. Put-Call Parity

Solution: The put-call parity dictates a no-arbitrage relationship between prices of puts
and calls sharing the same features.

P = C + P V (X) + P V (D) S0
2 5
P = 2 + 30e0.10.5 + 0.5e 12 0.1 + 0.5e 12 0.1 29 = 2.51 EUR

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V. Option Valuation with Binomial Trees

Solution:

(a) Binomial tree: G

A
I

End node Probability for one path Paths S3 Product

G p3 =0.343 1 133.1 45.65
H p2 (1 p) = 0.147 3 96.8 42.69
I p(1 p)2 = 0.063 3 70.4 13.31
J (1 p)3 = 0.027 1 51.2 1.38

The expected stock price is the sum of the values in the right column: 103.03
1+rd
(b) Risk-neutral probability of an upward movement: q = ud
, where u and d are the
upside and downside changes, respectively.
Here, u = 1.1, d = 0.8, r = 0.05 q = 5/6 = 0.83

(c) European calls:

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 S3 (i) (ii) (iii)
133.1 33.1 -33.1 0
G
D

H
B
96.8 0 0 3.2
E

A I
C
70.4 0 0 29.6

J
51.2 0 0 48.8

(i)

E q (S3 X) 33.1 q 3
C0 = = = 16.55
(1 + r)3 1.053

(ii) A short position in the same call as in (i) is just worth the same with flipped
sign: -16.55
(iii)

E q (X S3 ) 3.2 q 2 (1 q) 3 + 29.6 q(1 q)2 3 + 48.8 (1 q)3

P0 = =
(1 + r)3 1.053
10/9 + 37/18 + 61/270
= = 2.93
1.053

(d) American options:

(i) An American call option on non-dividend-paying stock is always worth as much

as a European call with equal properties. The rationale is that exercising the
call yields a payoff of St X, while the call value is at least St P V (X). Since
St P V (X) > St X early exercise is never optimal.
(ii) In the case of the American put, the value must be determined via backward
induction, i.e., you solve the binomial tree from right to left and determine in
each node whether it is optimal to exercise the put, yielding M ax(X St , 0), or
keep/sell it, whose value equals the present value obtained through risk-neutral
valuation.

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 S3 (ii)
133.1 0
D
S2=121 G
P(exercise)=0
P(keep/sell)=0.51
B
S1=110
P(exercise)=0
H
P(keep/sell)=2.31
96.8 3.2
E
S2=88
P(exercise)=12
P(keep/sell)=7.23
C
S1=80 I
A
P(exercise)=20
S0=100
P(exercise)=0 P(keep/sell)=15.24 70.4 29.6
F
P(keep/sell)=5.01 S2=64
P(exercise)=36
P(keep/sell)=31.24

51.2 48.8

You start by establishing the payoffs in the end nodes, M ax(X S3 , 0). Then,
for example in node D, you calculate the payoff from exercising, which is 0 since
100 121 < 0, and compare it to the holding the put for another period, which
is P2 = (15/6)3.2
1.05
= 0.51. Here exercising is clearly not optimal and an investor
would choose to keep or sell the option. In node E, the situation is different.
The optimal decisions are highlighted in bold face. Using this technique, we
work our way to the start of the tree.
The t0 -value of the put is P0 = 5.01.

(e) A straddle consists of a call and a put of the same strike price. The strike price is
typically identical or close to the current underlying price, which is the case here
(both 100). The investor is betting on a significant movement of the underlying in
any direction or a rise in the underlyings volatility.
The value of the straddle is the value of the European call plus the value of the
European put, that is 16.55 + 2.93 = 19.48. An investor willing to take on such a bet
would need to spend this amount initially.
At maturity, how large must the stock have moved for the investor to realise a profit,
i.e., what are the break-even points?
If S3 < 100 19.48 = 80.52 or S3 > 119.48, then the position is profitable.

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 Payoff

Net Payoff/
Profit

80.52 100 119.48 S3

19.48

Self-Study Exercises

VI. Option Price Determinants

Solution:

(i) The call price increases because the option is approaching the money or getting
deeper in the money (vice versa for put options).

(ii) The call price increases because the probability of ending up in the money increases
(also applies to put options). The probability of adverse events (for the option-
holder) is equally higher, however, given the asymmetry in the payoff profile of
options, he benefits disproportionately from positive events.

(iii) Depending on whether we look at European or American options, our conclusion

can vary as there may be opposite effects at work.
In any case, the following two negative effects on the call value are common to both
exercise styles:

The call price decreases because the probability for unexpected positive events
decreases (similar to the effect of volatility).
Also, the present value of the strike price, which is subtracted from the value
of the underlying, increases, thereby driving down the option value (see the
lower bound of the call option).

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BUT, there may be a contrary effect in the case of European options. Lets next
distinguish American and European options more closely.

American options: A longer time to expiration is always better for American

option holders because whatever happens the longer-maturity option has the
same opportunities as the shorter-maturity option, hence the former cant be
less valuable. (This the above two arguments all over again.)
European options: For European options, the situation is not clear, because a
long-life option holder has not all the exercise opportunities as the short-life
investor.
To see this point, imagine two calls, one maturing in 1, the other in 2 months,
and a large dividend being expected to be paid on the underlying stock in 6
weeks. The short-life option is clearly more valuable in this case because it
can be sold BEFORE the dividend lowers the stock price (and hence the call
value). Here, a shorter time to maturity would be clearly preferred.