Multiple choice questions (8 pts.

)
(1) Which of the following is true?
(5) The current value of a portfolio composed of a long po-
(a) Hedging can always be done more easily and
sition in a time-T European call option on an asset with
less costly by a company’s shareholders than by
a strike price equal to the T-forward price, and a short
the company itself;
position in a time-T European put option on the same
(b) avoiding expected costs of financial distress is a
asset with a strike price equal to the T-forward price is:
rational and value-creating reason to why com-
(a) S0 (= the current value of the underlying);
panies should hedge;
(b) – S0;
(c) hedging with linear instruments is always more
(c) 0;
beneficial to a company than using non-linear
(d) none of the above.
instruments;
(d) none of the above. (6) A company knows it will have to pay a certain amount
of a foreign currency to one of its suppliers in the fu-
(2) An interest rate is 5% per annum with continuous com-
ture. Which of the following is true?
pounding. What is the equivalent rate with semi-annual
(a) An option can be used to lock in the exchange
compounding?
rate;
(a) 5.03%;
(b) a forward can be used to lock in the exchange
(b) 5.06%;
rate;
(c) 4.97%;
(c) hedging with a plain-vanilla option does not
(d) none of the above.
cost anything;
(3) The long pure speculative futures demand of an agent (d) none of the above.
in a two-dates model (i.e., time 0 and time 1) is an in-
(7) Which of the following is true?
creasing function of:
(a) An American put option on a stock should nev-
(a) the agent’s risk aversion;
er be exercised early;
(b) the difference between the expected futures
(b) an American call option on a stock should nev-
price and the current futures price;
er be exercised early, when no dividends are
(c) the volatility of the futures market;
expected;
(d) none of the above.
(c) there is always some chance that an American
(4) You sell one December futures contracts when the fu- call option on a stock will be exercised early,
tures price is $1,010 per unit. Each contract is on 100 when no dividends are expected;
units and the initial margin per contract that you pro- (d) none of the above.
vide is $2,000. The maintenance margin per contract is
(8) Volatility of a stock is estimated to be 20% per year.
$1,500. During the next day the futures price rises to
What is the standard deviation of the stock in one
$1,012 per unit. What is the balance of your margin ac-
week?
count at the end of the day?
(a) 0.38%;
(a) $3,300;
(b) 20%;
(b) $1,800;
(c) 2.77%;
(c) $2,200;
(d) none of the above.
(d) none of the above.

Answer:

Question: (a) (b) (c) (d)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)
Page 1 of 4
Short answer question (6 pts.)

Consider a long-term call option on a non-dividend-paying stock granted to employees. It can be exercised at any
time after the end of year 1, but unlike a regular exchange-traded call option it cannot be sold. Discuss what the
likely impact of this restriction on early exercise is.

An employee stock option may be exercised early because the employee needs cash or because he or she is
01______________________________________________________________________________________________

uncertain about the company’s future prospects. Regular call options can be sold in the market in either of
02______________________________________________________________________________________________

these two situations, but employee stock options cannot be sold.

03______________________________________________________________________________________________

04______________________________________________________________________________________________

05______________________________________________________________________________________________

06______________________________________________________________________________________________

07______________________________________________________________________________________________

08______________________________________________________________________________________________

09______________________________________________________________________________________________

10______________________________________________________________________________________________

11______________________________________________________________________________________________

12______________________________________________________________________________________________

13______________________________________________________________________________________________

14______________________________________________________________________________________________

15______________________________________________________________________________________________

Page 2 of 4
Practice question 1 (8 pts.)
You are considering a non-plain-vanilla bond, issued at par 2 years ago by a mining company, with original ma-
turity of 5 years and paying semi-annual coupons. The coupon rate is 3% per annum, and the redemption value at
maturity is equal to the par plus a premium which depends on the increase of the gold price relative to the time
when the bond was issued (i.e., 2 years ago, when the price of 1 ounce of gold was $1,200). Such premium is zero
in case the price of gold at the maturity is lower than or equal to that at the time of the bond issuance, and it linear-
ly increases by 1% of the par per every $100 increase of the gold price. The current price of the bond is 98.40, and
the term structure of zero-rates is flat and equal to 3% for all maturities. On its financial debt the company pays an
annual credit spread (constant over time) of 150 bps over the zero-curve. With this information:
(a) draw (and interpret) the payoff diagram of the redemption value of the bond at maturity as a function of the
price of gold; (2 pts.)
(b) disentangle the value of the plain-vanilla debt instrument from the value of the option component; (3 pts.)
(c) compute the new price of the bond in response to a 50 bps positive shift of the zero-curve for all maturities,
assuming that the value of the option component is unchanged. (3 pts.)

Solution
(a) The payoff diagram of the redemption value of the bond at maturity is 100 (= the par) + 1%  max(ST –
$1,200, 0)/$100. The additive premium has the following payoff (as a function of the price of 1 ounce of
gold at maturity):
3.5
3
2.5
2
1.5
1
0.5
0
900 1000 1100 1200 1300 1400 1500

Hence, the face value is equal to 100 plus 1%/100 times the payoff of a long call option on gold struck at
$1,200 and maturing at T = 5.
(b) The pure fixed-income component of the bond is worth:
B0 = 1.5  A(6, 4.5%/2) + 100/(1 + 4.5%/2)6 = 95.83.
Since the current price of the bond is equal to 98.40, the option component is worth 2.57 (percent of the
par).
(c) If the value of the option component is assumed not to change, the value of the bond decreases to:
B0 = 1.5  A(6, 5%/2) + 100/(1 + 5%/2)6 + 2.57 = 97.06,
i.e. a – 1.36% change.

Page 3 of 4
Practice question 2 (8 pts.)
You are an equity portfolio manager. Your portfolio closely replicates the FTSE MIB index and is worth today
(April 11, 2018) €1.2 million. You wish to hedge your position for the next 8 months (up to the end of the year),
and the following futures contracts on the Italian market index are available for trading:
Maturity Price (index points)
June 2018 20,050
September 2018 20,150
December 2018 20,200
March 2019 20,400
According to the futures contract specifications, the multiplier (i.e., the value of each index point) is €5, the mini-
mum price variation (tick) is 5 index points, the margin requirement (both initial and maintenance margin) is 10%
of the value of the contract, and the contract is cash settled at expiry. The current value of the underlying equity
index (FTSE MIB) is 20,000 index points. With this information:
(a) discuss a hedging strategy (number of futures contracts, position, and maturity) for your spot position; (2
pts.)
(b) compute the P&L of the naked, hedging, and hedged position at the time the hedge is lifted, considering
that at the end of December 2018 the FTSE MIB index is worth 18,900 index points. (3 pts)
Suppose now that one day after you enter the futures market the futures price declines by 1.04%. Compute:
(c) the initial margin (the day you enter the futures market), the daily P&L following the 1-day decrease of fu-
tures price, and the consequent variation margin (if required). (3 pts.)

Solution
(a) Your spot position is long, and the hedge strategy is then short. Dividing the current value of the portfolio
by the futures contract multiplier (€5) we get 240,000 index points. This means 12 futures contracts (=
240,000/20,000). Hence, you will sell 12 equity futures contracts expiring in December 2018. Equity index
futures are cash settled and therefore there are no delivery issues.
(b) The P&L on the naked position is negative. Your portfolio loses 5.5% of its value (= 18,900/20,000 – 1),
that is – €66,000. However, you get a + €78,000 P&L on the hedging position (= (20,200 – 18,900)  €5 
12 contracts). Overall, the hedged position yields a positive P&L of €12,000. This is exactly the difference
between F = 20,200 and S = 20,000 index points, multiplied by the futures contract multiplier (€5), and by
12 futures contracts.
(c) The initial margin is equal to 10% of the value of the contract, i.e. a total of €121,200 (= 20,200  €5  12
contracts  10%). Since the futures price goes down to 19,990 index points after 1-day (i.e., a 1-day 1.04%
decrease), and you are short 12 contracts, the daily P&L is + €12,600 (= 210  5  12 contracts). No mar-
gin variation is then required.

Page 4 of 4