Problem 1.

28
The price of gold is currently $600 per ounce. Forward contracts are available to buy or sell
gold at $800 for delivery in one year. An arbitrageur can borrow money at 10% per annum.
What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold
provides no income.

Problem 1.30.
The current price of a stock is $94, and three-month call options with a strike price of $95
currently sell for $4.70. An investor who feels that the price of the stock will increase is trying
to decide between buying 100 shares and buying 2,000 call options (20 contracts). Both
strategies involve an investment of $9,400. What advice would you give? How high does the
stock price have to rise for the option strategy to be more profitable?

Problem 2.30.
The author’s Web page (www.rotman.utoronto.ca/~hull/data) contains daily closing prices for
the December 2001 crude oil futures contract and the December 2001 gold futures contract.
(Both contracts are traded on NYMEX.) You are required to download the data and answer
the following:
a) How high do the maintenance margin levels for oil and gold have to be set so that
there is a 1% chance that an investor with a balance slightly above the maintenance
margin level on a particular day has a negative balance two days later (i.e. one day
after a margin call). How high do they have to be for a 0.1% chance. Assume daily
price changes are normally distributed with mean zero.
Imagine an investor who starts with a long position in the oil contract at the beginning of the
period covered by the data and keeps the contract for the whole of the period of time covered
by the data. Margin balances in excess of the initial margin are withdrawn. Use the
maintenance margin you calculated in part (a) for a 1% risk level and assume that the
maintenance margin is 75% of the initial margin. Calculate the number of margin calls and
the number of times the investor has a negative margin balance and therefore an incentive to
walk away. Assume that all margin calls are met in your calculations. Repeat the calculations
for an investor who starts with a short position in the gold contract.

Problem 3.26.
It is now October 2010. A company anticipates that it will purchase 1 million pounds of
copper in each of February 2011, August 2011, February 2012, and August 2012. The
company has decided to use the futures contracts traded in the COMEX division of the CME
Group to hedge its risk. One contract is for the delivery of 25,000 pounds of copper. The
initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The
company’s policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months
into the future are considered to have sufficient liquidity to meet the company’s needs. Devise
a hedging strategy for the company.
Assume the market prices (in cents per pound) today and at future dates are as follows. What
is the impact of the strategy you propose on the price the company pays for copper? What is
the initial margin requirement in October 2010? Is the company subject to any margin calls?
 Date Oct 2010 Feb 2011 Aug 2011 Feb 2012 Aug 2012

Spot Price 372.00 369.00 365.00 377.00 388.00

Mar 2011 Futures Price 372.30 369.10
Sep 2011 Futures Price 372.80 370.20 364.80
Mar 2012 Futures Price 370.70 364.30 376.70
Sep 2012 Futures Price 364.20 376.50 388.20

Problem 3.27.
A fund manager has a portfolio worth $50 million with a beta of 0.87. The manager is
concerned about the performance of the market over the next two months and plans to use
three-month futures contracts on the S&P 500 to hedge the risk. The current level of the index
is 1250, one contract is on 250 times the index, the risk-free rate is 6% per annum, and the
dividend yield on the index is 3% per annum. The current 3 month futures price is 1259.
a) What position should the fund manager take to eliminate all exposure to the market
over the next two months?
b) Calculate the effect of your strategy on the fund manager’s returns if the level of the
market in two months is 1,000, 1,100, 1,200, 1,300, and 1,400. Assume that the one-
month futures price is 0.25% higher than the index level at this time.

Problem 5.27.
A bank offers a corporate client a choice between borrowing cash at 11% per annum and
borrowing gold at 2% per annum. (If gold is borrowed, interest must be repaid in gold. Thus,
100 ounces borrowed today would require 102 ounces to be repaid in one year.) The risk-free
interest rate is 9.25% per annum, and storage costs are 0.5% per annum. Discuss whether the
rate of interest on the gold loan is too high or too low in relation to the rate of interest on the
cash loan. The interest rates on the two loans are expressed with annual compounding. The
risk-free interest rate and storage costs are expressed with continuous compounding.

Problem 5.29.
A trader owns gold as part of a long-term investment portfolio. The trader can buy gold for
$950 per ounce and sell gold for $949 per ounce. The trader can borrow funds at 6% per
year and invest funds at 5.5% per year. (Both interest rates are expressed with annual
compounding.) For what range of one-year forward prices of gold does the trader have no
arbitrage opportunities? Assume there is no bid–offer spread for forward prices.

Problem 9.15
Explain carefully the difference between writing a put option and buying a call option.

Problem 9.25.
Use DerivaGem to calculate the value of an American put option on a nondividend paying
stock when the stock price is $30, the strike price is $32, the risk-free rate is 5%, the volatility
is 30%, and the time to maturity is 1.5 years. (Choose binomial American for the “option
type” and 50 time steps.)
a. What is the option’s intrinsic value?
b. What is the option’s time value?
c. What would a time value of zero indicate? What is the value of an option with zero
time value?
d. Using a trial and error approach calculate how low the stock price would have to be
for the time value of the option to be zero.
Problem 10.23.
Suppose that c1 , c2 , and c3 are the prices of European call options with strike prices K1 , K 2 ,
and K3 , respectively, where K3 > K 2 > K1 and K3 − K 2 = K 2 − K1. All options have the same
maturity. Show that
c2 ≤ 0.5(c1 + c3 )

(Hint: Consider a portfolio that is long one option with strike price K1 , long one option with
strike price K3 , and short two options with strike price K 2 .)

Problem 10.25.
Suppose that you are the manager and sole owner of a highly leveraged company. All the debt
will mature in one year. If at that time the value of the company is greater than the face value
of the debt, you will pay off the debt. If the value of the company is less than the face value of
the debt, you will declare bankruptcy and the debt holders will own the company.

a. Express your position as an option on the value of the company.

b. Express the position of the debt holders in terms of options on the value of the
company.
c. What can you do to increase the value of your position?

Problem 11.20.
A diagonal spread is created by buying a call with strike price K 2 and exercise date T2 and
selling a call with strike price K1 and exercise date T1 (T2 > T1 ) . Draw a diagram showing the
profit when (a) K 2 > K1 and (b) K 2 < K1 .

Problem 12.16.
A stock price is currently $50. It is known that at the end of six months it will be either $60 or
$42. The risk-free rate of interest with continuous compounding is 12% per annum. Calculate
the value of a six-month European call option on the stock with an exercise price of $48.
Verify that no-arbitrage arguments and risk-neutral valuation arguments give the same
answers.

Problem 12.19.
A stock price is currently $30. During each two-month period for the next four months it is
expected to increase by 8% or reduce by 10%. The risk-free interest rate is 5%. Use a two-
step tree to calculate the value of a derivative that pays off max[(30 − ST ), 0]2 where ST is the
stock price in four months? If the derivative is American-style, should it be exercised early?

Problem 12.20.
Consider a European call option on a non-dividend-paying stock where the stock price is $40,
the strike price is $40, the risk-free rate is 4% per annum, the volatility is 30% per annum,
and the time to maturity is six months.
a. Calculate u , d , and p for a two step tree
b. Value the option using a two step tree.
c. Verify that DerivaGem gives the same answer
Use DerivaGem to value the option with 5, 50, 100, and 500 time steps.
Problem 13.20.
Show that the Black–Scholes–Merton formulas for call and put options satisfy put–call parity.

Problem 13.23.
Suppose that observations on a stock price (in dollars) at the end of each of 15 consecutive
weeks are as follows:
30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0,
32.9, 33.0, 33.5, 33.5, 33.7, 33.5, 33.2
Estimate the stock price volatility. What is the standard error of your estimate?

Problem 13.24.
A financial institution plans to offer a derivative that pays off a dollar amount equal to ST2 at
time T where ST is the stock price at time T . Assume no dividends. Defining other variables
as necessary use risk-neutral valuation to calculate the price of the derivative at time zero.
(Hint: The expected value of ST2 can be calculated from the mean and variance of ST given in
Section 13.1.)

Problem 15.28
In Business Snapshot 15.1 what is the cost of a guarantee that the return on the fund will not
be negative over the next 10 years?

Problem 16.23.
It is February 4. July call options on corn futures with strike prices of 260, 270, 280, 290, and
300 cost 26.75, 21.25, 17.25, 14.00, and 11.375, respectively. July put options with these
strike prices cost 8.50, 13.50, 19.00, 25.625, and 32.625, respectively. The options mature on
June 19, the current July corn futures price is 278.25, and the risk-free interest rate is 1.1%.
Calculate implied volatilities for the options using DerivaGem. Comment on the results you
get.

Problem 17.24.
A financial institution has the following portfolio of over-the-counter options on sterling:

Type Position Delta of Option Gamma of Option Vega of Option

Call -1,000 0.5 2.2 1.8
Call -500 0.8 0.6 0.2
Put -2,000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4

A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
a. What position in the traded option and in sterling would make the portfolio both gamma
neutral and delta neutral?
b. What position in the traded option and in sterling would make the portfolio both vega
neutral and delta neutral?

Problem 17.25.
Consider again the situation in Problem 17.24. Suppose that a second traded option with a
delta of 0.1, a gamma of 0.5, and a vega of 0.6 is available. How could the portfolio be made
delta, gamma, and vega neutral?
Problem 17.26.
A deposit instrument offered by a bank guarantees that investors will receive a return during
a six-month period that is the greater of (a) zero and (b) 40% of the return provided by a
market index. An investor is planning to put $100,000 in the instrument. Describe the payoff
as an option on the index. Assuming that the risk-free rate of interest is 8% per annum, the
dividend yield on the index is 3% per annum, and the volatility of the index is 25% per
annum, is the product a good deal for the investor?

Problem 18.16.
An American put option to sell a Swiss franc for dollars has a strike price of $0.80 and a time
to maturity of one year. The volatility of the Swiss franc is 10%, the dollar interest rate is 6%,
the Swiss franc interest rate is 3%, and the current exchange rate is 0.81. Use a three-time-
step tree to value the option. Estimate the delta of the option from your tree.

Problem 18.21
How much is gained from exercising early at the lowest node at the nine-month point in
Example 18.2?

Problem 19.20.
A company is currently awaiting the outcome of a major lawsuit. This is expected to be known
within one month. The stock price is currently $20. If the outcome is positive, the stock price
is expected to be $24 at the end of one month. If the outcome is negative, it is expected to be
$18 at this time. The one-month risk-free interest rate is 8% per annum.
a. What is the risk-neutral probability of a positive outcome?
b. What are the values of one-month call options with strike prices of $19, $20, $21, $22,
and $23?
c. Use DerivaGem to calculate a volatility smile for one-month call options.
Verify that the same volatility smile is obtained for one-month put options.

Problem 19.24.
Consider a European call and a European put with the same strike price and time to maturity.
Show that they change in value by the same amount when the volatility increases from a level,
σ 1 , to a new level, σ 2 within a short period of time. (Hint Use put–call parity.)

Problem 4.24 (Excel file)

Suppose that LIBOR rates for maturities of one month, two months, three months, four
months, five months and six months are 2.6%, 2.9%, 3.1%, 3.2%, 3.25%, and 3.3% with
continuous compounding. What are the forward rates for future one month periods?

Problem 4.27.
An interest rate is quoted as 5% per annum with semiannual compounding. What is the
equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous
compounding.

Problem 4.30.
The following table gives the prices of bonds

Bond Principal ($) Time to Maturity (yrs) Annual Coupon ($)* Bond Price ($)
100 0.5 0.0 98
100 1.0 0.0 95
 100 1.5 6.2 101
100 2.0 8.0 104

*Half the stated coupon is paid every six months

a) Calculate zero rates for maturities of 6 months, 12 months, 18 months, and 24 months.
b) What are the forward rates for the periods: 6 months to 12 months, 12 months to 18
months, 18 months to 24 months?
c) What are the 6-month, 12-month, 18-month, and 24-month par yields for bonds that
provide semiannual coupon payments?
d) Estimate the price and yield of a two-year bond providing a semiannual coupon of 7%
per annum.

Problem 6.28.
Portfolio A consists of a one-year zero-coupon bond with a face value of $2,000 and a 10-
year zero-coupon bond with a face value of $6,000. Portfolio B consists of a 5.95-year zero-
coupon bond with a face value of $5,000. The current yield on all bonds is 10% per annum.

(a) Show that both portfolios have the same duration.

(b) Show that the percentage changes in the values of the two portfolios for a 0.1% per
annum increase in yields are the same.
(c) What are the percentage changes in the values of the two portfolios for a 5% per
annum increase in yields?

Problem 6.29.
It is June 25, 2010. The futures price for the June 2010 CBOT bond futures contract is 118-
23.
a. Calculate the conversion factor for a bond maturing on January 1, 2026, paying a coupon
of 10%.
b.Calculate the conversion factor for a bond maturing on October 1, 2031, paying coupon of
7%.
c. Suppose that the quoted prices of the bonds in (a) and (b) are 169.00 and 136.00,
respectively. Which bond is cheaper to deliver?
d.Assuming that the cheapest to deliver bond is actually delivered, what is the cash price
received for the bond?