-I

FINANCIAL ENGINEERING (M 3 6
C- 0 )
1.
ASSIGNMENT - l
Let 8(0 ) = Rs.100, B( l) = Rs.
110 and S(0) = Rs. 80. Also, let
S(l ) = fRs.100, wit h pro bab
ilit y p = 0.80
lRs . 60, wit h pro bab ilit y p = 0.20.
Design a portfolio with initial wea f
lth of Rs.100,000, split in the ra 0 Of 3 .2 between stock and bond.
Compute the expected return and ' d ·
the risk of the portfolio so con struc
te · COl,COS
2.
Let 8 (0) = Rs. 90, 8(1 ) = Rs.

Wh
l
S(l ) = Rs. 30,
Rs. 20,
100 and S(0) = Rs. 25 and let
wit h pro bab ilit y p
wit h pro bab ilit y 1 - p.
er: 0 < P < 1. For a portfol io with x = 10 shares and y = (0) V(
on this portfolio. 15 bonds calculate V ' l) and return
3.
let 8(0 ) - R C0 1,C 05
S(l ) = 1
R i5" lO0, B( l) = Rs.110 and S(0) = Rs. 80. Also,
l s . O0, wit h pro bab ilit y p = 0.80 let
Suppose ~:· t 0,6
wit h pro bab ilit y p
P
ortfol· . you have Rs. 10,000 to inv=est0.20. .
10 in a portfolio. For the above stoc .
expect d with an m,t · ··
,al we alth k and bond pnces, design a
of Rs. 10 ,000 split fifty-fifty bet
e return and . k ween stock and bonds. compu t the
ns as measured by standard dev e
4. iation.
LetB(0) = Rs 90 B(
\R ' l) = ~s. 100 and S(0) = Rs. CO2
S(l ) = l s . 30 , wit h pro bab ilit y p
25 and let
Rs. 20
Wh ere 0 < p <, 1 F'wit h pro bab ilit y 1 _ p
· md a portfolio whose valu· e at
V( l) = l 1,l 60 time 1 is .
if sto ck goe s up .
ll,0 40 if sto ck goe s down. What 1s the
value of this portfolio at time 07
5.
Let B(O) = Rs. l00 , B( l) = Rs,
110 and S(0) = Rs. 80. COl
S( l) = f Rs. 100 , wit h pro bab
ilit y p = 0.80
l Rs. 60, wit h pro bab ilit y p = o. _ .
European put with K = Rs.100 and 20 Also, let C and P respectively be
T = 1 year. a European call and
i. Determine C(O) and P(0).
ii. F'.nd the final we~lth of an inv
estment with initial capital of Rs.9
given stock, the given call and the 00 being invested equally in the
given put.
6. Let B(0 ) = Rs.100, B( l) = Rs. 110 and S(0) = Rs.100. Also COl
_ f Rs. 120, wit h pro bab iUt y p .
let
S( l) - lRs. BO, wit h pro bab ilit yl _ p. Find . .
the fma l wealth of an investor whose
Rs. 1,0 00 is split fifty-fifty between initial capital of
stock and options, with exercise
time 1 and strike price Rs.100.
7. Spot an arbitrage opportunity
(if it exists) in the following situatio COl
British pounds in an year from n. Suppose that a dealer A offers
now at a rate of Rs.79 a pound, to buy
immediately at a rate of Rs.80 while dealer B would sell British
a pound . Assume that a rupee can pounds
a British pound can be invested be borrowed at an annual rate of
in a bank at 6% annual interest. 4% and

8. Let B(0 ) = Rs. 100, 8(1 ) = COl

Rs. 110, S(0) = RS. 50. Determ
contract on the given stock. ine the forward price F of a
forward

9. An investor writes a put opt CO2

ion with strike price of Rs. 30.
circumstances does the investo The price of option is Rs. 4. Under what
r make a gain?
The current price of silver is COl
10. Rs. 5000 per l0Ogm . The storage
quarterly in advance. Assuming cost is Rs. 0.50 per gm per year payable .
tha t constant interest rate of
9% compounded. quarterly, calc
forward price of silver for 1kg ulate the
for delivery in 6 months.
CO2

1
 FINANCIAL ENGINEERING
ASSIGNMENT - 2

· fons have exercise time T and strike price COl

1. Let S(T) be the price of stock at time T. All of the f o II owing op 1
K. Give the payoff at time T that is earned by an investor who owns
(i) One call and one put option .
Le1
(ii) Two calls and has sold short one share of stock.
S( (iii) One share of stock and has sold one call. . .
(iv) One call having strike price K1 and has sold one put having strike price Kz.
w
or CO3
2. A certain stock is selling for Rs SO. The feeling is that for each month, for the next two month s,_th e st0 ck
LE price will rise by 10% or fall by 10%. Assuming that the risk free rate is 1%, calculate the price of th e
European call with the strike price of Rs 48.
5.
E d
s 3. Consider the data S(O) = 60, K = 62, u = 1.1, d = 0.95, r = 0.03 and T = 3. . Find C (0) an CO3
p pE(O).
e
4. Let S(O) = 120, u = 1.2, d = 0.9 and r = l %. Consider a call option with strike price K CO3
120 and T = 2. Find the option price an~ the replicating strategy.

S. A _n on-dividend paying stock is currently selling at Rs.100 with annual volatility 18%. Assume that the CO3
continuously compounded risk-free interest rate is 4%. Using a two-period CRR binomial model , find
the price .o f one European call option on this stock with strike price of Rs.80 and time to expiration 3
years.

6. Consider the following data: S(O) = = =

Rs. 51, K Rs. 50, er= 30%, r 8%. Assuming the Black- CO3
Scholes framework and that the stock pays no dividend, compute 3-months European call price and
3-months European put price using the Black-Scholes formula . Also compute the put price using the
put-call parity. Are the two values same?

7. The price of a stock is Rs.260. A 6-month European call option on the stock with strike price Rs.256 is CO3
priced using Black-Scholes formula. It is given that the continuously compounded risk-free rate is 4%·
the stock pays no dividend; the volatility of the stock is 25%. Determine the price of the call option. '

8. You own 100 shares of a stock whose current price is Rs.42 . You would like to hedge your downside CO3
exposure by buying 6-month European put option with a strike price of Rs.40. It is given that the
continuously compounded risk-free rate is 5%; the stock pays no dividends; the stock volatility is 22%.
Assuming the Black-Scholes framework determine the cost of the put option.

9. Consider purchase of 100 units of 3-month Rs.25-strike European call option. It is given that the stock CO3
is currently selling for Rs.20;·the continuous compounding risk free interest is 5%; the stocks volatility is
24% per annum . If the stock pays divide rids continuously at the rate of 3% per annum, determine the
price of block of 100 call optibns, assuming the Black-Scholes framework.

10. The current price of stock is Rs.100 and its volatility is 25% per year. The risk free interest rate is 5% per CO3
annum. A portfolio is constructed consisting of one 6-month European call option with strike price of
Rs.80 and the cash obtained from shorting D shares of stock. The portfolio value is non-random. What
is D?
 FINANCIAL ENGINEERING (MC- 306)
ASSI GNM ENT - 3

Consider n .. .
= {a, b, c, d}. Construct 4 d1stm field 'F 'Fz 'F3 'F4 such that 'F1 c C04
ct a - 11 ' '
'F2 C 'F3 C f4 .

2 What is the distribution of W(s) + W(t) , for O ~ s ~ t? C04

3 · g umfor
Let X and Y be i.i. d. random variables each havm · m d'1stn'b t·10 C04
inter val(- rr, rr) . Let Z(t) = cos(tX + Y), t 2: o. Is (Z(t)
u n the °? .
, t 2: O} wide sense stat10nary
proce ss?

4 Let Z be a norma lly distributed random variable, with mean

O and varian ce 1, Z ~ N (O, l). C04
Then_ consi der the contin uous time stochastic process X = {i,Z,
Show that the distri bution
of X 1s norm al with mean O and variance t. Is X(t) a Brow nian
motio n?
5
Let {W(t ), t 2: O}be a Wien er process. ls exp{a W(t) - 2
C04
. . a t} a marti ngale where a is a
pos1t1ve const ant? 2

6 Find the stoch astic differ ential of W 2 ( t) .

C04

Cons ider a stock whos e value S(t) follows sde dS = r.Sdt

+ a.SdW and has a current price C04
S(O). What is the proba bility that a call option is in the mone
y based on a strike price K =
1.25 S(O) at time of expir ation T? Given that T 0.5, r 0.04
= = and a = 0.10.
8
Use the first versio n ofito- Doeb lin formula to evaluate
I t W (t)dW(t )
0
2 C04

9 Find the stoch astic differ ential s of sin(W ( t)) .

C04
A stock price is curre ntly Rs.SO. Assume that the expected
return from the stock is 18% per C04
annu m and its volat ility is 30% per annum . What is the proba
bility distribution for the stock
price in two years ? Calcu late the mean and stand ard devia
tion of the distribution. Deter mine the
95% confi dence interv al.
 /
Financial Engineering
.,Assignment-4
1 Sup pos e ther e are thre e fina ncia · l mark · s Q = {w w2 w3} wit h diff eren CO l
pro bab iliti es of occ urre nce . Con side et sce nar io 1 '. , t
F r the foll owi ng tabl e sho wm g the retu C05
diff eren t stoc ks in thes e thre e sce nar rns on two
ios
Sce nar io Pro bab ility Return Kl% Return K2 %
W1 0.2 -10 -30
W2 0.5 0 20
W3 0.3 20
(a) Wh at are the exp ecte d retu rns on 15
the stoc ks?
(b) Sup pos e 60% of the ava ilab le fun
d is inve sted in stoc k 1 and the rem
inv este d in stoc k 2, the n wha t is the ain ing is
exp ecte d retu rn of the por tfol io?
(c) Com put e the .we ight s if the exp ecte
d retu rn o~ a port foli o is 20% .
2 Con side r the fo 11owi ng
d ata for two d 1'fferen t stock
s C05
Sce nar io Pro bab ility Retu rnK 1 % Ret urn K2 %
W1 0.4 -10 20
W2 0 .2 0 20
W3 0.4
Sup pos e a port foli o com pns es of 40% 20 10
of tota l inv estm ent in stoc k 1 and 60%
stoc k 2. Com par e the risk of the port in
foii o with the risk s of its indi vidu al
Wh at will be the risk situ atio n if com pon ents .
a port foli o is des igne d with inv estm
stoc k 1 and the rem aini ng in stoc ent of 80% in
k 2.
3 Pro ve tha t if sho rt sale s are not allo
wed the n the risk of the port foli o can
the gre ater of the risk s of the indi not exc eed CO 1
vidu al com pon ents of the port foli o.
COS
4 Sup pos e the por tfol ios are con stru
cted usin g thre e secu ritie s a1, a2, ~
retu rns , µ 1 = 20% , µ 2 = 13% , µ wit h exp ecte d COS
3 = 4% , stan dar d dev iati ons of retu rns ,
cr1 = 25% , cr2 = 28% , cr = 20% ,
3 and the corr elat ion betw een retu rns,
p 12 = 0.3, p 13 , = 0.15 and p = 0.4
23 . Am ong all the atta inab le port foli
wit h min imu m var ianc e. Wh at are os, find the one
the wei ghts of the thre e secu ritie s in
Als o com put e the exp ecte d retu rn this port foli o?
and stan dar d dev iatio n of this port foli
o.
5 Con side r the foll owi ng dat a for thre
e diff eren t stoc ks.
COS
Prob retu rn Kl retu rn K2 retu rn K3
0.1 0.3 0.08 -0.1
0 .5 0 .13 0.11 0.34
0.2 0.15 0.4 0 .11
0 .2 0.25 0 .12 0.15
Am ong all the atta ina ble por tfol ios,
find the on~ with min imu m vari anc
the wei ght s of the thre e sec urit ies e. Wh at are
in this port foli o? Also com put e the
and stan dar d dev iati on of this port exp ecte d retu rn
foli o.

6 Con side r the foll owi ng dat a

cos
µ CJ
Ass et 1 10% 5%
Ass et 2 8% 2
For eac h cor rela tion coe ffic ient %p . . .
= -1, -0.5 , 0, 0.5, 1, wha t 1s the co~b mat
two ass ets tha t yiel ds the min imu 101 :1 ?f the
m stan dar d dev iati on and wha t 1s
val ue of the stan dar d dev iati on? the m1m mum
;
7 Consider three risky assets with the variance-c ovariance matrix and expected cos
returns
lall data in %) as follows.

Variance-covariance matrix C Return M

10 4 0 5
4 12 6 6
0 6 10 1
Find two efficient portfolios. Also construct the portfolio giving the return of 2.8%
with minimum risk. Will this portfolio be also efficient?

8 Suppose an investor is interested in constructi ng a portfolio with one risk-free asset COS
a1, and three risky assets a2, fl3 and a4. Let the expected returns of a1, a2, cl3 and ~
be 6%, 10%, 12% and 18% respectively. Let the variance-c ovariance matrix C of the
4 20 40)
three risky assets be C = ( 20 10 70 Determine all efficient portfolios for the
. 40 70 14
investor.
9
Assume .that th~ following assets are correctly priced ~ccording to the security COS
marke_t hne. Denve the security market line. µ 1 = 6%, f31 = O.S, µ 2 = 12%, {32 = 1.5
What 1s the expected return on an asset with f3 = 2?
10 If the following two t • .
h t . h asse s are correctly pnced accordmg to the security market line COS
w a is t e return of the market portfolio? What is the risk-free return? '
µ1 = 9.5%, /31 = 0.8, µ 2 = 13.5%, {32 = 1.3