FINANCE DEPARTMENT
FINANCIAL ENGINEERING AND ASSET PRICING (4109)
GROUP ASSIGNMENT
MEMBER STUDENT NUMBER
TINASHE MAKOSI N02214421Y
BLESSMORE CHIPONDA N02221566Y
PANASHE KATSANDE N02221044X
NYASHA MUDZINGWA N02216094E
PANASHE GUMBO NO2220543M
1. Assume the rate of interest is 12 per cent. Compute the annual percentage/effective
rate if interest is paid:
a. quarterly and
b. monthly.
c. What are the implications of more frequent payments of interest?
Solution
𝑟 𝑚𝑛
a) (1 + 𝑚) −1
0.12 4
(1 + ) − 1 = 0.1255 = 𝟏𝟐. 𝟓𝟓%
4
0.12 12
b) (1 + ) − 1 = 0.1268 = 𝟏𝟐. 𝟔𝟖%
12
c) More frequent compounding increases the interest paid or earned.
2. Company ABC has just received $500 000 in two years after an investment of $400 000.
Find the percentage return per annum with
a. Annual compounding
b. Continuous compounding
Solution
a)400000(1 + 𝑟)2 = 500000
(1 + 𝑟)2 = 1.25
1 + 𝑟 = 1.118033981
𝑟 = 1.118033981 − 1 = 0.118
𝒓 = 𝟏𝟏. 𝟖%
b) 400000𝑒 𝑟𝑡 = 500000
400000𝑒 𝑟2 = 500000
𝑒 2𝑟 = 1.25
2𝑟 = 𝐼𝑛 1.25
𝑟 = 0.11157 = 𝟏𝟏. 𝟏𝟔%
3. Suppose that an investment manager enters into a 4-month forward contract on a non-
dividend-paying stock when the stock price is $30 and the risk-free interest rate (with
continuous compounding) is 12% per annum. What is the forward price?
Solution
Fo= 𝑆𝑜𝑒 𝑟𝑡
4
𝐹𝑜 = 30𝑒 0.12(12) = $31.22
4. An investor purchases three 3-month put option contracts for Silver. The strike price of
the options is $200, and the premium for each put option is $8. At maturity, Silver is
trading at $180.
a. Define a put option contract
b. Find the payoff of the put
c. What is the profit
Solution
a) A put option is the right and not the obligation to sell an underlying asset in the future.
b) payoff= max(𝐾 − 𝑆𝑡, 0)
max(200 − 180,0)
= $20 per contract and $60 total payoff, since there are 3 puts
c)Profit=Payoff- Premium
$20-$8=$12 per put and $36 is the total profit.
5) An investor has purchased a 4-month put option on the equity shares of Torwa
Company for $5. The current market price per share is $112, and the exercise price is
$120. At the end of 4 months, the investor expects the share price to be in the range of
$90 to $170.
a. Create a profit/loss table for the put option
b. How does the premium paid for an option affect overall profit and what is the maximum
profit?
c. What 3 factors could influence the call option price of Torwa Company over the next
four months and what is their effect?
Solution
Expected Price Spot price Exercise Price Payoff=max(K-St,0) Profit/loss
90 90 120 30 25
100 100 120 20 15
110 110 120 10 5
120 120 120 0 -5
130 130 120 0 -5
140 140 120 0 -5
170 170 120 0 -5
b) Premium is a sunk cost and reduces the amount of profit from the payoff, Maximum
profit is $25 at the lowest spot price of $90.
c)Volatility-If there is high volatility of price, there is greater chance favorable moves
hence the call value increases.
Time to expiration-the more time, the more likely favorable move of the stock price, the
higher the call option price.
Current price-Call option becomes more valuable as the stock price increases.
Strike price-call option becomes less valuable if the strike price increases.
6. State and explain the 4 assumptions used in the derivation of the Black-Scholes option
pricing model.
Solution
i)No-Arbitrage and Frictionless Markets
Financial markets are perfect, no taxes, no transaction costs and unlimited borrowing and
lending at the risk-free rate. Ensures that a riskless hedged portfolio earns exactly the risk-
free rate, not more or less.
ii) Constant Risk-Free Interest Rate
The risk-free rate is constant and known throughout the life of the option. This
Simplifies the pricing equation because there is no uncertainty around interest rates.
iii) Log normal distribution of underlying asset.
This means that the price changes continuously and not in jumps. The return is also
normal distribution.
iv) The underlying pays no dividends during the life of the option
The stock does not distribute dividends or other cash flows before option expiry. Dividends
reduce stock price, which would complicate hedging and the stock price process.
So, the basic Black–Scholes formula assumes the stock price grows without payouts.
7. What rate of interest with continuous compounding is equivalent to 15% per annum with
monthly compounding?
Solution
𝑟 𝑛𝑚
7) 𝑃𝑜𝑒 𝑟𝑛 = 𝑃𝑜 (1 + 𝑚)
𝑟 𝑛𝑚
𝑒 𝑅𝑛 = (1 + )
𝑚
𝑟
𝑅𝑛 = 𝑚𝑛 (1 + )
𝑚
𝑟
𝑅 = 𝑚 ln (1 + )
𝑚
Since m=12
n=1
r=0.15
0.15
𝑅 = 12 𝐼𝑛 (1 + ) = 𝟏𝟒. 𝟗𝟏%
12
8) 8. A one-month binomial call model assumes that the price of the underlying asset can change
from $12.00 today to either $16.00 or $10.00 at the end of the period. If the risk-free rate of
return over the period is 5%, what is
a. the risk-neutral probability of a price increase and [2]
b. hedge ratio
c. value of the call if the strike price is $12.50?
Solution
Su 16
So 12
Sd 10
16
𝑈= = 1.33
12
10
𝑑= = 0.833
12
a) Risk neutral probability= (1 + 𝑟 − 𝑑)/(𝑢 − 𝑑)
1.05 − 0.833)/(1.33 − 0.833) = 0.434
𝐶𝑢−𝐶𝑑
b). Hedge ratio = 𝑆𝑢−𝑆𝑑
Cu=max (16-12.5,0) =3.5
Co
Cd=max (10-12.5,0) =0
3.5−0
= 16−10=0.583
c). Value of a call option= [𝐶𝑢(𝜋𝑢) − 𝐶𝑑(𝜋𝑑)]𝑒 −𝑟𝑡
Where t=1 month=0.0833
=[3.5(0.434) + 0(1 − 0.434)]𝑒 0.05(0.0833)
=$1.51
9). Company ABC requires Floating rate
Company XYZ requires Fixed rate
Loan amount= $15 million
Tenure= 3 years
a). Swap rate is the fixed rate at which the party with the long position is willing to pay
when Pv of fixed payments is equal to the Pv of the floating payments.
b). Reduce the cost of borrowing
For planning and certainty
Balance sheet management, Asset liability matching
c). Cost If both parties borrow directly:
Company ABC= SONIA + 1%
Company XYZ =5.6%
Total=SONIA + 6.6%
It can be seen that Company ABC has an absolute advantage in both options but has the
comparative advantage on Fixed rate whilst XYZ has the comparative advantage on
borrowing at floating. However this would be the opposite of what they prefer but to
achieve the benefits of comparative advantage, they would borrow against their
preference.
Cost of borrowing if comparative advantage is used:
Company ABC=4%
Company XYZ=SONIA + 2.5%
Total= SONIA + 6.5%
It can be seen that there is 0.1% quality spread differential which can be shared between
company ABC and company XYZ given that there is no Swap bank in the contract. Thus,
0.05% benefit to ABC and 0,05% benefit to XYZ.
The effective interest rate that will be paid by each company:
Company ABC= SONIA + 1% -(0.05% benefit if the swap contract) = SONIA + 0.95%
Company XYZ= 5.6%-(0.05% benefit if the swap contract) =5.55%.
4%
ABC XYZ
SONIA +0.95%
4% $15m SONIA +2.5% $15m
Bank ABC Bank XYZ
Account for ABC
(-) Pay Bank ABC= 4%
(-) Pay =SONIA + 0.95%
(+) Receive from XYZ =4%
Effective rate=SONIA+0.95%
Account for XYZ
(-) Pay ABC= 4%
(-) Pay Bank XYZ=SONIA + 2.5%
(+) Receive from ABC =SONIA + 0.95%
Effective rate=5.5%
d). Because swaps only expose counterparties to the net cash flows, while loans expose
lenders to the entire principal amount. In a loan, the lender advances the full principal
upfront. If the borrower defaults, the lender risks losing the entire principal plus interest
but in a interest rate swap, the notional principal is never exchanged. Only the difference
between fixed and floating interest payments is exchanged periodically.
10. An XYZ stock price is currently $50.
a. It is known that at the end of 6 months it will be either $45 or $55. The risk free interest rate
is 10% per annum with continuous compounding.
b. What is the value of a 6-month European put option with a strike price of $50? Use no
arbitrage arguments.
c. A similar stock price is currently $50. Over each of the next two 3-month periods it is
expected to go up by 6% or down by 5%. The risk-free interest rate is 5% per annum with
continuous compounding.
Using a 2 step Binomial pricing model, what is the value of a 6-month European call option with
a strike price of $49?
Solution
10b). Su 55
So 50
So 45
U=1.1; d=0.9
r=0.1; 10%; t=0.5
[0.756(0) +(1-0.756) (5) e^-0.1*0.5= 1.159
10c). 56.18
53
50 50.35
47.5
45.125
r=0.03 ; k=49
𝑒0.05(0.25) −0.95
= 0.5689
1.06−0.95
(0.5689(7,18) + 0.4341 (1.35)) e^-0.05*0.25
= 4.609
(0.5689 (1.35)+0.4311(0)) e^-0.05*0.25
= 0.7585
[0.5689(4.6) +0.4311(0.789)] e^-0.03*0.25
= 2.91
QUESTION 11
In 60 days, National Holdings expects to make a bank deposit of $2 million for a period of 120
days at 120-day MRR set 60 days from today. National Holdings is concerned about a possible
decrease in interest rates. Its financial adviser suggests that it negotiate today a 2 × 6 FRA, an
instrument that expires in 60 days and is based on 120-day MRR. The company enters a $2
million notional amount 2 × 6 receive-fixed FRA that is advanced set, advanced settled (note the
company is the short-side of this FRA contract). The appropriate discount rate for the FRA
settlement cash flows is 8.6%. After 60 days, 120-day MRR in the dollar is 9.25%. Calculate:
a). Terminal value
TA = Principal(1+R*t/360)
120
= 2000000(1 + 0.0925(360)
=$2061666.67
b). Interest actually paid
Terminal Value- Principal
$2061666.67-2000000
=$61666.67
c). Settlement payment
𝑡
Payment = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙(𝑅 − 𝑅𝑘)(12)
=2000000*(0.925-0.088) *1/3
=$2910.27
Delta stock is expected to pay a dividend of $8 per share in 3 months, 7 months and in 9 months.
The Delta stock is priced at $100, and the risk-free rate of interest is 12% per annum with
continuous compounding for all maturities. An investor has just taken a short position in a 10-
month forward contract on the stock
d). State 3 distinctions between Futures and Forwards
i. Futures are traded on an organized exchange and have standardized contract term
while forwards are traded over-the-counter and are customized to the needs of the two
parties.
ii. Futures are marked-to-market daily, meaning profits and losses are settled every day
through the margin system while forwards are settled only once at maturity, with no
daily cash flows
iii. Futures have very low counterparty risk because a clearinghouse guarantees
performance while forwards have high counterparty risk since the agreement is only
between two private parties with no clearinghouse guarantee.
e). Present value
PV1=8e^−0.12(0.25) = 7.76356
PV2=8e^−0.12(0.58333) =7.45915
PV3=8e^−0.12(0.75) =7.23870
Total Present Values
PV= PV1+PV2+PV3
=7.76356+7.45915+7.23870
=22.46
f). Forward price
=Fo(So-PV of dividends)e^rt
=(100-22.46)e^rt
=85.69
g). Assuming the market quotes Fo = 105 what strategies would you implement in order
to benefit from the arbitrage opportunity.
Step1: Buy the stock today
Buy 1 share of the stock for $100.
Step 2: Borrow money to finance the purchase
You borrow $100 at the risk-free rate
Step 3: Short sell the forward at the market price Fo = 105
Enter a short forward contract locking in the right to sell the stock in 10 months for
$105.
12. 𝑺𝑜𝑁(𝑑1) − 𝐾𝑒 𝑟𝑡 𝑁(𝑑2)
S0=1120, K=1100
r=0.10 (continuously compounded),
T=1/12 year, σ=0.20
σ=0.20.
𝑆𝑜 𝜎2
𝐼𝑛 ( )+(𝑟+ )𝑇
𝑥 2
d1= 1
𝜎∗𝑇 2
1120 0.22 1
𝐼𝑛 ( )+(0.1+ )( )
1100 2 12
d1= 1
1
0.2∗( )2
12
d1=0.49
d2=0.43
N(d1) =0.679
N(d2) =0.6664
1
0.1( )
𝐾𝑒 −𝑟𝑡 = 1100𝑒 12 =1090.87
= 𝑺𝑜𝑁(𝑑1) − 𝐾𝑒 𝑟𝑡 𝑁(𝑑2)
= 1120(0.6879) − 1090.87(0.6664)
C=$45.02
b). Value of the put option according to the Put–call parity:
𝑃 = 𝐶 + 𝐾𝑒 −𝑟𝑡 − 𝑆𝑜
𝑃 = $45.02 + 1090.87-1120
𝑷 =$15.89
(c) There is arbitrage Opportunity
Market put = $38.50
Fair put value = $14.36
Put is overpriced by $25.00 thus arbitrage exists.
Arbitrage strategy at t = 0
1. Sell the overpriced put of $38.50
2. Buy the call of $45.02
3. Short the stock of $1120
4. Invest (Pv of K) = 1090.872 at the risk-free rate
Net cash inflow today:
38.50+1120−43.49−1090.87=$25
At expiry, positions offset perfectly (due to put–call parity), so the $25 is risk-free profit.
(d) Profit/Loss Diagram for the Call (Range: $1000–$1200)
Premium paid: $45.02
Strike price: 1100
Breakeven price=1145.02
(e) Do the Call Buyer and Put Seller Have the Same Expectations?
Their expectations and risks are different because
I. Call buyer expects a strong upward movement, enough to exceed the breakeven of 1143.49. Loss is limited
to the premium (43.49). Upside unlimited.
II. Put seller expects the stock not to fall below the strike (1100). Profit is limited to the premium ($14.36). Loss
can be large if the price crashes.