Special instructions for candidates:
- Calculators are
- This examination constitutes 60% of your assessment in this unit.
- This examination comprises 5 questions. Each question may have parts. You must complete all parts of all questions and need include any workings in your responds.
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- You must type your responses into a single Word document and upload the .docx to the Submission Dropbox on the CloudDeakin unit site. Number each question clearly.
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- Include all your calculations and/or reasonings to substantiate each answer.
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- The breakdown of marks in this is:
| Question | Marks | Question | Marks |
| 1 | 12 | 4 | 12 |
| 2 | 12 | 5 | 12 |
| 3 | 12 | N/A | N/A |
| Total Available Marks | 60 | ||
- All candidates MUST complete this section
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Question 1. (This question has three parts: I, II and III)
The following table gives the price of bonds:
| Bond Principal
($) |
Time To Maturity
(Months) |
Annual Coupon Rate
(%) |
Bond Price
($) |
| 100 | 6 | 0.0 | 96 |
| 100 | 12 | 0.0 | 90 |
| 100 | 18 | 8.0 | 95 |
Half the stated coupon is assumed to be paid every six months. Use semi-annual compounding as interest rate measurement.
Part I.
Calculate (annualized) zero rates for maturities of 6 months, 12 months and 18 months.
(6 Marks)
Part II.
What is the fair price of 18-months zero-coupon bond given current term structure of zero rates? The par value of bond is assumed to be $100.
(2 Marks)
Part III.
Assume you are treasury manager in a company and the company requires $1,000,000 ($1 Million) in 6 months for the duration of 1 year. You can finance this need by trading zero-coupon bonds, i.e., buying or selling zero-coupon bonds or go to bank to organize a forward contract.
The bank quotes a forward rate 14% per annum semi-annual compounding applied from 6 months to 18 months. The prices of zero-coupon bonds with maturity 6 months and 12 months are listed in the above table and the price of zero-coupon bond with maturity 18 months is calculated in Part II.
Ignoring all the other costs and given all the information above, are you going to accept the bank’s offer? Justify your decision.
(4 Marks)
(Total 6 Marks + 2 Marks + 4 Marks = 12 Marks)
Question 2. (This question has three parts: I, II, and III)
Assume you have observed the following information for a commodity:
| Spot price for commodity | $150 |
| Forward price for expiring in 1 year | $162 |
| Interest rate for 1 year | 5% p.a. semi-annual compounding |
| Storage cost | $1.5 p.a. payable semi-annually in arrears |
Part I.
Explain why it is important to differentiate investment assets and consumption assets in regards to forward price determination.
(4 Marks)
Part II.
Given the above information, if you identify an arbitrage opportunity, present your strategy to take it. If you believe there might not be an arbitrage opportunity, explain why.
(4 Marks)
Part III.
Assume instead you observe the following information:
| Spot price for commodity | $150 |
| Forward price for expiring in 1 year | $155 |
| Interest rate for 1 year | 5% p.a. semi-annual compounding |
| Storage cost | $1.5 p.a. payable semi-annually in arrears |
Given the above information, if you identify an arbitrage opportunity, present your strategy to take it. If you believe there might not be an arbitrage opportunity, explain why.
(4 Marks)
(Total 4 Marks + 4 Marks + 4 Marks = 12 Marks)
Question 3. (This question has three parts: I, II and III)
Part I.
A trader sells a strangle by selling a call option with a strike price of $52 for $1 and selling a put option with a strike price of $43 for $8. For what range of prices of the underlying asset does the trader make a profit?
(4 Marks)
Part II.
Assume that you observe the following. The spot exchange rate between the Swiss Franc and U.S. dollar was 1.0404 ($ per franc). Interest rates in the U.S. and Switzerland were 2.5% and 1.0% per annum, respectively, with continuous compounding. The three-month forward exchange rate was 1.0503 ($ per franc). Present a possible arbitrage strategy and show your profit.
(4 Marks)
Part III.
A hedge fund is currently engaged in a plain vanilla interest rate swap with a company. Under the terms of the swap, the hedge fund receives six-month LIBOR and pays 6% per annum on a principle of $100 million for five years. Payments are made every 6 months. Assume that the interest rates start to soar after two years and the company defaults on the sixth payment date when the LIBOR rate is 8 percent for all maturities (with semi-annual compounding). The 6-months LIBOR rate 6-months ago is 7.5%. What is the loss to the hedge fund?
(4 Marks)
(Total 4 Marks + 4 Marks + 4 Marks = 12 Marks)
Question 4. (This question has two parts: I and II)
A stock price is currently $48. Over each of the next two three-month periods it is expected to go up by 6% or down by 5%. The risk-free interest rate is 3% per annum with semi-annual compounding.
Part I.
Use the two-steps binomial tree model to price a 6-months European put option with an exercise price of $51.
(6 Marks)
Part II.
Assume you have sold the above put option to your client and charged him a fair price. Discuss how you can hedge your risk to avoid a big loss if the stock price turned out to be $1 in 6-months.
(6 Marks)
(Total 6 Marks + 6 Marks = 12 Marks)
Question 5. (This question has three parts: I, II and III)
Part I.
Suppose you subscribe to a service that gives you estimates of the theoretically correct volatility of stocks. You note that the implied volatility of a particular option is substantially higher than the theoretical volatility. What action should you take and why?
(4 Marks)
Part II.
Explain how to use call options and put options to create a synthetic short position in stock.
(4 Marks)
Part III.
Consider two investors who agree on the stock’s price and volatility but who do not agree on the stock’s expected return. One believes that the stock price will earn 15 percent over the next year, while the second believes that it will have a negative 5 percent return. Will they agree or disagree on the value of a one-year call option on the stock when using the Black-Scholes-Merton Model? Justify your answer. [Please note, by answering only “agree” or “disagree” without reasoning, a zero mark will be awarded.]
(4 Marks)
(Total 4 Marks + 4 Marks + 4 Marks = 12 Marks)