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FINA0301/FINA2322

Fall, 2016

Homework Questions 1: Due dateWednesday, Sep 28, 2016

Name:
Instructions:
Read the questions carefully, write all your steps where necessary.
You dont have to computer-type the solution. However, the hand-written version has to be
reader-friendly.
Hard copies of the solutions must be dropped in the TAs box by 6PM on the due date. No
later submission will be accepted.
You may work in groups of four or less, and only one solution set will be turned in by each
group. The grade on the problems turned by the group will be given to each member of the
group.
Please write clearly which subclass you are from: A, B or C.
1. Suppose you desire to short-sell 400 shares of JKI stock, which has a bid price of $25.12 and
an ask price of $25.31. You cover the short position 180 days later when the bid price is
$22.87 and the ask price is $23.06.
(a) Taking into account only the bid and ask prices (ignoring commissions and interest),
what profit did you earn?
(b) Suppose that there is a 0.3% commission to engage in the short-sale (this is the commission to sell the stock) and a 0.3% commission to close the short-sale (this is the
commission to buy the stock back). How do these commissions change the profit in the
previous answer?
(c) Suppose the 6-month interest rate is 3% and that you are paid nothing on the short-sale
proceeds. How much interest do you lose during the 6 months in which you have the
short position?
2. Suppose XYZ stock pays no dividends and has a current price of $50. The forward price for
delivery in 1 year is $55. Suppose the 1-year effective annual interest rate is 10%.
(a) Graph the payoff and profit diagrams for a forward contract on XYZ stock with a forward
price of $55.
(b) Is there any advantage to investing in the stock or the forward contract? Why?
(c) Suppose XYZ paid a dividend of $2 per year and everything else stayed the same. Now
is there any advantage to investing in the stock or the forward contract? Why?
3. Suppose the stock price is $40 and the effective annual interest rate is 8%. Draw payoff and
profit diagrams for the following options:
(a) 35-strike put with a premium of $1.53.
1

FINA0301/FINA2322

Fall, 2016

(b) 40-strike put with a premium of $3.26.


(c) 45-strike put with a premium of $5.75.
Consider your payoff diagram with all three options graphed together. Intuitively, why should
the option premium increase with the strike price?
4. For the following problems assume the effective 6-month interest rate is 2% and the S&R
6-month forward price is $1020, and use these premiums for S&R options with 6 months to
expiration:
Strike
$950
1000
1020
1050
1107

call
$120.405
93.809
84.470
71.802
51.873

put
$51.777
74.201
84.470
101.214
137.167

(a) Construct payoff and profit diagrams for the purchase of a 950-strike S&R call and sale
of a 1000-strike S&R call. Verify that you obtain exactly the same profit diagram for
the purchase of a 950-strike S&R put and sale of a 1000-strike S&R put. What is the
difference in the payoff diagrams for the call and put spreads? Why is there a difference?
(b) Compute profit diagrams for the following ratio spreads:
i. Buy 950-strike call, sell two 1050-strike calls.
ii. Buy two 950-strike calls, sell three 1050-strike calls.
iii. Consider buying n 950-strike calls and selling m 1050-strike calls so that the premium
of the position is zero. Considering your analysis in (a) and (b), what can you say
about n/m? What exact ratio gives you a zero premium?
5. Firm XYZ mines copper, with fixed costs of $0.5/lb and variable cost of $0.40/lb. The 1-year
forward price of copper is $1/lb. The 1-year continuously compounded interest rate is 6%.
The Table below shows 1-year option prices for copper.
Strike
0.9500
0.9750
1.0000
1.0250
1.0340
1.0500

Call
0.0649
0.0500
0.0376
0.0274
0.0243
0.0194

Put
0.0178
0.0265
0.0376
0.0509
0.0563
0.0665

Compute estimated hedged profit in 1 year if XYZ hedges by purchasing a put and sells a
call with the following strikes:
(a) $0.95 for the put and $1.00 for the call.
(b) $0.975 for the put and $1.025 for the call.
(c) $1.05 for the put and $1.05 for the call.

FINA0301/FINA2322

Fall, 2016

Draw a graph of profit in each case. In your answers, at a minimum consider copper prices
in 1 year of $0.80, $0.90, $1.00, $1.10, and $1.20.
6. Do you have any comments or suggestions regarding our class so far?