Fin404 Derivatives

Master in Financial Engineering

Spring 2019

Problem set 1. Due date: February 27

Basic questions
Question 1. A Swiss investor bought a zero coupon bond with face value P and
maturity 1Y denominated in Brazilian Reals but is now concerned about currency risk.
What can you do to help him?

Question 2. A stock price is S just before a dividend of D is paid. What is the price of
the stock immediately after the dividend payment? If you hold one share of that stock
how does the dividend payment affect your wealth?

Question 3. Write down the put/call parity for 7Y European options on a 10Y bond
that pays a semiannual coupon of CHF10. Assume that the risk free rate is zero.

Question 4. An up-and-out call (resp. up-and-in call) with barrier b, strike k and
maturity T provides the payoff of the corresponding European call if the underlying
asset price never exceeded b (exceeded b at least once) over the interval [0, T ] and zero
otherwise. What is the relation between the prices cUI UO
0 , c0 and c0 of the up-and-in, the
up-and-out and the standard call? What if b ≤ k?

Question 5. Give an upper and a lower bound for the price of a Bermudean put that
can be exercized once at either of the n dates {t1 , t2 , . . . , tn−1 , tn = T }. What if the risk
free rate is strictly negative? (Hint. Have a look at Exercise 8.c) below)

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Problems to be turned in
Exercise 1. Assume that the risk free rate is equal to r and consider a European
derivative with payoff given by
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g(ST ) = ST − erT S0 (1)

where St denotes the price at date t of an asset which does not pay dividends prior to
the maturity date T of the contract.

a) Show that the initial price of this derivative can be computed as

Z β Z ∞
rT
γ p0 (S0 ; x, T )( x − e S0 ) dx + γ
µ
c0 (S0 ; x, T )( x − erT S0 )µ dx (2)
0 β

where (γ, β, µ) are constants to be determined and p0 (S0 ; x, T ) (resp. c0 (S0 ; x, T ))

is the price of a European put (resp. call) with strike x and maturity T.

b) How would above the formula be modified if the buying or selling of options
was subject to a proportional transaction cost of ε > 0 per dollar?

Exercise 2. Use a static arbitrage argument to show that European put prices are
convex in the exercise price: For any k1 , k2 and α ∈ [0, 1] we have

αpt (s; k1 , T ) + (1 − α) pt (s; k2 , T ) − pt (s; αk1 + (1 − α)k2 , T ) ≥ 0. (3)

Does the same property also hold for calls? What does this property imply for the
price of a butterfly spread with attachements 0 < k1 < k2 and summit k∗ ∈ (k1 , k2 )?

Exercise 3. Let rd = r/360 denote the interest rate per day and denote by f n and Fn the
futures and forward prices on day n for delivery on day N.
Assume for simplicity that the underlying asset does not pay dividends over the life
of the contract and consider the following dynamic futures strategy:

Day 0: Enter a long position in erd contracts.

Day 1: Close the position, invest the gain or loss in the bank until day N and
reopen a new position in e2rd contracts.

Day 2: Close the position, invest the gain or loss in the bank until day N and
reopen a new position in e3rd contracts.

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 ...

Day N − 1: Close the position, invest the gain or loss in the bank until day N and
reopen a new position in erd N contracts.

Day N: Close the position and realize your total profit or loss.

Recall that entering a futures position entails no initial cost and that the profit or loss
generated by a position in q contract between days n and n + 1 is realized at the end
of day n + 1 and equal to the amount q( f n+1 − f n ).

a) Compute the terminal pay-off of the futures strategy.

b) Compare the terminal value of the futures strategy to that of a static strategy that
buys erd N forward contracts on Day 0 and holds on to this position until the last
day. What’s the conclusion?

c) Why does the argument break down with stochastic interest rates?

Exercise 4. Assume that the SMI pays dividends continuously at some rate δ so that
the cumulative amount paid by the index over the interval [0, t] is
Z t
δSτ dτ (4)
0

where Sτ denote the price of the index at date τ ≥ 0. Consider a trading strategy
that consists in buying n0 > 0 units of the index at date 0 and then reinvesting all the
dividends in the index as they are being paid.

a) Explain why the value of this strategy evolves according to

Z t
Xτ
X t = n 0 S0 + (dSτ + δSτ dτ ) (5)
0 Sτ

and show that the solution to this equation is Xt = eδt n0 St . What is the number
of units of the index that you need to buy at date 0 for the value of the strategy
to equal ST almost surely at date T?

b) Use the above result to derive the present value D0 ( T ) of the dividends paid by
the index over [0, T ], the forward price of the index at date 0 for delivery at date
T, and the corresponding put/call parity for European index options.

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 Hint. Decompose the initial price of the index as

S0 = P0 (ST ) + D0 ( T ) (6)

where P0 (ST ) is the price of a European derivative that pays the amount ST at
date T and use the result of a) to compute P0 (ST ) by choosing an appropriate
value of the constant n0 .

c) Suppose that you observe the initial price S0 of an index and the prices

(c0 (S0 ; k i , T ), p0 (S0 ; k i , T ))in=1 (7)

of European calls and puts with maturity T = 1Year and strikes (k i )in=1 written
on the index. Propose an econometric method (i.e. a regression) to evaluate the
validity of the put/call parity in this cross-section of option prices.

d) Implement the proposed method on the sample given in the file Data-PS1 and
interpret the results. How much would you be willing to pay for i) a claim to
the dividends paid by the index over the life of the observed options, and ii) a
European derivative that pays ST at the terminal time? What are your estimates
of the dividend yield δ on the index and the riskless rate of interest?

Additional problems
Exercise 5. Suppose that k1 and k2 satisfy k1 > k2 . Use a static no-arbitrage argument
to show that for European calls on a non-dividend paying asset, the difference in call
values satisfies

e−r(T −t) (k2 − k1 ) ≤ ct (s; k1 , T ) − ct (s; k2 , T ) ≤ 0 (8)

and deduce that

∂ct (s; k, T )
− e −r ( T − t ) ≤ ≤0 (9)
∂k

In other words, the derivative of the European call price with respect to the strike must
be non-positive and no greater in absolute value than the price of a zero-coupon bond
of the same maturity as the option.

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Exercise 6. Consider a forward contract on IBM. Assume that the stock is currently
traded at $100 per share. IBM pays quarterly dividends of $2 per share in the next 5
years and the riskless interest rate is r = 2%.

a) Compute the forward price of IBM at one and two-year maturities.

b) Assume that the market quote for the one-year forward contract is at $98. Derive
a trading strategy that allows you to make a riskless profit.

c) Consider another case where the market quote for the two-year forward contract
is $82. How can you trade to lock in a riskless profit?

Exercise 7. An horizontal spread is created by buying a European call with strike k and
maturity T1 , and selling a European call with strike k and maturity T2 > T1 written on
the same underlying asset. Assume for simplicity that the underlying asset does not
pay dividends before date T2 .

a) What is the payoff of the horizontal spread at date T2 under the assumption that
interim profits and losses can be reinvested at the constant rate r?

b) What can be said about the value of the horizontal spread at date T1 ? What does
this imply for the initial cost of the strategy ?

Exercise 8. Denote by pt and p∗t the prices at date t ∈ [0, T ] of a European and an
American put with strike price k and maturity date T.

a) Prove the inequality [•] that appears on slide 56 of Lecture 1.

b) Show that if r ≥ 0 then p∗t ≤ k for all t ∈ [0, T ].

c) Show that if r < 0 then

p∗t > k − St + Dt ( T ), t ∈ [0, T ). (10)

Use this inequality to argue that when the interest rate is strictly negative it
is never optimal to exercize an American put prior to maturity irrespective of
whether the underlying asset pays dividends or not.

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Exercise 9. Do the results of Exercise 2 above also hold for European/American calls
on a dividend paying asset?

Exercise 10. A bull spread is created by buying a call option with strike k1 and selling
a call option with strike k2 > k1 . Both calls are written on the same underlying asset
and have the same maturity date T.

a) Draw the pay-off diagram of the bull spread

b) Should the initial cost of the trade be positive, negative or zero? Why?

c) Construct a bull spread using put options.

Exercise 11. Suppose that you enter a long position into a 3M forward contract on a
non dividend asset when its price is S0 = 60 and the risk free rate is r = 5%.

a) Compute the forward price

b) A month has passed and the stock price is 54. What is the value of your position?

c) Show that the gain or loss that you would realize by selling the contract after one
month can be calculated as

a( F1M (3M) − F0 (3M)) (11)

where a > 0 is a constant to be determined and Ft (3M) denotes the forward price
of the asset at date t for delivery at date T = 3 Months.

Exercise 12. A 1M European put option on a non dividend paying stock is currently
selling for 2.50. The option has a strike of 50 and the underlying is currently worth 46.
What should you do (the answer depends on the interest rate r)?

Exercise 13. The price of a European call that expires in 6M and has strike of 30 is 2.
The underlying stock price is 28 and a dividend of 0.50 is expected in 2M and again
in 5M. Compute the price of a put with maturity 6M under the assumption that the
interest rate is r = 4%.

Exercise 14. The price of an American call on a non dividend paying stock is 4. The
stock price is 32, the strike is 30, the option has 3M until maturity and the interest rate

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is r = 7%. Derive upper and lower bounds for the price of an American put with strike
30 and maturity 3M.

Exercise 15. Three put options on the stock have the same maturity date and strike
prices of 55, 60 and 65. The market prices of these options are 3, 5 and 8 respectively.
Explain how a butterfly spread can be created. Construct a table showing the profit
from the strategy. For what range of terminal value does the butterfly spread lead to a
loss?

Exercise 16. Consider a European derivative with terminal payoff g(ST ) written on a
underlying with spot price S0 and forward price F0 ( T ). Assume that the function g is
C2 and that the riskless rate is r > 0. Use what you know of forward prices to show
that the initial price of this derivative can be written as
Z ∞
0
αg(0) + βg (0) + g00 (y)c0 (S0 ; y, T )dy (12)
0

where α, β are constants to be determined and c0 (S0 ; y, T ) is the price of a European

call with strike y and maturity T.

Exercise 17. A strangle is created by buying a call with strike k2 and buying a put with
strike k1 ≤ k2 , while a straddle is created by buying a call and a put with strike k. Draw
a diagram showing the pay-off of these strategies at the terminal time. What trading
position is obtained from a long strangle and a short straddle when both have the
same maturity date? Assume for simplicity that the strike of the straddle is halfway
between the strikes of the strangle.

Exercise 18. Let f t ( T ) denote the futures price of Apple at date t for delivery at some
future date T. Show that f t ( T1 ) ≥ er(T1 −T2 ) f t ( T2 ) for all T1 ≤ T2 where r is the constant
riskless rate. Under what condition(s) is the inequality strict?

Exercise 19. Suppose that you are the manager and sole owner of company JnH. All
the debt of the company matures in one year. If at that time the value of the company’s
assets is larger than the face value of debt you will pay debtholders this face value and
the remaining amount will be yours. Otherwise you will declare bankruptcy and the
debt holders will own the assets of the company.

a) Express your position as an option on the firm’s assets

b) Express the position of the debtholder’s as a portfolio of securities.