Assignment #2

1) Change in Spot Prices -29 -2 -20 Change in future prices -11.15 28.15 -106.5

Name: Mohammad Waseem Mehdi Research Assistant: 30593

Correlation in the change of spot prices & change in futures prices=0.459886 Standard deviation of change in spot prices=13.747727 Standard Deviation for the change in futures prices=69.24201 Optimal hedge ration= 0.459886*13.747727/69.24201 = 0.091309

1. B) Unit =10 MT Number of shares to required=200 /10 =20

The optimal number of contracts to hold for hedging would be =0.091309*200/10=1.826172 So total of two contracts should be hedged. Since futures price is more than the spot price, I shall Long 2 (optimal number) of contracts Note: here data taken is from Oct2811 & onwards

2) Underlying asset is the knowledge of that course & also the job prospects of that course. Option is hold by the students as they have the choice of selecting the elective Options is Shorted by ISB, (as they have floated the course, which is equivalent to shorting a future) Its a Put option as the writer/shorter of the course has the choice when to float the course & also which courses to float.

Premium borne by the student is the fees that he/she has to pay for that course 3a) If the value of the company is less than face value of the debts then I (as manager) will short the company. If the value of company is more than the face value of the debts I have longed the company. 3b) If the value of company is more than the face value of the debts then I (as lender) have shorted my position. If the value of the company is less than face value of debt then I have longed the position. 3c) To increase the value of my position, I should hedge my company against default. Alternatively, if I expect loss before maturity of the loans then I should issue the convertible bonds.

4) If bond holder expects the prices of the stocks to go up as well as that of underlying asset, he should exercise the convertible bond to share. Expected increase in share value should be more than money that I would have got by inverting it in the risk-free rate of return. To exercise the bond before dividends are paid or not depends on the value & timing of dividend & also whether I will get more money by investing money obtained by selling share . If money for the case when by selling shares now & investing at risk-free rate of return gives more money than the case when values of shares + dividends at the same time, so I will exercise the convertible bond. This is same case with non dividend paying American stock as we calculate the net gain by excising the option & then deposit in risk-free interest rate or value of the bond at maturation Same logic applies for dividend paying stocks. We are just concerned which will give the maximum value at the time of expiration & then we choose accordingly

5) For the first case, He buys share of $10 & invests $70 at 12% Money obtained by investing in the risk-free rate of return=70*e(^0.12*4/12) = $72.85675 Out of this he spends $70 to buy the stock, so his net profit is $ 2.85675 Second case is when one invests $80 in the bank money in the bank. His worth will be =80* e(^0.12*4/12)=$ 83.26486 So, he can long the European share & in the process he is earning $3.24846 Since earning in second case is more, so there is arbitrage opportunity of worth $ 0.408108

6) Money that put holder receives=Rs100 Strike Price S0 =Rs500 =Rs. 270

For reasonable rates of risk-free interest, there prices allows arbitrage. Profit that can be made: He exercises the option Long now one share by borrowing: Rs 270 Take put option with strike price: Rs 100 Invest Rs100 so earned for lending. So total amount of money that he had borrowed from bank=Rs. 270-100 =Rs 170 He will pay interest on Rs. 170 & sell it t Rs 500 at expiration. Money earned by arbitrageur is =Rs (500-270 interest to be paid) Ignoring interest, Money earned by arbitrageur is =Rs230 b) WE cannot follow the same strategy with European market as I cannot exercise my Put option now & invest the money in future.

7) For Call 1:

S0 Premium T

=Rs 500 =Rs200 =2months

Money that he would have got by investing this extra 200 in bank for one month=200 (e-rT)

=200(e-r1/12) Extra Money that he would have earned by investing all this money = (300+200(er1/12

))* (e-r1/12)

So total investment for call 1=300+200(e-r2/12)

For Call 2:

S0 Premium T

=Rs 600 =Rs250 =1months

Money that he would have got by investing this extra 250 in bank=250 (erT ) =250(e-r1/12) Total money he invested to by the bond=350+250(e-r1/12)

For reasonable values of r amount of money overpaid in Call 2 = 350+250(e-r1/12) - (300+200(e-r1/12))* (er1/12

)>0 So, there clearly exists an arbitrage opportunity. For getting benefitted by the opportunity one has to short Call 1 & Long Call 2 Profit thus made shall be: Rs: 350+250(e-r1/12) - (300+200(e-r1/12))* (e-r1/12)