Download Binomial Option Pricing Model - Seminar in Financial Economics - Exam and more Exams Finance in PDF only on Docsity!
Autumn Examinations 20 10 /
Exam Code(s) (^) 1MIF
Exam(s) M.Econ.Sc. in International Finance
Module Code(s) EC
Module(s) (^) SEMINAR IN FINANCIAL ECONOMICS II
Paper No. 1
External Examiner(s) Dr. C. Ryan Internal Examiner(s) Prof. J. McHale C. Twomey
Instructions: EC568 Students Answer 3 questions in Section A (23.3 marks each) Answer 1 question in Section B (30 marks each)
If you attempt MORE THAN the correct number indicate clearly those questions which you wish to be graded. The use of calculators is permitted - programmable calculators may not be used.
Duration 3hrs No. of Pages 4
Requirements : Statistical Tables - Yes
Discipline(s) Economics
SECTION A - Answer 3 Questions
(a) Explain briefly the no-arbitrage approach to valuing a European call option using a one-step binomial option-pricing model. (8 marks)
(b) Define put-call parity. Suppose a European call option and put option on a share both have a strike price of €20 and expire in 3 months. Both sell for €3. The risk-free interest rate is 5% per annum, the current share price is €19m and a €1 dividend is expected in 1 month. Identify the arbitrage opportunity open to the trader, if any. (9 marks)
(c) An investor believes that there will be a big jump in a stock price, but is uncertain as to the direction. Identify four (4) different strategies the investor can follow and explain briefly the differences among them. (16 marks)
2. (a) Using your own hypothetical numerical examples, critically evaluate any two reasons why investors may use plain vanilla currency swaps. (16 marks)
(b) A currency swap has a remaining life of 21 months. It involves exchanging interest at 4% on £50 million for interest at 2.5% on $80 million twice a year.
Assume the term structure of interest rates in the UK and US is currently flat and that if the swap were negotiated today the interest rates exchanged would be 4% in sterling and 2.5% in dollars. All interest rates are quoted with annual compounding. The current $/£ exchange rate is 1.62.
What is the value of the swap to the party paying sterling? What is the value of the swap to the party paying dollars? ( 17 marks )
3. Over the past 25 years there have been a number of high-profile derivatives related losses. For any two cases with which you are familiar: (i) Compare and contrast the trading strategies or actions primarily responsible for the losses in each case and
(ii) Discuss the main lessons that you believe should be learned from the cases in question. (33 marks)
SECTION B
Please Answer 1 Question: Each question is worth 33 marks
(a) A stock price is currently €50. It is known that at the end of 2 months it will either be €48 or €53. The risk-free interest rate is 10% p.a. with continuous compounding. What is the value of a 2-month European call option with a strike price of €49? Use the no-arbitrage method. (8 marks)
(b) A 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% p.a. with continuous compounding. What is the value of a 6-month European call option with a strike price of $51? What is the value of a 6-month European put option with a strike price of $51?
Verify that the European call and put prices satisfy put-call parity. ( 15 marks)
(b) Explain, using any two examples, why real options have the potential to be an important tool for firms in strategic and financial analysis_. (10 marks)_
(a) Explain the meaning of the terms convenience yield and cost of carry. What is the relationship between the futures price, spot price, convenience yield, and cost of carry? (8 marks)
(b) Explain carefully what is meant by the expected price of a commodity on a particular future date. Explain briefly why the futures price converges to the spot price of the underlying asset as the delivery period for a futures contract is approached. (10 marks)
(c) A German based fund manager has a portfolio worth €75 million with a beta of 0.90. The manager is concerned about the performance of the German stock market over the next two months and plans to use three-month futures on the DAX 30 to hedge the risk. The current level of the DAX 30 is 4,400, one futures contract is on 250 times the index, the risk-free rate is 3% p.a. with continuous compounding, and the dividend yield on the index is 4% per annum.
(i) Write out the theoretical relationship for the futures price. Calculate its value in the above case. (ii) What position should the fund manager take to eliminate all exposure to the market over the next two months? (iii) Suppose that the fund manager wishes to change the portfolio’s beta to 0.60. What position should the manager now take? (iv) Based on your strategy in part (ii), calculate its effects on the fund manager’s returns if the level of the DAX30 in two months is 4,500. (15 marks)
