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Ollscoil na hÉireann, Gaillimh GX_____
National University of Ireland, Galway
Semester II Examinations 20 12
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 Repeat Paper Special Paper
External Examiner(s) Dr. L. Delaney Internal Examiner(s) Prof. J. McHale C. Twomey
Instructions: EC568 Students Answer 3 questions in Section A (25 marks each) Answer 1 question in Section B (25 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 Answer Books 1
Requirements : Statistical Tables - Yes
Department(s) Economics
Answer 3 Questions – All questions are worth the same marks
(a) Suppose that a European put option to sell a share for €60 costs €8 and is held until maturity. Under what circumstances will the seller of the option (the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option. (7 marks)
(b) Explain the difference between writing a put option and buying a call option. ( marks)
(c) A stock price is currently €100. Over each of the next two six-month periods it is expected t o g o up b y 1 0% or dow n b y 10%. T he r isk-free i nterest r ate i s 8 % p er annum with continuous compounding. What is the value of a one-year European call option with a strike price of €100? Draw the binomial tree for this option. (9 marks)
(d) For the situation in part (c), what is the value of a one-year European put option with a strike price of €100? Verify that the European call and European put prices satisfy put–call parity. (6 marks)
2.
(a) Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain your answer. (5 marks)
(b) On July 1, an investor holds 50,000 shares. The market price is £30 per share. The investor is interested in hedging against movements in the UK stock market over the next month and decides to use the September FTSE 100 futures contract. The index is currently 1,500 and one contract is for delivery of £50 times the index. The beta of the stock is 1.3. What strategy should the investor follow? (5 marks)
(c) A futures contract is used for hedging. Explain why the daily settlement of the contract can give rise to cash flow problems. Use any case study with which you are familiar to explain your answer. (8 marks)
(d) Is the futures price of a stock index greater than or less than the expected future value of the index? Explain your answer using any theories that link futures prices and expected future spot prices. (7 marks)
SECTION B
Please Answer 1 Question. Each Question is worth 25 marks
NB: This section is for MSc. in International Finance students only
1. (a) A European call option and put option on a stock both have a strike price of $ and an expiration date in three months. Both sell for $3. The risk-free interest rate is 10% per annum, the current stock price is $19, and a $1 dividend is expected in one month. Identify the arbitrage opportunity open to a trader. (6 marks)
(b) What is the difference between a strangle and a straddle?
A call option with a strike price of €50 c osts €2. A putoption with a strike price of €45 costs €3. Explain how a strangle can be created from these two options. What is the pattern of profits from the strangle?
A call with a strike price of €60 costs €6. A put with the same strike price and expiration date costs €4. Construct a table that shows the profit from a straddle. For what range of stock prices would the straddle lead to a loss? (12 marks)
( c) When is it appropriate for an investor to purchase a butterfly spread? Suppose three put options on a stock have the same expiration date and strike prices of $55, $60, and $65. The market prices 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 stock prices would the butterfly spread lead to a loss? ( marks)
2. (a) “Real options capture the value of managerial flexibility in a way that NPV analysis does not,” Copeland, Koller, and Murrin, ‘Using Option Pricing Methods to Value Flexibility’, in Valuation: Measuring and Managing the Value of Companies 2/e, 1996, p. 464.
Explain, using any two case studies, why real options have the potential to be an important tool for firms in strategic and financial analysis. (15 marks)
(b) Explain the six levers of real options and how they differ from financial options. Use an example of investing in a gold mine versus purchasing a call option on a gold mining company’s share to explain your answer. (10 marks)
