FacultyofEconomicsandBusinessAdministration Exam: Investments3.4 Code: 60331090 Coordinator: dr.D.Stefanova Date: March26,2010 Time: 15.

0 Time: 15.15 Duration: 2hoursand45minutes Calculatorallowed: Yes Graphicalcalculator allowed: Yes Numberofquestions: 20multiplechoicequestionsand4openquestions Typeofquestions: Open/multiplechoice Answerin: English Remarks:Beconciseandcompleteinyouranswers(includingcalculations).Alwaysexplainyour answers,evenifnotexplicitlycalledfor.Useyourtimeefficiently,usingthemaximum number ofpointsperquestionasaguideline. Creditscore: Themaximumpossiblescoresforeachpartandquestionareindicated.Intotal, youcanearn100points.Yourfinalexamgradeisdeterminedbydividingthe numberofpointsby10. Grades: Thegradeswillbemadepublicon:April82010. Inspection: Thursday,April82010at10.00inroom1E67. Numberofpages: 12(includingfrontpage)

Goodluckandsuccess!

PART1(MULTIPLECHOICE;40pointsatmaximum) Readthequestionsandanswerscarefullyandwritedownyouransweronyouranswersheet. Yourfinalscoreisdeterminedas(#correctanswers2)*40/18.Negativescoresforthispart oftheexamaresettozero.

1. Whichofthefollowingstatementsis(are)true? I)Riskaverseinvestorsrejectinvestmentsthatarefairgames. II)Riskneutralinvestorsjudgeriskyinvestmentsonlybytheexpectedreturns. III)Riskaverseinvestorsjudgeinvestmentsonlybytheirriskiness. IV)Risklovinginvestorswillnotengageinfairgames. A.Ionly B.IIonly C.IandIIonly D.IIandIIIonly E.II,III,andIVonly Riskaverseinvestorsconsiderariskyinvestmentonlyiftheinvestmentoffersariskpremium. Riskneutralinvestorslookonlyatexpectedreturnswhenmakinganinvestmentdecision. 2. Aninvestorinvests70percentofhiswealthinariskyassetwithanexpectedrateofreturnof 0.15andavarianceof0.04and30percentinaTbillthatpays5percent.Hisportfolio's expectedreturnandstandarddeviationare__________and__________,respectively. A.0.120;0.14 B.0.087;0.06 C.0.295;0.12 D.0.087;0.12 E.noneoftheabove E(rP)=0.7(15%)+0.3(5%)=12.0%;sP=0.7(0.04)1/2=14%. 3. TheCapitalAllocationLineprovidedbyariskfreesecurityandNriskysecuritiesis A.thelinethatconnectstheriskfreerateandtheglobalminimumvarianceportfolioofthe riskysecurities. B.thelinethatconnectstheriskfreerateandtheportfoliooftheriskysecuritiesthathasthe highestexpectedreturnontheefficientfrontier. C.thelinetangenttotheefficientfrontierofriskysecuritiesdrawnfromtheriskfreerate. D.thehorizontallinedrawnfromtheriskfreerate. E.noneoftheabove.

TheCapitalAllocationLinerepresentsthemostefficientcombinationsoftheriskfreeassetand riskysecurities.OnlyCmeetsthatdefinition. 4. Considerthesingleindexmodel.Thealphaofastockis0%.Thereturnonthemarketindexis 16%.Theriskfreerateofreturnis5%.Thestockearnsareturnthatexceedstheriskfreerate by11%andtherearenofirmspecificeventsaffectingthestockperformance.Theofthestock is_______. A.0.67 B.0.75 C.1.0 D.1.33 E.1.50 11%=0%+b(11%);b=1.0. 5. AccordingtotheCapitalAssetPricingModel(CAPM),underpricedsecurities A.havepositivebetas. B.havezeroalphas. C.havenegativebetas. D.havepositivealphas. E.noneoftheabove. AccordingtotheCapitalAssetPricingModel(CAPM),underpricedsecuritieshavepositive alphas. 6. Youinvest50%ofyourmoneyinsecurityAwithabetaof1.6andtherestofyourmoneyin securityBwithabetaof0.7.Thebetaoftheresultingportfoliois A.1.40 B.1.15 C.0.36 D.1.08 E.0.80 0.5(1.6)+0.5(0.70)=1.15. 7. WhichofthefollowingfactorswereusedbyFamaandFrenchintheirmultifactormodel? A.Returnonthemarketindex B.Excessreturnofsmallstocksoverlargestocks. C.Excessreturnofhighbooktomarketstocksoverlowbooktomarketstocks.

D.Alloftheabovefactorswereincludedintheirmodel. E.Noneoftheabovefactorswereincludedintheirmodel. FamaandFrenchincludedallthreeofthefactorslisted. 8. Considertheregressionequation: rirf=g0+g1bi+g2s2(ei)+eit where: rirt=theaveragedifferencebetweenthemonthlyreturnonstockiandthemonthlyriskfree rate bi=thebetaofstocki s2(ei)=ameasureofthenonsystematicvarianceofthestocki IfyouestimatedthisregressionequationandtheCAPMwasvalid,youwouldexpectthe estimatedcoefficient,g2tobe A.0 B.1 C.equaltotheriskfreerateofreturn D.equaltotheaveragedifferencebetweenthemonthlyreturnonthemarketportfolioandthe monthlyriskfreerate E.noneoftheabove IftheCAPMisvalid,theexcessreturnonthestockispredictedbythesystematicriskofthe stockandtheexcessreturnonthemarket,notbythenonsystematicriskofthestock. 9. LowFlyAirlineisexpectedtopayadividendof$7inthecomingyear.Dividendsareexpectedto growattherateof15%peryear.Theriskfreerateofreturnis6%andtheexpectedreturnon themarketportfoliois14%.ThestockoflowFlyAirlinehasabetaof3.00.Theintrinsicvalueof thestockis______. A.$46.67 B.$50.00 C.$56.00 D.$62.50 E.noneoftheabove 6%+3(14%6%)=30%;P=7/(.30.15)=$46.67. 10. Supposetwoportfolioshavethesameaveragereturn,thesamestandarddeviationofreturns, butportfolioAhasahigherbetathanportfolioB.AccordingtotheSharpemeasure,the performanceofportfolioA__________. A.isbetterthantheperformanceofportfolioB 4

B.isthesameastheperformanceofportfolioB C.ispoorerthantheperformanceofportfolioB D.cannotbemeasuredasthereisnodataonthealphaoftheportfolio E.noneoftheaboveistrue. TheSharpeindexisameasureofaverageportfolioreturns(inexcessoftheriskfreereturn)per unitoftotalrisk(asmeasuredbystandarddeviation). 11. Whatistherelationshipbetweenthepriceofastraightbondandthepriceofacallablebond? A.Thestraightbond'spricewillbehigherthanthecallablebond'spriceforlowinterestrates. B.Thestraightbond'spricewillbelowerthanthecallablebond'spriceforlowinterestrates. C.Thestraightbond'spricewillchangeasinterestrateschange,butthecallablebond'sprice willstaythesame. D.Thestraightbondandthecallablebondwillhavethesameprice. E.Thereisnoconsistentrelationshipbetweenthetwotypesofbonds. Forlowinterestrates,thepricedifferenceisduetothevalueofthefirm'soptiontocallthe bondatthecallprice.Thefirmismorelikelytocalltheissueatlowinterestrates,sotheoption isvaluable.Athigherinterestratesthefirmislesslikelytocallandthisoptionlosesvalue.The pricesconvergeforhighinterestrates.AgraphicalrepresentationisshowninFigure14.4,page 463. 12. Theexpectationstheoryofthetermstructureofinterestratesstatesthat A.forwardratesaredeterminedbyinvestors'expectationsoffutureinterestrates. B.forwardratesexceedtheexpectedfutureinterestrates. C.yieldsonlongandshortmaturitybondsaredeterminedbythesupplyanddemandforthe securities. D.alloftheabove. E.noneoftheabove. Theforwardrateequalsthemarketconsensusexpectationoffutureshortinterestrates. 13. Giventhetimetomaturity,thedurationofazerocouponbondishigherwhenthediscountrate is A.higher. B.lower. C.equaltotheriskfreerate. D.Thebond'sdurationisindependentofthediscountrate. E.noneoftheabove.

Thedurationofazerocouponbondisequaltothematurityofthebond. 14. Whichofthefollowingbondshasthelongestduration? A.An8yearmaturity,0%couponbond. B.An8yearmaturity,5%couponbond. C.A10yearmaturity,5%couponbond. D.A10yearmaturity,0%couponbond. E.Cannottellfromtheinformationgiven. Thelongerthematurityandthelowerthecoupon,thegreatertheduration 15. Someoftheproblemswithimmunizationare A.durationassumesthattheyieldcurveisflat. B.durationassumesthatifshiftsintheyieldcurveoccur,theseshiftsareparallel. C.immunizationisvalidforoneinterestratechangeonly. D.durationsandhorizondateschangebythesameamountswiththepassageoftime. E.A,B,andC. Durationsandhorizondateschangewiththepassageoftime,butnotbythesameamounts. 16. Acoveredcallpositionis A.thesimultaneouspurchaseofthecallandtheunderlyingasset. B.thepurchaseofashareofstockwithasimultaneoussaleofaputonthatstock. C.theshortsaleofashareofstockwithasimultaneoussaleofacallonthatstock. D.thepurchaseofashareofstockwithasimultaneoussaleofacallonthatstock. E.thesimultaneouspurchaseofacallandsaleofaputonthesamestock. Writingacoveredcallisaverysafestrategy,asthewriterownstheunderlyingstock.Theonly risktothewriteristhatthestockwillbecalledaway,thuslimitingtheupsidepotential. 17. Allofthefollowingfactorsaffectthepriceofastockoptionexcept A.theriskfreerate. B.theriskinessofthestock. C.thetimetoexpiration. D.theexpectedrateofreturnonthestock. E.noneoftheabove.

A,B,andCaredirectlyrelatedtothepriceoftheoption;Ddoesnotaffectthepriceofthe option. 18. Ahedgeratioof0.70impliesthatahedgedportfolioshouldconsistof A.long0.70callsforeachshortstock. B.short0.70callsforeachlongstock. C.long0.70sharesforeachshortcall. D.long0.70sharesforeachlongcall. E.noneoftheabove. Thehedgeratioistheslopeoftheoptionvalueasafunctionofthestockvalue.Aslopeof0.70 meansthatasthestockincreasesinvalueby$1,theoptionincreasesbyapproximately$0.70. Thus,foreverycallwritten,0.70sharesofstockwouldbeneededtohedgetheinvestor's portfolio. 19. AnAmericancalloptionbuyeronanondividendpayingstockwill A.alwaysexercisethecallassoonasitisinthemoney. B.onlyexercisethecallwhenthestockpriceexceedstheprevioushigh C.neverexercisethecallearly. D.buyanoffsettingputwheneverthestockpricedropsbelowthestrikeprice. E.noneoftheabove. AnAmericancalloptionbuyerwillnotexerciseearlyifthestockdoesnotpaydividends; exercisingforfeitsthetimevalue.Rather,theoptionbuyerwillselltheoptiontocollectboththe intrinsicvalueandthetimevalue. 20. SupposethattheriskfreeratesintheUnitedStatesandintheUnitedKingdomare5%and4%, respectively.Thespotexchangeratebetweenthedollarandthepoundis$1.80/BP.What shouldthefuturespriceofthepoundforaoneyearcontractbetopreventarbitrage opportunities,ignoringtransactionscosts. A.$1.62/BP B.$1.72/BP C.$1.82/BP D.$1.92/BP E.noneoftheabove $1.80(1.05/1.04)=$1.82/BP.

PART2(OPENQUESTIONS;60pointsatmaximum) QUESTION1.(20points)Equilibriumpricingmodels Parta.(3points) Discuss the CAPM vs. the zerobeta CAPM give formulas, explain notation and assumptions. Giveagraphicalinterpretation.InwhatcasesisthezerobetaCAPMused?
ThezerobetaCAPM:mi=mz+betaix(mMmz),wheremiistheexpectedreturnofasseti,andmzisthe expected return of an asset (zerobeta portfolio) uncorrelated with the market return mM. Used in the absenceofariskfreeasset.ComparedtothetraditionalCAPM,BlackszerobetaCAPMreplacestherisk freeassetwiththezerobetaportfolioontheinefficientpartofthefrontier.

Partb.(5points) Assume that the CAPM holds. The riskfree rate rf is 2% and the market return rM is 7%. Considerthefollowingthreestocks: Stocks ROE 1b A 1.2 0.1 0.9 B 1 0.1 0.8 C 0.8 0.1 0.6 marketbetaofeachstock ROEreturnonequity bretentionratio ComputetheP/Eratioofthethreestocks,assumingaconstantgrowthmodelwithendogenous earningsgrowth.
The P/E ratio is computed using the formula: P/E = (1b)/(k b x ROE). The required rate of return k for thethreestocks: kA = 0.02 + 1.2 x (0.07 0.02) = 0.08; kB = 0.02 + 1 x (0.07 0.02) = 0.07; kC = 0.02 + 0.8 x (0.07 0.02) = 0.06. P/EA=0.9/(0.08 (10.9)x0.1)=12.86;P/EB=0.8/(0.07 (10.8) x0.1)=16;P/EC=0.6/(0.06 (10.6)x 0.1)=30;

Partc.(3points) Given your results in Part b, explain the differences in the P/E ratio between the three stocks, havinginmindtherelationshipbetweentherequiredreturn,ROEandtheplowbackratio(b).
ROE>k for each of the stocks; in this case the higher the plowback rate, the higher the P/E ratio. Also, holding other things equal, riskier stocks have higher required rates of return (i.e. higher k) and lower P/E. 8

Partd.(5points) Liquidity is a known priced factor in the crosssection of asset returns. Thus, consider the followingmodelinsteadoftheCAPM: ri = i + i rM + i Liq + ei where ri is the return on asset i (i=A, B, C), Liq is the return on a liquidity factor (i.e. the return of a portfolio that mimics the evolution of market liquidity), i is the loading on the liquidity factorforasseti,andeiistheidiosyncraticsourceofriskforasseti. ConsiderthesamethreestocksfromPartbandthefollowingadditionalinformation: Thevarianceofthemarketfactor:2(rM)=0.04 Thevarianceoftheliquidityfactor:2(Liq)=0.02 Thevarianceoftheidiosyncraticsourceofriskforthethreeassets:2(ei)=0.01foralli You can assume that the idiosyncratic sources of risk are uncorrelated, and that rM and Liq are uncorrelatedaswell. Theloadingsontheliquidityfactorforthethreestocksaregivenby: Stocks A 0.7 B 0.9 C 0.3 ComputethesystematicriskofstocksA,BandC.
2A(syst) = 1.22 x 0.04 + 0.72 x 0.02 = 0.067; 2B(syst) = 12 x 0.04 + 0.92 x 0.02 = 0.056; 2C(syst) = 0.82 x 0.04+0.32x0.02=0.027;

Construct an equally weighted portfolio of the three stocks and compute the variance of its nonsystematic risk component. How does it compare to the nonsystematic risk of each individualstock?
2Portfolio(nonsyst) = 1/3 x 0.01 = 0.0033 (lower than the variance of the nonsystematic component for theindividualstocks,equalto0.01).

Parte.(4points) Taking the same 3 stocks from Part b and d, construct a portfolio that has an exposure of 1 to theliquidityfactorand0tothemarketfactor.Shortsalesareallowed.
LetwA,wBandwCbetheweightsofthatportfolio.Theysatisfythefollowingsystemofequations: wA+wB+wC=1 1.2xwA+1xwB+0.8xwC=0(zeromarketexposure) 9

0.7xwA+0.9xwB+0.3xwC=1(unityliquidityriskexposure) SothatwA=3.875,wB=3.75,wC=1.125.

QUESTION2.(10points)Portfolioconstructionandperformancemeasurement Parta.(4points) A portfolio has an expected rate of return E(r) of 0.15 and a standard deviation s of 0.15. The riskfree rate is 6 percent. An investor has the following utility function: U = E(r) (A/2)s2. Which value of A makes this investor indifferent between the risky portfolio and the riskfree asset?
0.06=0.15A/2(0.15)2;0.060.15=A/2(0.0225);0.09=0.01125A;A=8;U=0.158/2(0.15)2=6%; U(Rf)=6%.

Partb.(3points) You are considering investing $1,000 in a Tbill that pays 0.05 and a risky portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an expectedrateofreturnof0.10andavarianceof0.0081. If you want to form a portfolio with an expected rate of return of 0.11, what percentages of yourmoneymustyouinvestintheTbillandP,respectively? Whatisthedollarvalueofthesepositions? E(rp)=0.6(14%)+0.4(10%)=12.4%;11%=5x+12.4(1x);x=0.189(Tbills)(1x)=0.811(riskyasset).
Thus$1,000x18.9%=$189inTbillsand$1,000x81.1%=$811intheriskyportfolio.

Partc.(3points) You want to evaluate three mutual funds using the information ratio measure for performance evaluation. The riskfree return during the sample period is 6%, and the average return on the market portfolio is 19%. The average returns, residual standard deviations, and betas for the threefundsaregivenbelow.

SortthethreefundsaccordingtoJensensalpha.WhatdoesJensensalphameasure? Sort the three funds according the information ratio criterion. What does the information ratiomeasure?Giveformulas.
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Informationratio=P/(eP);A:P=206.8(196)=3.6;3.6/4=0.9;B:P=2161(196)=2.0; 2/1.25=1.6;C:P=2361.2(196)=1.4;1.4/1.20=1.16.

QUESTION3.(15points)FixedIncome Parta.(3points) Youaregiventhefollowingcouponbondswithannualcouponpaymentsandfacevalueof100. Bond Maturity Coupon Price Yield to Facevalue maturity A 2 3% $100.41 2.79% $100 B 2 9% $104.32 6.63% $100 Computethezeroratesz1andz2(uptotwodecimalplaces)formaturitiesof1and2years.
Thezeroratesz1andz2solvethefollowingsystem: 3/(1+z1)+103/(1+z2)2=100.41 9/(1+z1)+109/(1+z2)2=104.32

Partb.(3points) You purchased an annual interest coupon bond one year ago with 6 years remaining to maturity at the time of purchase. The coupon rate is 10% and par value is $1,000. At the time youpurchasedthebond,theyieldtomaturitywas8%. Yousellthebondafterreceivingthefirstinterestpaymentandthebond'syieldtomaturityhas nowchangedto7%. Calculatetheannualtotalrateofreturnonholdingthebondforthatyear.
FV=1000,PMT=100,n=6,i=8,PV=1092.46;FV=1000,PMT=100,n=5,i=7,PV=1123.01;HPR= (1123.011092.46+100)/1092.46=11.95%.

Partc.(3points) Supposethatallinvestorsexpectthatinterestratesforthe4yearswillbeasfollows:

Provide the formula for the price of a 2year coupon bond with 10% annual coupon using forwardratesandcalculateitsprice.
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The 2year yield is obtained using: (1+y2)2 = (1+y1) x (1+f2). If we consider a face value of 1000, the couponpaymentsare100,thenforthepriceofa2yearbond: [(1.05)(1.07)]1/21=6%;FV=1000,n=2,PMT=100,y2=6%,PV=$1,073.34

Partd.(3points) You have purchased a bond for $973.02. The bond has a coupon rate of 6.4%, pays interest annually, has a face value of $1,000, 4 years to maturity, and a yield to maturity of 7.2%. The bond'sdurationis3.6481years.Youexpectthatinterestrateswillfallby0.3%latertoday. Use the modified duration to find the approximate percentage change in the bond's price. Findtheapproximatenewpriceofthebondfromthiscalculation. Dotheregularpresentvaluecalculationstofindthebond'sexactnewpriceatitsnewyieldto maturity. What is the amount of the difference between the two answers? Why are your answers different? Explainthereasoninwordsandillustrateitgraphically.
Calculationsareshownbelow. Find new price using modified duration: Modifiedduration=3.6481/1.072=3.403years. Approximate percentage price change using modified duration = 3.403 * (.0003) = 1.02%. NewPrice=$973.02*1.0102=$982.94($982.96ifdurationisn'trounded) Find new price by taking present value at the new yield to maturity: N=4,I=6.9%,PMT=64,FV=1000,CPTPV=983.03. The answers are different by $0.09. The reason is that using modified duration gives an approximation of the percentage change in price. It should only be used for small changes in yields because of bond price convexity. As you move farther away from the original yield, the slope of the straight line that showsthe durationapproximation nolonger matchestheslopeof the curvedlinethatshowstheactual pricechanges.

Parte.(3points) Assume that you have a portfolio with duration of 3.2 and convexity of 6.7282. The current yield curve is flat at 2%. Construct a portfolio of zero coupon bonds with maturities of 1 and 2 yearsandcash,suchthatitmatchesthedurationandconvexityofyourportfolio.
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Denotetheweightsofthe1and2yearzerocouponbondsbyw1andw2.Theirdurationsare1and2 respectively.TheconvexityCofazerocouponbondwithmaturityTisequaltoT(T+1)/(1+y)2,soC1= 1.92andC2=5.77.Thus,theweightsshouldsatisfy: w1x1+w2x2=3.2 w1x1.92+w2x5.77=6.7282 Hencew1=2.6,w2=0.3,andthecashpositionis1w1w2=1.9.

QUESTION4.(15points)Optionpricing Parta.(2points)
Discusstherelationshipbetweenoptionpricesandtimetoexpiration,volatilityoftheunderlyingstocks, andtheexerciseprice.

The longer the time to expiration, the higher the premium because it is more likely that an option will become more valuable (more time for the stock price to change). The greater the volatility of the underlying stock, the greater the option premium; the more volatile the stock, the more likely it is that theoptionwillbecomemorevaluable(e.g.,movefromanoutofthemoneytoaninthemoneyoption, or become more in the money). For call options, the lower the exercise price, the more valuable the option, as the option owner can buy the stock at a lower price. For a put option, the lower the exercise price, the less valuable the option, as the owner of the option may be required to sell the stock at a lowerthanmarketprice.

Partb.(2points) Considerthefollowingbinomialtreefortheevolutionofthestockpriceovertheperiodof1 year,assuming2steps(t=0,t=1,t=2).Thestockpricecanincreaseby10%anddecreaseby5% eachperiod.Theriskneutralprobabilityofanupwardmovementis43.33%.Calculatethe annualinterestrate.

S2uu=10.89 S1u=9.9 S0=9 S2du=9.405 S1d=8.55 S2dd=8.1225 S2ud=9.405

Theperiodicinterestraterfisobtainedusing:Q=(S0(1+rf)Sd)/(SuSd): 0.4333=(9x(1+rf)8.55)/(9.98.55),rf=0.015(periodic)or0.03(annual). 13

 Partc.(7points) A barrier option is a pathdependent option that becomes effective or expires if the underlying price reaches a predetermined barrier. One type of a barrier option is the upandout one, for which the spot price of the underlying is initially below a given knockout barrier. This option behaves like a standard one if the underlying price remains below the barrier. If however it moves above the barrier, the contract expires (regardless of whether the price moves back down afterwards or not). The opposite happens if we have an upandin option. It becomes effective once the price of the underlying has passed beyond a given barrier (regardless of whetheritstaysaboveitafterwards). Consider the binomial tree from Part (b). The strike price is 10.5, and the barrier price is 9.5. Compute the price of an upandout put option along that tree. As well, obtain the price of an upandin put option. Notice that in each of the 4 states at maturity exactly one of the two optionsiseffective. Alternatively, obtain the price of a standard put option. What do you notice about the relationshipbetweenthepriceofthestandardputandthesumofthepricesofthetwobarrier options?Offeranexplanation.
Upandout put: at the up node of step one of the tree the stock price Su=9.9 > 9.5, thus the option expires.ThusatthelastnodeCuu=Cud=0.FortheothertwonodesCdu=max(0,10.59.405)=1.095 andCdd=max(0,10.58.1225)=2.3775.Atthefirststep:Cu=0andCd=(0.4333x1.095+(10.4333) x 2.3775)/(1+0.015) = 1.7948. Thus, the price of the put is C0 = (0.4333 x 0 + (10.4333) x 1.7948)/(1+0.015)=1.002. Upandin put: the option becomes effective only after the price reaches beyond 9.5, i.e. in the upper twonodesofthetree.ThenCuu=max(0,10.510.89)=0;Cud=max(0,10.59.405)=1.095.Intheother two nodes the option is not effective, as at step 1 the price of the underlying Sd = 8.55<9.5, thus Cdu = Cdd = Cd = 0. At step 1, Cu = (0.4333 x 0 + (10.4333) x 1.095)/(1+0.015) = 0.61133, and at step 0 the pricetodayoftheputis:C0=(0.4333x0.61133+(10.4333)x0)/(1+0.015)=0.261. Plain vanilla put: Cuu = 0, Cud = Cdu = 1.095, Cdd = 2.3775. At step 1: Cu = (0.4333 x 0 + (10.4333) x 1.095)/(1+0.015) = 0.61133 and Cd = (0.4333 x 1.095 + (10.4333) x 2.3775)/(1+0.015) = 1.7948. At step 0 the price of the plain vanilla put is C0 = (0.4333 x 0.61133 + (10.4333) x 1.7948)/(1+0.015) = 1.263. Note that it is equal to the sum of the prices of the upandout put and the upandin put (they are complementaryduetoexercisebarriers).

Partd.(4points) Replicatethepayoffstructurebelowusingoptionsandtheriskfreeasset.Payattentiontothe scale of the horizontal and the vertical axes. When would you use such a strategy (comment in termsofthevolatilityandthedirectionofthemarket)?
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Therearetwopossibilitiestoreplicatethepayoff: 2longputs@15,1shortput@25andlendthepresentvalueof5attheriskfreerate Or: 1 long put @ 15, 1 long call @ 15, 1 short call at 25, and borrow the present value of 5 at the riskfree rate. This strategy is applied when you expect large movements in either direction in the price of the underlying.

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