F714 Assignment 2 Instructions This assignment can be done individually or with one partner, and is due in class on Thursday

sday December 1. Please use 4 decimal points in your answers. All interest rates herein are expressed with continuous compounding. Please use continuous compounding in your answers. Please ensure that your answers are as complete as possible. For numerical questions, simply calculating the numbers out will not be sufficient. Please also provide me with the reasons for your calculations. Correct thinking processes are much more important than correct numbers. Therefore, regardless of whether or not your numbers are correct, no marks will be given if (a) no explanation of your calculations is provided; or (b) the explanation provided is incorrect. On the other hand, even if your numbers are incorrect, partial marks will be given if your thinking process is correct. Please note that marks can only be given based on what you write. Therefore, I request that you attempt to convey your ideas to me as clearly as possible. I will not make a guess as to what you intend to mean if you do not make it obvious and clear. When your answers involve taking positions in securities or lending/borrowing, please mention all the relevant details such as the timing of the transactions, the side of the contracts (e.g., long or short forward), the length of the contracts (e.g., 6-month futures), the exercise prices (in case of options) and the interest rates (in case of lending or borrowing). Please be very careful with the logic of your solutions. For example, if the price of an asset at some future point in time is random, you cannot assume that you know that price. I consider this kind of mistake to be fundamental, and so anyone who makes it will get zero point for that question. The majority of the questions in this assignment are taken (or are adapted) from questions from past exams. Therefore, it is important that you try to do every question on your own (even though you're working with a partner). Please take this opportunity to familiarize yourself with what the exams will be like and, more importantly, to develop your thinking skill.

1) (3 points) Lalaa Corp. wants to invest its cash surplus of $1m. in a GIC (i.e., certificate of deposit) for a period of 6 months. The best GIC rate that it could find is 5.5% p.a. continuous compounding. [Note: This is the rate that Lalaa can lend its money. It is not its borrowing rate. Nor is it anybody else's lending or borrowing rate.] Mr. Dipsey, the companys treasurer, has asked you to explore the possibility of creating a synthetic lending transaction by a portfolio of options and stocks. You observed the following information: Security 6-month European call whose exercise price = $32 6-month European put whose exercise price = $32 the underlying (non-dividend-paying) stock Price $2.10 $2.92 $30

Based on the above observations, will Lalaa be better off with the GIC or the synthetic lending? If the synthetic lending is better, please also show how it can be created. 2) Consider a stock whose current price is $100 and volatility is 20% p.a. The stock is expected to pay a dividend of $2 in one months time. The risk-free rate is 5% p.a. continuously compounding. (a) (3 points) Using a two-period binomial tree, what is the value of a 2-month American call whose exercise price is $101? (b) (3 points) Using a two-period binomial tree, what is the value of a 2-month American put whose exercise price is $101? 3) (4 points) An Average Strike call is a type of Asian option that pays off max{0, ST Savg) at maturity where Savg is the average of the stock prices from the start of the call to its maturity. For example, consider the following path for stock prices: Day 0 Start of option 1 2 3 Price $100 $110 $121 $133.1

In this case, the average stock price = (100 + 110 + 121 + 133.1)/4 = $116.025. [Note that although there are 4 days and 3 periods, the average is taken from the start date (i.e. over the 4 prices).] Consider an Average Strike call with a maturity of 3 months (and can be exercised only at maturity). The underlying stock is currently traded at $100, while the riskfree rate is 5% p.a. Use a 3-period Binomial tree to price this call, given that you have determined that u = 1.1 and d = 0.9. Also, at time 0, what is the (risk-neutral) probability that this call will end up in the money?

Note that although the tree for the stock price recombines, the calls payoff depends on the path that the stock price has taken. For example, the payoff under the path uud is no longer the same as under the path udu, since the average prices under the two paths are not the same. Nevertheless, the probabilities that the two paths will occur are the same.

4) (4 points) In its most simple form, a convertible bond is similar to a fixed-rate bond with a provision that at maturity, the holders can choose to either receive the principal back, or convert the principal repayment into shares of the issuing company at a predetermined conversion rate. Suppose your company wants to raise funds by issuing this most simple form of convertible bonds. The bond will have a maturity of 3 years and will be issued at par (i.e., you sell the bond at its face value, $1,000). Coupons will be paid every year. At maturity, each bond allows its holder to convert the principal repayment into 20 shares of your companys stock. The stock is currently traded at $40/share. Its volatility is 25% per annum. The current risk-free rate is 4% for all terms. Your companys credit rating is currently BBB. Typically, BBB-rated firms have to pay 3% p.a. more than the risk-free rate when they borrow. That is, if your company wanted to issue a straight bond (i.e., one with no conversion provision) now, it would have to pay 7% p.a. in coupons in order for the bond to be priced at par. You were asked to set the coupon rate for the bond. Under a 3-period binomial framework, what coupon rate will you set? Note that according to bond convention, the coupon rate that you set will be in annual compounding because the bond in this case pays coupons every year. For example, if you set a coupon rate of 5% p.a., it means that every year the holder will receive $50. [Hint: The buyers of your convertible bonds have an option. They pay for this option by having to accept a lower coupon rate on the bond.] 5) Remember the friend who offered you a bet on Research in Motion (RIM) stock in the midterm exam? Shes back with a different offer. She still believes that the price of RIM, now at $20 per share, is still too high. She is prepared to back up her conviction by offering you the following bet. If in exactly one year from now RIM stock price is higher than $20/share, she will give you one hundred times the amount of the difference (e.g., suppose the price in one year is $23 per share, you will get $300). On the other hand, if the price in one year ends up below $20/share, you will have to give her only seventy times the amount of the difference (e.g., suppose the price in one year is $18 per share, you will have to give her $140). Suppose that the expected return on RIM stock is 9% p.a., and the volatility is 30% p.a. Suppose also that the current risk-free rate is 3% p.a. and Research in Motion does not plan to pay dividends in the next year. What is the value of this bet to you?

6) An investment bank recently introduced a new security called "SuperBear PrincipalProtected Note". This security has a 2-year term, and will make money for investors if the markets drop. That is, its return is based on the percentage decline, if any, in the S&P 500 index over its life. Specifically, the payoffs are as follows: If after 2 years, the S&P 500 index ends up below the current level, then the rate of return on this note will be positive and twice as much as the percentage decline in the index. For example, suppose the index drops by 10% over the 2-year term. The rate of return on this note will then be +20%. If after 2 years, the S&P 500 index ends up at the current level or higher, the rate of return on this note will be zero, and the investors will get their principal (i.e., $100 per unit) back.

Suppose that the S&P 500 index follows a geometric Brownian motion with an expected return of 9% p.a. and a standard deviation of 30% p.a. Suppose also that the dividend yield on the index is zero (i.e., no dividend), and that the risk-free rate is 4% p.a. for all terms. (a) (3 points) What should be the fair price of this note? (b) (2 points) What is the real-world probability that the rate of return on the note will be positive but not more than 20%?