THE UNIVERSITY OF IOWA

College of Liberal Arts and Sciences

Department of Statistics and Actuarial Science

ACTS:4130

Quantitative Methods for Actuaries

Assignment 3 (Fall 2014)
(5% of your total scores)

Instructor : Ambrose Lo
Grader : Yao Chen

INSTRUCTIONS

1. This assignment covers material in Chapters 3 to 5 and consists of 12 questions numbered

1 through 12 for a total of 150 points. The points for each question are indicated at the
beginning of the question.
2. Answer ALL TWELVE questions.
3. Remember to write your name and staple your work.
4. Hand in your work at the beginning of class on November 3, 2014 (Monday). Late work will
not be accepted.
5. You are welcome to discuss assignment problems with me during my office hours. You are
also encouraged to discuss homework problems with other students. However, what you hand
in must ultimately be your own work.

** BEGINNING OF ASSIGNMENT 3 **

1. (Combination of positions) (5 points) Name the option strategy that is equivalent to a long
protective put position combined with a short covered call position, with the call and put options having the same strike price K. Explain briefly how you come up with your conclusion.
2. (Profit comparison for paylater) (8 points) Consider the GM example in the lecture notes.
With the aid of appropriate profit diagram(s), determine the range of 1-year gold price such
that GM under a long 420-strike put strategy has a higher profit than under a paylater strategy,
but a lower profit than being unhedged.
(Note: Merely giving the price range without explanations scores no marks.)
3. (Proof by no-arbitrage) (8 points) Use no-arbitrage arguments (i.e. not by analogy) to show
that the fair T -year prepaid forward price of a stock that pays continuous dividends at a
dividend yield of is given by S0 e T .
4. (Derivatives Markets, Problem 5.10: (Reverse) Cash-and-carry arbitrage) (17 points)
The S&R index spot price is 1,100 and the continuously compounded risk-free rate is 5%.
You observe a 9-month forward price of 1,129.257.
(a) (3 points) What dividend yield is implied by this forward price?
(b) (7 points) Suppose you believe the dividend yield over the next 9 months will be only
0.5%. Describe actions you could take to exploit an arbitrage opportunity and calculate
the resulting profit (per index unit).
(c) (7 points) Suppose you believe the dividend yield will be 3% over the next 9 months.
Describe actions you could take to exploit an arbitrage opportunity and calculate the
resulting profit (per index unit).

5. (Varying dividend yield) (7 points) You are given:

(i) The continuously compounded annual risk-free interest rate is 9%.
(ii) The dividend yield on a stock index varies throughout the year. In February, May,
August, and November, dividends are paid at a rate of 5% per annum. In other months,
dividends are paid at a rate of 2% per annum.
(iii) The value of the index on July 31 is 1,300.
Calculate the price of a forward contract signed on July 31 and deliverable on December 31
of the same year.

ACTS:4130 (22S:174) Fall 2014

Assignment 3

-2-

GO ON TO NEXT PAGE

6. (Arbitrage in the presence of market frictions) (20 points) You are given:
You observe the following two prices of stock ABC in the market:
$30

and

$31.

Stock ABC pays a dividend of 2 every year, with the first dividend occurring 6 months
from now, i.e. dividends are paid at time 0.5 and time 1.5.
The following two continuously compounded rates are quoted from the bank:
5%

and

10%.

One rate is for borrowing and another rate is for lending.

(a) (8 points) Determine the no-arbitrage interval of the 2-year forward price on stock ABC.
(Hint: You can guess. Remember that the parameters enter the interval to make it as
wide as possible. Check that your guess is indeed correct after doing part (b).)
(b) (12 points) Demonstrate, with the aid of appropriate cash flow tables, how arbitrage
profit can be obtained in two years if the 2-year forward price is:
(i) 25
(ii) 35
7. (Derivatives Markets, Problem 5.15: Different kinds of transaction costs) (25 points)
Suppose the S&R index is 800, and that the dividend yield is 0. You are an arbitrageur with a
continuously compounded borrowing rate of 5.5% and a continuously compounded lending
rate of 5%. Assume that there is 1 year to maturity.
Calculate the no-arbitrage interval for the 1-year forward price under each of the following
cases:
(a) (5 points) There is a $1 transaction fee, paid at time 0, for going either long or short the
forward contract.
(b) (5 points) In addition to the fee for the forward contract in part (a), there is also a $2.40
fee for buying or selling the index. The fee is paid only at time 0.
(c) (7 points) Make the same assumptions as in parts (a) and (b), except that the stock index
transaction fee (but not the forward fee) has to be paid at both times 0 and 1.
(d) (8 points) Transactions in the index have a fee of 0.3% of the value of the index for both
purchases and sales. The index transaction fee has to be paid at time 1 only. Transactions
in the forward contract still have a fixed fee of $1 per unit of the index at time 0.
(Hint: I didnt want to give any hint here, because it would be too big a hint to suggest
tailing the stock position to reflect negative dividends, i.e. you have to pay as a result of
owning the index. As a result, you may need more than one share at time 0.)

ACTS:4130 (22S:174) Fall 2014

Assignment 3

-3-

GO ON TO NEXT PAGE

8. (Derivatives Markets, Problem 5.12: Futures) (8 points) Suppose the S&P 500 futures
price is currently 950 and the initial margin is 10%. You wish to enter into 10 S&P 500 long
futures contracts. The multiplier of each S&P 500 futures is 250.
(a) (3 points) What is the notional value of your position? What is the margin?
(b) (5 points) Suppose you earn a continuously compounded rate of 6% on your margin
balance, your position is marked to market weekly, and the maintenance margin is 80%
of the initial margin. What is the greatest S&P 500 index futures price 1 week from
today at which you will receive a margin call?
9. (Futures: Margin account balance calculation) (7 points) You are given the following
information about a futures contract:
Underlying asset:
Dividend rate:
Expiration date:
Size of futures contract:
Risk-free rate:
Mark-to-market frequency:
Initial margin requirement:

P&K Index
2.5%, compounded continuously
April 1, 2015
20 units
5%, compounded continuously
monthly
10% of notional value of futures

On April 1, 2014, Tidy takes a short position in one futures contract. On that date, the futures
contract is trading at 800 per unit. Tidy deposits the minimum amount required into a margin
account.
If the P&K Index closes at 770 on May 1, 2014, and if the futures contract closes at the corresponding no-arbitrage forward price, calculate the balance in Tidys account immediately
after it is marked to market on May 1, 2014.
10. (Arbitraging mispriced forward bond price) (8 points) You are given:
The following annual spot rates, compounded annually:
Year of maturity
1
2
3
4
5

Spot rate
2%
2.5%
2.3%
2.7%
3.0%

The forward price for a 3-year zero-coupon bond with a face value of $1 to be purchased/sold at the end of year 2 is $0.9 in the market.
Describe actions you could take at time 0 to exploit an arbitrage opportunity that results in
arbitrage profits at time 0 only, and calculate the resulting profit.
ACTS:4130 (22S:174) Fall 2014
Assignment 3

-4-

GO ON TO NEXT PAGE

11. (Derivatives Markets, Problems 8.2-8.4: Basic swap calculations) (22 points) Suppose
that oil forward prices for 1 year, 2 years, and 3 years are $20, $21, and $22. The 1-year
effective annual interest rate is 6.0%, the 2-year interest rate is 6.5%, and the 3-year interest
rate is 7.0%.
(a) (5 points) Calculate the 3-year swap price.
(b) (5 points) Calculate the price of a 2-year swap beginning in one year. That is, the first
swap settlement will be in 2 years and the second in 3 years.
Suppose you enter into the 3-year swap paying the swap price calculated in part (a).
(c) (5 points) What position in oil forward contracts will hedge oil price risk in your position? Verify that the present value of the locked-in net cash flows is zero.
(d) (7 points) How much have you overpaid relative to the forward price after the first swap
settlement? What is the cumulative overpayment after the second swap settlement?
Verify that the cumulative overpayment is zero after the third payment.

12. (Interest rate swap) (15 points) Your friend, Psy, has a 5-year floating-rate debt of $1 million.
At the end of the i-th year, i = 1, 2, 3, 4, 5, he has to make interest payment of $ri1 (i 1, i)
million. The principal is to be returned at the end of the fifth year.
You are given the following effective annual interest rates:
r(0, 4)
r0 (2, 3)
r0 (2, 5)
r0 (4, 5)
r0 (1, 5)

=
=
=
=
=

5.1%
5.2%
5.5%
6.5%
6.3%

(a) (7 points) Calculate the swap rate with five years to maturity.
(b) (8 points) Psy has decided to use an interest rate swap for hedging. Calculate the swaps
implicit loan balance at the end of each of the five years.

** END OF ASSIGNMENT 3 **

ACTS:4130 (22S:174) Fall 2014

Assignment 3

-5-

STOP

Figure 1: Have a nice cup of tea after completing this hard assignment.

Suggested solutions to ACTS:4130 (22S:174) Assignment 3

1. Solution. The payoff of a long protective put is
(
K, if ST K,
ST , if ST > K,

(1)

and that of a long covered call is

(
ST , if ST K,
K, if ST > K.

(2)

The overall payoff is given by (1) (2):

(
K ST , if ST K
= |ST K|,
ST K, if ST > K
which has the same payoff as a long K-strike straddle .
Remark 1. 3 points for straddle, 1 point for long, 1 point for K-strike.
Remark 2. You may more easily draw the same conclusion by drawing the payoff diagrams
of a long protective put and a short covered call, and observing that the resulting payoff has
the same shape as that of a long straddle.
2. Solution. The profit functions of different hedging strategies are sketched in Figure 2:
Unhedged

Profit

Paylater
Long put

54.6
40
30.79
25.4

380

420 434.6

Figure 2: Profit functions in Question 2.

ACTS:4130 (22S:174) Fall 2014

Assignment 3 Suggested Solutions

-7-

S1

The long put function crosses the paylater profit function at S1 = 425.39 (show this!) and
crosses the unhedged profit function at S1 = 420 (40 30.79) = 410.79. By inspection, the
required gold price range is
410.79 < S1 < 425.39.
P > S e T , then we sell a prepaid forward and buy e T units of stock
3. Solution.
If F0,T
0
at time 0. The cash flows are:

Cash Flows
Transaction
Sell a prepaid forward
Buy e T units of stock
Total

Time 0
P
F0,T
S0 e T

Time T
ST
+ST

P S e T
F0,T
0

P S e T is locked in at time 0 at no risk.

Hence a positive cash inflow of F0,T
0
P < S e T , then we buy a prepaid forward and sell e T units of stock at time 0.
If F0,T
0
The cash flows are:

Cash Flows
Transaction
Buy a prepaid forward
Sell e T units of stock
Total

Time 0
P
F0,T
+S0 e T

Time T
ST
ST

P
S0 e T F0,T

P is locked in at time 0 at no risk.

Hence a positive cash inflow of S0 e T F0,T
P is S e T .
By the no-arbitrage assumption, the fair price of F0,T
0

Remark 3. It is important that you state your final conclusion.

4. Solution.

(a) Solving
F0,0.75 = S0 e(r )T = 1, 100e(0.05 )(0.75) = 1, 129.257

yields = 1.50% .
(b) The dividend yield over the next 9 months will be only 0.5%, which means that the
forward in the market is underpriced. Then you engage in a reverse cash-and-carry
arbitrage, buying the forward in the market, selling e0.5%(0.75) units of the S&R index
and lending S0 e0.5%(0.75) . The associated cash flows are:
Cash Flows
Transaction
Buy a forward
Sell e0.5%(0.75) units of stock
Lend S0 e0.5%(0.75)

Time 0
0
0.00375
+S0 e
S0 e0.00375

Time 0.75
S0.75 1, 129.257
S0.75
1, 100e(5%0.5%)0.75

8.5016

Total
ACTS:4130 (22S:174) Fall 2014
Assignment 3 Suggested Solutions

-8-

Remark 4. Note that the forward price is a decreasing function of the dividend yield.
(c) If you believe that the dividend yield over the next 9 months will be 3%, this means the
forward in the market is overpriced. Then you engage in a cash-and-carry arbitrage, selling the forward in the market, buying e3%(0.75) units of the S&R index and borrowing
S0 e3%(0.75) . The associated cash flows are:
Cash Flows
Transaction
Sell a forward
Buy e3%(0.75) units of stock
Borrow S0 e3%(0.75)

Time 0
0
0.0225
S0 e
+S0 e0.0225

Time 0.75
1, 129.257 S0.75
+S0.75
1, 100e(5%3%)0.75

12.6326

Total

Remark 5. For both parts (b) and (c), your profit equals the absolute value of the difference
between the observed forward price and the fair forward price.
Remark 6. The fact that the strategies in parts (b) and (c) are indeed arbitrage depends critically on whether your belief on the dividend yield is correct or not.
5. Solution. The forward price is
F0,5/12 = S0 erT e

T
0

s ds

= 1, 300e0.09(5/12) e0.05(2/12)0.02(3/12)
= 1, 331.80 .

6. Solution. Note that S0b = 30, S0a = 31, rl = 5% and rb = 10%.

(a) The no-arbitrage interval of F0,2 is
[30e0.05(2) 2(e0.1(1.5) + e0.1(0.5) ), 31e0.1(2) 2(e0.05(1.5) + e0.05(0.5) )] = [28.73, 33.66] .
(b) (i) If F0,2 = 25, then we engage in a reverse cash-and-carry arbitrage by buying the forward, selling 1 unit of stock ABC and lending the required amount. The associated
cash flows are:

Transaction
Buy a forward
Sell 1 unit of stock
Borrow 2 at t = 0.5 and
t = 1.5, repay at t = 2
Lend S0b = 30 at t = 0
and collect proceeds at
t =2
Total
ACTS:4130 (22S:174) Fall 2014
Assignment 3 Suggested Solutions

Time 0
0
30
0

Time 0.5
0
2
2

30

Cash Flows
Time 1.5
Time 2
0
S2 25
2
+S2
0.1(1.5)
2
2(e
+ e0.1(0.5) )
0

30e(0.05)(2)

3.73
-9-

(ii) If F0,2 = 35, then we engage in a cash-and-carry arbitrage by selling the forward,
buying 1 unit of stock ABC and borrowing the required amount. The associated
cash flows are:

Transaction
Sell a forward
Buy 1 unit of stock
Lend 2 at t = 0.5 and
t = 1.5, collect
proceeds at t = 2
Borrow S0a = 31 at
t = 0 and repay at t = 2
Total

Time 0
0
31
0

Time 0.5
0
2
2

31

Cash Flows
Time 1.5
Time 2
0
35 S2
2
+S2
0.05(1.5)
2
2(e
+ e0.05(0.5) )

31e(0.1)(2)

1.34

Remark 7. Think about what if the question requires that every action be done at time 0.
7. Solution.

(a) The no-arbitrage interval is

[(800 1)e0.05 , (800 + 1)e0.055 ] = [839.97, 846.29] .

(b) The no-arbitrage interval is

[(800 3.4)e0.05 , (800 + 3.4)e0.055 ] = [837.44, 848.82] .
(c) The no-arbitrage interval is
[(800 3.4)e0.05 2.4, (800 + 3.4)e0.055 + 2.4] = [835.04, 851.22] .
(d) As a result of the proportional transaction cost of 0.3% on the index:
Long 1 unit of stock is only worth 0.997S1 at time 1. To result in exactly S1 , we
need 1/0.997 = 1.003 units of the stock at time 0.
Short 1 unit of stock will require that you pay 1.003S1 at time 1. To result in exactly
S1 , we need 1/1.003 = 0.997 units of the stock at time 0.
The no-arbitrage interval is
[(800 0.997 1)e0.05 , (800 1.003 + 1)e0.055 ] = [837.44, 848.82] .

Remark 8. If you are not sure about any of the above answers, construct a cash flow table.
8. Solution.

(a) The notional value of the position is

10 250 950 = 2, 375, 000 .

The margin is
10% Notional value = 237, 500 .
ACTS:4130 (22S:174) Fall 2014
Assignment 3 Suggested Solutions

-10-

(b) Solving the inequality

237, 500e0.06/52 + 10(250)(F1,T 950) (0.8)(237, 500)
|
{z
}
Maintenance margin

gives F1,T 930.89 . In other words, the greatest S&P 500 index futures price 1 week
from today that generates a margin call is 930.89.
9. Solution. The notional value of Tidys position is 20(800) = 16, 000, so the initial margin is
10% 16, 000 = 1, 600.
On May 1, 2014, the current futures price, which is assumed to equal the forward price, is
F1/12,1 = S0 e(r )T = 770e(0.050.025)(11/12) = 787.8496.
The mark-to-market proceed is
20(800 787.8496) = 243.0084.
The margin account is then
1, 600e0.05/12 + 243.0084 = 1849.69.
10. Solution. The fair forward bond price is
P0 (2, 5) =

[1 + r0 (0, 2)]2 1.0252

=
= 0.906278,
[1 + r0 (0, 5)]5
1.035

which is higher than the observed market price by 0.006278. In other words, the forward
bond in the market is underpriced. To exploit the mispricing, we:
Buy the forward bond in the market
Sell the synthetic bond by selling a 5-year ZCB with face value 1 and buying a 2-year
ZCB with face value P(0, 2).
The associated cash flows are:
Transaction
Buy a forward bond
Sell a 5-year ZCB with face value 1
Buy a 2-year ZCB with face value 0.9
Total

Cash Flows
Time 0
Time 2 Time 5
0
0.9
1
P(0, 5)
0
1
0.9P(0, 2)
0.9
0
?
0
0

The cash flow at time 0 is



1
1
P(0, 5) 0.9P(0, 2) =
0.9
= 0.005976 .
1.0252
1.035
ACTS:4130 (22S:174) Fall 2014
Assignment 3 Suggested Solutions

-11-

Remark 9. To buy the 3-year forward bond in the market is not the same as buying a 3-year
ZCB at time 2. Why?
Remark 10. How would you design the arbitrage strategy if you only want to earn arbitrage
profits at time 2? At time 5?
11. Solution.

(a) The 3-year swap price is

R=

20/1.06 + 21/1.0652 + 22/1.073

= 20.9519 .
1/1.06 + 1/1.0652 + 1/1.073

(b) The required swap price is

R=

21/1.0652 + 22/1.073
= 21.4808 .
1/1.0652 + 1/1.073

(c) To hedge your position, you should sell each of the 1-year forward, 2-year forward and
3-year forward on oil. The hedged cash flows are:
Year
1
2
3

Swap payoff
S1 20.9519
S2 20.9519
S3 20.9519

Short forward payoff

20 S1
21 S2
22 S3

Net cash flow

0.9519
0.0481
1.0481

The present value of the locked-in net cash flows is

0.9519 0.0481 1.0481
+
+
= 0.
1.06
1.0652
1.073
(d) As the fixed-price payer, you have, relative to the forward price:
Overpaid 0.9519 after the first swap settlement.
Cumulatively overpaid


1.0652
0.0481 = 0.97046
0.9519[1 + r0 (1, 2)] 0.0481 = 0.9519
1.06
after the second swap settlement.
Cumulatively overpaid
1.073
0.97046[1 + r0 (2, 3)] 1.0481 = 0.97046
1.0652


after the third swap settlement.

12. Why is there no solution for Question 12!?!?!?

** END OF SOLUTIONS **
ACTS:4130 (22S:174) Fall 2014
Assignment 3 Suggested Solutions

-12-


1.0481 = 0