Past exam questions 1 Solutions

George O. Aragon

1. a. Call XYZ appears to be relatively underpriced (lower implied volatility). Should

therefore buy XYZ and (to hedge the resulting stock exposure) sell Call ABC.
b. The lower strike price call has higher delta. So if you buy XYZ and sell an equal
number of ABC calls, you will end up delta negative. You need more positions in
the call option with the lower value of delta. This is XYZ.
c. The at-the-money option will have higher gamma. Because you sold ABC, you
are short gamma. If the stock price moves a lot in either direction, you will lose
money.
d. The possibility of jumps means that the difference in implied volatilities does not
mean the options are necessarily mispriced. Jumps can lead to option smirks,
exactly like the one observed. There may not be any relative mispricing here, so
the strategy in (a) may not be called for.
2.

121

121

110
100

Cu
99

90

99
Cd

81

a. p = = .75
Cu =

= 110

Cd =

= 70.714

C =

= 95.408

b. Hedge ratio = = 5.5

c. Elasticity = = 7.0
3. a. Put B. The lower strike price put would sell for less if it had the same implied
volatility. Its price is higher, so it must sell at a higher implied volatility.
b. Call B must have the higher implied volatility. If Call B had the same implied
volatility as Call A, its price would be no more than $5 greater than that of Call A: Bs
strike price is only $5 lower. Since Call Bs price is actually $6 greater than Call As,
its implied volatility must be higher.

c. The put has higher implied volatility. At the money call prices should be higher than
at the money puts if all other terms are the same (e.g., strike price, expiration). The
prices are actually equal.
d. Call B. The stock price and exercise price are both half the level of that of call A. At
equal implied volatilities, the price of option B would be one-half that of A as well,
but it is actually greater than this value.
4.
Period

FRA Rate

Spot Rate

0x1

2%

1x2

3%

2x3

4%

B
w
0.98039215 0.3443044
2.00%
7
48
0.95183704 0.3342761
2.50%
5
64
0.91522792 0.3214193
3.00%
8
88
2.84745713
1
1

SFR

2.98%

5. Yes, there is an arbitrage opportunity. One can create a riskless bond synthetically by
purchasing the corporate bond yielding 6% and a CDS on the same bond at a cost of
1.5%. The net yield on the synthetic riskless bond would be 4.5% (=6%-1.5%),
which is greater than the yield on the riskless bond (=4%). The arbitrage would
involve borrowing at 4% and investing in the synthetic riskless bond yielding 4.5%.
6.
u

1.2

0.8

105
0.0
5

0.625

Stock price
tree
144.
00
120.0
0
96.0
0

100.00

9.055
95

80.00
64.0
0

European put tree

0.00
3.21
9.06
9.00
20.00
41.0
0

American put
tree
0.00
3.21
10.84

9.00
25.00
41.0
0

7. a.

(i) Payoff to the stop-loss strategy: At time T, your proceeds will be ST if you never
cross the boundary (since you will continue to hold the stock), and X if you cross
the boundary (since you will then put all your money into bills that will mature to
X).
(ii) Payoff to the DOC strategy: The call will pay off max(ST X, 0) if you
never cross the out-boundary, and 0 if you do. Your bills will mature to X. The
total payoff is therefore, X plus and additional amount of max(ST X, 0) if you
never cross the boundary. For any stock price path, this portfolio will have the
same payoff as the stop-loss strategy.

b.

Because the payoffs are identical, there is a parity relationship that equates the
costs of establishing the two strategies:
S0 = PV0(X) + DOC
This implies that the value of the down-out call, DOC, equals S0 PV0(X). This
value is independent of variance, which is the surprising result. The result occurs
because volatility cuts two ways: it makes good outcomes more likely, but also
makes the probability of hitting the out boundary higher.

c.

If the stock price can jump below the out boundary, then strategy (ii) still provides a
guarantee that the payoff will equal X (you still hold bills with face value X), but
strategy (i) no longer does (you can jump from above the boundary to below it
without having the chance to do the stop-loss sale). Therefore, the DOC strategy
pays off at least as much and possibly more than the first.

d.

From (c), the DOC strategy must be worth more, since its payoff is at least as
high as, and sometimes more than the other strategy. Therefore,
S0 < PV0(X) + DOC
DOC > S0 PV0(X)

8. d1 = = = .55

N(d1) = .709

The delta of the implied put option provided by the portfolio insurer is N(d1) 1 =
.291. So you sell .326 $10 million worth of stock equivalents to match the
delta of the desired put. The appropriate number of futures contracts to sell is
1.1 = 12.804 contracts.