Corporate Finance

Tutorial 6 Questions

Corporate Finance
Tutorial 6: Derivatives
Questions
Exercises on Derivative Assets: Properties and Pricing
1.

2.

The current value of a share in Robotronics is $12.50.

a.

The one-year riskless rate is 6% p.a. What are the prices of 3-year and 5year forward contracts on Robotronics stock?

b.

3-year forward contracts are currently being sold for $16 in the market.
Outline an investment strategy that could take advantage of the
opportunities this presents.

The current spot exchange rate is 0.64 = $1. The riskless rate in the UK is
currently 6% p.a. and that in the US is 4% p.a. Using the equation below, derive
the implied 5-year and 10-year forward exchange rates.
&1 + rd
Fk = S $
$%1 + r f

3.

4.

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a.

A one-period European call option on ABC stock has an exercise price of

$120. The current price of ABC stock is $100 and, if things go well, the
price in the following period will be $150. If things go badly over the
coming period, the future price will be $90. The risk-free rate is 10% p.a.
What is the no-arbitrage price of this option?

b.

Using the stock price data from the previous example, price a
European put option on ABC stock with a strike price of $100.

ABC Corporations shares currently sell at $17.50 each. The volatility of ABC
stock is 15%. Given a risk-free rate of 7% p.a., price a European call with strike
price of $15 and time to maturity five years. Use put-call parity to price a put with
similar specifications. What are the no-arbitrage prices of the call and the put if
the risk-free rate rises to 10% p.a.?

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Tutorial 6 Questions

Samples Examination Question on Derivative Assets

1.

Describe the main features of forward and futures contracts. How do forward and
futures contracts differ? Derive the no-arbitrage price of a forward contract.
[10%]

2.

Describe the main features of options contracts. Show how to price a standard
European call option using a single-period binomial model.
[10%]

3.

British Telecom shares are currently trading at 312p. Historically, the (annualised)
volatility of BT shares has been 20 per cent. Compute the Black-Scholes price of
a European call on BT equity, assuming a strike price of 350p and time-tomaturity of six months. Assume that the risk-free rate is 5 per cent.
[5%]

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Tutorial 6 Questions

FE 2007 Zone B Question A4

The price of a stock is currently 100 and each year the price either goes up by
30% or down by 10%, each equally likely. The risk free rate of return is 5% and
the expected rate of return on the market index is 10%.
a. What is the expected return on the stock? What is the beta of the stock?
(6 marks)
b. Derive the price of a one-year call option on the stock with exercise price
100, using an arbitrage argument.
(6 marks)
c. Using put-call parity, derive the price of a corresponding put option with
exercise price 100.
(6 marks)
d. Explain what would happen to your answers in (b) and (c) if the risk of
the stock is increased (i.e. keeping the expected return constant, the return
in the up state is greater than 30% and the return in the down state is less
than minus 10%).
(7 marks)

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Tutorial 6 Questions

FE 2008 Zone B Question A3(a)

Let F be the k-period forward price, and S the current spot price of the
underlying. The risk free interest rate is r. Derive the expression for the k-period
forward price.
(5 marks)

Corporate Finance

Tutorial 6 Questions

FE 2009 Zone B Question A1

(a)

Using the concept of the put-call parity, show how a risk-free position can
be created with options can an underlying stock. Indicate clearly this
strategy on a position diagram.
(5 marks)

(b)

You observe that the UK FTSE 100 index is currently standing at 4210 and
a 3-month futures contract on the index traded at 4,190. The dividend
yield on the index is 4.5% and the interest rate is 5% per annum. Derive a
formula for the theoretical futures contract price. Explain how you might
take advantage of the current situation. If the interest rate is unexpectedly
raised to 7.5% , explain clearly what might happen to the FTSE 100 index,
the futures contract price on the index and the relationship between the
index and the futures.
(10 marks)

(c)

Lindel plc specializes in manufacturing luxury chocolates. The market

price of Lindels shares is 10 each. A 6 month call option on Lindels
share has an exercise of 8. The standard deviation of Lindels share price
is estimated to be 20% a year and the risk-free interest rate is 15% per
annum. Using the binomial method, calculate the upside and downside
change for the next 6 months and the value of the call option. Determine
the option delta for the next 6 months when the share price rises.
(10 marks)

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Tutorial 6 Questions

FE2010 Zone B Question A1

(a)

Aroma Inc operates a chain of coffee shops in Singapore. Its shares

currently trade at S$5 each. A one-year call option on Aromas share has
an exercise price of S$4. The standard deviation of Aromas share is
estimated to be 20% a year, and the risk-free interest rate is 15% per
year. Using the Black-Scholes model, value the call option on Aroma
Incs share.
(5 marks)

(b)

Explain clearly how each of the determinants in the Black-Scholes

model might affect the price of a call option.
(10 marks)

(c)

Derive the upper and lower bounds on the price of a European put
option.
(10 marks)