1. Determine whether the following statements are true or false (20 points maximum).

For each
correct answer you receive 4 points, for an incorrect answer you receive -2 points.

A) For Black-Scholes formula to be valid, it is necessary that volatility smile does not exist.

T F

B) Bermudan option gives the right to be exercised early at some points before the maturity.

T F

C) Knock-in option has the payoff of the regular call, unless the asset price goes above barrier at
least once.

T F

D) Quantos are options with two or more sources of uncertainty

T F

E) In order to replicate butterfly spread we need to have options with three different maturities

T F

2. Suppose that the stock price follows the geometric Brownian motion process
dS = µ Sdt + σ SdW
S (0) = S 0

Suppose, further, that the risk free rate is r. Derive the price of an option that gives you the right
to receive at time t1 either a European call or a European put option with the strike price K. Time
to expiration of the option is T. 20 points

3. Today, you are looking to purchase the right that would allow you to purchase a call option at
time t=1 for 8 euros. Strike price of the call option that you may decide to purchase at time t=1 is
100. Today, the price of the underlying asset is 95. Assume that a two-period binomial tree is
valid, with u=1.2 and d=0.8, and R=1.1. Find the fair price of the option on option. 20 points

4. A currency swap has a remaining life of 15 months. It involves exchanging interest at 14% on 20
million British Pounds for interest at 10% on 30 million US Dollars once a year. The term
structure of interest rates in both the United Kingdom and the United States is currently flat, and
if the swap were negotiated today the interest rates exchanged would be 8% in dollars and 11%
in sterling. All interest rates are quoted with annual compounding. The current exchange rate
(dollars per pound sterling) is 1.6500. What is the value of the swap to the party paying sterling?
What is the value of the swap to the party paying dollars?

5. Suppose that the total value of a company (its debt plus equity) is a stochastic process that is
described by the following equation (assume Black-Scholes is valid, riskless interest rate is r)

dV = rVdt + σ VdW
V (0) = V0

Suppose that at time t=0 the company took a debt that it needs to repay at time t=T. At the time
of repayment, the company needs to pay a single cash flow equal to K. No other payments such
as coupons are due at any time. Find the expression for the (risky) debt payoff at the time of
maturity t=T. Find the value of the risky debt today. 20 points