Financial Products and Markets – Class – A.Y.

2017-18

Exercise 1
BBB bank issues a 2.5-year coupon bond with semi-annual coupons and the following coupon
schedule: during the first year the annual coupon rate is equal to 1%, then it increases to 1.5% during
the second year, and finally it increases to 2% in year 3. The principal of the bond is returned to the
holder at maturity. Today’s relevant yield curve (zero rates) is the following:
Time (years) Zero rates (%)
0.5 0.80
1 0.90
1.5 1.05
2 1.10
2.5 1.35
Assume that BBB bank’s credit spread is 100 bps over the zero curve reported above (constant over
different maturities). Based on the previous data, calculate:
(a) the value of the coupon bond; (2 pts.)
(b) the 6-month forward interest rates consistent with the current zero-curve; (2 pts.)
(c) the value of a 12×18 FRA with a 1.10% fixed rate and principal equal to €1 mln; (2 pts.)
(d) the par rate with maturity 1 year. (2 pts.)

Solution.

(a) The present value of the coupon bond is obtained as cumulating discounted cash flows as
follows:
Time (years) Zero rates (ZR) ZR + spread CFs DCFs
0.5 0.80% 1.80% 0.5 0.4955
1 0.90% 1.90% 0.5 0.4906
1.5 1.05% 2.05% 0.75 0.7274
2 1.10% 2.10% 0.75 0.7193
2.5 1.35% 2.35% 101 95.2698
We find B0 = 97.7027.
(b) The 6-month forward curve follows:
Time (years) Zero rates Frw rates
0.5 0.80% 0.80%
1 0.90% 1.00%
1.5 1.05% 1.35%
2 1.10% 1.25%
2.5 1.35% 2.35%
(c) The 12×18 FRA is worth:

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 V0 
1.35%  1.1%  / 2  €1 mln  €1,230.52
1  1.05%/2 3
(d) The par rate with maturity 0.5 year is equal to the spot rate, i.e. 0.80%. The par rate with
maturity 1 year is found imposing:

c 1 1  1
1   2 

2  1  0.8% / 2  1  0.9%/2   1  0.9%/2 2

yielding c = 0.8998%.

Exercise 2
It is now the end of February 2016. You are the financial risk manager of a chemical company,
whose naked position is short on 2,500 tonnes of lead, to be used for production of lead-acid
batteries. In fact, the company will have to buy lead at the end of June 2016, and you are concerned
about the market price of the metal in 4 months time. To hedge your spot position you enter the lead
futures market. Each futures contract exchanges 25 tonnes of lead. Spot and futures prices (per tonne)
of traded contracts as of February 2016 are provided in the following table.
Date Feb-2016 Jun-2016
Spot price ($) 1,872.0 1,822.0
Mar-2016 futures price ($) 1,875.3
Sep-2016 futures price ($) 1,896.9 1,833.1
Using these data:
(a) devise a hedging strategy (number of contracts and maturity) for your company; (2 pts.)
(b) compute the current term structure (i.e., for Mar- and Sep-2016 futures contracts) of net carry
costs; (3 pts)
(c) compute the profit and loss of the naked position, the hedging position, and the overall
hedged position as of the end of June 2016, i.e. at the time when the hedge is lifted. (3 pts.)

Solution.

(a) The hedging strategy is to enter 100 long futures contracts on lead with maturity September
2016 (current futures price = $1,896.9). If the spot price of lead rises (decreases), as of
September 2016, you will lose (profit) on the spot position and profit (lose) on the futures
position.
(b) For the March-2016 contract the following spot-forward relationship holds:

1,875.3  1,872.0 expc  1 / 12

where c stands for the net cost of carry (i.e., r + u – y). It follows that c = 2.11%. For the
September-2016 contract the same reasoning leads to c = 2.27%.
(c) At the end of June 2016, the spot price of the metal has decreased to $1,822.0. Relative to the
spot price in February 2016 the P&L is:

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 P & L(naked)  1,872.0  1,822.0  25 tonnes 100 contracts  $125,000
The P&L on the futures position is:

P & L(futures)  1,833.1  1,896.9  25 tonnes 100 contracts  $159,500

The P&L on the overall hedged position is –$34,500.

Exercise 3
According to the terms of an interest rate swap (IRS), your company has agreed to pay 3.5% per
annum and receive 3-month LIBOR in return, on a notional principal of €100 million, with payments
being exchanged every 3 months. The swap has a remaining life of 9 months. Assume that the last
payment of the swap has just occurred. The present IRS curve for maturities up to 1 year is flat at the
level of 3.1%. Based on the previous data, calculate:

(a) the future expected cash flows in accordance to the IRS (as if forward rates realize); (3 pts.)
(b) the present value of the IRS; (3 pts.)
(c) the change in the value of the IRS in response to a parallel upward shift of the par curve
equal to 40 bps for all maturities. (2 pts.)

Solution.

(a) The fixed payments are equal to:

100  3.5%  14  €0.875 mln

The floating payments are equal to (the par curve—and hence the zero and the forward
curve—is flat):

100  3.1%  14  €0.775 mln

Future net cash flows to the payer are equal to – €0.100 mln.

(b) The IRS is a portfolio of a fixed-rate bond (short) and a floating-rate bond (long). The latter
has a present value of 100. The former has a present value of:

3 .5 / 4 3 .5 / 4 3.5 / 4  100
V0   2
  100 .2954
1  3.1% / 4 (1  3.1% / 4) (1  3.1% / 4) 3
The present value of the IRS to the payer is – 0.2954% of the notional, i.e. – €0.2954 mln.

(c) The par curve increases to the level of 3.5% for all maturities. Since this is exactly the
original IRS rate, the value of the IRS is now zero. This means that the contract acquires
value for the payer by an amount equal to €0.2954 mln. (Please note that this answer
assumes that the floating rate to be exchanged in 3 months’ time is automatically updated. If
not, and there is a 3-months reset period, the value of the swap is slightly negative to the
payer, and equal to the next payment discounted.)

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Exercise 4
You are provided with the following information on the price of European call and put options
written on stock FPM as of May 30, 2016 (figures are expressed in $ cent, ¢):
Calls Puts
Strike Jun Sep Dec Jun Sep Dec
750 31 48.5 65 7.5 29.5 37
800 7.5 25 41 35 58.5 65
The stock currently trades at ¢771, and the size of the trading unit is 1,000 shares. Using these data:
(a) draw the profit diagram (including the relevant break-even point and the maximum loss) for
an investor who buys a September call struck at ¢800; (4 pts.)
(b) devise a plain-vanilla hedging strategy for an equity portfolio manager who is long 100,000
shares of stock FMP, with a 4 months horizon, and the aim of minimizing the hedging cost;
(2 pts)
(c) regarding the previous point, draw the profit and loss diagram of the naked position, the
hedging position, and the overall hedged position at the time when the hedge is lifted. (2 pts.)

Solution.

(a) The profit diagram follows (the unit of measure is ¢). The break-even point is ¢825, while the
maximum loss, considering a trading unit of 1,000 shares, is $250.

(b) The plain-vanilla hedging strategy is to buy 100 September put options. Since the aim is
buying the cheapest options, it is the ¢750 strike price that matters. The hedging cost is ¢29.5
per share.

(c) At the end of September 2016 the profit to the hedging position is:

P & L(put) max750 S,0  29.51,000100contracts

The P&L on the naked position is:

P & L(naked) S  771 100,000shares

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 The P&L on the overall hedged position is:

P & L(hedge)  max750, S   800.5 1,000 100 contracts

Exercise 5
As a fixed-income portfolio manager, you are currently in charge of two portfolios, A and B.
Portfolio A is composed of a long 1-year zero-coupon bond with a face value of €20,000, and a long
10-year zero-coupon bond with a face value of €60,000. Portfolio B consists of a short zero-coupon
bond expiring in 6.04 years, with a face value of €50,000. The current yield-to-maturity to all bonds
is 10% per annum. Based on this information, calculate:

(a) the modified duration of portfolio A and portfolio B; (3 pts.)

(b) the dollar duration of portfolio A and portfolio B; (2 pts.)
(c) the change in the value of the overall portfolio (i.e., portfolio A plus portfolio B) in response
to a positive 130 bps change in the yield-to-maturity for all bonds, according to the
approximation provided by modified duration. (3 pts.)

Solution.

(a) The current value of portfolio A is €41,314.42, i.e. the sum of €18,181.82 (the 1-year ZCB:
quoted price 90.91) and 23,132.60 (the 10-year ZCB: quoted price 38.55). The modified
duration of the first bond is 0.91 years (= 1/(1 + 10%)), while the modified duration of the
second bond is 9.1 years (= 10/(1 + 10%)). The modified duration of portfolio A is the
weighted average of the modified duration of the two bonds, i.e. 5.49 years. The current
value of portfolio B is €28,118.98, and its modified duration is equal to 5.49 years (= 6.04/(1
+ 10%)).

(b) The dollar duration of the first and second bond of portfolio A is €16,528.93 and
€210,296.34, respectively. The dollar duration of portfolio A is the sum of the two, i.e.
€226,825.27. The dollar duration of portfolio B is €154,373.21.

(c) The change in the value of portfolio A is a loss of €2,948.73 (= 1.3% × 226,825.27). The
change in the value of portfolio B is a gain of 2,006.85 (= 1.3% × 154,373.21). Overall, you
experience a net loss of €941.88.

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Exercise 6

Consider a put option written on the stock Telecom Italia and traded at the Italian Derivatives
Market. The option has a strike price of €0.95, it expires in 4 months time, and it is written on 1,000
shares of stock. The current market price of the option is €0.0295, while the current market price of
the underlying is €1.12. You assume that the 4-month risk-free rate is 0.05%, and that the underlying
stock does not pay any dividends between today and the option expiration date. According to Black
and Scholes pricing formula, the implied volatility of the underlying stock is equal to 38%. Using
these data:
(a) draw the profit diagram (including the relevant break-even point and the maximum loss) for
an investor who buys this put option; (Hint: remember that the trading unit is 1,000 shares) (3
pts.)
(b) compute the market price of the corresponding call option (i.e., same underlying, maturity
and strike price), assuming that the implied volatility is unchanged; (2 pts)
(c) draw the profit diagram (including the relevant break-even point and the maximum loss) of
the straddle with the above call and put options (i.e., a long call option plus a long put option,
same strike and maturity). (3 pts.)

Solution.

(a) The payoff and the profit diagrams follow:

(b) Applying the put-call parity, the price of the corresponding call option is:

C  P  S  PV(k )  0.0295 1.12  0.95/(1  0.5% / 3)  €0.1997

(c) The profit diagram of the straddle follows:

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Exercise 7
Eight years ago a US subsidiary of your Italian company operating in Tennessee took up a $10
million bank loan, with 10 years maturity, fixed rate of interest equal to 6% per annum, and interest
paid twice a year. Assume for simplicity that the loan is of bullet type, i.e. the principal is not
amortized, and the company has to pay the principal back in full to the bank at the maturity of the
loan. The current EURUSD exchange rate is equal to $1.10. The following table shows the current 1-
year interbank rates in EUR and USD:
12 months
LIBOR (USD) 1.5%
LIBOR (EUR) 1.0%
Based on this information, calculate:

(a) the forward EURUSD exchange rate with 1-year maturity; (3 pts.)
(b) the expected payment in EUR to be made 1 year hence according to the terms of the loan,
assuming that the current forward exchange rate is the unbiased predictor of the future spot
exchange rate. (2 pts.)
Now assume that your company wishes to hedge its future cash flow (occurring 1 year hence) against
exchange rate fluctuations, and chooses to buy an ATM option, with a premium equal to 4.5% of the
value of the underlying asset. With this information, calculate:
(c) the future level of the EURUSD exchange rate which will allow your company to fully
recover the premium paid for the option (i.e., the break-even exchange rate). (3 pts.)

Solution.

(a) Applying the spot-forward relationship we obtain: F01 = 1.10 (1 + 1.5%)/(1 + 1.0%) =
$1.1054. Since the interest rate differential between USD and EUR is positive, the dollar
embeds a forward depreciation.

(b) The next payment is equal to $300,000 (= $10,000,000 × 6%/2). If F01 = E(S1), the expected
payment is equal to €271,394.97 (= 300,000/1.1054).

(c) The premium your company pays to buy the USD call option is equal to $13,500 (= 4.5% ×
$300,000), or €12,272.73 at the current exchange rate of $1.10. Say that the dollar
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 depreciates up to an exchange rate of X; if so, the positive P&L to your company’s naked
position is equal to: €272,727.27 – $300,000/X, where €272,727.27 is the value of $300,000
at the current exchange rate of $1.10. Equate this P&L to the option’s premium, i.e.
€12,272.73, to find X = $1.1518.

Exercise 8

Your company enters a €15 million notional interest rate swap. The swap calls for your company to
pay a fixed rate and receive the LIBOR. The payments will be made every 3 months for 1 year. The
term structure of LIBOR rates when the swap is initiated is the following.
Months Rate, %
3 1.00
6 1.25
9 1.45
12 1.55
With this information, compute:

(a) the fixed rate on the swap; (3 pts.)

(b) the first net payment to be made in 3 months according to the swap. (2 pts.)
Assume that it is now 9 month into the life of the swap, and that the third quarterly payment has just
been made. The new term structure of LIBOR rates has declined in a parallel manner by 35 bps
relative to that prevailing 9 months ago. With this information, calculate:
(c) the value of the swap. (3 pts.)

Solution

(a) Using the bond portfolio approach to IRS pricing, we write: 1 = (rIRS/4) × ΣZ(0, t) + Z(0, 1),
where the index of the sum is t = ¼ : ¼ : 1. Hence: rIRS = 4 × [1 – Z(0, 1)]/ΣZ(0, t). The
discount factors are:
Months Z(0, t)
3 0.9975
6 0.9938
9 0.9892
12 0.9846
and hence rIRS = 1.5486%.

(b) The first net payment is known as of today. It is equal to: (1% – 1.5486%)/4 × €15 million =
– €20,572.

(c) There is just 1 payment left. The relevant 3-month LIBOR is equal to 0.65%, and the last
payment (to be made in 3 months) is equal to (0.65% – 1.5486%)/4 × €15 million = –
€33,697. Discounting this payment at the current 3-month LIBOR yields – €33,643, the
current value of the swap.

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Exercise 9

You are considering a 6-months ATM European call option written on 100 stocks, each of them
worth €10. The stock has annual implied volatility of 20% and is expected to pay no dividend during
the next 6 months. The risk-free rate is 5% per annum (continuously compounded). The relevant
parameters of Black and Scholes pricing formula are N(d1) = 0.5977 and N(d2) = 0.5422. With this
information, compute:
(a) the current market value of the option. (2 pts.)
Assume now that you want to create a portfolio including both the European call option and its
underlying stock, in a way such that this portfolio is instantaneously risk-free. With this information:
(b) describe the composition of such portfolio and compute its current value; (Hint: remember
that each option is written on 100 stocks, and that it is not possible to trade a fraction of 1
stock) (3 pts.)
(c) compute the (approximate) 1-day change in the value of such portfolio, assuming that the
stock price rises by 5 percent. (3 pts.)

Solution

(a) The application of BS pricing formula leads to €0.6889 (= €10  0.5977 – €10  exp(–5%/2)
 0.5422) per share, hence a call option (written on 100 stocks) is worth €68.89.

(b) The portfolio may be composed of 1 short call option (written on 100 shares) and a long
position in 60 (= 59.77 rounded up) shares of stock. Its current value is P0 = 60  €10 –
€68.89 = €531.11.

(c) If S goes up to €10.5 the value of the call option also increases to €98.78 (= €68.89 + 0.5977
 €0.5  100). The value of the portfolio is then equal to €531.22 (= 60  €10.5 – €98.78).
There is a slight difference with respect to the previous value (€531.11), due to the rounding
of the number of shares included. The portfolio is hence hedged.

Exercise 10

Your company is exposed to interest rate risk, as a large portion of its cost of debt is indexed to
floating interest rates. To hedge the overall risk exposure, the risk manager enters a €20 million
notional principal interest rate swap. According to this swap, your company will pay a fixed rate of
2% and will receive the Euribor. The payments will be made every 12 months, for 5 years. The
current term structure of Euribor rates is the following:
Maturity (years) Rate (%)
1 1.5
2 1.8
3 2.5
4 3.0
5 2.6
With this information, compute:
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 (a) the upfront paid by your company to enter into the swap, assuming that the bank also charges
an immediate fee equal to 0.5% of the contract’s notional. (4 pts.)
Assume now that the company decides not to hedge immediately, but to wait instead for 12 more
months. Suppose also that the future term structure of Euribor rates 12 months from now is equal to
the current one plus a parallel shift of 20 bps. With this information, calculate:
(b) the IRS rate for a 4-year swap prevailing 12 months from now. (4 pts.)

Solution

(a) Using the bond portfolio approach to IRS pricing, we compute the fixed leg of the swap as
follows (figures in € million):
Maturity (years) Fixed leg Discounted fixed leg
1 -0.4 -0.3941
2 -0.4 -0.3860
3 -0.4 -0.3714
4 -0.4 -0.3554
5 -20.4 -17.9429
and the value of the fixed leg is – 19.4498 million. Since the value of the floating leg is + €20
million, the current value of the swap is + €0.5502 million. The bank fee is equal to €0.10
million. Hence, the upfront paid by the company is equal to €0.6502 million.

(b) The term structure 12 months from now will be:

Maturity (years) Rate (%)
1 1.7
2 2.0
3 2.7
4 3.2
5 2.8
The 4-year IRS rate is the par rate implied by the current term structure of Euribor rates. It
found through the identity Bfix = Bfloat, where Bfloat = 1. Solving for rIRS(0, 4) we find 3.16%.

Question 1

Illustrate Black’s (1975) approximation for computing the value of an American call option written
on a dividend-paying underlying stock.
Answer. Black and Scholes (1973) formula cannot accommodate the case of an American call option
written on a dividend-paying stock. The reason is that for such an option the early exercise right has
value. In fact, since the payment of a dividend decreases the value of the underlying, and hence that
of the corresponding call option, it may be optimal to exercise the American call option right before

10
the payout date: you lose the residual time value, but you cash in the dividend. Black (1975) proposes
an easy approximation method to price such American call option. Suppose that the dividend date is t
> 0, and that T is the option expiry. The first step is to price a European call option written on S and
expiring at t – dt, say C1. The second step is to price a European call option written on S* and
expiring at T, say C2. Here S* is equal to S minus the PV@r of the future (deterministic) dividend.
Finally, the approximate American call option value can be found as max{C1, C2}.

Question 2

Explain the difference between the forward price and the value of a forward contract.
Answer. The forward price of an asset today is the price at which you would agree to buy or sell the
asset at a future time. The value of a forward contract is zero when you first enter into it. As time
passes the underlying asset price changes and the value of the contract may become positive or
negative.

Question 3

Illustrate how it is possible that the price of a European put option is a decreasing function of its
time-to-maturity.
Answer. The price of the European put option decreases as the time-to-maturity increases when it is
very deep-in-the-money. In this situation it is better to have a short-life European option than a long
life European option. The strike price is almost certain to be received and the earlier this happens the
better. If the put option were of American type, in this case, it would be optimal to exercise it early.

Question 4

Explain what the cost of carry is for (a) a non-dividend-paying stock, (b) a stock index, (c) a
commodity, and (d) a foreign currency.
Answer. The cost of carry is: (a) the risk-free rate, (b) the excess of the risk-free rate over the average
dividend yield of the stocks in the index, (c) the risk-free rate plus the storage cost net of the
commodity’s convenience yield, (d) the excess of the domestic risk-free rate over the foreign risk-
free rate.

Question 5

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Rationalize the upper and lower bounds for the price at time t of a European put option on a non-
dividend paying stock maturing at T > t.
Answer. The upper bound of the American put price is the present value of the exercise price, PV(k).
This because the largest amount of cash the holder can get from the exercise of the option is k (when
S = 0 at maturity); hence PV(k) today. The lower bound of the American put price is the maximum
between PV(k) – S and zero. If not, there is an arbitrage to be exploited. Assume for instance that the
price of the European put is below this lower bound, that is P < PV(k) – S, when the put is ITM
(obviously it cannot be that P < 0). Hence, buy the put (– P), buy the share (– S), and borrow PV(k).
This yields a positive current cash flow (i.e., – P – S + PV(k) > 0). At the maturity of the option you
get zero if you exercise it (= get k, surrender the share, repay k), and something positive if you do not
exercise it (= sell the share at S > k, let the option expire OTM, and repay k).

Multiple choice questions

(1) The modified duration of a bond portfolio worth €1 million is 5 years. By approximately how
much does the value of the portfolio decrease if all yields increase by 5 basis points?
(a) €2,500;
(b) €5,000;
(c) €1,000;
(d) none of the above.
(2) Which of the following is true about a long forward contract?
(a) The contract becomes more valuable as the price of the asset declines;
(b) the contract becomes more valuable as the price of the asset rises;
(c) the contract is worth zero if the price of the asset changes after the contract inception;
(d) none of the above is true.
(3) Which of the following is false?
(a) Futures contracts always last longer than forward contracts;
(b) futures contracts are standardized, forward contracts are not;
(c) forward contracts are OTC, futures contract are traded in a futures exchange;
(d) none of the above is false.
(4) A 1-year call option on a stock with a strike price of €30 costs €3. A 1-year put option on the
same stock with a strike price of €30 costs €4. Suppose that a trader buys 2 call options and 1
put option. The break-even stock price above which the trader makes a profit is:
(a) €35;
(b) €40;
(c) €30;
(d) none of the above.
(5) An interest rate is 6% per annum with annual compounding. What is the equivalent rate with
continuous compounding?
(a) 5.79%;
(b) 6.21%;

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 (c) 5.83%;
(d) none of the above.
(6) Which of the following does not describe an interest rate swap?
(a) The exchange of a fixed-rate bond for a floating-rate bond;
(b) a portfolio of forward rate agreements;
(c) an agreement to exchange interest at a fixed rate for interest at a floating rate;
(d) none of the above.
(7) Duration matching immunizes a portfolio against:
(a) all shifts in the yield curve;
(b) changes in the steepness of the yield curve;
(c) small and parallel shifts in the yield curve;
(d) none of the above.
(8) The frequency with which futures margin accounts are adjusted for gains and losses is:
(a) daily;
(b) weekly;
(c) monthly;
(d) none of the above.
(9) You enter into a futures contract to sell 50,000 units of a commodity for $0.70 per unit. The
initial margin is $4,000 and the maintenance margin is $3,000. What is the futures price per
unit above which there will be a margin call?
(a) $0.78;
(b) $0.75;
(c) $0.72;
(d) none of the above.
(10) The price of a stock is €67. A trader sells 5 put option contracts on the stock with a strike price
of €70 when the option price is €4. The options are exercised when the stock price is €69. Each
option contract is written on 100 shares. What is the trader’s net profit or loss?
(a) Loss of €1,500;
(b) loss of €500;
(c) gain of €1,500;
(d) none of the above.
(11) Suppose that there is an increase in dividends paid by the underlying asset before the maturity
of the option. Which one of the following is true, ceteris paribus?
(a) Both calls and puts increase in value;
(b) both calls and puts decrease in value;
(c) calls increase in value, while puts decrease in value;
(d) none of the above.
(12) Yield curves are commonly constructed from observations of prices and yields in the Treasury
market. This is because the Treasury market:
(a) embeds default risk;
(b) offers the fewest problems of illiquidity;
(c) is affected by infrequent trading;
(d) none of the above.
(13) The 2-year zero rate is 6% and the 3-year zero rate is 6.5%. What is the forward rate for the
third year? (Assume that interest rates are continuously compounded.)

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 (a) 6.75%;
(b) 7%;
(c) 7.25%;
(d) none of the above.
(14) Which of the following regarding margin accounts in futures trading is false?
(a) They reduce the risk of one party regretting the deal and backing out;
(b) they ensure that funds are available to pay traders when they make a profit;
(c) they reduce systemic risk due to collapse of futures markets;
(d) none of the above is false.
(15) As the convenience yield increases, which of the following regarding the 1-year futures price as
a percentage of the spot price is true?
(a) It increases;
(b) it decreases;
(c) it stays the same;
(d) none of the above, as any of the above can happen;
(16) What is the lower bound for the price of 1-year call option on a non-dividend-paying stock
when the stock price is $80, the strike price is $75, and the risk-free interest rate is 10% per
annum continuously compounded?
(a) $0;
(b) $5;
(c) $12.14;
(d) none of the above.
(17) Which of the following is true for an IRS?
(a) It is worth zero immediately after a payment date;
(b) It is worth zero immediately before a payment date;
(c) the floater underlying the IRS is worth par immediately after a payment date;
(d) none of the above.
(18) Which of the following is true for the party paying fixed in a newly negotiated IRS, when the
yield curve is upward sloping?
(a) The early FRAs underlying the swap have a positive value and the later ones have a
negative value;
(b) the early FRAs underlying the swap have a negative value and the later ones have a
positive value;
(c) the swap is designed so that all FRAs have zero value;
(d) none of the above, as sometimes answer (a) is true and sometimes answer (b) is true.
(19) An investor has exchange-traded put options to sell 100 shares for €20 (strike price). There is a
€1 cash dividend. The investor has then a position on:
(a) put options to sell 100 shares for €19;
(b) put options to sell 100 shares for €20;
(c) put options to sell 105 shares for €19;
(d) none of the above.
(20) If the price of a stock, S, follows a geometric Brownian motion, then:
(a) S is normally distributed;
(b) dS/S is normally distributed;
(c) dS/S is lognormally distributed;

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 (d) none of the above.
(21) Which of the following is true for the delta of a European call option () before its maturity (k
denotes the option’s strike price and S the current price of the underlying asset)?
(a) –1 <  < 0;
(b)  increases as the ratio S/k decreases;
(c)    as S  ;
(d) none of the above.
(22) Suppose that an infinitely risk-averse hedger (producer) is endowed with a mean-variance
utility function and that the production at time 1, Q1, is non-stochastic. His/her optimal short
futures demand will be (S1 and F1 denote the spot and futures price of the asset at time 1,
respectively):
(a) Q1;
(b) Q1 × cov(S1, F1)/var(F1);
(c) Q1 × [E(F1) – F0]
(d) none of the above.
(23) Suppose you borrow €1 from time 0 to time T > 0, and lend €1 from time 0 to time 0 < t < T. If
the (continuously compounded) current spot rates are r(0, t) and r(0, T), respectively, you have
locked-in a borrowing rate from time t to time T equal to:
(a) tr(0, t) – Tr(0, T);
(b) [Tr(0, T) – tr(0, t)]/(T – t);
(c) [r(0, T) – r(0, t)]/T;
(d) none of the above.
(24) The yield-to-maturity on a bond is:
(a) below the coupon rate when the bond sells at a discount, and above the coupon rate when
the bond sells at a premium;
(b) based on the assumption that any payments received are reinvested at the coupon rate;
(c) the discount rate that will set the present value of the payments equal to the bond price;
(d) none of the above.
(25) Which of the following best describes the intrinsic value of an option?
(a) the value it would have if the owner had to exercise it immediately or not at all;
(b) the Black-Scholes price of the option;
(c) the amount paid for buying the option;
(d) none of the above.
(26) The zero curve is downward sloping. Define “X” as the 1-year par yield, “Y” as the 1-year zero
rate and “Z” as the forward rate for the period between 1 and 1.5 year. Which of the following
is true:
(a) X is less than Y which is less than Z;
(b) X is less than Z which is less than Y;
(c) Z is less than Y which is less than X;
(d) none of the above.
(27) Consider a put option and a call option with the same strike price and time-to-maturity. Which
of the following is true?
(a) It is possible for both options to be in-the-money;
(b) one of the options must be in-the-money;
(c) one of the options must be either in-the-money or at-the-money;

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 (d) none of the above.
(28) Ceteris paribus, the duration of a bond is positively correlated with the bond’s:
(a) time-to-maturity;
(b) coupon rate;
(c) yield-to-maturity;
(d) none of the above.
(29) Which of the following dynamics describes a (risk-neutral) square-root CEV model for a stock
price, S (here, dz = ε dt½, with ε ~ N(0, 1))?
(a) dS/S = rdt + σdz;
(b) dS/S = rdt + σS–½dz;
(c) dS/S = rdt + σS–1dz;
(d) none of the above.
(30) The GBP/USD spot exchange rate is 0.7754 (GBP/USD). The 6-month risk-free rates in the US
and the UK are 1.4% and 0.42%, respectively (both expressed with continuous compounding).
What is the forward exchange rate in GBP/USD?
(a) 0.7716;
(b) 0.7792;
(c) 0.7830;
(d) none of the above.

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