Exam 1_2013 Spring

MGMT 476 -- Derivatives 2:00 PM to 3:15 PM, February 7, 2013 (Thursday) Name (print): _________________________

Instructions
1. Please read the problems carefully and make sure you provide answers to all parts of problems. You have an option to choose 5 out of 6 calculation problems. Add a mark X to the calculation problem you will not work out. Alternatively, the grade for calculation problems can be the sum of the points from 5 numerical problems with higher points received (i.e., dropping the calculation problem with the lowest point received). 2. Use the last page as scratch paper. 3. Please do not talk to or exchange notes with any other students. 4. Please turn off your cell phone(s).

Numerical Problems (100%, please choose 5 out of 6 problems and add a mark X to the problem that you will not work out. Detail procedures must be provided):
1. (20%) The current stock price of CBOE (CBOE Holdings, the holding company for Chicago Board Options Exchange) is $26.87. CBOE March 26 put price is $1.00. Don has an original balance of $4,000 in his brokerage account. He expects that the stock price of CBOE will become either $23 (75% chance) or $29 (25% chance) at option expiration. Based on this expectation, Don buys 20 CBOE put option contracts for the purpose of speculation. (a) (4%) How much ($) does Don pay for buying 20 put option contracts (ignoring commission)? (b) (4%) During the trading hours of the next trading day, the stock price of CBOE is $26.32. The corresponding put option premium is $1.11. If Don decides to close (sell) all of his option positions at this put option price, calculate his net profit/loss (in $, ignoring commission). (c) (4%) If Don holds 20 put option contracts to option expiration, and the stock price of CBOE is $23 at that time, what is Dons net profit/loss (in $) at expiration? (d) (4%) If Don holds 20 put option contracts to option expiration, and the stock price of CBOE is $29 at that time, what is Dons total balance (in $) of his account at option expiration? (e) (4%) Based on Dons expectations as described above, what is the expected total balance of Dons brokerage account at expiration if he buys 20 CBOE put options? Answers: (a) 1.00*100*20 = $2,000 (b) (1.11-1.00)*100*20 = $220 (c) 2,000*[max(0, X-S)-P] = 2,000*(26-23-1.00) = 4,000 Note: The total balance = (4000-2000)+2000*max(0, 26-23) = 8,000 (d) The total balance = (4000-2000)+2000*max(0, 26-29) = 2,000 (e) The expected total balance = 75%*8000+25%*2000 = 6,500

2. (20%) Don bought 100 shares of CBOE at $25.5/share a few days ago. The current market information is: CBOEs stock price = $26.87; CBOE March 26 put price = $1.00. Don buys one put option contract today to hedge his stock position. (a) (6%) Find the breakeven stock price for the protective put strategy (100 shares and one put). (b) (4%) If CBOEs stock price = $23/share at expiration, calculate Dons return (%) in terms of both the final portfolio value at option expiration and the total cost (long 100 shares and one put option contract). (c) (4%) Without buying the put option contract, calculate Dons return (%) for buying CBOE shares if CBOEs stock price = $23/share at expiration (long 100 shares only). (d) (6%) Find the maximum loss ($) at expiration for the protective put strategy. Answers: (a) The net profit at option expiration = 100S+max(0, 26-S)*100-25.5*100-1*100 = 100*max(S, 26)-2650 Net profit (NP) = 100*(max(S, 26))-2650 = 0 max(S,26)=26.5 Case: S>26 S=26.5 Case: S<26 26=26.5 (no solution) (b) S=23 NP=100*max(23,26)-2650=2600-2650=(-50) (-50)/2650 = -1.89% (c) S=23 (2300-2550)/2550 = (-250)/2550 = -9.80% (d) Find the maximum loss: If S26 Net profit = 100*max(S, 26)-2650 = 100S-2650 (-50) If S<26 Net profit = 100*max(S, 26)-2650 = 2600-2650 = (-50) The maximum loss = (-50)

3. (20%) Don bought 100 shares of CBOE at $26.10/share a few days ago. The current market information is: CBOEs stock price = $26.87; CBOE March 26 put price = $1.00. CBOE March 28 call price = $0.80. Don buys one put and sells one call option contract today to hedge his stock position. (a) (4%) Find the portfolio value (long 100 shares, long one put, and short one call) if CBOEs stock price = $30/share at expiration (ignoring commission). (b) (6%) Find the breakeven stock price for the collar hedging strategy (long 100 shares and one put, short one call). (c) (6%) If CBOEs stock price = $21/share at expiration, calculate Dons return (%)

considering both the final payoff at option expiration and the total cost (long 100 shares
and one put option contract, short one call option contract). (d) (4%) Without using any option contract, calculate Dons return (%) for buying CBOE shares if CBOEs stock price = $21/share at expiration (long 100 CBOE shares only). Answers: (a) The portfolio value at option expiration = 100S+Max(0, 26-S)*100-Max(0, S-28)*100 = 100*[Max(S, 26)-Max(0, S-28)] S=30, portfolio value = 100*(30-2) = 2,800 (b) Total cost = 26.1*100+ 1.00*100-0.80*100 = 2,630 net profit = 100*[max(S,26)-max(0, S-28)]-2630 = 0 [max(S,26)-max(0, S-28)] = 26.3 Case: S<26 26-0 = 26.3 (no solution) Case: 26S<28 (S-0) = 26.3 S=26.3 Case: 28S S-(S-28) = 26.3 no solution (c) S=21 net profit = 100*[max(S,26)-max(0, S-28)]-2630 = 2600-2630 = (-30) (-30)/2630 = -1.14% (d) S=21 (2100-2610)/2610 = -19.54%

4. (20%) The current stock price of CBOE is $26.87. Don sells one CBOE March 26 call option contract at $1.55 and simultaneously sells one CBOE March 26 put option contract at $1.00. (a) (4%) What is Dons cost or gross revenue ($) when he sells one put and sells one call? (b) (6%) Calculate Dons net profit/loss from his strategy (selling 1 put and selling 1 call with the same strike price) if CBOEs stock price = $28/share at expiration. (c) (6%) Find two breakeven stock prices for his strategy. (d) (4%) For each breakeven point, calculate CBOEs stock return (%) from the current stock price to the breakeven stock price. Answers: (a) (Selling 1 call and selling 1 put) (1.55+1.00)*100 = 255 (revenue) (b) Net profit/loss = -max(0, S-26)*100-max(0,26-S)*100+255 If S=28, NP = (-200)+255 = 55 (c) Large up move (S>26) (-S+26)*100+255=0 S=26+2.55 = 28.55 Large down move (S<26) (-26+S)*100+255=0 S=26-2.55 = 23.45 (d) (28.55-26.87)/26.87 = 6.25% (23.45-26.87)/26.87 = -12.73% Note: This strategy (writing a straddle) applies to the situation of expecting small volatility.

5. (20%) Alex would like to speculate on a possible rise in the stock price of FB (Facebook). The current stock price of FB is $29. Alex expects that in one year the stock price of FB will be either $40 (up move) or $20 (down move). The exercise price of one-year European call option of FB=$30 and risk-free rate r=2% per annum. Alex would like to construct a portfolio with the stock and cash from borrowing to replicate the payoff of 200 units (2 contracts) of European call options of FB. (a) (6%) How many shares of FB does Alex need to buy now? (b) (4%) How much ($) does Alex need borrow now? (c) (4%) Calculate the percentage margin (Note: percentage margin=(equity)/(value of stock)). (d) (6%) Calculate the current price of European call option of FB (per unit) in the binomial setting. Answers: (a) Gross payoff per unit (up) = max(0, 40-30) = $10; Gross payoff per unit (down) = max(0, 20-30) = $0; 200*Cu=n*Su+B(1+r)......(1); 200*Cd=n*Sd+B(1+r)......(2) Take difference; n=200*(10-0)/(40-20) = 100 (purchasing shares) (b) From Equation (2), 200*0=100*20+B*1.02 B=(0-100*20)/1.02 = -$1,960.78 (borrowing money) (c) Assets Value of stock = Number of shares*current price Liabilities and Owners Equity Loan from broker Equity (net worth) = value of stock loan

Percentage margin = (Equity)/(Value of stock) = (Value of stock loan)/(Value of stock) Percentage margin = (100*29-1960.78)/(100*29) = 32.39% (d) Future payoff (buying 100 shares of FB + a loan) = future payoff (200 FB call options) Current value (buying 100 shares of FB + a loan) = current value (200 FB call options) (100*29-1960.78)=200*C C= $4.6961

6. (20%) The current stock price of FB is $29. Alex expects that in one year the stock price of FB will be either $40 (up move) or $20 (down move). The exercise price of one-year European put option of FB=$30 and risk-free rate r=2% per annum. Also, investors can freely trade (either buy or short sell) the GS fund, {200 units of FB European put option + 200 shares of FB stock}, and the MS fund, { N shares of FB stock + risk-free one-year CD with original investment $B} in the market. That is, no arbitrage opportunity exists. (a) (4%) Find the gross payoffs ($) of the GS fund in the up and down move, respectively. (b) (6%) The GS fund and MS fund have the same future payoffs in one year. Find the values of N and B. (c) (4%) Calculate the current price ($) of European put option of FB (per unit). (d) (6%) If the GS fund is perfectly equivalent to the MS fund, then we can see {200 units of FB European put option}={short sell Y shares of FB stocks + cash $C}. Use this idea to calculate the equivalent percentage margin (%) for 200 units of FB European put option. (Note: percentage margin=(equity)/(short position)). Answers: (a) Gross payoff (up) = 200*max(0, 30-40)+200*40 = 8,000; Gross payoff (down) = 200*max(0, 30-20)+200*20 = 6,000; (b) 8,000=N*Su+B(1+r)......(1); 6,000=N*Sd+B(1+r)......(2) Take difference; N=2,000/(40-20) = 100 From Equation (1), 8,000=4,000+B*1.02 B=4,000/1.02= $3,921.57 (saving) (c) Future payoff {200 units of FB European put option + 200 shares of FB stock} = future payoff {100 shares of FB stock + risk-free one-year CD with original investment $3,921.57} Current value {200 units of FB European put option + 200 shares of FB stock}=current value {100 shares of FB stock + risk-free one-year CD with original investment $3,921.57} (200*P+200*29)=100*29+3921.57 P=(3921.57-100*29)/200=5.1079 Note: Put-call parity (P+S) = [C+X/(1+r)^(T)] (5.1079+29)=34.1079=4.6961+30/1.02 (Call option price is taken from Question 5.) (d) From part (c), 200P=(3921.57-100*29) = cash-100*S0 Assets Cash Liabilities and Owners Equity Short position on stock = Number of shares*current price Equity (net worth) = Cash short position Equivalent percentage margin = (Equity)/(Short position) = (Equity)/(Value of stock short) Percentage margin = (3921.57-100*29)/(100*29) = 35.23%

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