This paper must be returned. Candidates are not permitted to remove any part of it from the examination room.

SEAT NUMBER....................................... ROOM:...................... STUDENTS SURNAME.............................................................. OTHER NAMES................................................................ STUDENT NUMBER........................................................

SAMPLE MID-YEAR EXAMINATION

Course Code: Course Name: Time and Date: Time allowed: Total No. of questions: Instructions Question 1 2 3 4 5 6 7 8 9 10 Total Marks /15 /15 /10 /10 /10 /25 /30 /20 /25 /20 /180
1. Attempt ALL questions in the space provided 2. Show all workings. 3. Handwriting must be legible. 4. You may write in pencil, but the preference is pen. 5. Non-programmable calculators without alphanumeric (text) capabilities may be used. 6. Dictionaries are NOT permitted. 7. No writing is permitted during the 10 mins reading time 8. Candidates are permitted to bring and utilise one single sided A4 page of hand-written notes. The page of notes must be submitted together with this exam paper, with name and student ID clearly marked. No part of this paper, or notes brought in to the examination room are to be removed.

ACCG329 SECURITY PRICING AND HEDGING CHECK TIMETABLE CAREFULLY THREE (3) HOURS PLUS 10 MINUTES READING TIME TEN (10)

1. (a) A stocks current price is $5 and the continuously compounded risk free rate is 10% p.a. for all maturities. An investor has just bought a 2 year futures contract on the stock. The stock pays yearly dividends. Exactly one month ago it paid a $0.40 dividend, which is expected to grow at 5% p.a. for the foreseeable future. All rates are continuously compounded. Compute the futures price. [3 marks]

(b) Compute the initial value of the futures contract. [1 mark]

One year later the price of the stock has fallen to $4 and the risk-free rate is unchanged. (c) Compute the new futures price. [2 marks]

(d) Compute the new value of the long position in the futures contract. [4 marks]

(e) Following on from part (a), suppose you observe a futures price of $5.00. Does this price imply a profitable trading opportunity? If so, describe the strategy, and if not give the reason. [5 marks]

2. Parts (a) and (b) of this question are based on the following information. A $5M interest rate swap has a remaining life of 10 months. The swap involves the exchange of 6-month LIBOR for a fixed rate of 9% p.a. (compounded semi-annually). The current swap rate for 6-month LIBOR swaps of all maturities is 10% p.a. (continuously compounded). The 6-month LIBOR rate was 11% p.a. 1 month ago, 11.5% p.a. 2 months ago, 11.75% p.a. 3 months ago and 12% p.a. 3 months ago (compounded semi-annually). (a) What is the current value of the swap to each of the counterparties (that is, the party paying floating and the party paying fixed? [10 marks]

(b) Discuss the following statement: Since the principal in an interest rate swap is not exchanged, there is no credit risk. [5 marks]

3. Table 1 summarises the borrowing costs confronting two companies: Table 1: Borrowing Costs Firm A Firm B Fixed Rate 6.5% 7.2% Floating Rate 6-month LIBOR + 0.6% 6-month LIBOR + 2.0%

Answer the following questions with reference to the information on Table 1 as required. (a) Suppose Firm B wishes to borrow fixed over a 10-year period at a fixed rate, whilst Firm A wants to borrow at a floating rate. Design an intermediated swap that provides a bank with a spread of 30 basis points p.a., and gives 10 basis points of swap benefits to firm A, and the rest to firm B. Use a clearly labelled diagram to summarise the terms of the arrangement. [10 marks]

4. Consider a European index call option with 2 years to maturity and a strike of 6000 points. The index is currently at 4500 points and the call is trading at 440 points. The continuously compounded risk free rate is 10% p.a., and the underlying index pays dividends at a continuously compounded rate of 4% p.a.. Each index point is worth $25. (a) What is the arbitrage free price of the equivalent European put? [5 marks]

(b) One month later the price of the call option increased to 500 points but the underlying index remained at the same level. Is there an arbitrage opportunity? If so, describe your strategy, but if not, describe why. [5 marks]

5. Equity in a firm can be viewed as a call option on the value of the firms assets, where the strike price is the face value of the firms debt. (a) If a firms equity can be thought of in this way, how can the value of the firms debt be expressed as an option or portfolio of options, assets and/or equity? [5 marks]

(b) Explain how an increase in the variance of the firms cash flows affects the value of debt and equity using option valuation arguments. Assume that all other aspects of the firm are the same, including the total value of the firms assets. [5 marks]

6. A stock has a current price of $50. Every 6 months the stock price goes up by 25% or falls by 20%. The stock will pay a single one-off special dividend of $4 in 6 months. The risk free rate is 10% p.a. continuously compounded. Note that if you can not answer one the following questions, you may assume an (incorrect) answer and use it in the calculations of the remaining questions. (a) Value a one year at-the-money European put option on the stock. [8 marks]

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(b) What is the value of the option if it is American-style? [6 marks]

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(c) Following on from part (a), what is the value of the equivalent European call option? Hint: Use put-call parity [5 marks]

(d) If the call option is trading on the market for $2 more than your answer to part (c), how would you take advantage of the arbitrage opportunity? [6 marks]

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7. (a) In the Black-Scholes model, is the distribution of stock prices assumed to be normal? Is the distribution of returns assumed to be normal? If either is not assumed to be normally distributed, describe the alternative distribution. [4 marks]

(b) Given that

, show that

. [3 marks]

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(c) A companys cash position, measured in millions, follows a Generalised Wiener process with a drift rate of $0.3m per quarter and a standard deviation of $0.5m per quarter. The initial cash position is $2m. i. What is the probability distribution of the cash position in 1 year? Hint: give your answer in N(mean, variance) form. [3 marks]

ii.

What is the probability of there being less than $1.8m of cash in 3 years? [5 marks]

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(d) A stocks price follows an Ito process. The current stock price is $1.50. It has an expected return of 10% p.a. and standard deviation of returns of 30% p.a.. What is the 95% confidence interval for the stock price in 2 years? Assume that the stock pays no dividends. [8 marks]

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(e) Similarly to the previous question, a stocks price follows an Ito process. The current stock price is $1.50. It has an expected return of 10% p.a. and standard deviation of returns of 30% p.a.. What is the probability that the stock price will be less than $1.60 in 18 months? Assume that the stock pays no dividends. [7 marks]

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(f) 8. Suppose that you own a portfolio of mining stocks with an estimated beta of 2 (with respect to the index) and a current market value of $1,000,000. Explain how you could use options on the index to hedge the risk. Assume that the risk free rate is 5%, the market risk premium is 10% and the dividend yield is 4% on the index and for mining stocks. The index is currently at 1000 points. Assume that an index point is multiplied by $50 to get the value of the notional portfolio underlying each option. (a) Describe and calculate how many put options should be bought to hedge the portfolio. [10 marks]

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(b) Explain how you could obtain portfolio insurance without trading the option (or any other derivative). Note the most important assumption(s). Hint: consider the option delta. [10 marks]

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9. In this question parts (b) and (c) are related. (a) Consider the following portfolio of options on a stock: Option A B Position -100 200 Option Delta 0.8 -0.5 Option Gamma 2 0.3

i) Label each option as either a call or a put. [2 marks]

ii) If the value of the underlying stock is $20 and the daily volatility of the stocks return is 3%, estimate the 1-day 95% Value at Risk (VaR) for the portfolio of options. [6 marks]

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(b) Consider a portfolio consisting of a $100 investment in stock A and a $300 investment in stock B. Suppose that the yearly volatility of the two assets is 40% and 30% respectively. What is the the 10-day 99% VaR for the portfolio? Assume that the stocks returns are independent and that there are 252 trading days in a year. [8 marks]

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(c) From the previous question, if the standard deviations of the values of assets A and B are simply added together to get the standard deviation of the portfolios value, what is being assumed about the correlation between the two stocks returns? [3 marks]

(d) The method used to compute VaR in the previous questions is called the parametric approach. Describe the non-parametric approach and its advantages. [3 marks]

(e) What is the main problem with using VaR for modelling losses on option contracts using the options deltas? [3 marks]

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10. (a) In Ed Thorpes article A Perspective on Quantitative Finance: Models for Beating the Market, one of his investment strategies is said to be a type of statistical arbitrage. What is the difference between statistical and pure arbitrage? [5 marks]

(b) According to the article Recipe For Disaster: The Formula that Killed Wall Street, what was the key problem with the way that banks and ratings agencies were using David X. Lis copula formula to price derivatives such as Credit Default Swaps (CDS)? [5 marks]

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(c) In 2002, Warren Buffet famously wrote: In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Discuss this quote with reference to the ideas in The Black Swan by Nassim Taleb. Your answer must be succinct and well-structured. [10 marks]

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