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ACTSC 446/846 Winter 2013 Mathematical Models for Finance

Assignment 1 Department of Statistics and Actuarial Science University of Waterloo, Canada

Due: Thursday Feb 7th, 2013 in class. Hard copy please. No electronic version. To earn the full credit of the assignment, your answer must be well justied. Simply listing the nal answer leads to zero credit. Only about half of questions will be randomly selected for grading, and your grade on this assignment will be calculated based on your performance on those selected questions. However, in order to obtain the full credit for this assignment, you have to do all the assigned questions. You must place the present page on the top of your solutions as the cover and combine them together, and put your last name, your rst name, and UW ID number very clearly in the corresponding blanks below.

Last Name:

First Name: UW ID #:

1. Assume that the eective 6-month interest rate is 2%, the S&R 6-month forward price is $1020, and premiums are charged as illustrated in the following table for S&R options with 6 months to expiration: Strike $950 $1000 $1020 $1050 $1107 Call $93.809 $84.470 $71.802 $51.873 Put $74.201 $84.470 $101.214 $137.167

$120.405 $51.777

Further assume the index pays no dividend, and let ST denote the S&R index in 6 months. (a) Suppose you buy the S&R index for $1000 and buy a 950-strike put. i) Derive an expression, as a function of ST , of the payo and prot respectively for this position. ii) Construct payo and prot diagrams for this position. iii) Verify that you obtain the same payo and prot diagram by investing $931.37 in zero-coupon bond and buying a 950-strike call. (b) Develop an expression for the prot in each of the following ratio spreads positions. Simplify your answer as much as possible and draw the corresponding prot diagrams. i) Buy 950-strike call, sell two 1050-strike calls. ii) Buy two 950-strike calls, sell three 1050-strike calls. 2. The S&R index spot price is $1,100, the risk-free rate is 5%, and the dividend yield on the index is 9%. (a) Compute the fair 6-month forward price on the S&R index. (b) Suppose you observe a 6-month forward price of $1,115. What arbitrage would you undertake? (c) Suppose you observe a 6-month forward price of $1,050. What arbitrage would you undertake?

For (b) and (c), build up your portfolio and explain the possible prot. 3. The price of a nondividend-paying stock is $100 and the continuously compounded risk-free rate is 5%. A one-year European call option with a strike price of $100 e0.05 = $105.127 has a premium of $11.924. A 1.5 year European call option with a strike price of $105.127 has a premium of $11.50. What arbitrage would you undertake? Build up your portfolio and explain the possible prot. 4. In each of the following cases identify the arbitrage and demonstrate how you would make money by creating a portfolio and showing your payo: (a) Consider two European options on the same stock with the same time to expiration. The 90-strike call costs $10 and the 95-strike call costs $4. (b) Now suppose these options have 2 years to expiration and the continuously compounded interest rate is 10%. The 90-strike call costs $10 and the 95-strike call costs $5.25. Show again that there is an arbitrage opportunity. (c) Suppose that a 90-strike European call sells for $15, a 100-strike call sells for $10, and a 105-strike call sells for $6. Show how you could use an asymmetric buttery to prot from this arbitrage opportunity. 5. Suppose that the current spot $/ exchange rate is 0.008, the one-year continuously compounded dollar-denominated rate is 5% and the one-year continuously compounded yen-denominated rate is 1%. If there is no arbitrage opportunity, calculate one year currency forward price on 1. For the next few questions, assume no arbitrage opportunity. 6. Suppose the European call function C (S, K, t, T ) and European put function P (S, K, t, T ) are dierentiable with respect to K . Show that 1 0 C 0, K

P 1. K

7. (Convexity, put version.) Using arbitrage-free argument, show that For K1 , K2 0, P (S, K1 , t, T ) + (1 )P (S, K2 , t, T ) P (S, K1 + (1 )K2 , t, T ), 3

p(S, K1 , t, T ) + (1 )p(S, K2 , t, T ) p(S, K1 + (1 )K2 , t, T ), That is, the European put option price P (S, K, t, T ) and the American put option price p(S, K, t, T ) are convex functions of K on R+ . 8. Using the result of (7.), show that if P is twice dierentiable with respect to K , then 2P 0. K 2 9. (Homogeneity.) Show that for > 0, C (S, K, t, T ) = C (S, K, t, T ). Here, C (S, K, t, T ) means a call option written on shares of S , with strike price K . (In fact, all four types of options C, c, P, p have this property.) 10. (Change of num eraire.) Let c$ (, K, t, T ) be an American call option on 1 with strike price K in currency $ and p ($K, 1, t, T ) be an American put option on $K with strike price 1 in currency . Show that c$ (, K, t, T ) = p ($K, 1, t, T ). The next question is for grad students only; for undergrad it is a bonus question. 11. Put-call parity holds only for European options. Show that for American option prices we have the following inequalities (the underlying pays no dividends): S0 K c p S0 Ker(T t) , where c and p denote the prices of American style call and put options on S with the same maturity T and strike price K , r is the continuously compounded interest rate, and S0 denotes the spot price on the underlying asset S . Hint: For the rst part of the relationship consider: (a) a portfolio consisting of a European call plus an amount of cash equal to K and (b) a portfolio consisting of an American put option plus one share of S .