Financial engineering proposed applications

Theodor Munteanu: Quantitative Analyst for Derivatives, Risk and Investment

Contents
Preface .......................................................................................................................................................... 1
Options and option strategies ...................................................................................................................... 1
Detection of arbitrage opportunities ............................................................................................................ 5
Forward/Futures contracts. Valuation and pricing. Margins. ....................................................................... 7
Bond prices. Duration and convexity ........................................................................................................ 8
Discrete time models. Binomial and trinomial models............................................................................... 10
Exotic option pricing using discrete time models ....................................................................................... 11
Converge towards continuous time models. Geometric Brownian Motion. Stochastic calculus............... 12
Black Scholes model for pricing & hedging, risk indicators ........................................................................ 14
Valuation of an enterprise and bonds under default risk. .......................................................................... 17
Exotic option pricing under Geometric BM/Black Scholes model .............................................................. 18
Credit derivatives and Interest Rate Derivatives ........................................................................................ 19

Preface
This material is supposed to be a good collection of frequently asked questions (or around these
question), for those pursuing Financial Markets masters or for students pursuing Financial Engineering
courses (3rd or 4th year of Bachelors).

The problems are mostly structured as mini case-studies, or where several concepts are used at once.

In the beginning of every chapter there is a warm-up level selection of problem, followed by subjects
that require a lot of reflection and work, which form a one-to-one match to the today’s exams and
interview questions in the financial markets field.

Options and option strategies

1. Write the initial cash-flow (initial cost), final cash-flow(payoff), the net result, the system of
slopes, the breakeven points and the graph of the payoff and P&L for the following instruments:
• Long/Short on an equity (LE, SE) (First long equity, then short equity)
• Long/Short on a bond (LB, SB, with notional 𝐹𝑉 = 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒)
• Long forward/futures and short forward/futures
• Long forward (𝐹1 ) + short forward (𝐹2 ) (as OTC contracts)
• Long call (𝐸 strike), short call (𝐸 strike)
• Long call (𝐸1 strike) + Short call (𝐸2 ) strike. Their premiums would be 𝑐1 , 𝑐2
• Long put (𝐸 strike), Short put (𝐸 strike)
 • Long put (𝐸1 ) + Short put (𝐸2 ) (𝐸1 < 𝐸2 )
• Long put (𝐸2 ) +Short put (𝐸1 )( 𝐸1 < 𝐸2 )
• Long put (𝐸) +long equity (𝑆𝑇 ) (𝑇 =expiry time,0 =initial time). (Also called
protective put)
2. Write the initial cash-flow, the final cash-flow (payoff), the net result (P&𝐿) for the following
strategies:
• Long Equity + Short futures contract
• Short Equity + Long Call (Covered call)
• Long stock + Short Forward (Forward price = 𝐹) + Short bond (face value = 𝐹)
• Long call + long put + short bond (face value = 𝐾 = call & put strike)
• Long call + short put + short forward (???) (What do you remark?)
• Short call + Long Call + Long Call + Short call (𝐾1 < 𝐾2 < 𝐾3 < 𝐾4 ) (condor call strategy)
• Short put + Long put + LP +SC (𝐾1 < ⋯ < 𝐾4 )(condor put strategy)
3. An investor goes on choosing which among the following strategies would be best suited for
them when considering the arbitrage possibilities:
The investment is on 100 shares of Alphabet Inc., their price being currently 𝑆0 = 139.7$

The following scenarios for 𝑆𝑇 are given within the table and also their probabilities:

𝑆𝑇 137 141 135 143 145 147

𝑝(𝑆𝑇 ) 1/6 1/6 1/6 1/6 1/6 1/6

Also the call and put prices with different strike prices are being considered:

Call strike price Call premium Put strike price Put premium
𝐾 = 140 𝑐0 = 5.3 ($) 𝐾 = 140($) 𝑝0 = 4.7($)
𝐾 = 142 𝑐0 = 4.3 ($) 𝐾 = 142($) 𝑝0 = 5.3($)
𝐾 = 144 𝑐0 = 3.7 ($) 𝐾 = 144($) 𝑝0 = 5.7($)
𝐾 = 146 𝑐0 = 3.1($) 𝐾 = 146($) 𝑝0 = 6.1($)
𝐾 = 148 𝑐0 = 2.4($) 𝐾 = 148($) 𝑝0 = 6.5($)
All options expire in 90 days

a. What is the PnL from investing in 1 call positioned LONG and 2 puts positioned short (𝐾1 =
𝐾2 = 140)? What is the probability of having profit?
b. What is the 𝑃&𝐿 from investing in 1 bull call spread with strike prices 𝐾1 = 140, 𝐾2 = 144
c. What is the 𝑃&𝐿 from investing in 1 bull call spread with strike prices 𝐾1 = 140, 𝐾2 = 146?
d. Same question for 1 bull call spread with 𝐾1 = 142, 𝐾2 = 144 and then a bear call spread.
e. Same question for 1 bear put spread 𝐾1 = 140, 𝐾2 = 146 and 𝐾1 , 𝐾2 = 140,148
f. What is the expected 𝑃𝑛𝐿 for each strategy above?
g. What is the expected 𝑃𝑛𝐿 for a straddle strategy, for each strike price 𝐾𝑖 ∈ {140,142,144,146}?
h. What is the expected 𝑃𝑛𝐿 for a strangle strategy with strike prices 𝐾1 = 140, 𝐾2 = 144?
i. What is the expected 𝑃𝑛𝐿 for a strip strategy for each strike price 𝐾𝑖 ∈ {140,142,144,146}?
j. What is the expected 𝑃𝑛𝐿 for a strap strategy for each strike price 𝐾𝑖 ∈ {140,142,144,146}?
k. What is the expected 𝑃𝑛𝐿 for a butterfly call strategy, position LONG, with strike prices 𝐾1 =
140, 𝐾2 = 144, 𝐾3 = 146? Same question for a butterfly strategy, 𝐾1 = 140, 𝐾2 = 144, 𝐾3 =
148 and for a butterfly put strategy 𝐾 = 140, 𝐾2 = 144, 𝐾3 = 148
 4. (Partial exam 2021): One considers a financial derivative 𝐷 with the payoff:
𝛼(𝐾1 − 𝑆𝑇 ), 𝑆𝑇 ≤ 𝐾1
𝐷(𝑇, 𝑆𝑇 , 𝛼) = { 0, 𝐾1 < 𝑆𝑇 ≤ 𝐾2
2(𝑆𝑇 − 𝐾2 ), 𝑆𝑇 ≥ 𝐾2
𝑎. On the market the put premium with strike 𝐾1 is 𝑝1 = 3 the call premium with strike 𝐾2 is
𝑐2 (𝐾2 ) = 2 and the value of the derivative is 𝐷(𝛼 = 3) = 9. Build an arbitrage portfolio.
𝑏. What should be the fair price of such a derivative if 𝛼 = 3?
c. Same question for 𝛼 = 2.
d. What is the monotony of the price function 𝐷(𝑡, 𝑆𝑡 , 𝛼) as a function of 𝛼

5. A financial institution will issue soon a new derivative 𝐷 with the payoff

𝛼(𝐾1 − 𝑆𝑇 ), 𝑆𝑇 ≤ 𝐾1
𝐷(𝑇, 𝑆𝑇 , 𝛼, 𝛽) = { 0, 𝐾1 < 𝑆𝑇 ≤ 𝐾2
𝛽(𝑆𝑇 − 𝐾2 ), 𝑆𝑇 ≥ 𝐾2

Suppose the call price 𝑐(𝐾1 ) = 5.7$, 𝑝(𝐾2 ) = 9.3$, 𝑆0 = 100$, the option expires in 122 days and the
risk-free interest rates are 𝑟 = 5.35% for 3𝑀 expiry and 𝑟 = 6.35% for 6𝑀 expiry.

a. What is the fair value of the new contract 𝐷 defined with parameters 𝛼 = 2, 𝛽 = 3?
b. What becomes the financial strategy 𝐷, when 𝛼 = 1, 𝛽 = 2, and (𝐾2 − 𝐾1 ) → 0?

6. (Partial exam 2021) Given the presidential elections in USA, the NYSE hasn’t registered
significant convulsions in terms of volatility. Wishing to profit from this situation, John, a player
on the local market wishes to invest in the derivatives issued on an ex-dividend stock called
𝐹𝑖𝑛𝑅𝑢𝑙𝑙𝑧 and his broker offers him the following strategy:
Position Option Type Exercise Price Premium
Long Put $ 35 $ 0.50
Short Put $ 40 $ 1.00
Long Call $ 45 $ 0.50
Short Call $ 50 $ 1.00
The current stock price is 45$, all options are European and expire in 3 months.

1. Represent graphically the payoff of such strategy.

2. What is the PnL of the strategy?
3. What are the breakeven points of the strategy?

7. On the OTC derivatives market in Germany, a truncated butterfly derivative has become very
popular:
0, 𝑆𝑇 < 𝐾1 , 𝑆𝑇 > 𝐾2
𝐾1 +𝐾2 𝐾 +𝐾
𝐹(𝑇, 𝑆𝑇 ) = { − 𝑆𝑇 , 𝑆𝑇 ∈ (𝐾1 , 1 2 )
2 2
(𝐾1 +𝐾2 ) 𝐾1 +𝐾2
𝑆𝑇 − , 𝑆𝑇 ∈ ( , 𝐾2 )
2 2
𝑎. Draw the graph of the given payoff
 𝑏. We consider the following additional instruments named call Asset or Nothing and call
cash – or – nothing (AoN/Con)

𝐿, 𝑆 ≥ 𝐾 𝑆 𝑆 ≥𝐾
The payoffs are Φ𝐶𝑜𝑁 (𝑇, 𝑆𝑇 ) = { 𝑇 , Φ (𝑇, 𝑆𝑇 ) = { 𝑇, 𝑇
0, 𝐿 𝑇 ≤ 𝐾 𝐴𝑜𝑁 0, 𝑆𝑇 ≤ 𝐾
a. What are the corresponding put Cash-or-Nothing and Asset-or-Nothing payoffs?
b. Can be the truncated butterfly decomposed in vanilla and binary options?

8. Consider now a new version of truncated butterfly spread

0, 𝑆𝑇 < 𝐾1 , 𝑆𝑇 > 𝐾2
𝐾1 + 2𝐾2 𝐾1 + 2𝐾2
) − 𝑆𝑇 , 𝑆𝑇 <
𝐹(𝑇, 𝑆𝑇 = 3 3
𝐾1 + 2𝐾2 𝐾1 + 2𝐾2
{𝑆𝑇 − 3
, 𝑆𝑇 >
3
Decompose the payoff of such a truncated butterfly into several options.

9. Suppose the following scenarios for a share price in 3 months from now hold:
𝑆𝑇 105$ 110$ 115$ 120$ 125$ 130$ 135$ 140
𝑃(𝑆𝑇 ) 18% 24% 19% 15% 9% 7% 5% 3%

The current share price is 112$. Suppose the risk-free interest rate for every term
(continuously compounded) is 𝑟 = 5%
a. What is the price of a european call with strike price 𝐾 = 120$?
b. What is the price of a european put with strike price 𝐾 = 120$?
c. What are the breakeven points of a straddle strategy with strike price 𝐾 = 120$?
d. What is the value of a binary call that offers 10$ if 𝑆𝑇 is above the 125$ and nothing
otherwise?
e. What are the breakeven points of a straddle strategy with strike price 𝐾 = 115$
f. Suppose we consider the following discrimination measure for a strategy 𝑆:
𝑀(𝑆𝑖 ; 𝑆𝑇 ) = 𝐸[𝑃𝑛𝐿(𝑆𝑖 (𝑆𝑇 ))] ⋅ 𝑃(𝑃𝑛𝐿(𝑆𝑖 (𝑆𝑇 )) > 0) (Utility measure)

For 𝑆𝑖 = 𝑠𝑡𝑟𝑎𝑑𝑑𝑙𝑒 with strike price 𝐾𝑖 , which strategy would be preferable for an
investor?
g. Suppose we consider the discrimination measure for a strategy 𝑆:
𝐸[𝑆𝑖 (𝑆𝑇 )]
𝑀2 (𝑆𝑖 , 𝑆𝑇 ) =
𝑃(𝑃𝑛𝐿(𝑆𝑖 (𝑆𝑇 )) < 0)
Which among the strategies defined as straddles is the most favorable?

10. The profit function 𝐺𝑇 at expiry for a combination of several options with the same expiry 𝑇, and
having the price at expiry 𝑆𝑇 as a function of four exercise prices 𝐸𝑖 , 𝑖 = 1,4 is given in the table
below:
𝑆𝑡 (0, 𝐸1 ) (𝐸1 , 𝐸2 ) (𝐸2 , 𝐸3 ) (𝐸3 , 𝐸4 ) (𝐸4 , +∞)
𝜕𝐺𝑡 0 5 −2 5 0
Slope:
𝜕𝑆𝑡
 Find two different combinations of call and put options that allow the profile described in the
table to be realized.

11. Replicate the following strategies in at least two different ways (for each and every one, write
the price paid or received by the investor):
a. Has the system of slopes (0,1) and the payoff is zero when 𝑆(𝑇) < 𝐾
b. Has the system of slopes (-1,0) and the payoff is zero when 𝑆(𝑇) < 𝐾
c. Has the system of slopes (0,1) and the payoff is 𝐾 when 𝑆𝑇 < 𝐾
d. Has the system of slopes (0, −1) and payoff is 0, when 𝑆𝑇 < 𝐾
e. Has the system of slopes (0,1,0) and the payoff is zero when 𝑆(𝑇) < 𝐾1
f. Has the system of slopes (0,-1,0) and the payoff is zero when 𝑆𝑇 < 𝐾1
g. Has the system of slopes (0;1;-1;0) and the payoff is zero when 𝑆𝑇 > 𝐾3 or 𝑆𝑇 < 𝐾1
h. Has the system of slopes (0; −1; 1; 0) and the payoff is zero when 𝑆𝑇 < 𝐾1 or 𝑆𝑇 > 𝐾3
i. Has the system of slopes (0; 1; 0; −1; 0) and the payoff is zero when 𝑆𝑇 < 𝐾1 or 𝑆𝑇 > 𝐾4
j. Has the system of slopes (−1,0,1) and the payoff is zero when 𝑆𝑇 ∈ (𝐾1 , 𝐾2 )

12. Use the AAO (Absence of Arbitrage Opportunities) to find relations between the market prices
of the following pairs of financial instruments:
a. Two calls with same expiry, same underlying asset and strike prices 𝐾1 < 𝐾2
(Find whether 𝑐0 (𝐾1 ) < 𝑐0 (𝐾2 ) or is the opposite)
b. Two puts (𝑝0 (𝐾1 ), 𝑝0 (𝐾2 ))
13. Using AAO find the relation between the prices of:
a. 1 call with strike 𝐾 and expiry 𝑇1 and another call with strike 𝐾 and expiry 𝑇2 where 𝑇1 < 𝑇2
b. 1 put with strike 𝐾 and expiry 𝑇1 , 𝑝0 (𝑇1 , 𝐾) & 𝑝0 (𝑇2 , 𝐾), 𝑇1 < 𝑇2
c. A put with expiry in 𝑇1 years and strike 𝐾1 versus a put that expires at a later time
𝑇2 , 𝑝0 (𝑇1 , 𝐾1 ), 𝑝0 (𝑇2 , 𝐾2 ) where 𝑇1 < 𝑇2 , 𝐾1 < 𝐾2.

Detection of arbitrage opportunities

1. On the AAPL stock which is ex-dividend, there are two call options trading on Tokyo and Paris
exchanges. The prices on the two exchanges are 18.13$ and 19.25$
Some traders have access to both Stock Exchanges.
a. Build an arbitrage portfolio.
b. Find the profit of the arbitrageur if the annual interest rate with continuous compounding is
4%, and if the option expiries are 6 months.
c. Same questions if the expiries are in 9 months, 1 year, 3 months and 3 weeks.
d. What is the maximum interest rate such that the arbitrageur would obtain some profit?

2. Suppose that the interest rates for USD borrowings (both bid and ask) are in Tokyo and Paris as
follows in the below table:
 Expiry Paris Tokyo
3 months 5.45% 4.5%
6 months 5.95% 5.5%
9 months 6.25% 6.5%
12 months 6.5% 7.75%
18 months 8.5% 9.25%

Under these conditions what is the arbitrage strategy and what is the profit of the arbitrageur?

3. The risk-free interest rates for 3 months and 6 months are 6% and 8% respectively.
On an ex-dividend stock, whose current share price is 100 euros, the following options are
traded:
Option Strike price Expiry Premium
CALL ATM 3 months 7.2209
CALL 105 3 months 4.9225
PUT 105 6 months 8.6431
PUT ATM 3 months 4.7519
CALL 105 6 months 8.6431
CALL 110 6 months 6.5209
a. Find all the arbitrage opportunities and specify which one gives the largest profit
b. Find an arbitrage opportunity if a put that expires in 3 months having a strike price 𝐾 = 105
is issued at a premium of 7.85 euros. What is the profit obtained from this arbitrage
opportunity?
c. What are the breakeven points of a calendar spread made of calls with strikes 100 euros,
105 euros and expiries 3 months and 6 months?

4. A diagonal spread is created by buying a call with strike price 𝐾2 and exercise date 𝑇2 and selling
a call with strike 𝐾1 and exercise date 𝑇1 , 𝑇2 > 𝑇1 . Draw a diagram showing the profit from the
spread at time 𝑇1 when: a) 𝐾2 > 𝐾1 , b) 𝐾2 < 𝐾1

5. (Partial exam 2021-2022):

We consider the following call and put options on the same underlyings and having the same
expiry:
Exercise price Call premium Put premium
50$ 18.00$ 7.00$
55$ 14.00$ 10.75$
60$ 9.50$ 14.45$

What arbitrage opportunities are lying with the given situation?

6. FOREX Investments:
Suppose the Bid/Ask values for the following pairs of currencies are:
Currency Bid Ask
 EUR/USD 1.0621 1.0621
USD/EUR 0.9395 0.9375
USD/CHF 0.91 0.93
EUR/CHF 0.96 0.985

Explore for possible arbitrage opportunities.

7. The call and put price on a share worth 50$, which pays a dividend of 1$ in one month, are
5.25$ and 6.25$. The call and put have strike price 52$ and expire in 6 months. Is there any
arbitrage opportunity?

8. Give a lower bound for the price of a 4 month call option on a non-dividend paying stock when
the stock price is $28, the strike price $25 and the risk free rate is 8%.

9. The price of an American call on a non-dividend paying stock is $4. The stock price is $31, the
strike price is $30, and the expiration date is in 3 months. The risk-free interest rate is 8%.
Deduce lower and upper bounds for the American put written on the same underlying asset.

What are these bounds when there is a dividend of 1.5$ due in 2 months?

10. If 𝑐1 , 𝑐2 , 𝑐3 are the prices of European call options with strike prices 𝐾1 < 𝐾2 < 𝐾3
𝑐1 +𝑐3
a. Show that if 𝐾2 − 𝐾1 = 𝐾3 − 𝐾2 then 𝑐2 ≤ 2
b. If 𝐾2 = 𝛼𝐾1 + (1 − 𝛼)𝐾3 then 𝑐2 ≤ 𝛼𝑐1 + (1 − 𝛼)𝑐3

Forward/Futures contracts. Valuation and pricing. Margins.

1. The MSFT share has the price of 140.3$. If the interest rate which is risk-free, annual and
continuously compounded is 6%, find:
a. Forward prices for 25 days, 6 weeks, 3 months, 6 months, 9 months and 1 year if the share
pays no dividend
b. The forward/futures price for expiries of 25 days, 6 weeks, 3 months, 6 months, 9 months
and 1 year if the continuously paid dividend is at a rate of 4%
c. The forward/futures prices for expiries of 25 days, 6 weeks, 3 months, 6 months, 9 months
and 1 year if the share pays 1.5$ in 2 months, 1.6$ in 5 months and 1.7$ in 8 months.
d. Find the value of a forward contract now if it expires in 3 months and has an exercise price
of 140.3$.
e. What will be the value of a forward in 3 months, if it expires in 1 year and its strike price is
the 1 year forward price, if:
𝑖. 𝑆𝑇 = 145, 𝑟𝑇 = 7%
ii. 𝑆𝑇 = 140.3, 𝑟𝑇 = 5%
Under which conditions for 𝑆𝑇 , 𝑟𝑇 one would obtain a profit from having a long position in
the forward contract?
 2. The interest rates for different expiries are given by the following term structure:
Expiry 1M 2M 4M 6M 1Y 2Y
Rate 5% 5.25% 5.5% 5.5% 6% 7%

At time 0, an investor enters a LONG position into a forward contract with expiry 6 months, with
underlying asset a share paying a dividend of 2$ in 1 month and a dividend of 3$ in 9 months.
The forward price at time 0 is 28.77$
a. What is the value of the share price at the moment of issuing the contract?
b. Find the value of the forward contract in 2 months if the share price would decrease by 5%
and the term structure would go down by 25bps.
c. Find the value of the forward contract in 2 months if the share price would increase by 5%
and the term structure would go up by 25 bps.

3. At the end of one day a clearinghouse member is long 100 contracts, and the settlement price is
50,000$ per contract. The original margin is 2,000$ per contract. On the following day the
member becomes responsible for clearing an additional 20 contracts entered into at a price of
51,000$ per contract. The settlement price at the end of this day is 50,200$. How much does the
member have to add to its margin account with the exchange clearinghouse?

4. A company enters into a short futures contract to sell 5,000 bushels of wheat for 450 cents per
bushel. The initial margin is 3,000$ and the maintenance margin is of 2,000$.

a. What price change would lead to a margin call?

Under what circumstances could 1,500$ be withdrawn from the margin account?

b. Suppose the next day the futures price goes to 𝑆𝑇 /𝑏𝑢𝑠ℎ𝑒𝑙

We know that 𝐹𝑇 = 𝐹0 + 𝑁(−0.1$; 1$). What is the probability that a margin call would be
triggered the following day?
c. Suppose that every day the futures price varies by Δ𝐹𝑡 ∼ 𝑁(𝜇 = 0$; 𝜎 = 0.2$)
What is the probability that within the first 5 days a margin call would be triggered?
d. Suppose the last 10 futures prices where 435,445,440,442,449,454,456,459,455.5,452.5
Estimate by using the normal distribution the expected change and variance of price in 10
days from now?

Bond prices. Duration and convexity

1. What is the price of a zero coupon bond without credit or liquidity risk which expires in 3 years
and has face value of 1,000,000$? The risk free rates are implied from SOFR and estimated at:
𝑟(0,1) = 4.45%, 𝑟(0,3) = 5.55%, 𝑟(0,5) = 6.75%
2. A. What is the price of a 8% coupon bond without credit or liquidity risk expiring in 4 years, if the
term structure of risk-free interest rates is as given in the below table:
The interest is payable annually.
B. What would be the price of a 8% coupon bond which pays semi-annually the interest?
Term Rate
1Y 4.5%
2Y 5.5%
3Y 6.5%
5Y 8.0%
3. What is the credit spread of a zero coupon bond worth 755,000$ for a 1,000,000$ notional
bond, if it expires in 5 years? A similar credit risk-free bond is worth 798,516.25$.
Consider continuous compounding and annual compounding.

4. What is the value of an amortizable bond, without any credit risk? The notional outstanding is
1,000,000 $, the expiry is in 5 years, the interest rate is 8%, payable yearly.
a. The risk-free term structure is the one from the table from exercise 2.
b. What is the value of an identical amortizable bond with the same credit risk as the one from
exercise 3? Consider continuous compounding.

5. A. What is the Modified and Macaulay duration of a zero coupon bond with expiry in 5 years?
B. What is the duration of a 9% coupon bond on a notional of 1,000,000 euros, if the interest is
payable annually. The bond is without credit risk.

6. a) What is the yield to maturity of a bond that pays 8.45% per year twice a year, its value is
9,750$ for a notional outstanding of 10,000$. The bond would expire in 5 years.
b) What is the credit spread if a similar sovereign bond is traded for 10,450$.

7. EVALUATION OF HOLDING PERIOD RETURN and RISK of a bond:

Suppose we invest in 5 zero coupon bonds with expiry in 3 years and 10 zero coupon bonds with
expiry in 5 years. The risk-free rates are 5.95% and 6.85% now (3 year and 5-year estimates)
The spreads are both 1%. The notional outstandings are 10,000$ for each bond, and are of bullet
type (full amortization at expiry)
a. What is the value of such a portfolio?
b. Suppose that tomorrow the 3 year risk free goes up with 50 bps, and 5 year risk free rate
goes up by 75bps. What is the loss to the bondholder?
c. What is the 6-month holding period return for each bond if the interest rates do not
change?
d. What is the 6-month holding period return for each bond if the interest rates go up by 50
bps or go down by 50 bps?
e. If the annual change in interest rates are 𝑁(𝜇𝑖 , 𝜎𝑖2 ), 𝑖 = 1,2, where 𝜇1 = 𝜇2 = 0, 𝜎1 = 𝜎2 =
18% what is the confidence interval 95% for the bond value of type I in 1 year?
f. What is the value of risk 95% of the bond portfolio?
Discrete time models. Binomial and trinomial models
1. Find the value of a European call option with strike price 𝐾 = 100$, and that expires in 1 year.
The underlying asset price is currently at a level of 98$ and the annual volatility is 22.45%
The risk free rates for terms up to 1 year are 6%.

Considering the CRR model with 4 periods:

a. What is the value of the option now?

b. What is the expected value of the option in 6 months?
c. What is the market risk of the option now?
d. What is the probability that the option will be exercised at expiry?

Considering the same CRR model with 2 periods:

a. What is the value of the option now?

b. What is the expected value of the option in 6 months?
c. What is the market risk of the option now and in 6 months?
d. What is the probability that the option will be exercised at expiry?

Find the expected PnL for horizons of 3 months, 6 months, 9 months and one year for the CRR
model with 4 periods.

➢ If, instead, one assumes that the up and down factors are 120% and 80% what is the
option value by considering binomial model with 2 and 4 periods?

2. Consider that American put options ATM are written on the share above.
a. What is the value of the American put option if one uses CRR model with 2 periods?
b. What is the value of the American put option if one uses CRR model with 4 periods?
c. Find the expected value of the option price in 6 months if one uses CRR with 2 periods.
Compare the result with the European option. Which one is more profitable? Compare the
expected ROIs.

3. Suppose the CHF/RON is now at an exchange rate of 5.1 RON/CHF and the volatility of the
exchange rate throughout 2023 is estimated at 29.24%.
The risk-free interest rates in the two countries (SARON and IRCC) are estimated at 1.7% and
5.7% respectively.

Suppose an importer in Romania wishes to hedge against possible increases of CHF against RON
and will have to pay 100,000 CHF in 3 months. Propose a hedging scheme. What is the cost of
the hedging scheme if one uses:
a. Binomial model with 3 periods, 𝑢 = 1.15, 𝑑 = 0.95?
b. CRR model with 3 periods?
c. Black & Scholes model?
 4. Suppose an investor seeks to buy 100 calls on share Alpha with spot value 𝑆0 = 100$, ATM,
with 9 months to expiration date.
The Alpha share will yield 3 dividends worth 2$, 3$ and 5$ in 2M, 5M and 8M?
a. What is the dividend yield?
b. Find the value of the European options if the volatility of the share is 20.8%?

Use CRR with at least 3 periods. Price also using the Black & Scholes model.

When is the call more riskier? When there are dividends/not?

5. Suppose the probability of exercise an ATM call option with expiry in 6 months is 25%. If the
risk-free rate is 5% per year, and the model under consideration is 𝐶𝑅𝑅(2 𝑝𝑒𝑟𝑖𝑜𝑑𝑠), what is the
value of the call option? The current share price is 39ℒ

6. The price of a 6 month call European option ATM, whose current share price is $90 is 7.4$
according to the CRR model with 2 periods. The interest rate is 0.

What is the value of a 9M European ATM option if one uses CRR with 3 periods?
7. Find the value of a European call option with strike price 𝐾 = 100$, 𝑆0 = 100$
The annual volatility is 𝜎 = 20%, the option expires in 9 months.
Consider the following models:
a. CRR model with 3 periods
b. Boyle model (trinomial with 𝑢 ⋅ 𝑑 = 1, 𝑚 = 1)
c. Black & Scholes model.

The risk-free rates for 6M and 1Y are 5.5% and 6.5% per year.

Exotic option pricing using discrete time models

1. An investor has issued cash-or-nothing options that would deliver 100 euros if the CAC 40 index
would go above 7,300 euro level in 2 months from now. The annual volatility of the index is
18.33%.
If the EUROZONE risk-free rates for 1 month and 3 months are EURIBOR 1M and EURIBOR 3M at
the level of 3.8% and 3.95% respectively, what should be the value of 100 cash-or-nothing
options using CRR with 2 periods and Black Scholes model?

What is the market risk of the portfolio of options and propose a method to hedge these
positions using stocks.

2. The TESLA share price is 255.7$ and its annual volatility was 24.45% last year.

A new investor considers the following possible investments for a 3 months horizon.
a. Buying 100 shares now and wait until the 3 months have passed.
b. Buying 100 european ATM calls with 3 months expiry
 c. Buying 100 european ATM up-and-out call options with the barrier at 280 $
d. Buying 100 european ATM up-and-in call options with the barrier at 260$.
e. Buying 100 european ATM down-and-in call options with the lower barrier at 250$
f. Buying 100 european ATM double Knock-in options at levels 250$, 260$.

Which option has the best ROI? Consider CRR model with 3 periods.

The risk-free rate is 3.75% in US area for the 3-month horizon.

3. What is the price of a lookback call option with fixed strike if 𝑆𝑡 = 300$, 𝐾 = 305$, 𝑟 =
5.75%, 𝑇 − 𝑡 = 8𝑀2𝑊
The volatility is quarterly 12.25%. Use CRR with 3, 4 and 5 periods.
Compare the ROIs of the 3 models and the expected PnLs under these models.

4. What is the price of a lookback call option with floating strike price, 𝑆𝑡 = 300, 𝐾 = min 𝑆𝑡 , 𝑟 =
𝑡≤𝑇
5.75%, 𝑇 − 𝑡 = 8𝑀2𝑊
The volatility is the same. Use CRR with 3, 4 and 5 periods.
Which derivative is riskier? The lookback call option with fixed strike or with floating strike?

Converge towards continuous time models. Geometric Brownian

Motion. Stochastic calculus

1. The dynamics of the share price which follows the geometric Brownian motion is 𝑑𝑆𝑡 = 𝜇𝑆𝑡 𝑑𝑡 +
𝜎𝑆𝑡 𝑑𝐵𝑡 , 𝜇, 𝜎 > 0. Write the dynamics of:
a. 𝑅𝑡 = log(𝑆𝑡 ) ; b. 𝐹𝑡 = 𝑆𝑡 𝑒 𝑟(𝑇−𝑡)
2. The dynamics of the exchange rate between EUR/USD is modelled by a geometric Brownian
motion of the form 𝑑𝑆𝑡 = (𝑟 − 𝑞)𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡
a. Write the dynamics of 𝑅𝑡 = ln (𝑆𝑡 )
b. 𝐹𝑡 = 𝑆𝑡 𝑒 (𝑟−𝑞)(𝑇−𝑡)
c. 𝑆𝑡′ = 1/𝑆𝑡
3. Show the following processes are martingales:
𝜃2
a. 𝑋𝑡 = 𝐵𝑡 ; b. 𝑋𝑡 = 𝐵𝑡2 − 𝑡; 𝑐. 𝑋𝑡 = 𝑒 𝜃𝐵𝑡 − 2 ⋅𝑡
d. 𝑋𝑡 = 𝐵𝑡3 − 𝑓(𝑡). Find 𝑓: [0, ∞) → 𝑅 such that 𝑋𝑡 is a martingale.

4. The dynamics of a share price that follows the GBM is 𝑑𝑆𝑡 = 𝜇𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡
Find the real parameters 𝑎, 𝑏, 𝑐 such that the following processes are martingales:
a. 𝑋𝑡 = 𝑆𝑡2 − 2𝑆𝑡 + 𝑎√𝑡
b. 𝑋𝑡 = log(𝑆𝑡 ) − 3𝑏 ⋅ 𝑆𝑡 + 𝑏 ⋅ log(√𝑡)
c. 𝑋𝑡 = 𝑐𝑡 2 − 2𝑆𝑡 + 𝑐√𝑆𝑡
For the processes from a), b), c) find the expected value of 𝑋𝑇 where 𝜇 = 9%, 𝜎 = 25%, 𝑆0 = 100$

5. Under a risk-neutral world the share price on an ET Market is following the process
𝑑𝑆𝑡 = 𝜇𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡
𝑎. Find the value of 𝑆𝑇 if 𝑆0 = 85 euros, the stock volatility is 8% monthly, the risk-free rates are
at 6% with continuous compounding. 𝑇 = 1 year

𝑏. Build a 95% confidence interval for 𝑆𝑇 where 𝑇 = 6 𝑚𝑜𝑛𝑡ℎ𝑠

𝑐. Suppose an investor enters into a forward contract with expiry in 6 months, and forward price
90 euros. What is the probability of a positive net result?

6. The dynamics of the YTM for a zero coupon bond is modelled by an Ito process of the form
𝑑𝑅𝑡 = 𝑘(𝜃 − 𝑅𝑡 )𝑑𝑡 + 𝜎𝑑𝐵𝑡 , 𝜎 > 0 (Vasicek process)
a. Write the dynamics of the bond price 𝑋𝑡 = 𝐾𝑒 −𝑅𝑡(𝑇−𝑡) where 𝐾 is the face value of the
bond
b. Find the parameter 𝛿 such that the stochastic process is 𝑋𝑡 = 𝑒 −𝑡𝑅𝑡 + 𝛿𝑡 is a martingale.
c. What is the expected return between times 𝑡1 and 𝑡2

7. The EUR/RON exchange rate is 4.80 and follows a geometric Brownian motion. The RON rate is
6% (represented by IRCC), the EURO risk free rate is 4% and the vol of the exchange rate is 22%.
Find confidence intervals with a probability of 95% on an investment horizon of:
a. 15 days; b. 7 months; c. 3 years.

0.2,0 ≤ 𝑡 ≤ 0.25
0.25,0.25 ≤ 𝑡 ≤ 0.5
8. Suppose that the volatility function 𝜎(𝑡) = { is estimated from forward
0.3, 0.5 ≤ 𝑡 < 1
0.335,1 < 𝑡 < 2
0.05,0 ≤ 𝑡 ≤ 0.25
prices of options and the risk free rates 𝑟(𝑡) = {0.06,0.25 ≤ 𝑡 < 0.5 are based on regression
0.07,0.5 ≤ 𝑡 ≤ 2
models of SOFR rates.
a. Find the expected value of a share price in a risk-neutral world in 2 years, if the current price
is 22.5$
b. Find the expected value of that share price in: 6 months, 1 year and 18 months
c. Find the confidence interval 90% and 95% for the share price in 6 months, 1 year, 18 months
and 2 years. Compare the results.
9. Compute the following quantities:
a. 𝐸[𝑆𝑇 ], 𝑆𝑇 = 𝑆0 𝑒 𝜎𝐵𝑇 , 𝜎 = 20%, 𝑇 = 1, 𝑆0 = 120$
b. 𝐸[𝑆𝑇 |𝑆𝑇 < 110], 𝑆𝑇 = 𝑆0 exp(𝜎𝐵𝑇 ) , 𝜎 = 20%, 𝑇 = 1, 𝑆0 = 120$
c. 𝑉𝑎𝑟(𝑆𝑇 ), as above, where 𝑇 = 1 year, 𝑇 = 6 months
d. Find the Value at Risk 99% for 20 days investment horizon, when investing in 20 stocks
e. Find the Expected Shortfall 99% for 20 days investment horizon, when investing in 20 shares
of the above stock.
 10. A share of MEDLIFE has a value of 39𝑅𝑂𝑁 and follows a GBM with an instantaneous rate of 12%
and a volatility of 20%. For an horizon of 4 weeks find:
a. A 98% confidence interval for the share price
b. 80% confidence interval for the futures price at expiry, if the expiry of the futures is 13
weeks and the risk free rate is 6%
c. 90% confidence interval for the forward value in 2 weeks if the forward expire in 6 months,
the risk free rate is 6%.

11. If 𝑋𝑡 = 𝑡𝐵𝑡 , 𝑌𝑡 = 𝑒 𝐵𝑡 −𝑡 where 𝐵𝑡 is a standard Brownian motion.

Find the dynamics of the process 𝑋𝑡 ⋅ 𝑌𝑡

12. Suppose the process 𝑋𝑡 has the drift component 𝜇(𝑡, 𝑋𝑡 ) = 𝑐𝑋𝑡 and the diffusion 𝜎 2 (𝑡, 𝑋𝑡 ) =
𝑋𝑡𝑎 where 𝑎, 𝑐 > 0 Let 𝑌𝑡 = 𝑋𝑡𝑏 . How much is 𝑏 such that the dynamics of 𝑌𝑡 has constant
diffusion coefficient?

13. Suppose 𝑋(𝑡) = 𝑡𝐵(𝑡), 𝑌(𝑡) = 𝑒 𝐵(𝑡) where 𝐵(𝑡) is a standard Brownian motion.

𝑋(𝑡)
Find the dynamic of 𝑑( )
𝑌(𝑡)
14. We assume that ln(𝑋𝑡 ) = ln(𝑋0 ) + 𝜇 ⋅ 𝑡 + 𝜎 ⋅ 𝐵𝑡 , 𝜇, 𝜎 ∈ 𝑅
1
−(𝜇⋅𝑚+ 𝜎 2 𝑚2 )𝑡
Let 𝑌𝑡 = 𝑋𝑡𝑚 , 𝑍𝑡 = 𝑌𝑡 𝑒 2 , 𝑚 ∈ 𝑅. Prove that:
a. 𝑑𝑍𝑡 = 𝜎𝑚𝑍𝑡 𝑑𝐵𝑡
1 2𝜎2𝑇
b. 𝐸[𝑋𝑇 |𝑋0 ] = 𝑋0 𝑒 𝜇𝑇+2𝑚
1
c. 𝐸[𝑋𝑇𝑚 |𝑋0 ] = 𝑋0𝑚 exp (𝑚𝜇𝑡 + 𝑚2 𝜎 2 𝑡)
2

Find 𝑉𝑎𝑟(𝑋𝑇 |𝑋𝑡 ), 𝑉𝑎𝑟(𝑋𝑇 |𝑋0 )

15. If the share price of a company follows a geometric Brownian motion what is the value of an
instrument that offers at expiry the arithmetic mean of the stock price.
1 𝑇
(That is ∫ 𝑆 𝑑𝑢).
𝑇−𝑡 𝑡 𝑢

Black Scholes model for pricing & hedging, risk indicators

1. A. Find the value of a portfolio formed out of a European call and put option that are both ATM,
on a share whose value is 122 CHF, the volatility is 𝜎 = 21% per year, the risk free rate is 3.85%
per year in CHF. The options have 6 months to expiry, and the share pays an annual rate of
dividend estimated at 7.45%.
b. What is the delta of such a portfolio? What about the gamma?
 c. Suppose the share price moves to 𝑃𝑡2 = 123.5 CHF tomorrow. Approximate the change in
the option portfolio position, by using greeks (Δ & Δ − Γ) and full repricing.
d. Suppose the next day after tomorrow the price would become 𝑃𝑡3 = 127.5 CHF.
Approximate the change in the option price. What do you observe?

2. An european put is issued on an ex-dividend share.

a. Find the option value, knowing that the share price is 85$, the exercise price is 90$, the
interest rate is 5%, the expiry is in 50 days, and the probability of exercise is 73.76%
b. What is the delta and gamma of such option?
c. What is the price of the call option with the same features as above?

3. An ex-dividend share follows the dynamics 𝑑𝑆𝑡 = 𝑟𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡∗ , 𝑟 = 2.5%, 𝜎 = 10%
Find the value of the following derivatives (that expire in 73 days) :
a. 𝐷𝑇 = 𝐾𝑅𝑇 , where 𝑅𝑇 is the return cumulative of the period and 𝐾 = 1,000$
0, 𝑅𝑇 ≥ 𝑐
b. 𝐷𝑇 = { 2 where 𝑐 = 5% and the 𝑅𝑇 is the cumulative return of the period
𝑅𝑇 , 𝑅𝑇 < 𝑐
0, 𝑅𝑇 ≤ 𝑐
c. 𝐷𝑇 = { where 𝐾 = 1,000$ and 𝑐 = 5%
𝐾𝑅𝑇 , 𝑅𝑇 ≥ 𝑐
0, 𝑅𝑇 ≤ 𝑐1
d. 𝐷𝑇 = {100 ⋅ 𝑅𝑇 , 𝑅𝑇 ∈ (𝑐1 , 𝑐2 ) where 𝑐1 = 4%, 𝑐2 = 9%
1,000𝑅𝑇 , 𝑅𝑇 ≥ 𝑐2

4. Find the value of the following financial derivatives:

a. 𝐷𝑇 = 𝑆𝑇 log(𝑆𝑇 ) , 𝑆𝑡 = 40$, 𝑟 = 2%, 𝜎 = 20%, 𝑇 − 𝑡 = 55/365
0, 𝑆𝑇 ≥ 𝐾
b. 𝐷𝑇 = { where 𝐾 = 40
𝑆𝑇 , 𝑆𝑇 < 𝐾
c. 𝐷𝑇 = [log(𝑆𝑇 )]2

5. Find whether the following prices can be the prices of derivatives?

𝜎2
a. 𝐷𝑡 = 𝑆𝑡 [log(𝑆𝑡 ) + (𝑟 + ) (𝑇 − 𝑡)]
2
3 15 2
b. 𝐷𝑡 = 𝑆𝑡 √𝑆𝑡 exp ( 𝑟 + 𝜎 ) (𝑇 − 𝑡)
2 8
𝑆 𝜎2
log( 𝑡 )+(𝑟+ )(𝑇−𝑡)
𝐾 2
c. 𝐷𝑡 = 𝑆𝑡 𝑁(𝑑) where 𝑑 = 𝜎 √𝑇−𝑡
𝐾 𝜎2
d. 𝐷𝑡 = 𝐾𝑒 −𝑟(𝑇−𝑡) 𝑁(𝑑), where 𝑑 = (ln ( ) − (𝑟 + ) (𝑇 − 𝑡))/(𝜎√𝑇 − 𝑡)
𝑆𝑡 2

2𝑟
− 2
6. Suppose that a market is perfectly described by the Black & Scholes model. Prove that 𝑆 𝜎 can
be the price of a financial derivative

7. A European call option with underlying a share non-paying dividend expires in 3 months.
 The spot value of the share is equal to the discounted strike price. The spot value is 15 euros and
𝑃(𝑆 ⋅ exp(𝑟(𝑇 − 𝑡) − 𝜎 2 (𝑇 − 𝑡)) ≤ 𝑆𝑇 ≤ 𝑆 ⋅ exp(𝑟(𝑇 − 𝑡))) = 16%
What is the current price of the option? (Financial Engineering exam 2011, 2016 and 2018)

8. We consider an European call ATM option that expires in 31st of December. On the 30th of June
the price of the underlying share is 30 euros, the risk free annual and continuously compounded
is 6%, and the probability that 𝑃(𝑆 ⋅ exp(𝑟(𝑇 − 𝑡) − 𝜎 2 (𝑇 − 𝑡)) ≤ 𝑆𝑇 ≤ 𝑆 ⋅ exp(𝑟(𝑇 − 𝑡))) =
8% under the Black & Scholes model.
a. What is the price and delta of the option on 30th of June?
b. What is the probability that the option be exercised?
c. What is the probability that a similar put with strike price equal to capitalized share price
with the interest rate be exercised?

9. Consider an European put on a non-dividend paying share. The price of share is currently 85
euros. The exercise price is 𝐾 = 90, the option lifetime is 50 days, the risk free rate is 5%.
The probability that the option be exercised at expiry is 73.76%

Find the value of a straddle strategy with the exercise price 𝐾 and what are the breakeven points of such
a strategy

𝑆 2
10. Let 𝑋𝑡 = (ln ( 𝐾𝑡 )) where 𝐾 > 0 and 𝑑𝑆𝑡 = 𝑟𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡
a. Can 𝑋𝑡 be the price of a financial derivative?
b. Can 𝑋𝑡 be a martingale?
c. Can 𝑋𝑡 be the payoff of a financial derivative at time 𝑇?

𝐸[𝑆𝑇2 ]
11. What is the value of a European call option with strike price defined as
𝑆𝑇
During the lifetime of the option the return of the stock price is 0. The probability that the share
price at expiry to be greater than its average is 48%. If the current share price is 𝑆𝑇 = 35$, the
lifetime of the option is 3 months, find the option value and its market risk.

12. The exchange rate between two currencies follows a geometric Brownian motion and one
knows that 𝐸 𝑄 [𝑆𝑇 ] = 𝑆𝑡 while Pr(𝑆𝑇 > 𝑆𝑡 ) = 46% where 𝑆𝑇 is the share price in 3 months.
a. What is the implied volatility of the stock?
b. If the exchange rate follows a binomial model and 𝐹(𝑡, 𝑇) = 𝑆𝑡 and Pr(𝑆𝑇 > 𝑆𝑡 ) = 20%
where 𝐹(𝑡, 𝑇) = forward price of the contract with expiry in 3 months find the implied
volatility of the option according to the binomial model with 2 periods.

13. For a portfolio containing 10 calls options on Alpha share and 5 put options with same strike
price 𝐾 = 120 𝑈𝑆𝐷, and expiry in 6 months.
a. Propose a delta-hedging strategy of the given portfolio.
 b. How many calls or puts on should use for a Δ − Γ strategy in case wishes to protect himself
against large movements of the share price.

The spot price is 115 USD, the annual volatility is 19% and the risk-free rate is 4.5%.

14. Call options on futures contracts are written. The futures are on GOOGLE stocks, 𝑆0 = 140$ and
the annual volatility of GOOGLE share is 16%.
a. What is the volatility of the futures price?
b. How many futures one should short to Δ − ℎ𝑒𝑑𝑔𝑒 the call option position?
c. How many shares one should short to Δ − ℎ𝑒𝑑𝑔𝑒 the futures option position?

The risk-free rate is 4.85% per year, the option and futures expire in 122 days, the option being
at-the-money.

Valuation of an enterprise and bonds under default risk.

1. The assets of an enterprise have the value 𝐴0 = 10,000,000$ and their volatility is 𝜎 = 40%
The company has issued a zero coupon bond with the face value of 7,500,000$ and expiry in 15
years. The risk free rate is 10%. The company also has issued 1,000 shares.
a. Find the equity value, the share price but also the bond value, volatility and the spread of
the bond.
b. Find the volatility of the share price.
c. How can a buyer of the bond protect itself such that the value of the portfolio is not
modified when the asset values change with 1%?
d. What the average recovery rate of the bond?

2. On the capital market there were issued two zero coupon bonds: one by a corporate and one by
the state. The present value of the sovereign bond is 5,000,000 $. The two bonds have the same
expiry and the same notional. The assets of the corporation are worth the same as the present
value of the sovereign bond. The asset volatility is 42%.
• Find the risk of the debt issued by the corporate entity.
• Find the equity value (if there is any) of the company.

3. The market value of a company is 1,600,000 euros and the debt towards creditors are 819,000
euros. The company wishes to refinance these debts under zero coupon bonds both expiring in
60 months. First is a senior credit with face value 1,100,000 and the second is a junior contract
with 900,000 euros. After the new refinancing of the company, the market value company has
increased to 1,700,000 euros and the risk is 48%. We know the risk free rates are 9%.
a. How much did the share price has changed after the refinancing if the number of
outstanding shares is 100.
b. Find the yield to maturity for each credit. What is the average risk premium of the
borrowing.
c. What is the probability of the junior debt to default?
 d. What is the average recovery value in case of default for the junior and senior debt
respectively?

4. Four similar companies have assets under management:

Company Assets value Volatility of Assets Bonds
Alpha 10,000,000$ 20% 10 × 700,000$
Beta 15,000,000$ 20% 20× 500,000$
Gamma 20,000,000$ 20% 15 × 1,000,000$
Delta 25,000,000$ 20% 20 × 1,000,000$

All bonds have 10 years to expiry.

An investor buys 5 bonds of each type.
a. What is the volatility of the investment?
b. Find a way to protect your investment against market risk. What is the disadvantage of
the hedging instrument in case of default?

We state that each company has an outstanding number of 1,000 shares. The risk-free rate is
7.9% per year.

5. For the data above:

a. Find the probability of default of each company
b. Suppose a financial contract bets on the default of at least one company amongst the
above. For each company that defaults before expiry the company offers 50,000$.

What is the value of such a contract?

c. What is the recovery value of each debt in case of default?

Exotic option pricing under Geometric BM/Black Scholes model

1. The price of a share 𝑆𝑇 follows the geometric Brownian motion 𝑑𝑆𝑡 = 𝜇𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝐵𝑡
Let 𝐷(𝑇) be the payoff of a financial derivative defined by:
𝑆 𝑆
ln2 ( 𝑆𝑇 ) , ln ( 𝑆𝑇 ) ≤ 𝑐
𝐷(𝑇) = { 0 0
0, 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
Find the current value of the derivative 𝐷(𝑡) of the financial derivative.

2. One considers the derivative offering 𝐷(𝑇, 𝑆𝑇 ) = 𝑆𝑇3. What is the value of the derivative at time
𝑡? Is it riskier than the underlying asset?
2
3 ( 𝑟+𝑎𝜎 2 )(𝑇−𝑡)
3. Suppose that 𝐷(𝑡, 𝑆𝑡 ) = 𝑆𝑡 √𝑆𝑡2 𝑒 3
a. Find 𝑎 > 0 such that 𝐷(𝑡, 𝑆𝑡 ) can represent the value of a financial derivative at time 𝑡
b. Is the financial derivative riskier than the underlying asset?
c. Assume somebody goes long 3 contracts on D. Propose a Δ − Γ neutral strategy for the
derivative 𝐷
4. A. What is the price of a call-asset-or-nothing having the payoff:
 𝑆 ,𝑆 > 𝐾
Φ(𝑆𝑇 ) = { 𝑇 𝑇
0, 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
Assume that the volatility of the underlying asset is 22%, the risk free rate is 6.5%, 𝑆0 =
104$, 𝐾 = 100$
B. Is the call asset-or-nothing riskier or not than the underlying asset?
C. Propose two Δ −strategies for hedging the call asset or nothing

5. Suppose an investor buys 10 calls cash-or-nothing and 5 puts asset-or-nothing with the same
strike price 100$
The underlying spot price is 95$, the monthly volatility is 6.5% and the riks free rate is 5.3% per
year for 3M expiry, 6.25% for 6M expiry and 6.75% for 1Y expiry.
The calls and puts expire in 7 months.
Propose a Δ −hedging strategy for the portfolio. What is the cost of such a hedging process?

Credit derivatives and Interest Rate Derivatives

1. We consider a credit default swap whose notional principal is $10 mn, maturity is 5 years and
payment frequency is quarterly. The credit event is the bankruptcy of the corporate entity A. We
assume the recovery rate is set to 40%, and the coupon rate is equal to 2%.
a. Draw the diagram of cash-flows for the CDS
b. What is the P&L to the seller if the corporate entity does not default?
c. What is the P&L to the buyer if the corporate entity defaults after 3 years and 5 months?

2. Consider a CDS written to hedge a loan of 1,000,000$ that expires in 5 years, amortizes at
expiry. The issuer of the loan is an SME that has default probability estimated at 3.5% in the first
year, 4.5% in the 2nd and 3rd year and 2.5% in the 4th and 5th year.
a. What is the annual default intensity for the issuer?
b. What is the premium to be paid annually so that the CDS is issued without any upfront?

The recovery rate of the borrowing in case of default is estimated at 50%, and the risk free rates
are all 6%.

3. A fixed-for-floating interest rate swap is traded on the over-the-counter market. The fixed rate
receiver agrees to pay USD LIBOR 12M and to pay 5.6% for 5 years on a notional of 10 million $.
If the LIBOR forward rates are 6%, 6.5%, 7%, 8% and 9% for each year and the risk-free OIS rates
are 3.35%, 4.55%, 5.65%, 6.45% and 6.75% find:
a. The value of the swap to the party receiving fixed if the OIS discounting curve is used
b. The value of the swap to the party receiving fixed if LIBOR curve is used.