Assignment 3

FINA4110 Options and Futures

Willem J. van Vliet

Due: November 8, 2024 at noon (12:00pm)

There are 100 points in total on this assignment. You may discuss your answers with other students,
but please hand in your own assignment in your own words. Make sure to include your name and
your student ID number. Assignments are due by noon, November 10, 2023. Please upload a single
PDF file of your submission to Blackboard. Make sure you leave enough time to export your PDF (if
typed) or make good quality scans/photos (if handwritten) for submission. Late assignments will not
be accepted.
Please note that for all questions (on homework and exams) I may include extra information that
you do not use. You should know what you need and what you do not need. Also, please keep your
answers short. Unnecessary or incorrect additional information will be penalized.

1 Multiple Choice Questions (3 points each, 15 points total)

1.1. A bullish options trading strategy is:
(A) One that does not favor the stock price moving in any particular direction.
(B) One that pays out nothing when the stock price falls and only pays out when the stock price
rises.
(C) One that may pay out when the stock price falls, but it pays out more when the stock price
rises.
(D) One that pays out more when the stock price falls.

1.2. Assuming the underlying stock pays no dividends, and that both options are European, put-call
parity is:
(A) A bound on the difference between the put price and the call price. It holds for each strike.
(B) An approximate equality on the difference between the put price and the call price. It should
hold for the average option.
(C) An exact difference between the put price and the call price. It should hold for each strike
price.
(D) A statement on the sum of the call price and the put price.
1.3. You should never exercise an American call option on a non-dividend paying stock early because:

(A) There are tax benefits to holding on to the option.

(B) We assumed you don’t need the cash now. If you do need cash before expiration, exercise it
early.
(C) You are better off selling the option than exercising it early.
(D) American options cannot be exercised until expiration.

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1.4. Suppose you see (you’ll never see this, but let’s pretend) both a European and American put option
being sold on the same underlying stock. The two options have the same time to expiration and
the same strike price. The underlying stock will not pay any dividends until expiration. Suppose
the European put sells for $100, and the American put sells for $105. Then:
(A) The $5 difference represents the value of being able to exercise the put option early.
(B) The $5 difference represents the value of being able to sell the option.
(C) This is an arbitrage opportunity: the two should have the same price because you never ex-
ercise an American put on a non-dividend-paying stock early.
(D) This is an arbitrage opportunity: the American put should be cheaper than the European put.
1.5. In our binomial model, we called 𝑞 a risk-neutral probability of the stock price going up because:

(A) We assume investors are risk-neutral.

(B) It’s a (made up) probability of the stock going up, under which it looks like all investors are
pricing options as if they are risk-neutral, even if they are not.
(C) We compensate for risk in option pricing by setting the required rate of return to be above or
below risk-free zero rates. 𝑞 has nothing to do with risk.
(D) The only way we can price is to pretend investors are risk-neutral, even if they are not. We
then pick this probability 𝑞 to make our formulas nice.

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2 Valuing a Cross-Currency Swap (15 points) Consider a Euro for HKD fixed-for-fixed cross-currency
swap. The notionals are HK$100,000,000 and €12,800,000. Suppose the Hong Kong Dollar leg has a swap
rate of 2.0%, and the Euro leg has a swap rate of 1.5%. Suppose payments are made annually, and sup-
pose there is only 6 months left on the swap. For discounting, the 6-month zero rate in HKD is 2.5%
(p.a., with continuous compounding) and the 6-month zero rate in Euro is 2% (p.a., with continuous
compounding). The current exchange rate is 7.78 HKD/€. What is the value of the swap to the payer of
the HKD leg (the party who makes swap payments in HKD and receives the Euro payments)? Express
the value in HKD.
Reminder: cross-currency swaps do feature the notional being exchanged.

3 Bootstrapping SOFR Rates (20 points) Suppose you are using SOFR discounting (use zero rates
implied by SOFR to discount payments). For this problem, all the swaps feature semiannual payments,
and all swap rates are expressed per annum (with semiannual compounding).

Swap Expiration Swap Rate

6 months 2.5%
1 year 3.0%

(a) (10 points) What is the 6-month SOFR zero rate? Express your answer per annum with continuous
compounding.
Hint: you can get this from just the 6-month swap rate.
(b) (10 points) Use your answer from part (a) together with the 1-year swap rate to obtain the 1-year
SOFR zero rate. Express your answer with continuous compounding.

4 Bootstrapping HIBOR Rates (20 points) Suppose you are using HONIA-based discounting, and
wish to bootstrap longer-term HIBOR rates from swaps. You are given the following rates, all given per
annum with continuous compounding:

Rate (p.a., cont. comp.)

6-month HIBOR 4.0%
12-month HIBOR 4.5%
6-month HONIA 3.8%
12-month HONIA 4.3%
18-month HONIA 4.6%

You observe that the swap rate on an 18-month fixed-for-floating HIBOR swap is 4.7%. The swap
features semiannual payments. What is the implied 18-month HIBOR zero rate? Express your answer
p.a. with continuous compounding.

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5 Puts vs. Calls (5 points) If you buy a call option or sell (write) a put option, in both cases you may
end up paying the strike price and receiving the asset. However, when you buy a call, you pay up front,
whereas if you sell a put, you get paid up front. Briefly (three sentences maximum) explain why there
is this difference in upfront payment.
(This is not a trick question. It is very easy, but also fundamental.)

6 Equity Collar (25 points) One option trading strategy we have not discussed is the equity collar.
It involves buying the underlying stock, buying a put option at strike price 𝐾1 (the “floor”) and writing
a call option at strike price 𝐾2 (the “cap”). The two options have the same expiration dates, and it is
assumed that 𝐾2 > 𝐾1 . Assume that all options are European and that the stock does not pay any
dividends.
As always, let 𝑆0 denote the stock price today, 𝑇 denote the years to expiration of the options, 𝑆𝑇 de-
note the stock price at expiration, and 𝑟 denote the risk-free zero rate from today to expiration expressed
per annum with continuous compounding. Also, for part (b) onward, let

𝑎 = 𝑆0 + 𝑝(𝐾1 ) − 𝑐(𝐾2 )

denote the cost (price) of this equity collar: the price of the stock plus a put option minus a call option.
Note that for this problem, reading the supplement to options trading strategies is helpful. It will
teach you a quick way of deriving price bounds from just the payoff graphs. The idea is that if we find
a portfolio of the stock and risk-free borrowing and savings that always does better than the option
portfolio, it must have a higher price than the option portfolio. Likewise, if we find a portfolio of the
stock and risk-free borrowing and savings that always does worse than the option portfolio, it must have
a lower price than the option portfolio.
(a) (5 points) Draw the payoff (not profit) function.
(b) (5 points) Find the largest lower bound for the price 𝑎 of this equity collar in terms of 𝑆0 , 𝐾1 , 𝐾2 , 𝑟,
and/or 𝑇.
To find this bound, find the minimal payoff of this equity collar strategy. Now, consider saving
the present value of this minimal equity collar payoff. The equity collar always dominates this
strategy, so the equity collar must have a higher price than the savings strategy.
(c) (10 points) Find the smallest upper bound for the price 𝑎 of this equity collar. Your answer will be
of the form
min{𝑎1̄ , 𝑎2̄ }
𝑎1̄ is in terms of 𝐾1 , 𝐾2 , 𝑟, and/or 𝑇, while 𝑎2̄ is in terms of 𝑆0 , 𝐾1 , 𝐾2 , 𝑟, and/or 𝑇.
Note that this is the hardest question on this assignment. Just give it a try! Hint:

• To find 𝑎1̄ , think about the maximal payoff of the equity collar. What is the time 𝑡 = 0 value if
you were guaranteed this largest payoff?
• To find 𝑎2̄ , think about a portfolio consisting of the risk-free asset and the underlying asset of
the option. Suppose you save 𝑏 dollars and you buy Δ units of the underlying asset. The cost
at time 𝑡 = 0 is 𝑏 + Δ𝑆0 . The payoff at time 𝑡 = 𝑇 is 𝑏𝑒𝑟𝑇 + Δ𝑆𝑇 . Note that this payoff is a line
when graphed: it has 𝑦-intercept 𝑏𝑒𝑟𝑇 and slope Δ. You’ll be able to find this lower bound
by picking 𝑏 so that 𝑦-intercept matches the 𝑦-intercept of the equity collar payoff in (a), and
then picking the smallest Δ that guarantees that the payoff of this portfolio is always at least
the equity collar payoff in (a). The bound 𝑎2̄ is the cost of this portfolio: 𝑏 + Δ𝑆0 .
(d) (5 points) Suppose that the 𝐾1 and 𝐾2 are chosen so that the price of a put option with strike 𝐾1 is
exactly equal to the price of a call option with strike 𝐾2 . Draw the profit function. Make sure you
compute and mark the value of 𝑆𝑇 where the profit is zero, if any.