Financial Derivatives

Assignment

Class: MBA-NBE 4th (MORNING)

Submitted to: Sir Javed Iqbal
Submitted by: Areeba Naseer
Roll No: MBNBM-22-06

IMS BZU Multan

Qno1.A financial institution has entered into a 10-year currency swap with company Y. Under
the terms of the swap, the financial institution receives interest at 3% per annum in Swiss francs
and pays interest at 8% per annum in U.S. dollars. Interest payments are exchanged once a year.
The principal amounts are 7 million dollars and 10 million francs. Suppose that company Y
declares bankruptcy at the end of year 6, when the exchange rate is $0.80 per franc. What is the
cost to the financial institution? Assume that, at the end of year 6, the interest rate is 3% per
annum in Swiss francs and 8% per annum in U.S. dollars for all maturities. All interest rates are
quoted with annual compounding.
When interest rates are compounded annually

where F is the 7-year forward rate, S, is the spot rate, is the domestic risk-free rate, and is the
foreign risk-free rate. As r = 0.08 and r, = 0.03, the spot and forward exchange rates at the end of
year 6 are
Spot: 0.8000
1 year forward: 0.8388
year forward: 0.8796
3 year forward: 0.9223
4 year forward: 0.9670
The value of the swap at the time of the default can be calculated on the assumption that forward
rates are realized. The cash flows lost as a result of the default are therefore as follows:

Discounting the numbers in the final column to the end of year 6 at 8% per annum, the cost of
the default is $679,800.
Note that, if this were the only contract entered into by company Y, it would make no sense
for the company to default at the end of year six as the exchange of payments at that time has a
positive value to company Y. In practice, company Y is likely to be defaulting and declaring
bankruptcy for reasons unrelated to this particular contract and payments on the contract are
likely to stop when bankruptcy is declared.
Problem 9.9.
Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held until
maturity. Under what circumstances will the holder of the option make a profit? Under what
circumstances will the option be exercised? Draw a diagram illustrating how the profit from a
long position in the option depends on the stock price at maturity of the option.
Ignoring the time value of money, the holder of the option will make a profit if the stock price at
maturity of the option is greater than $105. This is because the payoff to the holder of the option
is, in these circumstances, greater than the $5 paid for the option. The option will be exercised if
the stock price at maturity is greater than $100. Note that if the stock price is between $100 and
$105 the option is exercised, but the holder of the option takes a loss overall. The profit from a
long position is as shown in Figure S9.3.

Problem 10.2.
What is a lower bound for the price of a four-month call option on a non-dividend-paying stock
when the stock price is $28, the strike price is $25, and the risk-free interest rate is 8% per
annum?
The lower bound is
28−25e0.08x0.3333 = $3.66
Problem 11.17.
What is the result if the strike price of the put is higher than the strike price of the call in a
strangle?
The result is shown in Figure S11.1. The profit pattern from a long position in a call and a put
when the put has a higher strike price than a call is much the same as when the call has a higher
strike price than the put. Both the initial investment and the final payoff are much higher in the
first case

Problem 15.1.
Why was it attractive for companies to grant at-the-money stock options prior to 2005? What
changed in 2005?
Prior to 2005 companies did not have to expense at-the-money options on the income statement.
They merely had to report the value of the options in notes to the accounts. FAS 123 and IAS 2
required the fair value of the options to be reported as a cost on the income statement starting in
2005.
Problem 16.1.
A portfolio is currently worth $10 million and has a beta of 1.0. An index is currently standing at
800. Explain how a put option on the index with a strike of 700 can be used to provide portfolio
insurance.
When the index goes down to 700, the value of the portfolio can be expected to be 10× (700/800)
= $8.75 million. (This assumes that the dividend yield on the portfolio equals the dividend yield
on the index.) Buying put options on 10,000,000/800 = 12,500 times the index with a strike of
700 therefore provides protection against a drop in the value of the portfolio below $8.75
million. If each contract is on 100 times the index a total of 125 contracts would be required.

Problem 17.20.
Calculate the price of a three-month European call option on the spot price of silver. The three-
month futures price is $12, the strike price is $13, the risk-free rate is 4%, and the volatility of
the price of silver is 25%.
This has the same value as a three-month call option on silver futures where the futures contract
expires in three months. It can therefore be valued using equation (17.9) with F12, K13, r = 0.04,
σ = 0.25 and 7 = 0.25. The value is 0.244.
8. Which of the following can be estimated for an American option by constructing a single
binomial tree: delta, gamma, vega, theta, rho?

9.
What is the difference between the exponentially weighted moving average model and the
GARCH(1,1) model for updating volatilities?
The EWMA model produces a forecast of the daily variance rate for day n which is a weighted
average of (i) the forecast for day n-1, and (ii) the square of the proportional change on day n−1.
The GARCH (1,1) model produces a forecast of the daily variance for day n which is a weighted
average of (i) the forecast for day n−1, (ii) the square of the proportional change on day n−1. and
(iii) a long run average variance rate. GARCH (1,1) adapts the EWMA model by giving some
weight to a long run average variance rate. Whereas the EWMA has no mean reversion, GARCH
(1,1) is consistent with a mean- reverting variance rate model.
10.
What is the formula relating the payoff on a CDS to the notional principal and the recovery rate?
The payoff is L(1-R) where L is the notional principal and R is the recovery rate.