Assignment -2

Due date: 28th Oct, 2023

1. Suppose that the standard deviation of quarterly changes in the prices of a commodity is
$0.65, the standard deviation of quarterly changes in a futures price on the commodity is
$0.81, and the coefficient of correlation between the two changes is 0.8.
a. What is the optimal hedge ratio for a 3-month contract?
b. What should be the size of the futures position relative to the size of exposure?
c. What is the effectiveness of this hedge i.e. how much of the cash flow variance is getting
removed by the optimal hedge?
2. A company has a Rs. 2 million portfolio with a beta 1.2. It would like to use futures
contracts on the Nifty 50 to hedge its risk. The index is currently standing at 8400 and
each contract is for delivery of Rs. 200 times the index.
a. What is the hedge that minimizes risk?
b. What should the company do if it wants to reduce the beta of the
portfolio to 0.6?
c. What should the company do to eliminate all exposure to the market?
3. A 1-year long forward contract on a non-dividend-paying stock is entered into when the
stock price is $40 and the risk-free rate of interest is 5% per annum with continuous
compounding.
(a) What are the forward price and the initial value of the forward contract?
(b) Six months later, the price of the stock is $45 and the risk-free interest rate is still 5%.
What are the forward price and the value of the forward contract?
4. A stock index currently stands at 350. The risk-free interest rate is 4% per annum (with
continuous compounding) and the dividend yield on the index is 3% per annum. What
should the futures price for a 4-month contract be?
5. The 2-month interest rates in Switzerland and the United States are, respectively, 1% and
2% per annum with continuous compounding. The spot price of the Swiss franc is
$1.0500. The futures price for a contract deliverable in 2 months is also $1.0500. What
arbitrage opportunities does this create?
6. The spot price of silver is $25 per ounce. The storage costs are $0.24 per ounce per year
payable quarterly in advance. Assuming that interest rates are 5% per annum for all
maturities, calculate the futures price of silver for delivery in 9 months
7. A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. The
stock price is $50, and the risk-free rate of interest is 8% per annum with continuous
compounding for all maturities. An investor has just taken a short position in a 6-month
forward contract on the stock.
(a) What are the forward price and the initial value of the forward contract?
(b) Three months later, the price of the stock is $48 and the risk-free rate of interest is
still 8% per annum. What are the forward price and the value of the short position in
the forward contract?
8. An investor buys a European put on a share for $3. The stock price is $42 and the strike
price is $40. Under what circumstances does the investor make a profit? Under what
circumstances will the option be exercised? Draw a diagram showing the variation of the
investor’s profit with the stock price at the maturity of the option.
9. An investor sells a European call on a share for $4. The stock price is $47 and the strike
price is $50. Under what circumstances does the investor make a profit? Under what
circumstances will the option be exercised? Draw a diagram showing the variation of the
investor’s profit with the stock price at the maturity of the option.
10. An investor sells a European call option with strike price of K and maturity T and buys a
put with the same strike price and maturity. Describe the investor’s position
11. A 4-month European call option on a dividend-paying stock is currently selling for $5.
The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in
1 month. The risk-free interest rate is 12% per annum for all maturities. What opportunities are
there for an arbitrageur?
12. A 1-month European put option on a non-dividend-paying stock is currently selling
for $2:50. The stock price is $47, the strike price is $50, and the risk-free interest rate is
6% per annum. What opportunities are there for an arbitrageur?
13. The price of a non-dividend-paying stock is $19 and the price of a 3-month European
call option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per
annum. What is the price of a 3-month European put option with a strike price of $20?
14. Calls were traded on exchanges before puts. During the period of time when calls were
traded but puts were not traded, how would you create a European put option on a non dividend-
paying stock synthetically
15. What is meant by a protective put? What position in call options is equivalent to a
protective put?
16. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7,
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the profit and payoff for both spreads.
17. How can a forward contract on a stock with a particular delivery price and delivery date
be created from options?
18. Suppose we simultaneously enter into the following two transactions:
1. Buy a 40-strike call and sell a 40-strike put on a stock with 3 months to expiry
2. Sell a 45-strike call and buy a 45-strike put. on the same stock with 3 months to expiry

Assume risk free rate = 8% p.a. continuously compounded

a) Does this transaction have any stock price risk upon expiry? Explain
b) What is the payoff at expiration?
c) What is this strategy known as?
d) What should the cost of this strategy?

19. Show the payoff for the following portfolio of options, all with the same
maturity in tabular format and as a payoff diagram :
(a) long a call at strike 75, (b) long two calls at strike 80, and (c) long three calls at strike 85.
What is the view of the stock price change consistent with this
portfolio?

Hint: Why would you buy Out of Money (OTM) options

20. Assume that a stock is currently trading at INR 2,300. There is a call option and a put option on the
stock with an exercise price of INR 2,400 and with 90 days to maturity. The call option is priced at
INR 165. Stock is expected to pay a dividend of INR 100 after 30 days. If the annualized risk-free
interest rate is 8% for 90 days and 5.5% for 30 days, what is the put price according to put–call
parity?

Hint: We had covered put-call parity for European options on a non-dividend paying asset in the
asset. How would you modify the argument to include dividend paying assets?