Question 1: Explain the difference between the credit risk and market risk in financial

contract.
Answer: Credit risk rises from the possibility of a default by the counterparty. Market risks
arises from the movements in market variables such as interest rates and exchange rate. A
complication is that the credit risk in a swap is contingent on the value of market variables. A
company's position in a swap has credit risk only when the value of the swap to the company
is positive.
Question 2: Explain why an American option is always worth at least as much as its
intrinsic value.
Answer: The holder of an American option has the right to exercise it immediately. The
American option must therefore be worth at least as much as it's intrinsic value. If it were not
an arbitrageur could lock in a sure profit by buying the option and exercising it immediately.
Question 3: Consider a five year call option on a non-dividend-paying stock granted to
employees. The option can be exercise at any time after the end of the five year. Unlike a
regular exchange traded call option, the employee stock option cannot be sold. What is
the likely impact of this restriction on early exercise?
Answer: Employees stock option may be exercised early because the employee needs cash or
because he or she is uncertain about the company's future prospects. Regular call option can
be sold in the market in either of these two situations, but employee stock options cannot be
sold. In theory an employee can short the company's stock as an alternative to exercising. In
practice this is not usually encouraged and may even be illegal for senior managers.
Question 4: When is it appropriate for an investor to purchase a butterfly spread?
Answer: A butterfly is spread in walls opposition in option with three different strike prices
( K1, K2, K3). A butterfly spread should be purchased when the investor considers that the
price of the underlaying stock is likely to stay close to the central strick price K2.
Question 5: Explain how you would do the analysis to produce a chart such as the one in
figure 15.2.
Answer: It would be necessary to look at returns on each stock in the sample (possibility
adjusted for the returns on the market and the beta of the stock) around the reported employee
stock option grant date. One could designate Day 0 as a grand date and look at returns on
each stock each day from day -30 to day +30. The returns would then be averaged across the
stocks.
Question 6: Suppose that a portfolio is worth 60 million dollars and the S&P 500 is at
1200. If the value of the portfolio mirrors the value of the index, what options should be
purchased to provide protection against the value of the portfolio falling low 54 million
dollars in 1 year's time.
Answer: It's the value of the portfolio mirrors the value of the index, The index can be
expected to have drop by 10% when the value of portfolio drops by 10%. Hence when the
value of the portfolio drops to 54 million dollars the value of the index can be expected to be
1080. This indicates that put options with an exercise price of 1080 should be purchased. The
options should be on: 60,000,000/1200= 50,000
Question 7: Consider and American future's collection where the future's contract and
the option contract expire at the same time under circumstances in the future's option
worth more than the corresponding American option on the underlaying asset?
Answer: The American futures call option is worth more than the corresponding American
option on the underlaying asset. When the future price is greater than the spot price prior to
the maturity of the future contract. This is the case when the risk-free rate is greater than the
income on the asset plus the convenience yield.
Question 8: "For a dividend-paying stock, the tree for the stock price does not
recombine; but the tree for the stock price less the present value of the future dividends
does recombine." Explain this statement.
Answer: Supposed a dividend equal to D is paid during a certain time interval. If S is the
stock price at the beginning of the time interval, it will be either Su-D Or Sd-D at the end of
the time interval. At the end of the next time interval, it will be one of (Su-D)u, (Su-D)d, (Sd-
D)u and (Sd-D)d. Since (Su-D)d does not equal (Sd-D)u the tree does not recombine. If S is
equal to the stock price less the present value of future dividends, this problem is avoided.
Question 9: The volatility of a certain market variable is 30% per annum. Calculate a
90% confidence interval for the size of the percentage daily change in the variable.
Answer: The volatility per day is 30 / √252=1.89%. there is a 99% chance that a normally
distributed variable will be within 2.57 standard aviation. We are therefore 99% confidence
that the daily change will be less than 2.57 * 1.89 = 4.86%.
Question 10: Explain why a total returns swap can be useful as a financing tool.
Answer: Suppose a company wants to buy some assets if a total return swap is used, a
financial institutions buys the assets and enters into a swap with the company where it pays
the company the return on the assets and receives from the company LIBOR plus a spread.
The financial institution has less risk than it would have if it lends the company money and
use the assets as collateral. This is because, the event of the default by the company, it owns
the assets.