Week 11 Assessment

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```					Chapter 20, Problem 5, Parts a, b, c, Page 760
5. The common stock of Company XYZ is currently trading at a price of \$42, Both a put and a call
option are available for XYZ stock, each having an exercise price of \$40 and an expiration date in
exactly six months. The current market prices for the put and call are \$1.45 and \$3.90, respectively.
The risk-free holding period return for the next six months is 4 percent, which corresponds to an
8 percent annual rate.

a. For each possible stock price in the following sequence, calculate the expiration date payoffs (net
of the initial purchase price) for the following positions: (1) buy one XYZ call option, and (2) short
one XYZ call option.
(1) Buy One XYZ Call Option
Enter Exercise Price of Option 40.00                    Enter Correct Data from Problem
Enter Price of Call Option     3.90

Initial          Stock
0          3.90          20         (3.90)
0          3.90          25         (3.90)
0          3.90          30         (3.90)
0          3.90          35         (3.90)
0          3.90          40         (3.90)
5          3.90          45          1.10
10          3.90          50          6.10
15          3.90          55        11.10
20          3.90          60        16.10

Draw a graph of these payoff relationships, using net profit on the vertical axis.
Be sure to specify the prices at which these respective positions will break even
(i.e., produce a net profit of zero).

20.00

15.00

10.00
Net Profit

5.00

0.00
0        10       20      30        40   50   60
(5.00)

(10.00)
Stock Price
(2) Short One XYZ Call Option
Enter Exercise Price of Option                                      Enter Correct Data from Problem
Enter Price of Call Option

Initial     Stock
0             0.00     20         0.00
0             0.00     25         0.00
0             0.00     30         0.00
0             0.00     35         0.00
0             0.00     40         0.00
45             0.00     45      (45.00)
50             0.00     50      (50.00)
55             0.00     55      (55.00)
60             0.00     60      (60.00)

Short One XYZ Call Option
10.00
0.00
(10.00) 0          10      20     30         40   50    60        70

(20.00)
Net Profit

(30.00)
(40.00)
(50.00)
(60.00)
(70.00)
Stock Price

b. Using the same potential stock prices as in Part a, calculate the expiration date payoffs and profits
(Net of initial purchase price) for the following positions: (1) buy one XYZ put option, and (2) short one
XYZ put option. Draw a graph of these relationships, labeling the prices at which these investments
will break even.

(1) Buy One XYZ Put Option
Enter Exercise Price of Option                                      Enter Correct Data from Problem
Enter Price of Put Option

Initial     Stock
-20            0.00     20        (20.00)
-25            0.00     25        (25.00)
-30            0.00     30        (30.00)
-35            0.00     35        (35.00)
0            0.00     40          0.00
0            0.00     45          0.00
0            0.00     50          0.00
0            0.00     55          0.00
0            0.00     60          0.00

5.00
0.00
(5.00) 0          10      20     30         40   50    60        70
(10.00)
Net Profit

(15.00)
(20.00)
(25.00)
(30.00)
(35.00)
(40.00)
Stock Price

(2) Short One XYZ Put Option
Enter Exercise Price of Option                                    Enter Correct Data from Problem
Enter Price of Put Option

Initial     Stock
0            0.00     20         0.00
0            0.00     25         0.00
0            0.00     30         0.00
0            0.00     35         0.00
0            0.00     40         0.00
0            0.00     45         0.00
0            0.00     50         0.00
0            0.00     55         0.00
0            0.00     60         0.00

Short One XYZ Put Option
1.00
1.00

0.80

Net Profit
0.60

0.40

0.20

0.00
0          10   20      30        40       50   60       70
Stock Price

c. Determine whether the \$2.45 difference in the market prices between the call and put options is consistent with
the put-call parity relationship for European-style contracts.

Enter Call Premium                                      Enter Correct Data from Problem
Enter Exercise Price
Enter Risk-free Rate
Enter Stock Price
Enter Number of Months to Maturity

Call                   -          Put         =      Stock Price     -        PV Exercise Price

0.00                               0.00                  0.00                  0.00

0.00                   0.00
Put Call Parity holds
70
70
70
70

ptions is consistent with

PV Exercise Price
Chapter 21, Problem 2, Page 796
You are a coffee dealer anticipating the purchase of 82,000 pounds of coffee in three months. You are
concerned that the price of coffee will rise, so you take a position in coffee futures. Each contract
covers 37,500 pounds, and so, rounding to the nearest contract, you decide to go long in two contracts.
The futures price at the time you initiate your hedge is 55.95 cents per pound. Three months later,
the actual spot price of coffee turns out to be 58.56 cents per pound and the futures price is 59.20 cents
per pound.

a. Determine the effective price at which you purchased your coffee?
How do you account for the difference n amounts for the spot and hedge positions?
*

Determining Effective Price
Futures Contract Beginning Price of Coffee per Pound
Futures Contract Ending Price of Coffee per Pound
Spot Price of Coffee in 3 Months (cents per pound)
Pounds of Coffee in 1 Futures Contract
Number of Futures Contracts Purchased
Total Number of Pounds of Coffee to be Purchased

Number of Pounds of Coffee Covered by Futures Contracts           0
Initial Cost of Futures Contract      0.00
Ending Value of Futures Contract        0.00
Gain or Loss on Futures Contract        0.00

Cash Cost for First     0       Pounds      0.00
Net Cost for First     0       Pounds      0.00   Cash Cost Less Futures Contract Gain or Loss
Effective Per Pound Cost for First      0       Pounds     #DIV/0!

Cost to Purchase Remaining         0       Pounds      0.00
Total Cost for      0       Pounds      0.00   Excluding Gain/Loss on Futures Contract
Effective Cost per Pound for       0       Pounds     #DIV/0! Excluding Gain/Loss on Futures Contract
Effective Cost per Pound for       0       Pounds     #DIV/0! Including Gain/Loss on Futures Contract

b. Describe the nature of basis risk in this long hedge.
hs. You are

wo contracts.

s 59.20 cents

Less Futures Contract Gain or Loss

Gain/Loss on Futures Contract
Gain/Loss on Futures Contract
Gain/Loss on Futures Contract
Chapter 21, Problem 7, Page 797
Suppose that one day in early April, you observe the following prices on futures contracts maturing
in June: 93.35 for Eurodollar and 94.07 for T-bill. These prices imply three-month LIBOR and T-bill
settlement yields of 6.65 percent and 5.93, respectively. You think that over the next quarter the
general level of interest rates will rise while the credit spread built into LIBOR will widen.
Demonstrate how you can use a TED (Treasury/Eurodollar) spread, which is a simultaneous
long (short) position in a Eurodollar contract and short (long) position in the T-bill contract, to
create a position that will benefit from these views.
(Note: See discussion of TED spread on pages 780-781.)

T-Bill and Eurodollar Futures Contracts

(Basis       t Yield T-   t Yield
T-bill       Eurodollar    Points)           bill   Eurodollar
June Contracts                                   0.00         100.00     100.00

September Contracts (Estimated)                                     0.00        100.00      100.00

Position = Long T-bill Contract; Short Eurodollar Contract
Profit on Transaction is Caculated as:

Evaluating the Position
Change in TED spreads    0.00            -          0.00       =                  0.00

Returns on Components           0.00           -           0.00           =         0.00
Loss on Long                 Gain on
Position in                  Short
T-Bill                       Position in
Eurodollar
Basis Points

Basis Points
Chapter 22, Problem No. 5, Page 842

Consider the following questions on the pricing of options on the stock of ARB Inc.:

a. A share of ARB stock sells for \$75 and has a standard deviation of returns equal to 20 percent per year.
The current risk-free rate is 9 percent and the stock pays two dividends: (1) a \$2 dividend just prior
to the option's expiration day, which is 91 days from now (i.e., exactly one-quarter of a year); and,
(2) a \$2 dividend 182 days from now (i.e., exactly one-half year).
Calculate the Black-Scholes value for a European-style call option with an exercise price of \$70.

The attached model will calculate the Black-Scholes and Binominal Option Pricing Model
values for the call option.

b. What would be the price of a 91-day European-style put option on ARB stock having the same
exercise price:

The attached model automatically calculates the Black-Scholes and Binomial Option Pricing Model
values for the put option.

Alternatively, Put-Call Parity can be used to solve for the value of the put option.

Enter Exercise Price
Enter Risk-free Rate
Enter Stock Price
Dividend Payment
Enter Number of Months to Maturity
exp                Value is 2.7183

Call           -     Stock Price     +           PV Exercise Price           =       Put

0.00            -        0.00         +         #NUM!                         =     #NUM!

c. Calculate the change in the call option's value that would occur if ARB's management suddenly decided
to suspend dividend payments and this action had no effect on the price of the company's stock.

The new call option price is               , which is      0.00       greater than the initial value of

d. Briefly describe (without calculations) how your answer in Part a would differ under the following separate circumstances:

Note: See page 819 to learn how changes in factors affect Black-Scholes Option Values.
rcent per year.

tion Pricing Model

ddenly decided

than the initial value of          0.00   .

following separate circumstances:
Chapter 22, Problem 11, Page 844
In mid-May, there are two outstanding call option contracts available on the stock of ARB Co.:

Number
Exercise        Expiration     Market                      Purchased
Call #           Price            Date          Price                       or Sold
1                50            Aug. 19          8.40                          1
2                60            Aug. 19          3.34                          2

a. Assuming that you form a portfolio consisting of one Call #1 held long, and two Calls #2 held short,
complete the following table showing your intermediate steps. In calculating net profit, be sure to
include the net initial cost of the options.

Price of ARB
Initial Cost       Profit on       Profit on      Stock at       Net Profit
of             Call #1         Call #2      Expiration      on Total
Portfolio         Position        Position          (\$)         Portfolio
(1.72)            0.00            0.00            40           (1.72)
(1.72)            0.00            0.00            45           (1.72)
(1.72)            0.00            0.00            50           (1.72)
(1.72)            5.00            0.00            55            3.28
(1.72)           10.00            0.00            60            8.28
(1.72)           15.00           (10.00)          65            3.28
(1.72)           20.00           (20.00)          70           (1.72)
(1.72)           25.00           (30.00)          75           (6.72)

b. Graph the net profit relationship in Part a, using stock price on the horizontal axis. What is
(are) the breakeven stock price(s)? What is the point of maximum profit?

Net Profit on Total Portfolio
10
N     8
e
6
t
4
2
P
r    0
o   -2 40            45       50       55          60      65        70       75   80
f   -4
i   -6
t   -8
Stock Price
Stock Price

Breakeven on Low Side:
Occurs at Long Call Strike Price       50       plus              1.72      or total of,

Breakeven on High Side:
Occurs with the position's cost, (1.72), Profit on the Call (P - Strike), and loss on the short c

c. Under what market conditions will this strategy (which is known as a call ratio spread ), generally make sense?
Does the holder of this position have limited or unlimited liability?
Enter correct data from problem!
51.72    ,to cover cost.

, and loss on the short calls 2(Strike - P) equal zero:

make sense?
Week 11, Assignment No. 5, Essay Question, "Ethics and Regulation in the Professional Asset Management Industry"

Chapter 24 identifies and discusses ethical conflicts that can arise between professional investment managers
(e.g., financial advisors, investment counselors, etc.) and investors whose assets they are employed to manage.

a. Describe at least three potential ethical conflicts that can arise between financial advisors and investors.
This explanation should describe the basis for the conflict (what causes it?) and how it is potentially
damaging to the investor? Be specific.

b. How should government legislation (laws) and regulatory oversight (regulations) be structured
to protect individual investors from such conflicts? Please be specific.
set Management Industry"

estment managers
mployed to manage.

s and investors.

Black-Scholes-Merton and Binomial Option Pricing
BSMbin7e.xls

Inputs:                                                   Black-Scholes-Merton Model           Binomial Model                  Run Binomial
Model
Asset price (S0)                   75                                    European     European    Steps:               100
Exercise price (X)                 70                                         Call         Put                   European     European
Time to expiration (T)         0.2500                           Price    #NAME?      #NAME?                            Call         Put
Standard deviation (s)        20.00%                         Delta (D)   #NAME?      #NAME?         Price           5.6500       1.1135
discrete          Gamma (G)                             Delta (D)
Risk-free rate (r or rc)       9.00%                                     #NAME?      #NAME?                         0.7542      -0.2458
continuous
Dividends:                     0.00%                        Theta (Q)    #NAME?      #NAME?    Gamma (G)            0.0429       0.0429
continuous yield (dc) or discrete dividends below:            Vega #NAME?          #NAME?         Theta (Q)     -8.8598       -2.9559
Rho #NAME?          #NAME?                      American     American
In lieu of a continuously compounded yield, place below                                                             Call          Put
up to fifty discrete dividends and the time in years to           d1 #NAME?                           Price      7.1310        1.1135
each ex-dividend date. Leave all unused cells blank.
Set the yield above to zero. If yield is not set to zero,         d2 #NAME?                        Delta (D)     0.8361       -0.2458
all discrete dividends are disregarded.                        N(d1) #NAME?                      Gamma (G)        0.0338       0.0429
N(d2) #NAME?                       Theta (Q)      -8.2735      -2.9559

Dividend #       Dividend Time to ex    Present
1        2.0000     0.2500      1.9555
2                               0.0000
3                               0.0000
4                               0.0000
5                               0.0000
6                               0.0000
7                               0.0000
8                               0.0000
9                               0.0000
10                               0.0000
11                               0.0000
12                               0.0000
13                               0.0000
14                               0.0000
15                               0.0000
16                               0.0000
17                               0.0000
18                               0.0000
19                               0.0000
20                               0.0000
21                               0.0000
22                               0.0000
23                               0.0000
24                               0.0000
25                               0.0000
26                               0.0000
27                               0.0000
28                               0.0000
29                               0.0000
30                               0.0000
31                               0.0000
32                               0.0000
33                               0.0000
34                               0.0000
35                               0.0000
36                               0.0000
37                               0.0000
38                               0.0000
39                               0.0000
40                               0.0000
41                               0.0000
42                               0.0000
43                               0.0000

Page 21

44                     0.0000
45                     0.0000
46                     0.0000
47                     0.0000
48                     0.0000
49                     0.0000
50                     0.0000
========== ======== ======== =======
Sum        0.0000

Page 22
Instructions:

Insert values in highlighted cells. Risk-free rate, standard deviation and yield can be
entered as decimal or percentage (e.g., .052 or 5.2 for 5.2 %). Select form (discrete
or continuous) for risk-free rate. Black-Scholes values automatically recalculate.
Click on "Run Binomial Option Pricing Model" button to recalculate binomial values.
Input cells have double borders. Output cells have single borders. Up to 1,000 time
steps can be used in the binomial model.

Input a continuous dividend yield or up to 50 discrete dividends. Do not enter both
or the discrete dividends will be ignored.

This spreadsheet can be used to calculate options on forwards or futures using the
Black variation of the Black-Scholes model. Input the forward or futures price
instead of the asset price and input the risk-free rate as both the risk-free rate and
the dividend yield. Do not enter discrete dividends.

To price foreign currency options, input the spot rate as the asset price, the domestic
interest rate as the risk-free rate and the foreign interest rate as the dividend yield.
Do not enter discrete dividends.
Written by Don M. Chance and Robert E. Brooks
For use with An Introduction to Derivatives and Risk Management,
7th ed.
(Mason, Ohio: South-Western Thomson, Inc., 2007)
Date: 9/02
Last updated: 12/28/05

Black-Scholes-Merton and Binomial Option Pricing
BSMbin7e.xls

Inputs:                                                   Black-Scholes-Merton Model           Binomial Model                  Run Binomial
Model
Asset price (S0)                   75                                    European     European    Steps:               100
Exercise price (X)                 70                                         Call         Put                   European     European
Time to expiration (T)         0.2500                           Price    #NAME?      #NAME?                            Call         Put
Standard deviation (s)        20.00%                         Delta (D)   #NAME?      #NAME?         Price           5.6500       1.1135
discrete          Gamma (G)                             Delta (D)
Risk-free rate (r or rc)       9.00%                                     #NAME?      #NAME?                         0.7542      -0.2458
continuous
Dividends:                     0.00%                        Theta (Q)    #NAME?      #NAME?    Gamma (G)            0.0429       0.0429
continuous yield (dc) or discrete dividends below:            Vega #NAME?          #NAME?         Theta (Q)     -8.8598       -2.9559
Rho #NAME?          #NAME?                      American     American
In lieu of a continuously compounded yield, place below                                                             Call          Put
up to fifty discrete dividends and the time in years to           d1 #NAME?                           Price      7.1310        1.1135
each ex-dividend date. Leave all unused cells blank.
Set the yield above to zero. If yield is not set to zero,         d2 #NAME?                        Delta (D)     0.8361       -0.2458
all discrete dividends are disregarded.                        N(d1) #NAME?                      Gamma (G)        0.0338       0.0429
N(d2) #NAME?                       Theta (Q)      -8.2735      -2.9559

Dividend #       Dividend Time to ex    Present
1                               0.0000
2                               0.0000
3                               0.0000
4                               0.0000
5                               0.0000
6                               0.0000
7                               0.0000
8                               0.0000
9                               0.0000
10                               0.0000
11                               0.0000
12                               0.0000
13                               0.0000
14                               0.0000
15                               0.0000
16                               0.0000
17                               0.0000
18                               0.0000
19                               0.0000
20                               0.0000
21                               0.0000
22                               0.0000
23                               0.0000
24                               0.0000
25                               0.0000
26                               0.0000
27                               0.0000
28                               0.0000
29                               0.0000
30                               0.0000
31                               0.0000
32                               0.0000
33                               0.0000
34                               0.0000
35                               0.0000
36                               0.0000
37                               0.0000
38                               0.0000
39                               0.0000
40                               0.0000
41                               0.0000
42                               0.0000
43                               0.0000

Page 26

44                     0.0000
45                     0.0000
46                     0.0000
47                     0.0000
48                     0.0000
49                     0.0000
50                     0.0000
========== ======== ======== =======
Sum        0.0000

Page 27
Instructions:

Insert values in highlighted cells. Risk-free rate, standard deviation and yield can be
entered as decimal or percentage (e.g., .052 or 5.2 for 5.2 %). Select form (discrete
or continuous) for risk-free rate. Black-Scholes values automatically recalculate.
Click on "Run Binomial Option Pricing Model" button to recalculate binomial values.
Input cells have double borders. Output cells have single borders. Up to 1,000 time
steps can be used in the binomial model.

Input a continuous dividend yield or up to 50 discrete dividends. Do not enter both
or the discrete dividends will be ignored.

This spreadsheet can be used to calculate options on forwards or futures using the
Black variation of the Black-Scholes model. Input the forward or futures price
instead of the asset price and input the risk-free rate as both the risk-free rate and
the dividend yield. Do not enter discrete dividends.

To price foreign currency options, input the spot rate as the asset price, the domestic
interest rate as the risk-free rate and the foreign interest rate as the dividend yield.
Do not enter discrete dividends.
Written by Don M. Chance and Robert E. Brooks
For use with An Introduction to Derivatives and Risk Management,
7th ed.
(Mason, Ohio: South-Western Thomson, Inc., 2007)
Date: 9/02
Last updated: 12/28/05

```
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