FIN359 Examination - January Semester 2009

FIN359 Examination – January Semester 2009

Derivative Securities Friday, 22 May 2009

4:00 pm – 6:00 pm

____________________________________________________________________________________

Time allowed: 2 hours ____________________________________________________________________________________

INSTRUCTIONS TO STUDENTS: 1. This examination contains FOUR (4) questions and comprises THREE (3) printed pages (including cover page). 2. You must answer ALL questions. 3. All answers must be written in the answer book.

At the end of the examination Please ensure that you have written your examination number on each answer book used. Failure to do so will mean that your work cannot be identified. If you have used more than one answer book, please tie them together with the string provided.

THE UNIVERSITY RESERVES THE RIGHT NOT TO MARK YOUR SCRIPT IF YOU FAIL TO FOLLOW THESE INSTRUCTIONS.

FIN359 Copyright © 2009 SIM University Examination – January Semester 2009

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You must answer ALL the questions. (Total 100 marks)

Question 1 (a)

Your friend is interested in trading futures contracts. However, he does not quite understand the terms “mark-to-market” and “initial margin” and he is seeking your assistance. Explain the meaning of these terms to him. (10 marks)

(b)

Josephine attended a three-day workshop on using derivatives to hedge portfolio risk. During the seminar, the instructor presented a slide on the futures market. This slide is shown below:

Futures Markets 1. In the futures market, convergence on the futures price at expiration to the current spot price is expected. If this is not the case, then an arbitrage opportunity would exist. 2. The futures price is simplistically viewed by some as a market consensus for what the spot price will be at contract expiration, but in reality the current futures price and the expected spot price of the asset reflect different degrees of risk. Comment on the two points made in the slide with regard to their correctness. (10 marks) (c)

Explain the difference between (i) an arbitrageur and (ii) a speculator. (5 marks)

Question 2 Today is 1 March. Use the European option quote information below to answer the questions that follow. The stock is currently selling for $78. Assuming that the continuously compounded risk-free rate, r = 5% and the option expires at the end of each month.

Option ABC Corp

(a)

Expiration

Strike price

Mar Apr

80 80

Calls Volume Last 230 170

2.80 6

Puts Volume

Last

160 127

0.80 1.40

Are the call options in the money? What are the intrinsic values of ABC Corp. call options? (4 marks)

FIN359 Copyright © 2009 SIM University Examination – January Semester 2009

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(b)

Are the put options in the money? What are the intrinsic values of an ABC Corp. put options? (8 marks)

(c)

Identify two of the options which are clearly mispriced. At a minimum, what should the mispriced option sell for? Explain how you could profit from the mispricing in each case. (13 marks)

Question 3 (a)

Usually, there is some chance that an American option may be exercised prior to expiration. Explain why it is never justified to exercise deep in-the-money American call options on non-dividend paying stock early. (6 marks)

(b)

“The buyer of the call and the seller of the put both hope that the underlying asset price will rise. Therefore the two positions are identical”. Is the speaker correct? Illustrate your answer with a profit and loss diagram. (9 marks)

(c)

A trader believes that the underlying asset price will swing widely after an upcoming major event, but is uncertain of its direction. How can he take advantage of this expectation by using option contracts on the underlying asset? (5 marks)

(d)

A spread trader expects the market to trade higher but the volatility will remain the same. How can he use the spread trading strategy to profit from this expectation? (5 marks)

Question 4 (a)

The risk-free rate of interest is 7% per annum with continuous compounding and the dividend yield on a stock index is 3.2% per annum. The current value of the index is 150. What is the six-month futures price? (10 marks)

(b)

Explain the difference between (i) Interest Rate Swaps and (ii) Currency Swaps. (15 marks)

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FIN359 Copyright © 2009 SIM University Examination – January Semester 2009

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