FIN359

Derivative Securities

Tutor-Marked Assignment

July 2018 Presentation

FIN359 Tutor-Marked Assignment

TUTOR-MARKED ASSIGNMENT (TMA)

This assignment is worth 38% of the final mark for FIN359 Derivative Securities.

The cut-off date for this assignment is 4 September 2018, 2355hrs.

Note to Students:

You are to include the following particulars in your submission: Course Code, Title of the
TMA, SUSS PI No., Your Name, and Submission Date.

Question 1

Inno Bank has a new product in currency deposits. Below is how it’s main terms are presented
to its customers:

Customer makes a Euro Dollar (€) deposit with the bank. At the same time, he is required to
select another currency US Dollar, say ($) to be linked to the €. The bank will then work out
the conversion rate between these two currencies, (assume it is € 1 = $1.1965), and this is to
be applied as below when the € deposit matures in 1 month (say).

Customer is then told that the € currency deposit will yield 12.6% p.a. (which is very attractive
as it is about 3.2% higher than a basic € deposit).

However, there is caveat: Upon the deposit’s maturity (i.e. after 1 month), the bank will return
the matured deposit (principal cum interest) in the weaker currency denomination (relative to
€ 1 = $1.1965) to be converted at $1.1965.

You are required to answer the following questions:

(a) Analyse the structure of this innovative financial instrument, in terms of the payoff of
the customer. You may simulate the various market scenarios upon the deposit’s
maturity based on €100,000 deposit.
(10 marks)

(b) What positions have the bank and the customer taken respectively in this deal? Why is
the bank prepared to pay such a high interest rate to the customer?
(10 marks)

(c) What is the bank’s outlook on the currencies in the next 1 month?
(5 marks)

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FIN359 Tutor-Marked Assignment

Question 2

(a) Explain why an Interest Rate Swap (assume LIBOR as the floating rate) with quarterly
settlement (assume 90 days per quarter) can be viewed as a strip of Eurodollar futures
contracts. (Note: A strip is a sequence of ED futures with successive expirations)
(10 marks)

(b) The following table gives the bid and offer fixed rates in the swap market and the
corresponding swap rates

Maturity (years) Bid (%) Offer (%) Swap Rate (%)

2 5.03 5.06 5.045

4 5.35 5.39 5.370
7 5.65 5.68 5.665
10 5.83 5.87 5.850

(i) Suppose that Company X can invest for 4 years at 4.5%. Recommend a floating
rate, can it swap this fixed rate into?
(5 marks)

(ii) Company Y can invest for 10 years at LIBOR minus 50 basis points.
Recommend a fixed rate, can it swap this floating rate into?
(5 marks)

Question 3

A game is defined by its payoff which is dependent on the terminal price of stock ABC (ST)
and its expiry at time T. The table and the chart below give the payoff of this game.

Stock Price (ST) Payoff

ST <= $80 $20

$80 < ST <=$90 ST - $60

$90 < ST <=$110 $120 - ST

$110 < ST <=$120 ST - $100

ST >= $120 $20

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FIN359 Tutor-Marked Assignment

30

28

26

24

22

20

18

16

14

12

10
40 50 60 70 80 90 100 110 120 130 140 150 160

Construct a strategy to use call and put options or other instruments (if necessary) to replicate
this game’s payoff.
(20 marks)

Question 4

Two call options are written on the same stock that trades for $70 and both call options have
the same exercise price of $85. Call 1 expires in 6 months and Call 2 expires in 3 months.
Assume that Call 1 trades for $6 and that Call 2 trades for $7. Do these prices allow arbitrage?
Analyse. If they do permit arbitrage, then explain the arbitrage transactions.
(15 marks)

Question 5

Given the following option pricing parameters:

Stock: $60
Strike: $60
Volatility: 20% per annum
Maturity: 180 days (assume 360 day-year)
Risk-free rate: 9% per annum
Dividend yield: 12% per annum

(a) Price an American Call option with a 5-step Binomial Tree.

(10 marks)

(b) Price a Call option again with the Black-Schole Option Pricing Model.
(5 marks)

(c) Analyse the reasons for the difference in Call option premiums in parts (a) and (b)
above.
(5 marks)

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