Assignment 4

Due date 29th Nov, 2023

1. Describe the payoff from a portfolio consisting of a floating lookback call and a floating
lookback put with the same maturity.

2. Explain why a down-and-out put is worth zero when the barrier is greater than the strike price.

3. Derive expressions for the payoffs from a

a. Long position in an average price call and Short position in an average price put.
b. Long position in an average price call and Short position in an average price put.
c. Long position in a plain vanilla European call and short position in a plain vanilla European put
d. All options have the same strike price and time to maturity. Use the results to derive a
relationship between the prices of the six options that you have considered.

4. Does a basket option become more or less valuable as the correlation between the asset returns in the
basket increases?

5. Calculate the delta of an at-the-money six-month European call option on a non-dividend-paying stock
when the risk-free interest rate is 10% per annum and the stock price volatility is 25% per annum.
Hint: Black Scholes equation

6. A company uses delta hedging to hedge a portfolio of long positions in put and call options on a currency.
Which would give the most favourable result: (a) a virtually constant spot rate or (b) wild movements in
the spot rate? Explain your answer.

7. Use the put–call parity relationship to derive, for a non-dividend-paying stock, the relationship between:
(a) The delta of a European call and the delta of a European put
(b) The gamma of a European call and the gamma of a European put
(c) The vega of a European call and the vega of a European put
(d) The theta of a European call and the theta of a European put.

8. A financial institution has the following portfolio of over-the-counter options on sterling:

Delta of Gamma of Vega of
Type Position
option option option
Call -1,000 0.50 2.2 1.8
Call -500 0.80 0.6 0.2
Put -2,000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in sterling would make the portfolio both gamma neutral and
delta neutral?
(b) What position in the traded option and in sterling would make the portfolio both vega neutral and delta
neutral? Assume that all implied volatilities change by the same amount so that vegas can be aggregated.

9. A bank’s position in options on the dollar/CAD exchange rate has a delta of 30,000 and a
gamma of -80,000.
a. Explain how these numbers can be interpreted.
b. The exchange rate (dollars per CAD) is 0.90. What position would you take to make the position
delta neutral?
c. After a short period of time, the exchange rate moves to 0.93. Estimate the new delta.
d. What additional trade is necessary to keep the position delta neutral?
 e. Assuming the bank did set up a delta-neutral position originally, has it gained or lost money from
the exchange rate movement?

10. How can a short position in 1,000 options be made delta neutral when the delta of each option is 0.7?

11. Why does hedging a short call option involve a “buy high, sell low” strategy?
Hint: How do you hedge a short call position? What happens to the amount of hedging instrument that
you would need as the price of underlying increases or decreases

12. The theta of a call option is -0.1. What does this mean?

13. A company has a five-year investment earning 3% per year. Five-year interest rate swaps are quoted as bid
3.21%, ask 3.25%. What floating investment rate investment can be achieved with a swap?

(Hint: bid / ask rate - Financial institutions act as market makers and provide bid and ask quotes for the
fixed rates that they are prepared to exchange in swaps. The bid quote is the fixed rate that applies when
the financial institution is paying the fixed rate and receiving floating. The ask quote is the fixed rate that
applies when it is receiving the fixed rate and paying floating)
14. Companies A and B have been offered the following rates per annum on a $20 million five-year loan:
Fixed rate Floating rate
Company A 5.0% SOFR + 0.1%
Company B 6.4% SOFR + 0.6%
Company A requires a floating-rate loan; Company B requires a fixed-rate loan. Design a swap that will
net a bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both
companies.

Hint: Total apparent gain from this type of interest rate swap arrangement is a - b, where a is the
difference between the interest rates facing the two companies in fixed-rate markets, and b is the
difference between the interest rates facing the two companies in floating-rate markets. Financial
institution will take away part of this gain. The two companies can share the net gain equally amongst
themselves.

15. Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y wishes to borrow Japanese
yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the
current exchange rate. The companies have been quoted the following interest rates, which have been
adjusted for the impact of taxes:
Yen Dollar
Company X 5.0% 9.6%
Company Y 6.5% 10.0%
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap
equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the
bank.

16. A currency swap has a remaining life of 15 months. It involves exchanging interest at 10% on £20 million
for interest at 6% on $30 million once a year. The term structure of risk-free interest rates in the United
Kingdom is flat at 7% and the term structure of risk-free interest rates in the United States is flat at 4%
(both with annual compounding). The current exchange rate (dollars per pound sterling) is 1.5500. What is
the value of the swap to the party paying sterling? What is the value of the swap to the party paying
dollars
17. Explain why borrowing at a floating rate and swapping to fixed does not necessarily give rise to borrowing
at the same fixed rate every year.
Hint: floating rate to the borrower = benchmark + spread

18. A corporate treasurer tells you that he has just negotiated a five-year loan at a competitive fixed rate of
interest of 5.2%. The treasurer explains that he achieved the 5.2% rate by borrowing at a six-month
floating reference rate plus 150 basis points and swapping the floating reference rate for 3.7%. He goes on
to say that this was possible because his company has a comparative advantage in the floating-rate
market. What has the treasurer overlooked?

19. A financial institution has entered into a 10-year currency swap with company Y. Under the terms of the
swap, the financial institution receives interest at 3% per annum in Swiss francs and pays interest at 8% per
annum in U.S. dollars. Interest payments are exchanged once a year. The principal amounts are 7 million
dollars and 10 million francs. Suppose that company Y declares bankruptcy at the end of year 6, when the
exchange rate is $0.80 per franc. What is the cost to the financial institution? Assume that, at the end of
year 6, risk-free interest rates are 3% per annum in Swiss francs and 8% per annum in U.S. dollars for all
maturities. All interest rates are quoted with annual compounding.

20. Why is the expected loss to a bank from a default on a swap with a counterparty less than the expected
loss from the default on a loan to the counterparty when the loan and swap have the same principal?
Assume that there are no other derivatives transactions between the bank and the counterparty, that the
swap is cleared bilaterally, and that no collateral is provided by the counterparty in the case of either the
swap or the loan.