1. A financial institution has entered into an interest rate swap with company X.

Under
the terms of the swap, it receives 10% per annum and pays 6-month LIBOR on a
principal of $10 million for 5 years. Payments are made every 6 months. Suppose that
company X defaults on the sixth payment date (at the end of year 3) when the interest
rate (with semi-annual compounding) is 8% per annum for all maturities. What is the
loss to the financial institution? Assume that 6-month LIBOR was 9% per annum
halfway through year 3.
At the end of year 3 the financial institution was due to receive $500,000 (=0.5×10% of $10
million) and pay $450,000 (=0.5x9% of $10 million). The immediate loss is therefore
$50,000. To value the remaining swap we assume than forward rates are realized. All forward
rates are 8% per annum. The remaining cash flows are therefore valued on the assumption
that the floating payment is 0.5x0.08×10,000,000-$400,000 and the net payment that would
be received is 500,000-400,000-$100,000. The total cost of default is therefore the cost of
foregoing the following cash flows:
3 year: $50,000
3.5 year: $100,000
4 year: $100,000
4.5 year: $100,000
5 year: $100,000
Discounting these cash flows to year 3 at 4% per six months we obtain the cost of the default
as $413,000.
2. Explain why the market maker’s bid–offer spread represents a real cost to options
investors.
A "fair" price for the option can reasonably be assumed to be half way between the bid and
the offer price quoted by a market maker. An investor typically buys at the market maker's
offer and sells at the market maker's bid. Each time he or she does this there is a hidden cost
equal to half the bid-offer spread.
3.The price of an American call on a non-dividend-paying stock is $4. The stock price is
$31, the strike price is $30, and the expiration date is in 3 months. The risk-free interest
rate is 8%. Derive upper and lower bounds for the price of an American put on the
same stock with the same strike price and expiration date.
So - K ≤ C - P ≤ So - K * e ^ (- r * t)
31 - 30 ≤ 4 - P ≤ 31 - 30e ^ (-0.08 * 25)
1.00 ≤4.00 - P ≤1.59
2.41 ≤ P ≤3
Upper and lower bounds for the price of an American put are therefore $2.41 and $3.00.
4. Explain two ways in which a bear spread can be created.
A bear spread can be created using two call options with the same maturity and different
strike prices. The investor shorts the call option with the lower strike price and buys the call
option with the higher strike price. A bear spread can also be created using two put options
with the same maturity and different strike prices. In this case, the investor shorts the put
option with the lower strike price and buys the put option with the higher strike price.
5. In what way would the benefits of backdating be reduced if a stock option grant had
to be revalued at the end of each quarter?
If a stock option grant had to be revalued each quarter the value of the option of the grant
date (however determined) would become less important. Stock price movements following
the reported grant date would be incorporated in the next revaluation. The total cost of the
options would be independent of the stock price on the grant date.
6. A foreign currency is currently worth $1.50. The domestic and foreign risk-free
interest rates are 5% and 9%, respectively. Calculate a lower bound for the value of a
six-month call option on the currency with a strike price of $1.40 if it is (a) European
and (b) American
Lower bound for European option is
So* e ^ (- r * T) - K * e ^ (- r * T)
= 1.5e ^ (-0.09 * 0.5) - 1.4e ^ (-0.05 * 5) = 0.069
Lower bound for American option is
So - K = 0.10
7. How does the put–call parity formula for a futures option differ from put–call parity
for an option on a non-dividend-paying stock?
The put-call parity formula for futures options is the same as the put-call parity formula for
stock options except that the stock price is replaced by Fe, where F is the current futures
price, r is the risk-free interest rate, and 7 is the life of the option.
8. A nine-month American put option on a non-dividend-paying stock has a strike price
of $49. The stock price is $50, the risk-free rate is 5% per annum, and the volatility is
30% per annum. Use a three-step binomial tree to calculate the option price.
9. What is the difference between the exponentially weighted moving average model
and the GARCH(1, 1) model for updating volatilities?

The EWMA model produces a forecast of the daily variance rate for day which is a weighted
average of (i) the forecast for day n-1, and (ii) the square of the proportional change on day-1.
The GARCH (1,1) model produces a forecast of the daily variance for day which is a
weighted average of (i) the forecast for day n-1, (ii) the square of the proportional change on
day n-1. and (iii) a long run average variance rate. GARCH (1,1) adapts the EWMA model
by giving some weight to a long run average variance rate. Whereas the EWMA has no mean
reversion, GARCH (1,1) is consistent with a mean- reverting variance rate model.
10. ow does a five-year nth-to-default credit default swap work? Consider a hasket of 100
reference entities where each reference entity has a probability of defaulting in each year of
1%. As the default correlation between the reference entities increases what would you
expect to happen to the value of the swap when a) kappa = 1 and b) n = 25 Explain your
answer.