ACT 2020 MIDTERM 1 - 07

# ACT 2020 MIDTERM 1 - 07 - ECONOMIC ACT 2020 MIDTERM#1 AND...

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ACT 2020, MIDTERM #1 ECONOMIC AND FINANCIAL APPLICATIONS FEBRUARY 8, 2007 HAL W. PEDERSEN You have 70 minutes to complete this exam. \\Then the invigilator instructs you to stop writing you must do so immediately. If you do not abide by this instruction you will be penalised. All invigilators have full authority to disqualify your paper if, in their judgement, you are found to have violated the code of academic honesty. Each question is worth 10 points. Provide sufficient reasoning to back up your answer but do not write more than necessary. This exam consists of 8 questions. Answer each question on a separate page of the exam book. Write your name and student number on each exam book that you use to answer the questions. Good luck! Question 1. Bill and Jim enter into a binding contract involving the exchange of an asset in nine months time. The current market price of the asset is \$100. The continuously compounded interest rate is r = 0.045. The contract calls for Jim to sell the asset to Bill at that time at a price G that is set today. The price G is set so that a fair valuation of the contract requires Jim to pay Bill \$2.20 today. If the price of the asset in nine months time is \$98 what is Jim's total profit or loss at the time the asset is sold? Question 2. John has just purchased a home for \$200,000. The insurance policy will cover any losses due to fire subject to a deductible of \$10,000. The one-year premium on the insurance policy is \$3,000 which is due at the start of the policy year. (1) [5 points] Let NI denote the market value of John's home at the end of the policy year.1 Draw a chart of the net value of John's home and insurance policy versus AI at the end of the policy year. Assume r = 0 for simplicity. (2) [3 points] Explain in what sense there is a put option implicit in this transaction, possibly drawing an appropriate chart. (3) [2 points] Explain in what sense there is a call option implicit in this transaction, . possibly drawing an appropriate chart. llf there is a devastating fire the market value of John's home could be close to zero. If there is no fire and the real estate market soars then the market value of John's home could be more than John's purchase price of \$200,000.

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2 ACT 2020 - r.I1DTERM # 1 Question 3. Your client currently owns one share of XYZ Corporation and has an investment horizon of six months. The current market price of one share of XYZ Corporation is \$25. Your client is considering writing one European call option on XYZ Corp. that expires in six months. The market
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