1. What is a derivative security?
Answer: A derivative security is a financial security whose value depends
on (or derives
from) other, more fundamental, underlying variables such as the price of a
stock, a
commodity price, an interest rate, an exchange r
Sample Questions
Question 1
(a) The one-year zero rate equals 5% and the two-year zero rate equals
5.5%. What is the forward rate for the second year? All rates are
continuously compounded.
(b) The yield curve is flat at 4% per annum. What is the value of
16. In the previous question, how do you implement the same trading idea
without using
futures contracts?
Answer: Futures contracts are traded on exchanges and are known as
\exchange-traded"
securities. An alternative approach to achieving the goal would
5. Define a forward contract. Explain at what time are cash ows generated
for this
contract. How is settlement determined?
Answer: A forward contract is an agreement to buy or sell an asset at a
future date
(denoted T), at a specified price called the del
7. What risks are being managed by trading derivatives on exchanges?
Answer: An important one is counterparty default risk. In a typical futures
exchange,
the exchange interposes itself between buyer and seller and guarantees
performance
on the contract.
3. Can a derivative security be the underlying for another derivative
security? Give an
example.
Answer: Yes, it can. The simplest example is an option (say, a call) that
gives you the
right to purchase another option (say, a put written on some underlyin
12. Suppose you are holding a stock position, and wish to hedge it. What
forward contract
would you use, a long or a short? What option contract might you use?
Compare
the forward versus the option on the following three criteria: (a)
uncertainty of hedge
Question 1
Q=
a
Q=
Returnof RIsk Freed S
uSdS
1.100.9
1.200.9
Q = 2/3
Ans: The risk-neutral probabilities are 2/3.
b
Since the call delta is equal to the difference in call values at the next two nodes that
divided by the difference in the stock prices at
On designing swaps
From slide 21
Given the borrowing rates below (liability)
Fixed (5yr)
Floating (6mo)
AAA Co.
4.0%
LIBOR-0.1%
BBB Co.
5.2%
LIBOR+0.6%
AAA can save _ in fixed market; but only
_ in the floating market
On the other hand, BBB have to spe
Option boundary conditions
Boundaries
Upper bounds (p.g 214 or 2327th edition)
c So and C So
p Ke rT and P K
Lower bounds (p.g 221-2 or 235-2417th edition)
p Ke
So
c So Ke
rT
rT
and C So Ke
and P K So
rT
Put call parity
p So c Ke
rT
Page 236 (7th
On valuing FRAs
Value of FRA
Given the date is 31 March 2014 today. Yield
curve is flat at 5% continuous compounding.
Design a FRA for a client to receive a fixed rate
Rk for a 6-month period starting 1.5 years (18
months) from now such that no exchange
On valuation of swaps
From Slide 25
A bank agrees to receive fixed in a monthly
swap with a maturity of 3 months. Monthly
compound LIBOR zero rates for 1m, 2m, 3m
are 5%, 5.5% & 6.0% respectively. The
principal is $12 million. What is the no-arb
swap rat
Assignment 2
Due date Friday 27 May at 4pm
Question 1
Assume KBC stock is currently at S = $100. After one period, the price will move to one of the
following two values: [uS and dS], where [u = 1.2; d = 0.9]. A $1.00 investment in the risk-free asset
usi
Angela April George
Week 2
Tutorial
Derivatives
Tutorial 2
Textbook: Fundamentals of Futures and Options Markets by John C. Hull. Pearson new
International Edition. Ed 8. ISBN number: 978-1-29204-190-2
Note: Questions with * must be covered in tutorial cl