Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set 1

Stefano Di Colli
Finance Review

1) What is the duration of a bond with nominal value $5,000, coupon rate
5.0% (annual payments) and maturity in 10 years if interest rate is
5.0%?
Sol. 8.1 years

2) What is the duration of a bond with nominal value $5,000, coupon rate
5.0% (annual payments) and maturity in 10 years if interest rate is
10.0%?
Sol. 7.7 years

3) What is the duration of a bond with nominal value $20,000, coupon

rate 7.5% (annual payments) and maturity in 4 years if interest rate is
7.5%?
Sol. 3.6 years

4) What is the duration of a bond with nominal value $20,000, coupon

rate 7.5% (annual payments) and maturity in 4 years if interest rate is
0.0%?
Sol. 3.7 years

5) What is the duration of a bond with nominal value $10,000, coupon

rate 10.0% (annual payments) and maturity in 7 years if interest rate is
10.0%?
Sol. 5.4 years

6) What is the duration of a bond with nominal value $10,000, coupon

rate 10.0% (annual payments) and maturity in 7 years if interest rate is
1.0%?
Sol. 5.7 years

7) What is the final value in 1 year of $1,000 with an annual interest rate
of 7.0% using an annual compounding frequency?
 𝑟 𝑚 0.07 1
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $1,070
𝑚 1

8) What is the final value in 1 year of $1,000 with an annual interest rate
of 7.0% using a semi-annual compounding frequency?
𝑟 𝑚 0.07 2
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $1,071.23
𝑚 2

9) What is the final value in 1 year of $1,000 with an annual interest rate
of 7.0% using a quarterly compounding frequency?
𝑟 𝑚 0.07 4
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $1,071.86
𝑚 4

10) What is the final value in 1 year of $1,000 with an annual interest
rate of 7.0% using a monthly compounding frequency?
𝑟 𝑚 0.07 12
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $1,072.29
𝑚 12

11) What is the final value in 1 year of $1,000 with an annual interest
rate of 7.0% using a weekly compounding frequency?
𝑟 𝑚 0.07 52
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $1,072.43
𝑚 52

12) What is the final value in 1 year of $1,000 with an annual interest
rate of 7.0% using a continuous compounding frequency?
Sol. 𝐹𝑉 = 𝐴 ∙ 𝑒 𝑟∙𝑇 = $1,000 ∙ 𝑒 0.07∙1 = $1,072.51

13) What is the final value in 6 months of $750 with an annual

interest rate of 5.7% using a continuous compounding frequency?
Sol. 𝐹𝑉 = 𝐴 ∙ 𝑒 𝑟∙𝑇 = $750 ∙ 𝑒 0.057∙0.5 = $771.68

14) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using an annual discounting frequency?
𝑟 −𝑚 0.07 −1
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $934.58
𝑚 1
15) What is the present value of $1,000 in 1 year with an annual
interest rate of 7.0% using a semi-annual discounting frequency?
𝑟 −𝑚 0.07 −2
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $933.51
𝑚 2

16) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using a quarterly discounting frequency?
𝑟 −𝑚 0.07 −4
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $932.96
𝑚 4

17) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using a monthly discounting frequency?
𝑟 −𝑚 0.07 −12
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $932.58
𝑚 12

18) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using a weekly discounting frequency?
𝑟 −𝑚 0.07 −52
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $932.44
𝑚 52

19) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using a daily discounting frequency?
𝑟 −𝑚 0.07 −365
Sol. 𝐹𝑉 = 𝐴 ∙ (1 + ) = $1,000 ∙ (1 + ) = $932.40
𝑚 365

20) What is the present value of $1,000 in 1 year with an annual

interest rate of 7.0% using a continuous discounting frequency?
Sol. 𝐹𝑉 = 𝐴 ∙ 𝑒 −(𝑟∙𝑇) = $1,000 ∙ 𝑒 −(0.07∙1) = $932.39

21) What is the present value of $840 in 3 months with an annual

interest rate of 9.3% using a continuous discounting frequency?
Sol. 𝐹𝑉 = 𝐴 ∙ 𝑒 −(𝑟∙𝑇) = $840 ∙ 𝑒 −(0.093∙0.25) = $820.70
Assuming the €/$ spot exchange rate is €0,85/$1, the interest rate on European bonds is
0,85% per annum and the interest rate on American bonds is 0,45% per annum, calculate
the 3-month forward exchange rate. Check that CIP holds in this case.

Solution

1 + 0,0085(90/360) 1 + 0,002125
0,85085 = 0,85 [ ] = 0,85 [ ] = 0,85 ∗ 1,0009
1 + 0,0045(90/360) 1 + 0,001125

Ft; t + 1 − St it − it ∗
=
St 1 + it ∗
(0,85085−0,85)/0,85=(0,002125−0,001125)/1,001125

0,001= 0,001. Ok
Assume €/$ is €0,92/1$, the US price level is 100$, the european price level of 90€,
Compute the real exchange rate. If the nominal exchange rate would be 0,88 €/$
assuming constant prices, compute the percentage change in the real exchange rate?

𝑆𝑡 𝑃𝑡∗
𝑄𝑡 =
𝑃𝑡

0,92 ∗ 100
𝑄𝑡 = = 1,02
90

𝑆𝑡 𝑃𝑡∗
𝑄𝑡 =
𝑃𝑡

0,88 ∗ 100
𝑄𝑡 = = 0,97
90

0,97−1,02
%= = −0,05 = −5%
1,02
 Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set #2

Stefano Di Colli
Bond price and interest rate change
1) What is the expected return on a bond if its return in t+1 can be 7.5%
with probability 65.0% or 12.8% with probability 35.0%?
𝑒
Sol. 𝑅𝑡+1 = 𝑝1 𝑅1 + 𝑝2 𝑅2 = 0.65 ∙ 0.075 + 0.35 ∙ 0.128 = 0,094

2) What is the expected return on a bond if its return in t+1 can be 4.5%
with probability 22.5%, 7.3% with probability 45.5% or 14.6% with
probability 32.0%?
𝑒
Sol. 𝑅𝑡+1 = 𝑝1 𝑅1 + 𝑝2 𝑅2 + 𝑝3 𝑅3 = 0.225 ∙ 0.045 + 0.455 ∙
0.073 + 0.32 ∙ 0.146 = 0,090

3) Project A has a forecasted return in t+1 of 17.0% with probability

25.0% or 3.0% with probability 75.0%, project B has a forecasted
return in t+1 of 6.0% with probability 50.0% or 7.0% with probability
50.0%. Which project is preferable?
𝑒,𝐴
Sol. 𝑅𝑡+1 = 𝑝1𝐴 𝑅1𝐴 +𝑝2𝐴 𝑅2𝐴 = 0.25 ∙ 0.17 + 0.75 ∙ 0.03 = 0,065
𝑒,𝐴 2 𝑒,𝐴 2
with risk 𝜎 𝐴 = √𝑝1𝐴 (𝑅1𝐴 − 𝑅𝑡+1 ) + 𝑝2𝐴 (𝑅2𝐴 − 𝑅𝑡+1 ) =
= √0.25(0.17 − 0.065)2 + 0.75(0.03 − 0.065)2 = 0.061

𝑒,𝐵
𝑅𝑡+1 = 𝑝1𝐵 𝑅1𝐵 +𝑝2𝐵 𝑅2𝐵 = 0.50 ∙ 0.06 + 0.50 ∙ 0.07 = 0.065
𝑒,𝐵 2 𝑒,𝐵 2
with risk 𝜎 𝐵 = √𝑝1𝐵 (𝑅1𝐵 − 𝑅𝑡+1 ) + 𝑝2𝐵 (𝑅2𝐵 − 𝑅𝑡+1 ) =
= √0.50(0.06 − 0.065)2 + 0.50(0.07 − 0.065)2 = 0.005
Project A and B have the same expected return, but project B is
preferable because of the lower risk.
Monetary markets
1) Suppose you can purchase a $10 million security that is currently
selling on a discount basis (with no explicit interest payments) at
98.9% of its FV. The security is 90 days from maturity (when the
$10 million will be paid). Please calculate the dividend yield, the
bond equivalent yield and the effective annual return.
Sol.
𝑆𝑓 − 𝑆0 360 ($10𝑚𝑙𝑛 − $9.89𝑚𝑙𝑛) 360
𝑖𝑑𝑦 = ( )∙ = ∙ = 4.44%
𝑆𝑓 𝑛 $10𝑚𝑙𝑛 90
(𝑆𝑓 − 𝑆0 ) 365 ($10𝑚𝑙𝑛 − $9.89𝑚𝑙𝑛) 365
𝑖𝑏𝑒𝑦 = ∙ = ∙ = 4.51%
𝑆0 𝑛 $10𝑚𝑙𝑛 90

𝑖𝑏𝑒𝑦 365/𝑛 0.0451 365/90

𝐸𝐴𝑅 = (1 + ) − 1 = (1 + ) −1
365/𝑛 365/90
= 4.59%

2) Suppose you can purchase a $5 million security with 75 days from

maturity. It has a quoted annual interest rate of 3.51% for a 360-day
year. Please calculate the bond equivalent yield and the effective
annual return.
365 365
𝑖𝑏𝑒𝑦 = 𝑖𝑠𝑝𝑦 ∙ = 3.51% ∙ = 3.56%
360 360
𝑖𝑏𝑒𝑦 365/𝑛
𝐸𝐴𝑅 = (1 + ) −1=
365/𝑛
0.0356 365/75
= (1 + ) − 1 = 3.61%
365/75
3) A T-bill with FV=$1,000 and 30 days until maturity has an asked
discount rate of 5.12% and a bid discount rate of 5.25%. Please
determine the bid-asked spread.
Sol.
𝐴𝑠𝑘 𝑛 30
𝑆 𝐴𝑠𝑘 = 𝐹𝑉 ∙ [1 − 𝑖𝑑𝑦 ∙( )] = $1,000 ∙ [1 − 0.0512 ∙ ( )]
360 360
= $995.73
 𝐵𝑖𝑑 𝐵𝑖𝑑
𝑛 30
𝑆 = 𝐹𝑉 ∙ [1 − 𝑖𝑑𝑦 ∙( )] = $1,000 ∙ [1 − 0.0525 ∙ ( )]
360 360
= $995.63
𝑆 𝐴𝑠𝑘 − 𝑆 𝐵𝑖𝑑 = $995.73 − $995.63 = $0.11
4) A T-bill with FV=$1,000 and 30 days until maturity has an asked
discount rate of 5.12% and a bid discount rate of 5.25%. Please
determine the asked effective annual return.
Sol. Knowing SAsk=$995.73 from previous exercise,
(𝐹𝑉 − 𝑆 𝐴𝑠𝑘 ) 365 ($1,000 − $995.73) 365
𝑖𝑏𝑒𝑦 = ∙ = ∙ = 5.21%
𝑆𝐴𝑠𝑘 𝑛 $995.73 30
365
30
𝑖𝑏𝑒𝑦 365/𝑛 0.0521
𝐸𝐴𝑅 = (1 + ) − 1 = (1 + ) −1=
365/𝑛 365
30
= 0.0534 = 5.34%

5) A T-bill with FV=$1,000 and 75 days until maturity has an asked

discount rate of 6.50% and a bid discount rate of 6.85%. Determine:
a) the asked price for the T-bill, b) the bid price for the T-bill, c) the
asked yield to maturity, d) the effective annual rate of return for the
T-bill, e) the bid-ask spread, f) the bid-ask spread rate?
Sol.
𝑛 75
a) 𝑆 𝐴𝑠𝑘 = 𝐹𝑉 ∙ [1 − 𝑖𝐷𝐴𝑠𝑘 ∙ ( )] = $1,000 ∙ [1 − 0.065 ∙ (360)] =
360
=$986.46
𝑛 75
b) 𝑆 𝐵𝑖𝑑 = 𝐹𝑉 ∙ [1 − 𝑖𝐷𝐵𝑖𝑑 ∙ ( )] = $1,000 ∙ [1 − 0.0685 ∙ (360)] =
360
=$985.73
(𝐹𝑉−𝑆 𝐴𝑠𝑘 ) 365 ($1,000−$986.46) 365
c) 𝑖𝑌𝐴𝑠𝑘 = ∙ = ∙ = 0.0668
𝑆 𝐴𝑠𝑘 𝑛 $986.46 75
365 365
𝐹𝑉 𝑛 $1,000 75
d) 𝑅 = ( ) −1=( ) − 1 = 0.0686
𝑆 𝐴𝑠𝑘 $986.46
𝐴𝑠𝑘 𝐵𝑖𝑑
e) 𝑆 −𝑆 = $986.46 − $985.73 =$0.73
𝑆 𝐴𝑠𝑘 −𝑆 𝐵𝑖𝑑 $986.46−$985.73
f) = = 0.00073
𝐹𝑉 $1,000
Term structure of interest rates
1) One-year interest rates over the next five years are: 2%, 3%, 6%, 8%,
and 10%. Please, calculate interest rates on two to five-year bonds
applying the pure expectation theory.
Sol.
𝑒
𝑖1𝑌 + 𝑖2𝑌 0.02 + 0.03
𝑖2𝑌 = = = 0.025
2 2
𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 0.02 + 0.03 + 0.06
𝑖3𝑌 = = = 0.037
3 3
𝑒 𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 + 𝑖4𝑌 0.02 + 0.03 + 0.06 + 0.08
𝑖4𝑌 = = = 0.048
4 4
𝑒 𝑒 𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 + 𝑖4𝑌 + 𝑖5𝑌
𝑖5𝑌 = =
5
0.02 + 0.03 + 0.06 + 0.08 + 0.1
= = 0.058
5

2) One-year interest rates over the next five years are: 2%, 3%, 6%, 8%,
and 10%. Liquidity premium for one to five-year bonds are: 0%, 0.3%,
0.5%, 0.8%, and 1.0%. Please, calculate interest rates on two to five-
year bonds applying the liquidity premium theory.
Sol.
𝑒
𝑖1𝑌 + 𝑖2𝑌 0.02 + 0.03
𝑖2𝑌 = + 𝑙2𝑌 = + 0.003 = 0.028
2 2
𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 0.02 + 0.03 + 0.06
𝑖3𝑌 = + 𝑙3𝑌 = + 0.005 = 0.042
3 3
𝑒 𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 + 𝑖4𝑌
𝑖4𝑌 = + 𝑙4𝑌
4
0.02 + 0.03 + 0.06 + 0.08
= + 0.008 = 0.056
4
𝑒 𝑒 𝑒 𝑒
𝑖1𝑌 + 𝑖2𝑌 + 𝑖3𝑌 + 𝑖4𝑌 + 𝑖5𝑌
𝑖5𝑌 = + 𝑙5𝑌 =
4
0.02 + 0.03 + 0.06 + 0.08 + 0.1
= + 0.01 = 0.068
5
Bond market
1) What is the current yield for a bond with a face value of $1,000,
maturity in 1 year, a current price of $970.15, and a coupon rate of
8.25%?
𝐶 $82,5
Sol. 𝑖𝑐 = = = 0.0850
𝑆0 $970.15
where: 𝐶 = $1,000 ∙ 0.0825 = $82.5

2) What is the price of three-year, coupon bond with a coupon rate of

7.5% (annual coupon payments) with a face value of $1,000 and a
discount rate of 9%?
Sol. 𝐶 = $1,000 ∙ 0.075 = $75
𝑆0 = $75 ∙ (1 + 0.09)−1 + $75 ∙ (1 + 0.09)−2 +
+$75 ∙ (1 + 0.09)−3 + $1,000 ∙ (1 + 0.09)−3 = $962.03

3) Mr X bought a $1,000 T-bond with a 6.0% annual coupon rate for

$975 and sold it prior to its maturity 1 year later for $1,020. What is
Mr X 1 year rate of return?
𝑆𝑡+1 −𝑆𝑡 𝐶 $1,020−$975 $1,000∙0.06
Sol. 𝑅𝑡+1 = + = + =
𝑆𝑡 𝑆𝑡 $975 $975
= 0.0462 + 0.0615 = 0.1077

4) Suppose the rate on a corporate bond is 7% and the rate on a municipal

bond is 4.8%. Which should a person with a marginal tax rate of 35%
prefer?
Sol. The equivalent tax-free rate of the corporate bond is
𝑖𝐶𝐸𝑇𝐹𝑅 = 𝑖𝑐 ∙ (1 − 𝑇) = 0.07 ∙ (1 − 0.32) = 0.0455 < 0.048 = 𝑖𝑀
The municipal bond is preferable.

5) Mrs Y is in the 28% income tax bracket when she bought a $10,000
municipal bond with r=7.0% for $9,700 and sold it for $9,900 one year
later (prior to its maturity). What is Mrs Jones pre-tax 1 year rate of
return? What is Mrs Jones after-tax 1 year rate of return?
Sol.
𝑃𝑇
($9,900 − $9,700) + (0.07 ∙ $10,000)
𝑅𝑡+1 = = 0.0928
$9,700
 𝐴𝑇
($9,900 − $9,700) ∙ (1 − 0.28) + (0.07 ∙ $10,000)
𝑅𝑡+1 =
$9,700
= 0.0870
1) As the price of a bond ________ and the expected return ________, bonds become more
attractive to investors and the quantity demanded rises.
A) falls; rises
B) falls; falls
C) rises; rises
D) rises; falls
Answer: A

2) A ________ prefers stock in a less risky asset than in a riskier asset.

A) risk preferrer
B) risk-averse person
C) risk lover
D) risk-favorable person
Answer: B
Topic: Chapter 4.1 Determining Asset Demand

3) Factors that determine the demand for an asset include changes in the
A) wealth of investors.
B) liquidity of bonds relative to alternative assets.
C) expected returns on bonds relative to alternative assets.
D) risk of bonds relative to alternative assets.
E) all of the other answers.
Answer: E
Topic: Chapter 4.1 Determining Asset Demand

4) When the price of a bond is below the equilibrium price, there is excess ________ in the bond
market and the price will ________.
A) demand; rise
B) demand; fall
C) supply; fall
D) supply; rise
Answer: A
Topic: Chapter 4.2 Supply and Demand in the Bond Market

5) (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher
interest rates the firm must pay.
(II) The spread between the interest rates on bonds with default risk and default-free bonds is called
the risk premium.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: B
Topic: Chapter 5.1 Risk Structure of Interest Rates

6) As a result of the subprime collapse, the demand for low -quality corporate bonds ________, the
demand for high-quality Treasury bonds ________, and the risk spread ________.
A) increased; decreased; was unchanged
B) decreased; increased; increased
C) increased; decreased; decreased
D) decreased; increased; was unchanged
Answer: B
Topic: Chapter 5.1 Risk Structure of Interest Rates

7) The most influential participant(s) in the U.S. money market

A) is the Federal Reserve.
B) is the U.S. Treasury Department.
C) are the large money center banks.
D) are the investment banks that underwrite securities.
Answer: A
Topic: Chapter 11.3 Who Participates in the Money Markets?

8) Money market instruments issued by the U.S. Treasury are called

A) Treasury bills.
B) Treasury notes.
C) Treasury bonds.
D) Treasury strips.
Answer: A
Topic: Chapter 11.4 Money Market Instruments

9) (I) Securities that have an original maturity greater than one year are traded in capital markets.
(II) The best known capital market securities are stocks and bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C
Topic: Chapter 12. 1 Purpose of the Capital Market

10) The primary issuers of capital market securities include

A) the federal and local governments.
B) the federal and local governments, and corporations.
C) the federal and local governments, corporations, and financial institutions.
D) local governments and corporations.
Answer: B
Topic: Chapter 12. 2 Capital Market Participants

11) What is the duration of a bond with nominal value $1,000, coupon rate 5.0% (annual payments)
and maturity in 4 years if interest rate is 4.0%?
A) 5.12
B) 4.00
C) 3.73
D) 2.27
Answer: C)
Topic: PS #1 (Duration)

12) What is the final value in 2 years of $1,000 with an annual interest rate of 6.0% using a monthly
compounding frequency?
A) 997.37
B) 1,127.16
C) 1,022.71
D) 1,215.99
Answer: B)
Topic: PS #1 (Compounding/Discounting)

13) A T-bill with FV=$5,000 and 25 days until maturity has an asked discount rate of 4.07% and a
bid discount rate of 4.31%. Please determine the bid-asked spread.
A) 3.74
B) 0.00
C) 2.12
D) 0.83
Answer: D)
Topic: PS #2 (Monetary markets)

14) A T-bill with FV=$10,000 and 35 days until maturity has an asked discount rate of 5.00% and a
bid discount rate of 5.34%. Please determine the asked effective annual return.
A) 5.21%
B) 5.41%
C) 4.87%
D) 5.30%
Answer: A)
Topic: PS #2 (Monetary markets)

15) One-year interest rates over the next five years are: 3.0%, 3.5%, 4.1%, 4.8%, and 5.6%.
Liquidity premium for one to five-year bonds are: 0%, 0.2%, 0.5%, 0.9%, and 1.4%. Please,
calculate interest rates on three-year bonds applying the liquidity premium theory.
A) 5.11%
B) 4.03%
C) 4.92%
D) 5.74%
Answer: A)
Topic: PS #2 (Monetary markets)
 Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set #3

Stefano Di Colli
 Stock markets

1) What is the current price for a stock with an expected dividend of

$7.32 and price next year of $87.43? Use a 7.5% discount rate
𝐷 𝑆 $7.32 $87.43
Sol. 𝑆0 = (1+𝑟1 ) + (1+𝑟
1
)
= (1+0.075) + (1+0.075) = $88.14
𝑒 𝑒

2) What is the current price for a stock with an expected dividend of

$2.50 and price next year of $100.00? Use a 10.0% discount rate
𝐷 𝑆 $2.50 $100.00
Sol. 𝑆0 = (1+𝑟1 ) + (1+𝑟
1
)
= (1+0.10) + (1+0.10) = $93.18
𝑒 𝑒

3) What is the current price for a stock with current dividend of $5.00 an
expected growth rate of dividends of 15% and expected price next year
of $50.00? Use 5.5% discount rate
Sol. 𝐷1 = 𝐷0 ∙ (1 + 𝑔) = $5 ∙ (1 + 0.15) = $5.75
𝐷 𝑆 $5.75 $50.00
𝑆0 = (1+𝑟1 ) + (1+𝑟
1
)
= (1+0.055) + (1+0.055) = $52.84
𝑒 𝑒

4) What is the price for a stock with an expected dividend of $7.32 for
the next 4 years and selling price of $93.57? Use a 7.5% discount rate
Sol.
𝐷1 𝐷𝑛 𝑆𝑛
𝑆0 = + ⋯ + + =
(1 + 𝑟𝑒 )1 (1 + 𝑟𝑒 )𝑛 (1 + 𝑟𝑒 )𝑛
$7.32 $7.32 $93.57
= + ⋯ + +
(1 + 0.075)1 (1 + 0.075)4 (1 + 0.075)4
= $94.58

5) What is the price for a stock with an expected dividend of $2.50 for
the next 20 years and selling price of $100.00? Use a 4.5% discount
rate
Sol.
 𝐷1 𝐷𝑛 𝑆𝑛
𝑆0 = + ⋯ + + =
(1 + 𝑟𝑒 )1 (1 + 𝑟𝑒 )𝑛 (1 + 𝑟𝑒 )𝑛
$2.50 $2.50 $100.00
= + ⋯ + +
(1 + 0.045)1 (1 + 0.045)20 (1 + 0.045)20
= $65.68

6) Find the current price of a stock assuming dividends grow at a constant

rate of 2.00%, D0 = $7.32, and the discount rate is 7.50%.
𝐷0 ∙(1+𝑔) $7.32∙(1+0.02)
Sol. 𝑆0 = (𝑟𝑒 −𝑔)
= (0.075−0.02)
= $135.75

7) Find the current price of a stock assuming dividends grow at a constant

rate of 4.00%, D1 = $5.00, and the discount rate is 7.00%.
𝐷1 $5.00
Sol. 𝑆0 = (𝑟 = (0.07−0.04) = $166.67
𝑒 −𝑔)

8) If the industry PE ratio for a firm is 16, what is the current stock price
for a firm with earnings per share of $5.58?
𝐸𝑎𝑟𝑛
Sol. 𝑆0 = 𝑃𝐸 ∙ = 16 ∙ 5.58$ = $89.28
𝐸
Futures

1) Google stock has a current price of 90.00$. On November 23rd the

treasurer of a corporation enters into a long forward contract to buy
100 Google stocks in six months at a price of 100$. What is the final
profit of the contract if ST =$112.4?
Profit: (ST - F) ∙ #shares= 100 ∙ ($112.40-$100.00) = 1,240.00

2) Google stock has a current price of 90.00$. On November 23rd the

treasurer of a corporation enters into a short forward contract to buy
100 Google stocks in six months at a price of 100.00$. What is the
final profit of the contract if ST =$112.40?
Profit: (F - ST ) ∙ #shares = 100 ∙ ($100.00-$112.40) = -1,240.00

3) Apple stock has a current price of 150.00$. On November 23rd the

treasurer of a corporation enters into a long forward contract to buy
1,000 Apple stocks in nine months at a price of 169.00$. What is the
final profit of the contract if ST =$183.17?
Profit: (ST - F) ∙ #shares = 1,000 ∙ ($183.17-$169.00) = 14,170.00

4) Apple stock has a current price of 150.00$. On November 23rd the

treasurer of a corporation enters into a short forward contract to buy
1,000 Apple stocks in nine months at a price of 169.00$. What is the
final profit of the contract if ST =$153.17?
Profit: (F - ST ) ∙ #shares = 1,000 ∙ ($169.00-$153.17) = 15,830.00

5) Suppose that the spot price of a non-dividend-paying stock is $100,

the 6-month forward price is $102, the 6-month US$ interest rate is
8% per annum.
a. Is there an arbitrage opportunity? If yes, please illustrate:
b. Which is the strategy to get the arbitrage profit?
c. How much is the arbitrage profit?
Sol.
a. The no arbitrage value of F is:
 FNA = S0 * er*T = $104.0811

F = $102 < FNA → then there is an arbitrage opportunity.

b. If F < FNA futures is underpriced then, in order to get the

arbitrage profit, at time t = 0 you have to:
− Short sell the stock (+$100.00)
− Invest the proceeds at 8% per 6 months (-$100.00)
− Take a long position in a 6-month futures

c. At time t = T, in your portfolio you have

i. 1 long position on a futures contract
ii. 1 short selling position on the stock to be closed out
iii. $100 invested at 8.0% for 6 months with a compounded value
of $104.0811.

The certain profit of this portfolio at time t = T is:

profit = (ST – F) – ST + $104.0811 = $104.0811 – $102 = $2.0811

6) Suppose that the spot price of a non-dividend-paying stock is $100,

the 6-month forward price is $107, the 6-month US$ interest rate is
8% per annum.
a. Is there an arbitrage opportunity? If yes, please illustrate:
b. Which is the strategy to get the arbitrage profit?
c. How much is the arbitrage profit?
Sol.
a. The no arbitrage value of F is:

FNA = S0 * er*T = $104.0811

F = $107 > FNA → then there is an arbitrage opportunity.

b. If F > FNA futures is overpriced then, in order to get the

arbitrage profit, at time t = 0 you have to:
− Long the stock (-$100.00)
 − Borrow $100.00 at 8% per 6 months (+$100.00)
− Take a short position in a 6-month futures

c. At time t = T, in your portfolio you have

iv. 1 short position on a futures contract
v. 1 stock
vi. A debt of $104.0811 ($100 compounded at annual rate of 8.0%
for 6 months).

The certain profit of this portfolio at time t = T is:

profit = – (ST – F) + ST – $104.0811 = $107 – $104.0811 = $2.9189
 Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set #4

Stefano Di Colli
Options – Payoff
1) Consider holding a long position on a call option written on a stock with maturity in 1 year. The
current price of the stock is $50.00, the strike price of the call option is $55.00, its initial fee is $3.00.
If the price of the underlying asset at the expiration date is $57.00, would you exercise the option? In
case, what is the payoff? And the profit?
Sol. Yes
𝜋 = max(𝑆𝑡 − 𝐾, 0) = $57 − $55 = $2
𝑃𝑟 = max(𝑆𝑡 − 𝐾, 0) − 𝑐 = 𝜋 − 𝑐 = ($57 − $55) − $3 = −$1
2) Consider holding a long position on a call option written on a stock with maturity in 3 months. The
current price of the stock is $70.00, the strike price of the call option is $67.00, its initial fee is $2.50.
If the price of the underlying asset at the expiration date is $70.00, would you exercise the option? In
case, what is your payoff? And your profit?
Sol. Yes
𝜋 = max(𝑆𝑡 − 𝐾, 0) = $70 − $67 = $3
𝑃𝑟 = max(𝑆𝑡 − 𝐾, 0) − 𝑐 = 𝜋 − 𝑐 = ($70 − $67) − $2.50 = $0.50
3) Consider holding a long position on a call option written on a stock with maturity in 6 months. The
current price of the stock is $30.00, the strike price of the call option is $30.00, its initial fee is $3.00.
If the price of the underlying asset at the expiration date is $28.00, would you exercise the option? In
case, what is your payoff? And your profit?
Sol. No
𝜋 = max(𝑆𝑡 − 𝐾, 0) = max(28 − 30, 0) = $0
𝑃𝑟 = max(𝑆𝑡 − 𝐾, 0) − 𝑐 = 𝜋 − 𝑐 = $0 − $3 = −$3
4) Consider holding a long position on a call option written on a stock with maturity in 9 months. The
current price of the stock is $60.00, the strike price of the call option is $62.00, its initial fee is $4.00.
If the price of the underlying asset at the expiration date is $62.00, would you exercise the option? In
case, what is your payoff? And your profit?
Sol. No
𝜋 = max(𝑆𝑡 − 𝐾, 0) = max(62 − 62, 0) = $0
𝑃𝑟 = max(𝑆𝑡 − 𝐾, 0) − 𝑐 = 𝜋 − 𝑐 = $0 − $4 = −$4
5) Consider holding a short position on a call option written on a stock with maturity in 9 months.
The current price of the stock is $100.00, the strike price of the call option is $107.00, its initial fee
is $6.00. If the price of the underlying asset at the expiration date is $110.00, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. Yes
𝜋 = −max(𝑆𝑡 − 𝐾, 0) = −($110 − $107) = −$3
𝑃𝑟 = −max(𝑆𝑡 − 𝐾, 0) ∓ 𝑐 = −𝜋 + 𝑐 = −($110 − $107) + $6 = +$3
6) Consider holding a short position on a call option written on a stock with maturity in 2 years. The
current price of the stock is $41.00, the strike price of the call option is $37.00, its initial fee is $2.00.
If the price of the underlying asset at the expiration date is $39.00, would the option be exercised? In
case, what is your payoff? And your profit?
Sol. Yes
𝜋 = −max(𝑆𝑡 − 𝐾, 0) = −($39 − $37) = −$2
𝑃𝑟 = −max(𝑆𝑡 − 𝐾, 0) + 𝑐 = −𝜋 + 𝑐 = −($39 − $37) + $2 = $0
7) Consider holding a short position on a call option written on a stock with maturity in 3 months.
The current price of the stock is $63.00, the strike price of the call option is $68.00, its initial fee is
$3.50. If the price of the underlying asset at the expiration date is $67.00, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. No
𝜋 = −max(𝑆𝑡 − 𝐾, 0) = − max($67 − $68, 0) = $0
𝑃𝑟 = −max(𝑆𝑡 − 𝐾, 0) + 𝑐 = −𝜋 + 𝑐 = −0 + $3.50 = $3.50
8) Consider holding a short position on a call option written on a stock with maturity in 1 year. The
current price of the stock is $52.00, the strike price of the call option is $60.00, its initial fee is $2.50.
If the price of the underlying asset at the expiration date is $60.00, would the option be exercised? In
case, what is your payoff? And your profit?
Sol. No
𝜋 = −max(𝑆𝑡 − 𝐾, 0) = − max($60 − $60, 0) = $0
𝑃𝑟 = −max(𝑆𝑡 − 𝐾, 0) + 𝑐 = −𝜋 + 𝑐 = −0 + $2.50 = $2.50
9) Consider holding a short position on a call option written on a stock with maturity in 6 months.
The current price of the stock is $47.15, the strike price of the call option is $50.00, its initial fee is
$3.00. If the price of the underlying asset at the expiration date is $75.12, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. Yes
𝜋 = −max(𝑆𝑡 − 𝐾, 0) = − max($75.12 − $50, 0) = −$25.12
𝑃𝑟 = −max(𝑆𝑡 − 𝐾, 0) + 𝑐 = −𝜋 + 𝑐 = −25.12 + $3.00 = −$22.12
10) Consider holding a long position on a put option written on a stock with maturity in 3 months.
The current price of the stock is $37.15, the strike price of the call option is $42.00, its initial fee is
$3.00. If the price of the underlying asset at the expiration date is $38.51, would you exercise the
option? In case, what is the payoff? And the profit?
Sol. Yes
𝜋 = max(𝐾 − 𝑆𝑡 , 0) = max($42.00 − $38.51, 0) = $3.49
𝑃𝑟 = max(𝐾 − 𝑆𝑡 , 0) − 𝑝 = 𝜋 − 𝑝 = $3.59 − $3.00 = $0.49
11) Consider holding a long position on a put option written on a stock with maturity in 9 months.
The current price of the stock is $62.36, the strike price of the call option is $59.00, its initial fee is
$3.50. If the price of the underlying asset at the expiration date is $57.13, would you exercise the
option? In case, what is the payoff? And the profit?
Sol. Yes
𝜋 = max(𝐾 − 𝑆𝑡 , 0) = max($59.00 − $57.13, 0) = $1.87
𝑃𝑟 = max(𝐾 − 𝑆𝑡 , 0) − 𝑝 = 𝜋 − 𝑝 = $1.87 − $3.50 = −$1.63
12) Consider holding a long position on a put option written on a stock with maturity in 2 years. The
current price of the stock is $112.56, the strike price of the call option is $115.00, its initial fee is
$6.00. If the price of the underlying asset at the expiration date is $116.22, would you exercise the
option? In case, what is the payoff? And the profit?
Sol. No
𝜋 = max(𝐾 − 𝑆𝑡 , 0) = max($115.00 − $116.22, 0.00) = $0.00
𝑃𝑟 = max(𝐾 − 𝑆𝑡 , 0) − 𝑝 = 𝜋 − 𝑝 = $0.00 − $6.00 = −$6.00
13) Consider holding a long position on a put option written on a stock with maturity in 6 months.
The current price of the stock is $13.12, the strike price of the call option is $15.00, its initial fee is
$1.00. If the price of the underlying asset at the expiration date is $15.00, would you exercise the
option? In case, what is the payoff? And the profit?
Sol. No
𝜋 = max(𝐾 − 𝑆𝑡 , 0) = max($15.00 − $15.00, 0.00) = $0.00
𝑃𝑟 = max(𝐾 − 𝑆𝑡 , 0) − 𝑝 = 𝜋 − 𝑝 = $0.00 − $1.00 = −$1.00
14) Consider holding a short position on a put option written on a stock with maturity in 1 year. The
current price of the stock is $24.12, the strike price of the put option is $21.00, its initial fee is $2.50.
If the price of the underlying asset at the expiration date is $19.84, would the option be exercised? In
case, what is your payoff? And your profit?
Sol. Yes
𝜋 = −max(𝐾 − 𝑆𝑡 , 0) = −max($21.00 − $19.84, 0.00) = −$1.16
𝑃𝑟 = −max(𝐾 − 𝑆𝑡 , 0) + 𝑝 = 𝜋 + 𝑝 = −$1.16 + $2.50 = $1.34
15) Consider holding a short position on a put option written on a stock with maturity in 3 months.
The current price of the stock is $35.81, the strike price of the put option is $37.00, its initial fee is
$2.80. If the price of the underlying asset at the expiration date is $32.61, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. Yes
𝜋 = −max(𝐾 − 𝑆𝑡 , 0) = −max($37.00 − $32.61, 0.00) = −$4.39
𝑃𝑟 = −max(𝐾 − 𝑆𝑡 , 0) + 𝑝 = 𝜋 + 𝑝 = −$4.39 + $2.80 = −$1.59
16) Consider holding a short position on a put option written on a stock with maturity in 9 months.
The current price of the stock is $63.14, the strike price of the call option is $60.00, its initial fee is
$4.50. If the price of the underlying asset at the expiration date is $60.00, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. No
𝜋 = −max(𝐾 − 𝑆𝑡 , 0) = −max($60.00 − $60.00, 0.00) = $0.00
𝑃𝑟 = −max(𝐾 − 𝑆𝑡 , 0) + 𝑝 = 𝜋 + 𝑝 = $0.00 + $4.50 = $4.50
17) Consider holding a short position on a put option written on a stock with maturity in 6 months.
The current price of the stock is $12.38, the strike price of the call option is $11.00, its initial fee is
$1.10. If the price of the underlying asset at the expiration date is $30.00, would the option be
exercised? In case, what is your payoff? And your profit?
Sol. No
𝜋 = −max(𝐾 − 𝑆𝑡 , 0) = −max($11.00 − $30.00, 0.00) = $0.00
𝑃𝑟 = −max(𝐾 − 𝑆𝑡 , 0) + 𝑝 = 𝜋 + 𝑝 = $0.00 + $1.10 = $1.10
Options – upper/lower bounds and put call parity
1. You are at the time 0. Suppose that

c = $4 S0 = $65 T = 1.0
r = 0.1 K = $65
where S is the price of a stock and c is the price of a call option written on the same stock with maturity
T and strike price K.
a. What is the lower bound for call price? Is there an arbitrage opportunity? If yes, please
illustrate:
b. Which is the strategy to get the arbitrage profit?
c. How much is the arbitrage profit?

Solution
a. The lower bound of c is

cLB = max(S0 - K*e-r*T, 0) = max($65 - $65* e-0.1*1,0) = $6.1856

c = $4 < cLB → call price is under the lower bound, then there is an arbitrage opportunity.

b. If c < cLB is underpriced. In order to get the arbitrage profit, at time t = 0 you have to:

− Short sell the stock (+$65.00)

− Buy the call (-$4.00)
− The net inflow (+$61) can be invested at r until t =T

c. At time t = T, in your portfolio you have

i. 1 long position on a call
ii. 1 short selling position on the stock to be closed out
iii. $61 invested at 10.0% until T with a compounded value of $67.4154.

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $65 ST = $65 ST > $65

Investment +$67.4154 +$67.4154 +$67.4154
Closing out short sell. -ST -ST = $65.0000 -ST
1 Long Call $0.0000 $0.0000 ST - $65.0000
Total payoff ($67.4154-ST)> +$2.4154 +$2.4154 +$2.4154

The arbitrage profit is at least $2.4154

2. You are at the time 0. Suppose that

p = $2 S0 = $65 T = 0.25
r = 0.1 K = $69
where S is the price of a stock and p is the price of a put option written on the same stock with maturity
T and strike price K.
a. What is the lower bound for put price? Is there an arbitrage opportunity? If yes, please
illustrate:
b. Which is the strategy to get the arbitrage profit?
c. How much is the arbitrage profit?

Solution
a. The lower bound of p is
pLB
= max(K*e-r*T - S0, 0) = max($69* e-0.1*0.25- $65 ,0) = $2.2964

p = $2 < pLB → put price is under the lower bound, then there is an arbitrage opportunity.

b. If p < pLB the put is underpriced. In order to get the arbitrage profit, at time t = 0 you
have to:

− Buy the share (-$65.00)

− Buy the put (-$2.00)
− The net outflow (-$67) can be borrowed at r until t =T

c. At time t = T, in your portfolio you have

i. 1 long position on a put
ii. 1 share
iii. $68.6961 (compounded value of $67.0000) to pay back.

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $69 ST = $69 ST > $69

Debt -$68.6961 -$68.6961 -$68.6961
1 Share +ST +ST = $69.0000 +ST
1 Long Put $69.0000 - ST $0.0000 $0.0000
Total payoff +$0.3039 +$0.3039 (ST -$68.6961) > $0.3039

The arbitrage profit is at least $0.3039.

3. You are at the time 0. Suppose that

c = $4 S0 = $65 T = 0.5
r = 0.1 K = $68
where S is the price of a stock and c is the price of a call option written on it with maturity T and
strike price K.
a. What is the put-call parity value of a put option written on the same stock with the same
strike price K = $68 and the same maturity T = 0.5?
b. Is there an arbitrage opportunity if p = $3? If yes, please illustrate:
c. Which is the strategy to get the arbitrage profit?
d. How much is the arbitrage profit?

Solution
a. The put-call parity value of p is

ppcp = c +K*e-r*T - S0 = $4.000 + $68* e-0.1*0.5 - $65.000 = $3.6836

b. p = $3 < ppcp → put price is under the put-call parity value, then there is an arbitrage
opportunity.
c. In order to get the arbitrage profit, at time t = 0 you have to:

− Long the put option (-$3.0000)

− Buy the share (-$65.000)
− Short the call (+$4.0000)
− The net outflow (-$64.0000) can be borrowed at r until t =T

d. At time t = T, in your portfolio you have

− 1 long put
− 1 share
− A debt of $67.2814 (compounded value of $64.0000) to pay back
− 1 short call

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $68 ST = $68 ST > $68

1 Long put $68.0000 - ST $0.0000 $0.0000
1 Share +ST +ST = $68.0000 +ST
Debt -$67.2814 -$67.2814 -$67.2814
1 Short call $0.0000 $0.0000 -(ST - $68.0000)
Total payoff +$0.7186 +$0.7186 +$0.7186

The arbitrage profit is at least $0.7186

4. You are at the time 0. Suppose that

c = $4 S0 = $65 T = 0.5
r = 0.1 K = $68 D = $0
where S is the price of a stock and c is the price of a call option written on it with maturity T and
strike price K.
a. What is the put-call parity value of a put option written on the same stock with the same
strike price K = $68 and the same maturity T = 0.5?
b. Is there an arbitrage opportunity if p = $5? If yes, please illustrate:
c. Which is the strategy to get the arbitrage profit?
d. How much is the arbitrage profit?

Solution
a. The put-call parity value of p is

ppcp = c +K*e-r*T - S0 = $4.000 + $68* e-0.1*0.5 - $65.000 = $3.6836

b. p = $5 > ppcp → put price is over the put-call parity value, then there is an arbitrage
opportunity. In order to get the arbitrage profit, at time t = 0 you have to:

− Short the put option (+$5.0000)

− Short sell the share (+$65.000)
− Long the call (-$4.0000)
− The net inflow (+$66.0000) can be invested at r until t =T

c. At time t = T, in your portfolio you have

iv. 1 Short put
v. 1 Share to buy in order to close out the short selling
vi. $69.3839 (compounded value of $66.0000) to get back from the investment
vii. 1 Long call

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $68 ST = $68 ST > $68

1 Short put -($68.0000 - ST) $0.0000 $0.0000
1 Share to buy -ST -ST = $68.0000 -ST
Investment +$69.3839 +$69.3839 +$69.3839
1 Long call $0.0000 $0.0000 ST - $68.0000
Total payoff +$1.3839 +$1.3839 +$1.3839

The arbitrage profit is at least $1.3839

5. You are at the time 0. Suppose that

p = $4 S0 = $65 T = 0.5
r = 0.1 K = $68
where S is the price of a stock and p is the price of a put option written on it with maturity T and strike
price K.
e. What is the put-call parity value of a call option written on the same stock with the same
strike price K = $68 and the same maturity T = 0.5?
f. Is there an arbitrage opportunity if c = $4? If yes, please illustrate:
g. Which is the strategy to get the arbitrage profit?
h. How much is the arbitrage profit?

Solution
d. The put-call parity value of c is

cpcp = p + S0 - K*e-r*T = $4.000 +$65.000 - $68* e-0.1*0.5 = $4.3164

e. c = $4 < cpcp → call price is under the put-call parity value, then there is an arbitrage
opportunity. Portfolio A (1 call option + 1 zero-coupon bond providing a payoff of K at
T) is underpriced with respect to portfolio C (1 put option + 1 share). In order to get the
arbitrage profit, at time t = 0 you have to:

− Short the put option (+$4.0000)

− Short sell the share (+$65.000)
− Long the call (-$4.0000)
− The net inflow (+$65.0000) can be invested at r until t =T

f. At time t = T, in your portfolio you have

viii. 1 Short put
ix. 1 Share to buy in order to close out the short selling
x. $68.3326 (compounded value of $65.0000) to get back from the investment
xi. 1 Long call

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $68 ST = $68 ST > $68

1 Short put -($68.0000 - ST) $0.0000 $0.0000
1 Share to buy -ST -ST = $68.0000 -ST
Investment +$68.3326 +$68.3326 +$68.3326
1 Long call $0.0000 $0.0000 ST - $68.0000
Total payoff +$0.3326 +$0.3326 +$0.3326

The arbitrage profit is at least +$0.3326

6. You are at the time 0. Suppose that

p = $4 S0 = $65 T = 0.5
r = 0.1 K = $68
where S is the price of a stock and p is the price of a put option written on it with maturity T and strike
price K.
a. What is the put-call parity value of a call option written on the same stock with the same
strike price K = $68 and the same maturity T = 0.5?
b. Is there an arbitrage opportunity if c = $5.5? If yes, please illustrate:
c. Which is the strategy to get the arbitrage profit?
d. How much is the arbitrage profit?

Solution
a. The put-call parity value of c is

cpcp = p + S0 - K*e-r*T = $4.000 +$65.000 - $68* e-0.1*0.5 = $4.3164

b. c = $5 > cpcp → call price is over the put-call parity value, then there is an arbitrage
opportunity. Portfolio A (1 call option + 1 zero-coupon bond providing a payoff of K at
T) is overpriced with respect to portfolio C (1 put option + 1 share). In order to get the
arbitrage profit, at time t = 0 you have to:

− Long the put option (-$4.0000)

− Buy the share (-$65.000)
− Short the call (+$5.5000)
− The net outflow (-$63.5000) can be borrowed at r until t =T

c. At time t = T, in your portfolio you have

xii. 1 Long put
xiii. 1 Share
xiv. A debt of $66.7557 (compounded value of $63.5000) to pay back
xv. 1 Short call

Payoff of this portfolio at time t = T depends on ST. Possible payoff values are:

ST < $68 ST = $68 ST > $68

1 Long put $68.0000 - ST $0.0000 $0.0000
1 Share +ST +ST = $68.0000 +ST
Debt -$66.7557 -$66.7557 -$66.7557
1 Short call $0.0000 $0.0000 -(ST - $68.0000)
Total payoff +$1.2443 +$1.2443 +$1.2443

The arbitrage profit is at least $1.2443

1) (I) A share of common stock in a firm represents an ownership interest in that firm.
(II) A share of preferred stock is as much like a bond as it is like common stock.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

2) Preferred stockholders hold a claim on assets that has priority over the claims of
A) both common stockholders and bondholders.
B) neither common stockholders nor bondholders.
C) common stockholders, but after that of bondholders.
D) bondholders, but after that of common stockholders.
Answer: C

3) The riskiest capital market security is

A) preferred stock.
B) common stock.
C) corporate bonds.
D) Treasury bonds.
Answer: B

4) A share of common stock in a firm represents an ownership interest in that firm and allows
stockholders to
A) vote.
B) receive dividends.
C) receive interest payments.
D) vote and receive dividends.
Answer: D

5) A high price earnings ratio (PE) gives what interpretation?

A) The market expects earnings to fall in the future.
B) The market feels the firm's earnings are very high risk and are willing to pay a premium for them.
C) The market expects the earnings to rise in the future.
D) The firm is not paying a dividend.
Answer: C

6) In the one-period valuation model, a stock's value will be higher

A) the higher its expected future price is.
B) the lower its dividend is.
C) the higher the required return on investments in equity is.
D) all of the other anwers.
Answer: A

7) The party that has agreed to buy a forward contract is termed

A) shorter.
B) arbitrageur.
C) risk lover.
D) longer.
Answer: D
8) On November 1st the treasurer of a corporation enters into a long forward contract to buy £1 million
in six months at an exchange rate of 1.45. What is the outcome if ST =$1.6?
A) 0.15$.
B) 150,000$.
C) -150,000$.
D) 120,000$.
Answer: B

9) Futures contracts are typically traded

A) on a spot market.
B) on an over-the-counter market.
C) on an exchange.
D) on a current market.
Answer: C

10) Arbitrageurs
A) use derivatives to reduce risk.
B) use derivatives to bet on the future direction of markets.
C) act as referees in soccer matches.
D) take offsetting positions in two or more instruments to lock in a profit.
Answer: D

11) What is the current price for a stock with current dividend of $20.00 an expected growth rate of
dividends of 10% and expected price next year of $100.00? Use 4.0% discount rate.
A) 117.31$
B) 115.38$
C) 96.34$
D) 133.75$
Answer: A

12) What is the price for a stock with an expected dividend of $6.12 for the next 8 years and selling
price of $122.11? Use a 5.0% discount rate
A) 137.16$
B) 95.25$
C) 122.20$
D) 102.12$
Answer: C

13) Find the current price of a stock assuming dividends grow at a constant rate of 4.12%, D0 = $6.14,
and the discount rate is 7.00%.
A) 112.41$
B) 151.37$
C) 199.32$
D) 221.98$
Answer: D
14) Suppose that the spot price of a non-dividend-paying stock is $50.00, the 2-years forward price
is $56.37, the 2-years US$ interest rate is 6% per annum. Is there an arbitrage opportunity? If yes,
how much is the arbitrage profit?
A) There is not an arbitrage opportunity; 0$
B) There is an arbitrage opportunity; 1.35$
C) There is an arbitrage opportunity; 0.35$
D) There is an arbitrage opportunity; 2.35$
Answer: A

15) Suppose that the spot price of a non-dividend-paying stock is $43.00, the 9-month futures price
is $43.5, the 9-months US$ interest rate is 5% per annum. What is the strategy to get an arbitrage
profit? How much is it?
A) Short sell the stock, invest the proceeds at 5% per 9 months, long 9-month futures; 1.03$
B) Long the stock, borrow $43.00 at 5% per 9 months, short 9-month futures; 1.14$
C) Long the stock, borrow $43.00 at 5% per 9 months, short 9-month futures; 1.03$
D) Short sell the stock, invest the proceeds at 5% per 9 months, long 9-month futures; 1.14$
Answer: D
1) The elimination of riskless profit opportunities in the futures market is referred to as
A) speculation.
B) hedging.
C) arbitrage.
D) open interest.
E) mark to market.
Answer: C

2) Futures differ from forwards because they are

A) used to hedge portfolios.
B) used to hedge individual securities.
C) used in both financial and foreign exchange markets.
D) standardized contracts.
Answer: D

3) If a firm is due to be paid in euros in two months, to hedge against exchange rate risk the firm
should
A) sell foreign exchange futures short.
B) buy foreign exchange futures long.
C) stay out of the exchange futures market.
D) do none of the above.
Answer: A

4) Options are contracts that give the purchasers the

A) opportunity to buy or sell an underlying asset.
B) the obligation to buy or sell an underlying asset.
C) the right to hold an underlying asset.
D) the right to switch payment streams.
Answer: A

5) The price specified in an option contract at which the holder can buy or sell the underlying asset
is called the
A) premium.
B) call.
C) strike price.
D) put.
Answer: C

6) The seller of an option has the ________ to buy or sell the underlying asset, while the purchaser
of an option has the ________ to buy or sell the asset.
A) obligation; right
B) right; obligation
C) obligation; obligation
D) right; right
Answer: A
Topic: Chapter 24.5 Options
Question Status: Previous Edition
7) An option that can be exercised at any time up to maturity is called a(n)
A) swap.
B) stock option.
C) European option.
D) American option.
Answer: D

8) If you buy an option to buy Treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
Answer: A

9) If a bank manager wants to protect the bank against losses that would be incurred on its portfolio
of Treasury securities should interest rates rise, he could ________ options on financial futures.
A) buy put.
B) buy call.
C) sell put.
D) sell call.
Answer: A

10) A valid concern about financial derivatives is that

A) they allow financial institutions to increase their leverage.
B) they are too sophisticated because they are so complicated.
C) the notional amounts can greatly exceed a financial institution's capital.
D) all of the other answers valid concerns.
E) none of the other answers are valid concerns.
Answer: A

11) Consider holding a long position on a call option written on a stock with maturity in 1 year. The
current price of the stock is $42.16, the strike price of the call option is $45.00, its initial fee is $4.00.
If the price of the underlying asset at the expiration date is $47.00, what is your final profit?
A) 2.00$
B) -2.00$
C) 4.00$
D) -4.00$
Answer: B

12) Consider holding a short position on a put option written on a stock with maturity in 1 year. The
current price of the stock is $34.18, the strike price of the put option is $36.00, its initial fee is $3.00.
If the price of the underlying asset at the expiration date is $34.12, what is your payoff at the maturity?
A) 1.22$
B) -1.22$
C) 1.88$
D) -1.88$
Answer: D
13) What is the lower bound for the price of a six-month European call option on a non-dividend-
paying stock when the stock price is $51.18, the strike price is $55.00, and the risk-free interest rate
is 5% per annum?
A) -$1.0
B) $0.0
C) $1.7
D) $3.8
Answer: B

14) What is the lower bound for the price of a nine-month European call option on a non-dividend-
paying stock when the stock price is $37.41, the strike price is $38.00, and the risk-free interest rate
is 4.5% per annum?
A) -$1.21
B) $0.00
C) $1.91
D) $0.67
Answer: D

15) The price of a one year European put option written on a non-dividend-paying stock when the
stock price is $65.33, the strike price is $68.00, and the risk-free interest rate is 3.0% per annum is
p=$0.50. How much is the arbitrage profit, if possible?
A) At least $0.17
B) $0.17
C) At least $2.67
D) $0.50
Answer: A

16) The price of a three-month European call option on a non-dividend-paying stock when the stock
price is $42.12, the strike price is $45.00, and the risk-free interest rate is 4.0% per annum is c=$2.00.
How much is the arbitrage profit for p=$4.00 (where p is the price of a put written on the same
underlying asset for the same maturity), if possible?
A) $2.17
B) -$0.58
C) $0.44
D) $1.50
Answer: C
1) In a recession when income and wealth are falling, the demand for bonds ________ and the
demand curve shifts to the ________.
A) falls; right
B) falls; left
C) rises; right
D) rises; left
Answer: B

2) When the demand for bonds ________ or the supply of bonds ________, interest rates rise.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases
Answer: D

3) Which of the following long-term bonds should have the highest interest rate?
A) Corporate Baa bonds
B) U.S. Treasury bonds
C) Corporate Aaa bonds
D) Municipal bonds
Answer: A

4) Federal funds
A) are short-term funds transferred between financial institutions, usually for a period of one day.
B) actually have nothing to do with the federal government.
C) provide banks with an immediate infusion of reserves.
D) are all of the others.
Answer: D

5) Treasury bonds are subject to ________ risk but are essentially free of ________ risk.
A) default; interest-rate
B) default; underwriting
C) interest-rate; default
D) interest-rate; underwriting
Answer: C

6) The security with the longest maturity is a Treasury

A) note.
B) bond.
C) acceptance.
D) bill.
Answer: B
7) According to the Gordon growth model, what is an investor's valuation of a stock whose current
dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a
long period of time and the investor's required return is 15 percent?
A) $20
B) $11
C) $22
D) $7.33
E) $4.40
Answer: C

8) If a corporation's earnings rise, then the default risk on its bonds will ________ and the
equilibrium interest rate on these bonds will ________.
A) increase; decrease
B) decrease; decrease
C) increase; increase
D) decrease; increase
Answer: B

9) Hedging risk involves engaging in a financial transaction that offsets a long position by taking an
additional ________ position, or offsets a short position by taking an additional ________ position.
A) long; long
B) long; short
C) short; long
D) short; short
Answer: C

10) By selling short a futures contract of $100,000 at a price of 115, you are agreeing to deliver
________ face value securities for ________.
A) $100,000; $115,000
B) $115,000; $110,000
C) $100,000; $100,000
D) $115,000; $115,000
Answer: A

11) What is the lower bound for the price of a one year European call option on a non-dividend-
paying stock when the stock price is $25.13, the strike price is $26.00, and the risk-free interest rate
is 5.75% per annum?
A) -$0.36
B) $0.00
C) $2.74
D) $0.58
Answer: D

12) The price of a one year European put option written on a non-dividend-paying stock when the
stock price is $82.78, the strike price is $86.00, and the risk-free interest rate is 3.00% per annum is
p=$0.30. How much is the arbitrage profit, if possible?
A) $0.39
B) $2.00
C) At least $2.00
D) At least $0.39
Answer: D
13) The price of a six-month European call option on a non-dividend-paying stock when the stock
price is $38.63, the strike price is $40.50, and the risk-free interest rate is 5.25% per annum is c=$3.50.
How much is the arbitrage profit for p=$3.50 (where p is the price of a put written on the same
underlying asset for the same maturity), if possible?
A) $2.52
B) $0.84
C) At least $0.84
D) At least $2.52
Answer: B

14) At time t=0, an investor can create a bull spread with two 6-month call options with strike prices
K1=$65 (c1=$7) and K2=$69 (c2=$5), both written on a stock with current price S0=$66. Show the
profit of this strategy at time T if ST=68.
A) $4
B) -$2
C) $1
D) $2
Answer: C

15) At time t=0, an investor can create a bear spread with two 9-month put options with strike prices
K1=$32 (p1=$3) and K2=$36 (p2=$4), both written on a stock with current price S0=$33. Show the
profit of this strategy at time T if ST=38.
A) $2
B) -$1
C) $1
D) $3
Answer: B
 Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set #5

Stefano Di Colli
Options – Trading strategies
1. At time t=0, an investor can create a bull spread with two 3-month call options with strike prices
K1=$50 (c1=$7) and K2=$60 (c2=$5), both written on a stock with current price S0=$53. Show the
possible profit of this strategy at time T.

Sol. The bull spread consists in buying the call with strike price K1=$50 and selling the call
with strike price K2=$60 with an initial investment of $2 (=+$5-$7). Payoff of this strategy at
time t = T depends on ST in the following way:

ST ≤ $50 $50 < ST ≤ $60 ST > $60

1 Long call $0.0000 ST - $50.0000 ST - $50.0000
1 Short call $0.0000 $0.0000 -(ST - $60.0000)
Total payoff $0.0000 ST - $50.0000 +$10.0000
Total payoff + initial CF -$2.0000 ST - $52.0000 +$8.0000

2. At time t=0, an investor can create a bear spread with two 3-month call options with strike prices
K1=$50 (c1=$8) and K2=$54 (c2=$5.5), both written on a stock with current price S0=$53. Show the
possible profit of this strategy at time T.

Sol. The bear spread consists in selling the call with strike price K1=$50 and buying the call
with strike price K2=$54 with an initial inflow of $2.5 (=-$5.5+$8). Payoff of this strategy at
time t = T depends on ST in the following way:

ST ≤ $50 $50 < ST ≤ $54 ST > $54

1 Short call $0.0000 -(ST - $50.0000) -(ST - $50.0000)
1 Long call $0.0000 $0.0000 ST - $54.0000
Total payoff $0.0000 $50.0000-ST -$4.0000
Total payoff + initial CF +$2.5000 $52.5000-ST -$1.5000

3. At time t=0, an investor can create a bull spread with two 3-month put options with strike prices
K1=$70 (p1=$6) and K2=$73 (p2=$8), both written on a stock with current price S0=$73. Show the
possible profit of this strategy at time T.

Sol. The bull spread consists in buying the put with strike price K1=$70 and selling the put
with strike price K2=$73 with an initial inflow of $2 (=-$6+$8). Payoff of this strategy at time
t = T depends on ST in the following way:

ST < $70 $70 ≤ ST < $73 ST ≥ $73

1 Long put $70.0000-ST $0.0000 $0.0000
1 Short put -($73.0000-ST) -($73.0000-ST) $0.0000
Total payoff -$3.0000 ST - $73.0000 $0.0000
Total payoff + initial CF -$1.0000 ST - $71.0000 +$2.0000
4. At time t=0, an investor can create a bear spread with two 3-month put options with strike prices
K1=$70 (p1=$6) and K2=$75 (p2=$8), both written on a stock with current price S0=$73. Show the
possible profit of this strategy at time T.

Sol. The bear spread consists in selling the put with strike price K1=$70 and buying the put
with strike price K2=$75 with an initial investment of $2 (=+$6-$8). Payoff of this strategy at
time t = T depends on ST in the following way:

ST < $70 $70 ≤ ST < $75 ST ≥ $75

1 Short put -($70.0000-ST) $0.0000 $0.0000
1 Long put $75.0000-ST $75.0000-ST $0.0000
Total payoff +$5.0000 $75.0000-ST $0.0000
Total payoff + initial CF +$3.0000 $73.0000-ST -$2.0000

5. At time t=0, an investor can create a butterfly spread with four 3-month call options with strike
prices K1=$50 (c1=$10), K2=$55 (c2=$7) and K3=$60 (c3=$5), all written on a stock with current price
S0=$53. Show the possible profit of this strategy at time T.

Sol. The butterfly spread consists in buying one call with strike price K1=$50, selling two calls
with strike price K2=$55 and buying the call with strike price K3=$60 with an initial
investment of $1 (=-$10+14-$5). Payoff of this strategy at time t = T depends on ST in the
following way:

ST ≤ $50 $50 < ST ≤ $55 $55 < ST ≤ $60 ST > $60

1 Long call $0.0000 ST - $50.0000 ST - $50.0000 ST - $50.0000
2 Short calls $0.0000 $0.0000 -2(ST - $55.0000) -2(ST - $55.0000)
1 Long call $0.0000 $0.0000 $0.0000 ST - $60.0000
Total payoff $0.0000 ST - $50.0000 $60.0000 - ST +$0.0000
Total payoff -$1.0000 ST - $51.0000 $59.0000 - ST -$1.0000
+ initial CF

6. At time t=0, an investor can create a butterfly spread with four 3-month put options with strike
prices K1=$60 (p1=$7), K2=$66 (p2=$8) and K3=$72 (p3=$11), all written on a stock with current
price S0=$53. Show the possible profit of this strategy at time T.

Sol. The butterfly spread consists in buying one put with strike price K1=$60, selling two calls
with strike price K2=$66 and buying one put with strike price K3=$72 with an initial
investment of $2 (=+$7-$16+$11). Payoff of this strategy at time t = T depends on ST in the
following way:

ST < $60 $60 ≤ ST < $66 $66 ≤ ST < $72 ST ≥ $72

1 Long put $60.0000- ST $0.0000 $0.0000 $0.0000
2 Short puts -2($66.0000- ST) -2($66.0000- ST) $0.0000 $0.0000
1 Long put $72.0000- ST $72.0000- ST $72.0000- ST $0.0000
Total payoff $0.0000 ST - $60.0000 $72.0000- ST +$0.0000
Total payoff -$2.0000 ST - $62.0000 $70.0000- ST -$2.0000
+ initial CF
7. At time t=0, an investor can create a straddle combination with one 3-month call option with strike
price K=$40 (c=$4) and one 3-month put option with strike price K=$40 (p=$3), both written on the
same stock with current price S0=$38. Show the possible profit of this strategy at time T.

Sol. The straddle consists in buying one call and one put with the same strike price K=$50
with an initial investment of $7 (=-$4-$3). Payoff of this strategy at time t = T depends on ST
in the following way:

ST < $40 ST =$40 ST > $40

1 Long call $40.0000-ST $0.0000 $0.0000
1 Long put $0.0000 $0.0000 ST -$40.0000
Total payoff $40.0000-ST $0.0000 ST -$40.0000
Total payoff + initial CF $33.0000-ST -$7.0000 ST -$47.0000

8. At time t=0, an investor can create a strangle combination with one 3-month call option with strike
price K2=$45 (c=$2) and a 3-month put option with strike price K1=$40 (p=$3), both written on the
same stock with current price S0=$42. Show the possible profit of this strategy at time T.

Sol. The strangle consists in buying one call with strike price K2=$45 and one put with lower
strike price K1=$40 with an initial investment of $5 (=-$2-$3). Payoff of this strategy at time
t = T depends on ST in the following way:

ST < $40 $40 ≤ ST ≤ $45 ST > $45

1 Long call $0.0000 $0.0000 ST -$45.0000
1 Long put $40.0000 - ST $0.0000 $0.0000
Total payoff $40.0000 - ST $0.0000 ST -$45.0000
Total payoff + initial CF $35.0000 - ST -$5.0000 ST -$50.0000

9) At time t=0, an investor can create a bull spread with two 3-month call options with strike prices
K1=$26 (c1=$3) and K2=$32 (c2=$2), both written on a stock with current price S0=$29. Show the
profit of this strategy at time T if ST = 35.
Sol. (K2 – K1) – (c1 – c2) = ($32 – $26) – ($3 – $2) = $5

10) At time t=0, an investor can create a bull spread with two 6-month put options with strike prices
K1=$62 (p1=$5) and K2=$67 (p2=$7), both written on a stock with current price S0=$60. Show the
profit of this strategy at time T if ST = 43.
Sol. – (K2 – K1) + (p2 – p1) = – ($67 – $62) + ($7 – $5) = – $3

11) At time t=0, an investor can create a bear spread with two 9-month call options with strike prices
K1=$87 (c1=$9) and K2=$95 (c2=$7), both written on a stock with current price S0=$85. Show the
profit of this strategy at time T if ST = $73.
Sol. (c1 – c2) = ($9 – $7) = $2

12) At time t=0, an investor can create a bear spread with two 6-month put options with strike prices
K1=$40 (p1=$3) and K2=$45 (p2=$4), both written on a stock with current price S0=$42. Show the
profit of this strategy at time T if ST = 42.5.
Sol. (K2 – ST) – (p2 – p1) = ($45 – $42.5) – ($4 – $3) = $1.5
13) At time t=0, an investor can create a butterfly spread with three 3-month call options with strike
prices K1=$33 (c1=$6), K2=$37 (c2=$4), and K3=$41 (c3=$3), all of them written on a stock with
current price S0=$35. Show the profit of this strategy at time T if ST = 36.
Sol. (ST – K1) + (2∙c2 – c1 – c3) = ($36 – $33) + (2∙$4 – $6 – $3) = $2

14) At time t=0, an investor can create a butterfly spread with three 9-month put options with strike
prices K1=$45 (p1=$4.5), K2=$50 (p2=$5.5), and K3=$55 (p3=$7), all of them written on a stock with
current price S0=$51. Show the profit of this strategy at time T if ST = 50.5.
Sol. (2∙K2 – K1) – ST + (2∙p2 – p1 – p3) = (2∙$50 – $45) – $50.5 + (2∙$5.5 – $4.5 – $7) =
= $55 – $50.5 – $0.5 = $4

15) At time t=0, an investor can create a straddle with a 6-month call option with strike price K=$30
(c=$3) and a 6-month put option with strike price K=$30 (p=$2), both written on the same stock with
current price S0=$29. Show the profit of this strategy at time T if ST = 65.
Sol. (ST – K) – (c + p) = ($65 – $30) – ($3 + $2) = $30

16) At time t=0, an investor can create a strangle with a 9-month call option with strike price K1=$54
(c=$4.5) and a 9-month put option with strike price K2=$48 (p=$4), both written on the same stock
with current price S0=$50. Show the profit of this strategy at time T if ST = 53.
Sol. – (c + p) = – ($4.5 + $4) = – $8.5
1) The higher the standard deviation of returns on an asset, the ________ the asset's ________.
A) greater; risk
B) smaller; risk
C) greater; expected return
D) smaller; expected return
Answer: A

2) The supply curve for bonds has the usual upward slope, indicating that as the price ________,
ceteris paribus, the ________ increases.
A) falls; supply
B) falls; quantity supplied
C) rises; supply
D) rises; quantity supplied
Answer: D

3) The risk structure of interest rates is

A) the structure of how interest rates move over time.
B) the relationship among interest rates of different bonds with the same maturity.
C) the relationship among the terms to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
Answer: B

4) The Fed is an active participant in money markets mainly because of its responsibility to
A) lower borrowing costs to encourage capital investment.
B) control the money supply.
C) increase the interest income of retirees holding money market instruments.
D) assist the Securities and Exchange Commission in regulating the behavior of other money
market participants.
Answer: B

5) Bonds
A) are securities that represent a debt owed by the issuer to the investor.
B) obligate the issuer to pay a specified amount at a given date, generally without periodic interest
payments.
C) both A and B of the above.
D) none of the above.
Answer: A

6) A stock currently sells for $30 per share and pays $1.00 per year in dividends. What is an
investor's valuation of this stock if he expects it to be selling for $37 in one year and requires a 12
percent return on equity investments?
A) $38
B) $33.50
C) $34.50
D) $33.93
Answer: D
7) With a long contract, the investor (may)
A) sell securities in the future.
B) buy securities in the future.
C) hedge in the future.
D) close out his position in the future.
Answer: B

8) By selling short a futures contract of $100,000 at a price of 96, you are agreeing to deliver
________ face value securities for ________.
A) $100,000; $104,167
B) $96,000; $100,000
C) $100,000; $96,000
D) $100,000; $100,000
Answer: C

9) The payoff of a long position on a call option with strike price K, written on a stock with current
price S0, for a maturity K is:
A) -max(ST - K, 0).
B) max(K - ST , 0).
C) max(ST - K, 0).
D) max(ST - K, 0) - c
Answer: C

10) The advantage of a strangle trading strategy if compared with a straddle is that
A) it makes less probable having a loss.
B) it limits downside risk.
C) it provides higher profits if things go well.
D) it is more aggressive.
Answer: B

11) What is the lower bound for the price of a three-month European call option on a non-dividend-
paying stock when the stock price is $33.13, the strike price is $35.00, and the risk-free interest rate
is 5.12% per annum?
A) -$0.91
B) $0.00
C) $1.13
D) $2.58
Answer: B

12) The price of a nine-month European call option on a non-dividend-paying stock when the stock
price is $25.31, the strike price is $26.50, and the risk-free interest rate is 4.87% per annum is c=$2.50.
How much is the arbitrage profit for p=$2.50 (where p is the price of a put written on the same
underlying asset for the same maturity), if possible?
A) $0.25
B) $1.12
C) At least $1.12
D) $0.00
Answer: A
13) At time t=0, an investor can create a bull spread with two 3-month put options with strike prices
K1=$32 (p1=$3) and K2=$36 (p2=$4), both written on a stock with current price S0=$33. Show the
profit of this strategy at time T if ST = 28.
A) $0.00
B) -$2.00
C) $3.00
D) -$3.00
Answer: C

14) At time t=0, an investor can create a butterfly spread with three 6-month put options with strike
prices K1=$25 (p1=$2.5), K2=$30 (p2=$3.5), and K3=$35 (p3=$5.5), all of them written on a stock
with current price S0=$29. Show the profit of this strategy at time T if ST = 29.5.
A) $3.50
B) -$3.00
C) $2.00
D) -$1.00
Answer: A

15) At time t=0, an investor can create a straddle with a 3-month call option with strike price K=$60
(c=$3) and a 3-month put option with strike price K=$60 (p=$3), both written on the same stock with
current price S0=$59. Show the profit of this strategy at time T if ST = 52.
A) -$2.00
B) $0.00
C) -$6.00
D) $2.00
Answer: D
 Luiss Guido Carli

Course in Financial Markets and Institutions

a. y. 2022 – 2023

Problem set #6

Stefano Di Colli
Options – Binomial trees
1. A stock price is currently $50. Over the next nine months it is expected to go up by 7% or down
by 7%. The risk-free interest rate is 8% per annum with continuous compounding. What is the value
of a nine-month call option written on it with a strike price of $52?
Sol. u = 1.07, d = 0.93, then
𝑒 𝑟∙𝑇 −𝑑 𝑒 0.08∙0.75 −0.93
𝑝= = = 0.9417 and 1 − 𝑝 = 1 − 0.9417 = 0.0583
𝑢−𝑑 1.07−0.93

𝜋 𝑢 = max(𝑆𝑇𝑢 − 𝐾, 0) = max(𝑆0 ∙ 𝑢 − 𝐾, 0) = max($53.5 − $52.0,0) = $1.5

𝜋 𝑑 = max(𝑆𝑇𝑑 − 𝐾, 0) = max(𝑆0 ∙ 𝑑 − 𝐾, 0) = max($46.5 − $52.0,0) = $0
𝑐 = [𝑝 ∙ 𝜋 𝑢 + (1 − 𝑝) ∙ 𝜋 𝑢𝑑 ] ∙ 𝑒 −𝑟∙𝑇 = [0.9417 ∙ $1.5 + 0.0583 ∙ $0] ∙ 𝑒 −0.08∙0.75 = $1.33

2. A stock price is currently $35. Over the next three months it is expected to go up by 12% or down
by 12%. The risk-free interest rate is 5.5% per annum with continuous compounding. What is the
value of a three-month put option written on it with a strike price of $37?
Sol. u = 1.12, d = 0.88, then
𝑒 𝑟∙𝑇 −𝑑 𝑒 0.055∙0.25 −0.88
𝑝= = = 0.5577 and 1 − 𝑝 = 1 − 0.5577 = 0.4423
𝑢−𝑑 1.12−0.88

𝜋 𝑢 = max(𝐾 − 𝑆𝑇𝑢 , 0) = max(𝐾 − 𝑆0 ∙ 𝑢, 0) = max($37.0 − $39.2,0) = $0.0

𝜋 𝑑 = max(𝐾 − 𝑆𝑇𝑑 , 0) = max(𝐾 − 𝑆0 ∙ 𝑑, 0) = max($37.0 − $30.8,0) = $6.2
𝑐 = [𝑝 ∙ 𝜋 𝑢 + (1 − 𝑝) ∙ 𝜋 𝑢𝑑 ] ∙ 𝑒 −𝑟∙𝑇 =
= [0.5577 ∙ $0.0 + 0.4423 ∙ $6.2] ∙ 𝑒 −0.0055∙0.25 = $2.70

3. A stock price is currently $100. Over each of the next two six-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a one-year call option written on it with a strike price of $100?

In this case u = 1.10, d = 0.90, T = Δt = 0.5, 2T=1.0 and r = 0.08, so that

𝑒 0.08∙0.5 − 0.90
𝑝= = 0.7041
1.1 − 0.90

The tree for stock price movements is shown in the following figure. We can work back from
the end of the tree to the beginning, to give the value of the option as $9.6105.
 The option value can also be calculated directly from the equation:
c = [0.70412∙ $21 + 2∙0.7041∙0.2959∙$0 + 0.29592∙$0] e-2∙0.08∙0.5 = $9.61

4. A stock price is currently $100. Over each of the next two six-month periods it is expected to go
up by 10% or down by 10%. The risk-free interest rate is 8% per annum with continuous
compounding. What is the value of a one-year put option written on it with a strike price of $100?
Verify that the call (from exercise 15.) and put prices satisfy put–call parity.

In this case u = 1.10, d = 0.90, T = Δt = 0.5, 2T=1.0 and r = 0.08, so that

𝑒 0.08∙0.5 − 0.90
𝑝= = 0.7041
1.1 − 0.90

The tree for stock price movements is shown in the following figure. We can work back from
the end of the tree to the beginning, to give the value of the option as $1.9203.

The option value can also be calculated directly from the equation:
c = [0.70412∙ $0 + 2∙0.7041∙0.2959∙$1 + 0.29592∙$19] e-2∙0.08∙0.5 = $1.92

c pcp = p + S0 - K*e-r*T = $1.9203 + $100 - $100 e-2∙0.08∙0.5 = $9.61 → Put-call parity is satisfied

Options – BSM Formula (not included in the exam)

5. Calculate the price of a three-month put option on a non-dividend-paying stock with a strike price
of $50 when the current stock price is $50, the risk-free interest rate is 10% per annum, and the
volatility is 30% per annum.

In this case, S0 = $50, K = $50, r = 0.1, T = 0.25 and σ = 0.3, so that

50 0.32
ln ( ) + (0.1 + 2 ) ∙ 0.25
𝑑1 = 50 = 0.2417
0.3 ∙ √0.25
𝑑2 = 𝑑1 − 0.3 ∙ √0.25 = 0.0917

Applying the B-S-M formula, the put option price is

𝑝 = 50 ∙ 𝑁(−0.09) ∙ 𝑒 −0.1∙0.25 − 50𝑁(−0.24) = 50 ∙ 0.4641 − 50 ∙ 0.4052 = $2.95
 Financial Markets and Institutions
Second Mid-term mock
(prof. Canofari / Di Colli)

Rules

a) The exam must be completed in in one hour and a half. Points for each question
are reported in parenthesis.

Part II (19 points)

Please, circle right answers

1. Factors that determine the supply for bonds include: (0.5 points)
A) expected inflation
B) government deficits
C) wealth of investors
D) expected inflation and government deficits
Answer: D

2. The assumption of the Market segmentation theory for the term structure of interest rate is
that: (0.5 points)
A) bonds of different maturities are not substitutes at all
B) bonds of different maturities are perfect substitutes
C) bonds of different maturities are substitutes but not perfectly
D) markets are not completely segmented
Answer: A

3. In case of a decrease in the wealth of investors, the demand for bonds ________ and the
demand curve shifts to the ________ (0.5 points)
A) increases, left
B) increases, right
C) decreases, left
D) decreases, right
Answer: C

1
4. What is a typical example of bond markets security? (0.5 points)
A) T-Bills and T-Notes
B) T-Notes and T-Bonds
C) T-Bills
D) T-Bills and T-Bonds
Answer: B

5. The term structure of interest rates… (0.5 points)

A) … is typically upward sloping and tends to have steep downward slope when short rates
are low
B) … tends to be flat
C) …is typically downward sloping and tends to have steep downward slope when short
rates are low
D) … is typically upward sloping and tends to have steep upward slope when short rates
are low
Answer: D

6. When the price of a bond is ________ the equilibrium price, there is an excess supply of
bonds and the price will ________.
A) above; rise
B) above; fall
C) below; fall
D) below; rise
Answer: B

7. What is one of the main issues of the municipal bonds? (0.5 points)
A) Their coupon interest payments and capital gains are tax exempted
B) Their coupon interest payments are tax exempted, but capital gains are not
C) Their total return is tax exempted
D) Their capital gains are tax exempted, but coupon interest payments are not
Answer: B

8. Which of the following is the largest borrower in the money markets?

A) Commercial banks
B) Large corporations
C) Governments
D) Firms engaged in foreign trade
Answer: C

2
9. A stock currently sells for $25 per share and pays $0.24 per year in dividends. What is an
investor's valuation of this stock if she expects it to be selling for $30 in one year and
requires a 15 percent return on equity investments?
A) $30.24
B) $26.30
C) $26.09
D) $27.74
Answer: B

10. Among the following instruments, what are those typically NOT traded in the money
markets: (0.5 points)
A) T-notes
B) repurchase agreements
C) Treasury bills
D) commercial papers
Answer: A

11. The bond equivalent yield is: (0.5 points)

A) a discount rate
B) the product of the periodic rate and the number of periods in a year
C) the yield an investor will earn if the bond is purchased at the current market price and
held until maturity
D) always the same then the coupon rate
Answer: B

12. A trader enters into a one-year long forward contract to buy an asset for $63 when the spot
price is $61. The spot price in one year proves to be $65. What is the trader’s gain or loss?
(0.5 points)
A) $2.0
B) -$3.0
C) -$2.0
D) $3.0
Answer: A

13. Suppose that you short a call option contract with a strike price of $50, a price of $3 and
an expiration date in four months. The current stock price is $50 and the contract is on 100
shares. How much could you gain or lose if the stock price at T is $52.5? (0.5 points)
A) $65.0
B) -$50.0
C) $50.0
D) -$65.0
Answer: C

3
14. What is the duration of a four years zero-coupon bond if the discount rate is 7%? (0.5
points)
A) 3.14 years
B) 4.00 years
C) 3.00 years
D) 2.75 years
Answer: B

15. An option strategy in which the investor holds a long position on a call option with strike
price K1 and a short position on a call option written on the same underlying asset for the
same maturity with strike price K2 (where K1< K2) is called: (0.5 points)
A) a strangle
B) portfolio insurance
C) a bull spread
D) a straddle
Answer: C

16. The payoff of the holder of a put option is given by: (0.5 points)
A) min(K - ST, 0)
B) max(ST - K, 0)
C) min(ST - K, 0)
D) max(K-ST, 0)
Answer: D

17. Which of the following statements is FALSE? (1 point)

A) For ST<K the put is out of the money while the call is in the money
B) For ST>K the call is in the money while the put is out of the money
C) For ST<K the call is out of the money while the put is in the money
D) For ST=K the put and the call are both at the money
Answer: A

18. Mrs X is in the 33% income tax bracket when she bought a $10,000 municipal bond with
r= 6.0% for 9,850 and sold it in 1 year (prior to its maturity) for $9,950. What is Mrs Smith
pre-tax 1 year rate of return? (1 point)
A) 4.3%
B) 5.5%
C) 7.1%
D) 6.5%
Answer: C

4
19. A $1,000 treasury bill has a maturity of 20 days and a bond equivalent yield of 3.0%. What
is selling price and bond discount yield? (1 point)
A) $995.3; 6.1%
B) $997.3; 4.8%
C) $1,025.7; 5.40%
D) $998.4; 3.0%
Answer: D

20. A T-bill with FV=$1,000 and 40 days until maturity has an asked discount rate of 4.12%
and a bid discount rate of 4.25%. Please determine the bid-asked spread. (1 point)
A) $0.14
B) $1.25
C) $0.45
D) $0.75
Answer: A

21. One-year interest rates over the next five years are respectively: 0.5%, 0.8%, 0.9%, 1.1%,
and 1.2%. At the same time, investors' preferences for holding short-term bonds are
associated with the following liquidity premiums respectively for one-to five-year bonds:
0%, 0.1%, 0.2%, 0.3%, and 0.4%. What is the interest rate on the three-year bond under
the Expectations Theory? (1 point)
A) 1.50%
B) 0.94%
C) 0.73%
D) 0.51%
Answer: C

22. You know the current price for a stock is 100$. The expected dividend and price next year
are $5.0 and $102, respectively. What is the theoretical price of the stock applying the
Gordon Growth Model if the discount rate is 4% and dividends will grow at a constant rate
of 1.0%? Is the stock currently under-priced or over-priced? (1 point)
A) $100.0; neither under nor overpriced
B) $166.7; under-priced
C) $141.1; over-priced
D) $179.2; over-priced
Answer: B

23. What is a lower bound for the price of a three-month European call option on a non-
dividend-paying stock when the stock price is $68.0, the strike price is $65.0, and the risk-
free interest rate is 5% per annum? (1 point)
A) -$1.0
B) $0.0
C) $2.1
D) $3.8
Answer: D

5
24. The price of a three-month European put option on a stock with current price $86, with
strike price $88 is $3. The risk-free rate is 2% per annum. What is the price of a three-
month European call option written on the same stock for the same maturity with the same
K? (1 point)
A) $1.4
B) $2.1
C) $3.2
D) $4.7
Answer: A

25. If the spot price of a stock is $50, the nine month risk free interest rate is 5% per annum
what is the futures price on the same asset with maturity in nine months under the no
arbitrage opportunity hypothesis? (1 point)
A) $45.5
B) $51.9
C) $41.3
D) $62.6
Answer: B

26. A call option with a strike price of $100 costs $7. Another call option with a strike price of
$110 costs $4. What is the final profit/loss of a bull spread strategy if the spot price at the
expiration date is $106? (1 point)
A) -$6.0
B) -$4.0
C) $3.0
D) -$3.0
Answer: C

27. Consider a put with K=$100 and T=0.75, written on a stock with S0=100. The risk-free
interest rate is r=4.0%. What is p if the price of the stock at T may go up by 7% or down
by 7%? (1 point)
A) $0.8
B) $1.9
C) $2.7
D) -$0.8
Answer: B