The University of Hong Kong School of Economics and Finance FINA0304 Advanced Corporate Finance Assignment 2 Due: March

h 4, 2013

1. From the nancial page, you nd the following information. HSBC is trading at $115. An European call option on HSBC that has an exercise price of $130 and expires one year from now is selling at $9. An European put option on the same stock that has the same exercise price and expiration date is selling at $18. The riskless rate of interest rate is 6% per year. Show how you can make riskless prots, if any, from these ndings.

2. Consider a rm whose stock price at the end of the year depends on the state of the economy (good or bad with equal probability) and the outcome of a lawsuit (win with probability 0.8 and lost with probability 0.2): Win Lawsuit $5.30 $0.45 Lose Lawsuit $3.30 $0.20

Good Economy Bad Economy

The rms current stock price (i.e., at the beginning of the year) is $2 per share. The riskless rate of interest is 10% per year. (a) Form a tracking portfolio using the underlying stock and the riskless asset to evaluate a European call option on this stock, which expires at the end of the year with the strike price set equal to $3.5. (b) Show that there are tracking errors in part (a). Why dont you worry about the tracking errors?