Tutorial Questions

Nick Stavrou Lectures 10, 11 &12

QUESTIONS FOR LECTURE 10

1. ABC is trading currently at $100. Assume a one period Binomial Model, that the stock
price will either go up or down by 10% over the next period and the risk-free rate
over the period is 5% (Take the period to be a year).
(a)
Build a replicating portfolio to value a call option written today with a
strike price of 100. What is the value hedge ratio

(b)

Calculate the risk-neutral probabilities and value the call using the riskneutral probabilities. (Check that you get the same answer as in a. above)
(c)
Using the risk-neutral probabilities above also calculate the value of the
find the value of a put option written today, lasting one period, and with an
exercise price of 100.
(d)
Verify that the same price for the put results from put-call parity.
2. Microsoft stock is currently trading at $41. Consider call and put options with a strike
of $42.00 expiring in 30 days (=0.082 years). Suppose that the volatility of Microsoft
stock is 40% and that the interest rate is 3%. What are the Black-Scholes prices of
the call and the put? What are the option deltas?

QUESTIONS FOR LECTURE 11

1. This question refers to the volatility smile;
a) What is the option smile?
b) Why does it arise from fat-tailed stock return distributions?
c) A skewed implied volatility smile occurs more often than a symmetric smile in
equity markets. Explain?
d) Suppose that S&P 500 options display a smile with an upward skew on the
left.
If your view that the market has overestimated crash risk(large negative
return) and the smile has a skew that is much steeper than it should be, what
options trading strategy could you adopt to profit from this?

2. This question refers to the various aspects of Value at Risk (VaR).

a) What are the three different approaches to computing VaR?
b) State some advantages and disadvantages of each method.
c) How is Value-at-Risk (VaR) different as a measure of risk than the variance of
return?

QUESTIONS FOR LECTURE 12

1. You are a desk quant and asked to price a two-year annual payment credit default
swap (CDS). The market convention is to determine and quote the CDS spread

s .
The risk-free interest rate is for two-years
probability of default each year

r=10 . Suppose the conditional

is also constant.

Please find the relationship expresses the two-year fair value CDS spread

in

terms of time to maturity, recovery rate and notional value of the contract.
(Assume that all default payments are made at the end of the period, and all
premium payments are made at the beginning of each period. Also assume that
recovery is

R=40

of notional value is 100.)

2. The Merton (1974) model may be used to value bonds with default risk in a
company. Explain how debt is viewed as an option in this framework.