NPTEL

INDUSTRIAL AND MANAGEMENT ENGINEERING DEPARTMENT, IIT KANPUR

QUANTITATIVE FINANCE
ASSIGNMENT-6 (2015 JULY-AUG ONLINE COURSE)

NOTE THE FOLLOWING

1) There are five questions and you are required to answer all of them.
2) Deadline for submission is Monday; 31st August, 2015 at 23:59 Hrs
3) The total marks is 50.
4) To get full credit do your calculations carefully.

Question 1:
a) For a two-period binomial model, you are given:
(i) Each period is one year
(ii) The current price for a non-dividend-paying stock is 20
(iii) u = 1.2840, where u is one plus the rate of capital gain on the stock per period if the
stock price goes up
(iv) d = 0.8607, where d is one plus the rate of capital loss on the stock per period if the
stock price goes down
(v) The continuously compounded risk-free interest rate is 5%.
Calculate the price of an American call option on the stock with a strike price of 22.
b) A company's cash position, measured in millions of dollars, follows a generalized Wiener
process with a drift rate of 0.1 per month and a variance rate of 0.16 per month. The initial
cash position is 2.0.
(i) What are the probability distributions of the cash position after 1 month, 6 months,
and 1 year?
(ii) What are the probabilities of a negative cash position at the end of 6 months and 1
year?
(iii) At what time in the future is the probability of a negative cash position greatest?

Question 2:
a) A stock price is currently 50. Its expected return and volatility are 12% and 30%, respectively.
What is the probability that the stock price will be greater than 80 in 2 years? (Hint: Sr > 80
when lnSr > ln80.)
b) Suppose that x is the yield on a perpetual government bond that pays interest at the rate of $1
per annum. Assume that x is expressed with continuous compounding, that interest is paid
continuously on the bond, and that x follows the process:
dx = a(x0 - x)dt +sxdz
where a, x0, and s are positive constants, and dz is a Wiener process. What is the process
followed by the bond price? What is the expected instantaneous return (including interest and
capital gains) to the holder of the bond?
Question 3:
a) The stock price 6 months from the expiration of an option is $42, the exercise price of the option
is $40, the risk-free interest rate is 10% per annum, and the volatility is 20% per annum. This
means that So = 42, K = 40, r = 0.1, a = 0:2, T = 0.5,
b) A call option on a non-dividend-paying stock has a market price of $2.5. The stock price is $15,
the exercise price is $13, the time to maturity is 3 months, and the risk-free interest rate is 5%
per annum. What is the implied volatility?
Question 4:
a) Consider an American call option on a stock. The stock price is $50, the time to maturity is 15
months, the risk-free rate of interest is 8% per annum, the exercise price is $55, and the volatility
is 25%. Dividends of$1.50 are expected in 4 months and 10 months. Show that it can never be
optimal to exercise the option on either of the two dividend dates. Calculate the price of the
option.
b) A stock price is currently $50. Assume that the expected return from the stock is 18% and its
volatility is 30%. What is the probability distribution for the stock price in 2 years? Calculate
the mean and standard deviation of the distribution. Determine the 95% confidence interval.

Question 5:
Suppose you have 28 observations on y, x, and w, and believe that y = α + βx + δw + ε where
the CLR model holds. You run ordinary least squares and obtain estimates 1.0, 1.5 and 3.0 of
α, β and δ, saving the residuals in a vector res. You have programmed a computer to do the
following:
- Draw 28 e values randomly with replacement from the elements of res.
- Compute 28 y values as 1.0 + 1.5*x + 3.0*w + 1.058*e.
- Regress y on x and w, obtaining an estimate 𝛽̂ of β and 𝛿̂ of δ.
- Compute r = 𝛿̂ / 𝛽̂ and save it.
- Repeat from i) to obtain 4000 r values.
- Compute and print average, the average of the r values, and variance, their variance.
- Order these r values from smallest to largest.
Explain how to use these results to produce
i) an estimate of the bias of 𝛿̂ / 𝛽̂ as an estimate of δ/β
ii) an estimate of the standard error of 𝛿̂ / 𝛽̂
iii) a test of the null that the bias is zero; and d) a 90 percent confidence interval for δ/β.