Question 1 (2010)

XYZ’s stock is a non-dividend paying stock trading at Rs100 on SEMDEX today. In one month’s time, XYZ’s stock price can either
increase of decrease and the market volatility of XYZ’s stock prices is known to be 15%. Furthermore, the interest rate on
savings account is quoted as 5% continuously compounded per annum.

(i) Show that the probability of an upward tick in XYZ’s stock price is 0.5374 under the risk neutral pricing of a Binomial model.
[6 marks]
(ii) Construct a Binomial tree to show the evolution of the XYZ’s stock prices over the next two months. [3 marks]
(iii) Calculate the option prices for a European put option on XYZ’s stock and an American put option on the same underlying
stock if both financial contracts have the same strike price of Rs100 and a maturity of two months.
[4 + 3 marks]
(iv)Explain the difference in the values of the above two options. [3 marks]
(v) What must be the value of an American call option on XYZ’s stock? The answer must be given without using the Binomial
model again to calculate the
American call option’s value and you should clearly outline the reasoning used. [4 marks]
(vi)Discuss what will happen to the Binomial option pricing model if the volatility of XYZ’s stock prices was zero. [2 marks]
[Total: 25 marks]

Question 2
A bond is available in financial markets, it offers an annual coupon of 5%, it possesses a maturity of two years and has a nominal
value of Rs100. It is assumed that the coupons are continuously compounded at a yield to maturity of 4%.
(i) Calculate the actual price and duration of the bond; without using the exponential touch available in your calculators. Specify
the answer to 3 decimal places. [7 marks]
(ii) If the yield to maturity increases by 0.01%, estimate the new price of the bond by using Taylor approximation of order 1.
[3 marks]
(iii) If the yield to maturity increases by 1%, estimate the new price of the bond by using Taylor approximation of order 1.
[2 marks]
(iv) Explain whether the estimates obtained in parts (ii) and (iii) are good estimations of the new bond price. Detail. [3 marks]
[Total: 15 marks]

Question 3
An individual wants to set up a portfolio with assets 1 and 2. The risk and return characteristics of the two assets are given in
the table below:

Asset Expected Return/% Standard Deviation/% Covariance of Asset 1 and Asset 2

1 10 10
2 13 30 -0.0150

(i) Determine the weights of the two assets (1 & 2) that will minimize the variance of the portfolio. Use matrix representation
and apply Cramer’s rule, to find the weights. [10 marks]

The individual decides to invest in a third asset (asset 3), which has an expected return of 11% and standard deviation of 15%.
The covariance between assets 1 and 3 is equal to 0.0075 and the covariance between assets 2 and 3 is equal to -0.0225.

(ii) Calculate the weights of assets 1, 2 and 3 in a minimum variance portfolio. [14 marks]

(iii) Draw the efficient frontier curve for the minimum variance portfolio in part (ii) above. [6 marks]
[Total marks 30]