BUSS386, Spring 2023

Problem Set 3
Topics 6 through 8

Due: 5pm, Wednesday, May 24

Turn in your answers to questions with an asterisk (*).

1. (OFOD 7.3) Company X wishes to borrow U.S. dollars at a fixed rate of interest.
Company Y wishes to borrow Japanese yen at a fixed rate of interest. The amounts
required by the two companies are roughly the same at the current exchange rate.
The companies have been quoted the following interest rates, which have been
adjusted for the impact of taxes:

Yen Dollars
Company X 5.0% 9.6%
Company Y 6.5% 10.0%

Design a swap that will net a bank, acting as intermediary, 50 basis points per
annum. Make the swap equally attractive to the two companies and ensure that
all foreign exchange risk is assumed by the bank.

2. (OFOD 7.9) A financial institution has entered into an interest rate swap with
company X. Under the terms of the swap, it receives 4% per annum and pays
six-month LIBOR on a principal of $10 million for five years. Payments are made
every six months. Suppose that company X defaults on the sixth payment date
(end of year 3) when six-month forward LIBOR rates for all maturities are 2%
per annum. What is the loss to the financial institution? Assume that six-month
LIBOR was 3% per annum halfway through year 3 and that at the time of the
default all OIS rates are 1.8% per annum. OIS rates are expressed with continuous
compounding: other rates are expressed with semiannual compounding.

3. (OFOD 7.18) A financial institution has entered into a swap where it agreed to
make quarterly payments at a rate of 3% per annum and receive the SOFR three-
month reference rate on a notional principal of $100 million. The swap now has
a remaining life of 7.5 months. Assume the risk-free rates with continuous com-
pounding (calculated from SOFR) for 1.5, 4.5, and 7.5 months are 2.8%, 3.0%,
and 3.1%, respectively. Assume also that the continuously compounded risk-free
rate observed for the last 1.5 months is 2.7%. Estimate the value of the swap.

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4. (*) (FFOM 7.26) For all maturities, the U.S. dollar (USD) interest rate is 7% per
annum and the Australian dollar (AUD) rate is 9% per annum. The current value
of the AUD is 0.62 USD. In a swap agreement, a financial institution pays 8%
per annum in AUD and receives 4% per annum in USD. The principals in the
two currencies are $12 million USD and 20 million AUD. Payments are exchanged
every year, with one exchange having just taken place. The swap will last two
more years. What is the value of the swap to the financial institution? Assume all
interest rates are continuously compounded.

5. (OFOD 7.4) A currency swap has a remaining life of 15 months. It involves

exchanging interest at 10% on £20 million for interest at 6% on $30 million once
a year. The term structure of risk-free interest rates in the United Kingdom is
flat at 7% and the term structure of risk-free interest rates in the United States is
flat at 4% (both with annual compounding). The current exchange rate (dollars
per pound sterling) is 1.5500. What is the value of the swap to the party paying
sterling? What is the value of the swap to the party paying dollars?

6. (FFOM 10.19) Prove the following for American option prices:

S0 − D − K ≤ C − P ≤ S0 − Ke−rT .

(Hint: For the first inequality, consider (a) a portfolio consisting of a European
call plus an amount of cash equal to D + K, and (b) a portfolio consisting of an
American put option plus one share.)

7. (OFOD 11.23) The prices of European call and put options on a non-dividend-
paying stock with an expiration date in 12 months and a strike price of $120 are
$20 and $5, respectively. The current stock price is $130. What is the implied
risk-free rate?

8. (FFOM 10.27) Suppose that you are the manager and sole owner of a highly
leveraged company. All the debt will mature in one year. If at that time the value
of the company is greater than the face value of the debt, you will pay off the debt.
If the value of the company is less than the face value of the debt, you will declare
bankruptcy and the debt holders will own the company.
(a) Express your position as an option on the value of the company.
(b) Express the debt holders’ position in terms of options on the value of the
company.
(c) What can you do to increase the value of your position?

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 9. (OFOD, 11.24) A European call option and put option on a stock both have a
strike price of $20 and an expiration date in 3 months. Both sell for $3. The
risk-free interest rate is 10% per annum, the current stock price is $19, and a $1
dividend is expected in 1 month. Identify the arbitrage opportunity open to a
trader.

10. (*) Consider the following American put prices. Assume the current stock price is
45, r = 9.5%, t = 0.25 for the July puts and no dividends will be paid prior to the
January expiration date.

Expiration Month
Strike Price July October January
40 0.57 1.07 3.80
45 3.05 3.18 3.04
50 5.08 5.32 8.50

Find three mispricings (there are more). Explain what arbitrage restrictions on
put prices are being violated and explain how you could take advantage for these
mispricings.

11. (FFOM 11.28) A bank decides to create a five-year principal-protected note on

a non-dividend-paying stock by offering investors a zero-coupon bond plus a bull
spread created from calls. The risk-free rate is 4% and the stock price volatility is
25%. The low-strike-price option in the bull spread is at the money. What is the
maximum ratio of the high strike price to the low strike price in the bull spread.
Use DerivaGem.

12. (OFOD 12.3) Use put-call parity to relate the initial investment for a bull spread
created using calls to the initial investment for a bull spread created using puts.