STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

BACHELOR OF BUSINESS SCIENCE IN FINANCIAL ENGINEERING

DERIVATIVES SECURITIES AND MARKETS
CAT 2

Date: 6th July 2023 , Due Date: 14th July 2023

1. Explain how arbitrage strategies can be pursued in forward and futures contracts for
buyers in long positions and sellers in short positions (6 Marks)
2. Explain the shortfall of any 3 of the assumptions postulated in the Black-Scholes
model framework (6 Marks)
3. Explain how the following contracts may provide leverage for an investor. A) Futures
b) Swaps c) Options (6 Marks)
4. Explain 6 differences between forwards and futures contracts (6 Marks)
5. Explain 3 factors that may lead to the backwardation of the futures yield curve. (6
Marks)
6. Explain 3 types of risk exposable in swap contracts. (6 Marks)
7. Explain any 3 products that result from tax-based innovation (6 Marks)
8. Explain any 3 of the options strategies which can be pursued for risk management
purposes - butterfly spread, straddle, strangle, risk reversal – show the relevant payoff
diagrams. (6 marks)
9. Explain the equivalence of the Black-Scholes formula and the Black-Scholes PDE in
pricing American or European options (6 Marks)
10. Any price for an American call option that is less than the fair price of a
corresponding European call option is unfair in the sense that in presents an arbitrage
opportunity. Show how the arbitrage opportunities presents itself in the instance that . (6
marks)
11. Suppose we take a short position in a European Call option with maturity 4 months and
with strike of 20 euros, having a stock with current price of 20 euros as underlying. In
the next 4 months, the stock price may increase by a growth factor u = 1.2 or decrease
by a factor d = 0.8. The risk-free interest rate available on the market is of 4% per year.

a) Find the replicating strategy of the option. (3 marks)

b) Compute the initial price of the option. (2 marks)
c) Suppose now that the stock price does not follow a binomial model any more, but that
in 4 months it may either increase by a growth factor u = 1.2, decrease by a factor d = 0.8
or remain unchanged. Discuss whether it is still possible to replicate the Call option above
only with the underlying and with cash (to be deposited or borrowed). (2 Marks)
12. Consider a market where a bond (corresponding to a risk-free rate of 4% per year) and
a stock are traded. The current price of the stock is euros that, in one year, may move
up to 16 euros or to 12 euros, or down to 2 euros. A European Call option can be
written on the stock above, with strike of 8 euros and with maturity of one year.
Another stock of current price euros and that, in one year, may cost 20, 8 or 6 euros
whenever the other stock costs, respectively, 16, 12 or 2 euros is also traded in this
market. A new option is also available, with maturity T of one year, with the same
strike K as the European Call above and with maturity payoff of

where . Verify if it is possible to replicate the option above. If yes, find the cost of the
replicating strategy. (8 Marks)