Research School of Finance, Actuarial Studies and Statistics
FINM2002 DERIVATIVES / FINM7041 APPLIED DERIVATIVES
FINAL EXAM – ANSWER WILL NOT BE PROVIDED
Semester 1, 2021
Writing Time:
180 minutes + 15 minutes reading time = 195 minutes
Exam Conditions:
Wattle-based
Permitted Materials:
Any
Instructions to Students:
1. It is not permitted to disclose, disseminate, reproduce, or publish any portion of this assessment in
any manner.
2. This assessment consists of a total of SEVEN questions with subparts. Questions are of unequal value,
with marks indicated for each question. Please answer all questions.
3. All answers must be typed and provided within the Wattle exam interface. Only answers submitted
and typed within the answer space will be read and graded.
4. Incorrect choices for multiple-choice questions will be penalized.
5. Please show all working for marks. An answer without intermediate steps and explanations – even if
a number is correct – will be awarded a mark of zero.
6. Emailed answers will not be accepted.
7. Follow rounding rules on slide 4 of Lecture 8. For all questions, unless stated otherwise in a question
or the situation falls within slide 4 of Lecture 8, please keep all decimal places for interim numerical
answers, final answers should be rounded up to 4 decimal places. Failure to do so will result in 1-mark
penalty for each incidence.
8. Please remember to save your answers often by clicking either “next page” or “previous page” as per
the discussion on how to prepare for Test 1 in Lecture 4, including how to work with Wattle quiz
interface.
Total Marks = 89 for 2002 / 95 for 7041
This final exam and counts towards 60% of your final grade for the course.
QUESTION 1 (Total 16 marks)
I. Which of the following is correct Select all that apply. (2 marks)
a. Forward contracts are typically used for hedging to eliminate cash-flow uncertainty, put options are
used to insure against a decrease in the underlying’s price.
b. Futures contracts are similar to forward contracts except they are traded on organized exchanges.
c. Swaps are like forwards except the swap counterparties commit to multiple transactions.
d. As of 2020, the most popularly traded derivative class is interest rate derivatives, followed by foreign
exchange derivatives.
II. Which of the following is correct Select all that apply. (2 marks)
a. In a long forward position, the forward price is the price paid today, so as to lock into the buying price
of the underlying delivered in the future on the maturity date of the contract.
b. In over-the-counter contracts, two counterparties deal directly with each other, and are directly
exposed to credit risk from the other party.
c. If you think the price of some underlying is going to increase, you can speculate on this view by a long
forward on that underlying.
d. Derivatives are zero-sum financial instruments in that the profits made by the long comes at the
expense of the short.
III. Which of the following is correct Select all that apply. (2 marks)
a. We assume the following for all pricing in the course: no transaction costs; the same tax rate for all
market participants; borrowing and lending can be done at the same risk-free rate; and arbitrage
opportunities are immediately recognized and exploited.
b. In over-the-counter contracts, two counterparties deal directly with each other, and are directly
exposed to credit risk from the other party.
c. The Black-Scholes-Merton model assumes there are no transaction costs, all securities are perfectly
divisible, security trading takes place continuously in time, and volatility is continuously changing with
market conditions.
d. The Black-Scholes-Merton model is a pricing approach based on relative pricing.
IV. You are a market maker and one of your clients just called you to price a 3-month European call with
strike $20 on the stock of a new company. The company just went public a month ago, so you don’t
have much information on the stock other than it’s currently trading at $15 and the yield-curve is flat at
2% for all maturities (continuously compounded). Which of the following could be possible prices
a. $19.9
b. -$4.9
c. $5
d. $15
V. A company has a commitment to buy Q units of an asset on date T. To hedge the position, which of
the following typically happen The choices are not in order, choose all that apply.
a. The company takes long futures position of size N at price F0 at inception of the hedge.
b. The company, before T, takes short futures position to close out the long positions from inception.
c. The company buys Q units of the asset on the spot market at T.
d. The company should manage its positions so basis risk remains at 0 throughout the life of the hedge.
VI. AB5 Corp. has a five-year $200M debt at LIBOR, but would prefer to have fixed rate debt. The
company can borrow fixed rate at 5%. XY6 Ltd. has an existing five-year $200M debt at 6% and can
wishes to have floating-rate debt instead. It could borrow floating at LIBOR+2%. If the two companies
enter into an interest rate swap, and suppose both would be equally better off, what would each end up
paying
a. AB5 pays 4.5%, XY6 pays LIBOR+1.5%
b. AB5 pays 5.5%, XY6 pays LIBOR+1.5%
c. AB5 pays LIBOR+0.5%, XY6 pays 4.5%
d. AB5 pays LIBOR+1.5%, XY6 pays 5.5%
VII. Which of the following is correct Select all that apply.
a. A 1-month 95 call on a stock that is currently trading at $50 has a delta that’s very close to zero.
b. Option A has a rho of -5. Option B has a rho of -4. A is more sensitive to small changes in the
underlying’s volatility.
c. Delta, gamma, beta, and vega are used by option traders to calculate how changes in the underlying
affect option prices.
d. In general, theta should be positive for call options and negative for put options.
VIII. A new drug company will release clinical trial results of an experimental drug in two days. If
successful, the company can begin product and its market value will be boosted significantly; if not, it
will be close to bankruptcy because the drug was the only research the company had been developing in
the past two years. Which of the following best describes a strategy for a trader who is speculating on
the company’s stock Select all that apply.
a. Long one 50 call and long one 50 put.
b. Long one 45 call, sho
rt two 50 call and long one 55 call.
c. Short one 45 call and long one 55 call.
d. Long one 45 put and short one 55 put.
QUESTION TWO (TOTAL 17 MARKS)
You are the chief risk officer (CRO) of an agricultural corporation. You expect to sell 100M bushels of
corn in September. You are concerned about changing prices. You are considering three strategies: (i)
Do nothing and wait until September to trade at the spot price. (ii) Use futures. (iii) Use options. The
current spot price is $6.27/bu. September futures price is $5.68/bu. September $5.70 call is priced at
$0.045. September $5.70 put is priced at $0.046.
a. If you chose strategy (ii), what position do you need to take (i.e., long or short) (1 mark)
b. If you chose strategy (iii), what type of contract and what position do you need to take (2 marks)
c. If the spot price in September is $5.85/bu, what is the net cash flow from each strategy Show
calculations. (5 marks)
d. Repeat (c), but suppose the spot price is $5.59/bu. (5 marks)
e. As the CRO, which strategy would you choose Discuss your thought process, list the pros and cons. (4
marks)
QUESTION THREE (TOTAL 12 MARKS)
You are using the binomial tree model (drawn and labelled below) to price a 6-month European option
on a stock that is currently trading at $20. The risk-free interest rate is 2% p.a.c.c. The option values at
nodes D and E are 2.25 and 0, respectively; the stock price at node B is $25.
a) Is this a call or a put (1 mark)
b) Calculate the remaining stock prices and option values that correspond to every node on the tree.
Complete working process must be shown for marks. (10 marks)
c) If the option is instead on a futures contract, identify the adjustment you need to make in part (b). (1
mark)
QUESTION FOUR (TOTAL 8 MARKS)
You are working on the options trading desk of FINM Investment Bank. Three-month European call and
puts on stock BUSN with strike $60 are selling for $5 and $3, respectively. BUSN is currently trading at
$60 and does not pay dividends. The interest rate is 3% p.a.c.c. Are you able to make an immediate and
riskless profit without any out-of-pocket expenses If so, show all steps and calculations for the entire
duration of your strategy. (8 marks)
QUESTION FIVE (TOTAL 11 MARKS)
You are a trader for GreekLetters Ltd. You have sold 100,000 put options on a stock at strike $24.5 and
also short 50,000 of the stock. The options expire in 9 months. The stock is currently trading at $24.09,
and its volatility is estimated at 25% p.a.c.c. It pays a dividend of 2% p.a.c.c. The risk free rate of interest
is 3% p.a.c.c and the option is currently selling for $0.70. How can you make your portfolio delta
neutral Show full working process for marks. (11 marks)
QUESTION SIX (TOTAL 13 MARKS)
I. In class, we saw a Bloomberg report of a group of investment banks that sold equity swaps to
Archegos Capital attempted to “reach some sort of temporary standstill to figure out how to untie
positions without sparking panic”, before the public learned of any problems. If this is true, do you think
the banks’ actions are consistent with capital market integrity Clearly state your stance and provide
brief reasoning. (2 marks)
II. The best part about learning is to be able to apply what we’ve learned in the real world. In the run-up
to the U.S. subprime mortgage crisis, hedge fund manager Michael Burry was worried, (a) what was he
worried about (b) what derivatives product did he trade during this time, what was the underlying and
was he long or short in these (c) knowing the product that Burry traded in, what would be Burry’s
responsibility per the standard contract terms during the life of the contract while the trade was open
(d) was his trade an arbitrage, speculation, or hedge (8 marks)
III. As promised, a question based on the content of Adrian’s live chat: Adrian concluded his job as a
derivatives market maker was very intense and not a job someone would typically do for a long time.
Describe in point form what Adrian shared as expectations of a trader/market maker that make it
intense. (3 marks)
QUESTION SEVEN (TOTAL 12 MARKS for 2002 / 18 MARKS for 7041)
At the beginning of February 2020, you purchased June vanilla European calls with strike $65 on Intel
(NASDAQ: INTC), which is due to expire today (June 4) and notice-to-exercise must be made by 5pm. At
the time of purchase, the stock was trading at $58/share. After the purchase, you documented the
stock’s movements: after slowly gaining strength from February through to April to reach a 52-week
high of $68.49 at the beginning of April, the stock kept falling and closed at $51 yesterday. The stock has
a volatility of 30% p.a., and pays a dividend yield of 2.51% p.a.c.c. The risk-free rate of interest is 3%
p.a.c.c.
a) Explain your market view on the underlying stocks at the time of your trade in February. (2 marks)
b) What is the moneyness of the option when you made the trade in February and does it have any
intrinsic value (2 marks)
c) You time traveled back to February with your memory, assume history would repeat itself as
described in the question. If you could take a position in an exotic option instead of the vanilla option
you had (keeping the same strike), would you switch and which option would you choose Explain your
choice and include calculation of payoff for both cases (the original option, and the new option). Assume
INTC will close with a new YTD low of $49 at 4pm today. Be sure to state both advantages and
disadvantages associated with your choice. (6 marks) ONLY FOR 7041
d) As in part (c), you time travelled back to February. This time, you are free to enter any position (or
multiple positions) in the stock and/or any derivatives learned in this course. What kind of positions and
instruments would you trade to earn the highest profit with the lowest cost You may choose any time
to maturity for the instruments and you may choose any strike/delivery price between $49 and $69. You
must enter all positions on the same day in early February when the stock was trading at $58/share; but
you may exit any of these positions between that starting date in February and today, as long as all
positions are closed out or expire by today (June 4). Explain your rationale in clear but brief points and
include calculation. (8 marks)