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Risk management

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Introduction

Homework #4 FIN 377.2 Due: Thursday, March 4, 2010 1. ABC Corp and XYZ Inc have been offered the following rates per annum on a $20 million five-year loan: Floating Rate Fixed Rate ABC Libor + 10 bps 5.0% XYZ Libor + 60 bps 6.4% ABC requires a floating rate loan, XYZ requires a fixed rate loan. Design a swap that will net a bank acting as an intermediary 0.1% per annum and that will be equally attractive to both companies. There are many different ways to structure this solution and the one below is just an example. First determine the quality spread differential between ABC and XYZ. Fixed Rate Floating Rate QSD ABC 5.0% Libor + 10 bps 1.4% Fixed Rate XYZ 6.4% Libor + 60 bps 50 bps Floating Rate Total QSD = 90 bps. The swap is structured as such: LIBOR LIBOR 5.3% 5.4% 5.0% Libor+60bps Pay 5.0% Libor+60bps Pay in Swap Libor 5.4% Receive (5.3%) ...read more.

Middle

Call buyers must pay a premium for the option. Short puts and long calls are both designed to profit in a bullish market. Thus, they are considered to be on the same side of the market. 3. Explain the difference between an American option and a European option. What do they have in common? An American option can be exercised at any time up to and including the expiration date. A European option can be exercised only on the expiration date. An American option is more valuable than a European option because it has all the features of a European option, plus early exercise. 4. Determine whether each of the following arrangements is an option. If so, decide whether it is a call or a put and identify the premium. a. You purchase automobile insurance for your car. Auto insurance is a put option. ...read more.

Conclusion

The lower bound is 28-25e-0.08*0.3333 = $3.66 6. A 4-month European call option on a dividend-paying stock is currently selling for $5. The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one-month. The risk-free interest rate is 12% p.a. for all maturities. What opportunities are there for an arbitrageur? The present value of the strike price is 60e-0.3333*0.12 = $57.65. The present value of the dividend is 0.80e-0.083333*0.12 = $0.79. Since $5 < $64-57.65-0.79, the no-arbitrage condition is violated. An arbitrageur should buy the option and short the stock. Regardless of what happens a profit will materialize. If the stock price < 60, the arb loses $5 spent on the option, but gains at least $5.56 in present value terms from the short position. If the stock price > 60 at expiration, the arb gains exactly 5.56-5 = 0.56. ...read more.

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