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# ECOM044: Advanced Asset Pricing and Modelling

## Queen Mary University of London 2013/2014 COURSEWORK: ASSIGNMENT 1

Attempt all questions. The deadline and the form of submission will be soon announced via QMplus. 1. (Forward price and price of the forward contract). (a) Consider a forward contract maturing at time T written on a stock which will pay a single discrete dividend amount D at time tD where 0 tD T . Denote the time t = 0 price of the stock as S0 and the continuously-compounded risk-free interest rate to the dividend date as rD , and to the maturity of the contract as rT . Use no-arbitrage arguments and construct a trading strategy to determine the time t = 0 forward price F0 . (b) A stock currently trades at 52. The 6-month risk-free interest rate is 1.70% p.a. and the 1-year rate is 2.00% p.a., both with continuous compounding. Calculate the 1-year forward price of the stock, and the price of a 6-month forward contract written on the stock struck at 50, in each of the following scenarios: (i) The stock will pay a cash dividend of 1.50 in 9 months and the 9-month risk-free interest rate is 1.80% p.a. with continuous compounding, (ii) The stock is assumed to have a dividend yield of 5% p.a. with continuous compounding. Hint: For part (a) you need to consider cashows at times t = 0, t = tD and t = T . (25 marks) 2. (European call option prices). Suppose that c1 , c2 and c3 are the prices of European call options with strike prices K1 , K2 and K3 , respectively, where K1 < K2 < K3 and K3 K2 = K2 K1 . All options have the same maturity and are written on the same underlying. (i) Find an inequality relating the call prices, c1 , c2 and c3 . (ii) What is the corresponding result in the case of European put options? 1