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THE UNIVERSITY OF IOWA

College of Liberal Arts and Sciences


Department of Statistics and Actuarial Science

ACTS:4130

Quantitative Methods for Actuaries


Assignment 1 (Fall 2014)
Instructor : Ambrose Lo

INSTRUCTIONS

1. This assignment covers material in Chapter 1 to Chapter 2.1 and consists of 9 questions
numbered 1 through 9 for a total of 100 points. The points for each question are indicated at
the beginning of the question.
2. Answer ALL NINE questions.
3. Write legibly and show your steps clearly.
4. Hand in your work at the beginning of class on September 17, 2014 (Wednesday). Late work
will not be accepted.
5. You are welcome to discuss assignment problems with me during my office hours. You are
also encouraged to discuss homework problems with other students. However, what you hand
in must ultimately be your own work.

** BEGINNING OF ASSIGNMENT 1 **

1. (Derivatives Markets Exercise 2.5 (a)-(b): Trivial payoff calculations) (10 points)
(a) (5 points) Suppose you enter into a short 6-month forward position at a forward price of
$50. What is the payoff in 6 months for prices of $40, $45, $50, $55, and $60?
(b) (5 points) Suppose you buy a 6-month put option with a strike price of $50. What is the
payoff in 6 months at the same prices for the underlying asset in part (a)?

2. (Payoff/profit of forward) (10 points) Zhuo enters into a long forward contract. If the spot
price at expiration were S, his payoff would be $10. If the spot price at expiration were 20%
higher, his payoff would be $8.
Determine Zhuos profit if the spot price at expiration were 30% higher.

3. (Derivatives Markets Exercise 2.11: Long put V.S. short forward) (10 points) Consider a
purchased 1,000-strike put option with a price of 74.20 and a short forward with a forward
price of 1,020. Both of them expire in 6 months. The interest rate is 2% effective per 6
months.
(a) (5 points) Calculate the spot price at which the profit of the put option is zero.
(b) (5 points) Calculate the spot price at which the put option and forward contract have the
same profit.

4. (Derivatives Markets Exercise 2.14 (Adapted): Comparing three puts with different
strikes) (15 points) Suppose the current stock price is $40 and the effective annual interest
rate is 8%.
(a) (6 points) Draw the payoff and profit diagrams for the following options:
(i) 35-strike 1-year put with a premium of $1.53.
(ii) 40-strike 1-year put with a premium of $3.26.
(iii) 45-strike 1-year put with a premium of $5.75.
You may draw the three payoff functions on the same diagram and the three profit functions on another diagram.
(b) (9 points) Assuming that all put positions in part (a) being compared are long, determine
the range of 1-year stock price such that the 45-strike put produces a higher profit than
the 40-strike put, but a lower profit than the 35-strike put.

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5. (Short put) (10 points) Xinyang writes a one-year 110-strike put with a premium of $10.93.
The effective annual risk-free rate of interest is 3.85%.
Determine the difference between Xinyangs maximum profit and her minimum profit.
6. (Call V.S. put) (10 points) Jack buys a 50-strike 1-year call option on stock ABC at a price
of 8.50. Peter buys a 50-strike 1-year put option on the same stock at a price of 6.00. The
continuously compounded annual risk-free interest rate is 0.04.
One year later, Jack suffers a loss while Peter realizes a profit, with Peters profit being twice
as large as Jacks loss. Determine the price of stock ABC at the end of one year.
7. (A strange derivative position) (10 points) The price of a 30-strike 1-year call option is 4.25.
The price of a 30-strike 1-year put option is 3.03. As a way to speculate on the volatility of the
underlying asset, you buy one put option and two call options. The continuously compounded
annual risk-free rate of return is 4%.
Determine all possible spot price(s) at expiration that result(s) in a profit of 5.
8. (Equity-linked derivative) (10 points) For a special equity-linked financial instrument on
stock XYZ, you are given:
The maturity date is 1 year later.
If the stock price of XYZ at maturity is $90 or above, the instrument pays the investor
$100.
If the stock price of XYZ at maturity is below $90, the investor receives 100/90 shares
of stock XYZ.
Express the price of this financial instrument in terms of the prices of appropriate call/put
options and/or zero-coupon bonds. Specify the contractual details of the options and zerocoupon bonds.
9. (ACTS:4130 Spring 2013 Midterm 1 Question 1: Synthetic forward (Adapted)) (15
points) The one-year forward price on a stock is 84. By buying or selling European put
and call options with a strike price of $82, you want to lock in the ability to buy one share of
the stock in one year for a price of $82. Suppose that the effective annual interest rate is 5%.
(a) (5 points) Describe exactly which option(s) you are going to buy and/or sell.
(b) (5 points) Compute the cost today of your strategy.
(c) (5 points) Find the range of stock price in one year for which you would make a profit
on your strategy.

** END OF ASSIGNMENT 1 **

ACTS:4130 (22S:174) Fall 2014


Assignment 1

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Suggested solutions to ACTS:4130 (22S:174) Assignment 1


1. Solution. (a) The payoffs of the short forward for different spot prices at expiration are
given below:
Payoff (= F0,0.5 S0.5 = 50 S0.5 )
10
5
0
5
10

S0.5
40
45
50
55
60

(b) The payoffs of the long put for different spot prices at expiration are tabulated below:
S0.5
40
45
50
55
60

Payoff (= (K S0.5 )+ = (50 S0.5 )+ )


10
5
0
0
0

2. Solution. Solving
(

S F0,T = 10
1.2S F0,T = 8

we get S = 90 and F0,T = 100. If the spot price at expiration were 30% higher, then Zhuos
profit is
1.3S F0,T = 1.3(90) 100 = 17 .
3. Solution.

(a) We set the profit of the put to be zero, that is,


Profit = (1, 000 S0.5 )+ 74.20(1.02) = 0,

or
(1, 000 S0.5 )+ = 75.684,
which gives S0.5 = 924.316 .
(b) Equating the profits of the put and the short forward, that is,
(1, 000 S0.5 )+ 75.684 = 1, 020 S0.5 .
To solve this equation for S0.5 , consider two cases:
Case 1.

If S0.5 < 1, 000, then (1) becomes


(1, 000 S0.5 ) 75.684 = 1, 020 S0.5 ,
which gives 924.316 = 1, 020, a contradiction.

ACTS:4130 (22S:174) Fall 2014


Assignment 1 Suggested Solutions

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(1)

Case 2.

If S0.5 1, 000, then (1) becomes


75.684 = 1, 020 S0.5 ,
which implies that S0.5 = 1, 095.68 .

Remark 1. For both parts, you may get the answers more easily by drawing profit diagrams.
4. Solution.

(a) (i) Here are the payoff diagrams of the three puts:

(ii) The future values of the put premiums are:


Strike Price Future Value of Put Premium
35
(1.53)(1.08) = 1.6524
40
(3.26)(1.08) = 3.5208
45
(5.75)(1.08) = 6.21
Here are the profit diagrams:

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(b) The 45-strike profit function crosses the 40-strike profit function at S1 = 45 (6.21
3.5208) = 42.31 and crosses the 35-strike profit function at S1 = 45 (6.21 1.6524) =
40.44. By inspection, the 45-strike put produces a higher profit than the 40-strike put,
but a lower profit than the 35-strike put, when 40.44 < S1 < 42.31 .

5. Solution.
Xinyangs maximum profit is the future value of the put premium, which is
10.93(1.0385) = 11.3508.
Xinyangs minimum profit is 11.3508 110 = 98.6492.
The difference between the maximum profit and the minimum profit is
11.3508 (98.6492) = 110 .
6. Solution. Because Peter purchases a put and makes a profit, it must be the case that S1 < 50.
With this information at hand, Jacks loss is
Profit = 8.5e0.04 (S1 50)+ = 8.8469,
| {z }
0

and Peters profit is


(50 S1 )+ 6e0.04 = (50 S1 ) 6e0.04 = 43.7551 S1 .
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As Peters profit is twice as large as Jacks loss, we have


43.7551 S1 = 2(8.8469),
which implies that S1 = 26.06 .
7. Solution. The total cost is 3.03 + 2(4.25) = 11.53, which accumulates to 11.53e0.04 = 12 in
one year. For the profit to be 5, the payoff must be 5 + 12 = 7. Now because the put and
call have the same strike price, one and only one of them will pay off at expiration.
If the put pays off, then
K S1 = 30 S1 = 7

S1 = 23.

If the two calls pay off, each of them pays 7/2 = 3.5. This means
S1 30 = 3.5

S1 = 33.5.

Therefore, the possible spot prices at expiration are 23 and 33.5 .


8. Solution. The payoff of the financial instrument can be written as
(
100,
if S1 90
Payoff =
100
90 S1 , if S1 < 90
10
= 100 (90 S1 )+ ,
9
from which we conclude that the price of the financial instrument equals:
The price of a 1-year zero-coupon bond with face value $100 , less
The price of 10/9 90-strike 1-year put option on stock XYZ.
9. Solution.

(a) Buy the 82-strike call and sell the 82-strike put.

(b) The cost today is the present value of the bargain element, which is
PV(84 82) = 2/1.05 = 1.9048 .
(c)

Solution 1: The profit is S1 82 1.9048(1.05) = S1 84.


Solution 2: The profit of the synthetic forward equals that of a genuine forward.
The latter equals S1 84.
The profit is positive if and only if S1 > 84 .

** END OF SOLUTIONS **

ACTS:4130 (22S:174) Fall 2014


Assignment 1 Suggested Solutions

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