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Questions and Answers of Corporate Finance

Suppose that S and Q follow equations (20.36) and (20.37). Derive the value of a claim paying S(T )aQ(T )b by each of the following methods:a. Compute the expected value of the claim and discounting
Assume that one stock follows the process dS/S = αdt + σdZ (20.44)Another stock follows the process dQ/Q = αQdt + σdZ + dq1+ dq2 (20.45)a. If there were no jump terms (i.e., λ1 = λ2 = 0), what
Use Itˆo’s Lemma to evaluate dS2.For the following four problems, use Itˆo’s Lemma to determine the process followed by the specified equation, assuming that S(t) follows (a)
Use Itˆo’s Lemma to evaluate dS−1.For the following four problems, use Itˆo’s Lemma to determine the process followed by the specified equation, assuming that S(t) follows (a)
Use Itˆo’s Lemma to evaluate d(√S).For the following four problems, use Itˆo’s Lemma to determine the procedure followed by the specified equation, assuming that S(t) follows1. Arithmetic
Suppose that S follows equation (20.36) and Q follows equation (20.37). Use Itˆo’s Lemma to find the process followed by S2Q0.5.
Suppose that S follows equation (20.36) and Q follows equation (20.37). Use Itˆo’sLemma to find the process followed by ln(SQ).
Suppose S(0) = $100, r = 0.06, σS = 0.4, and δ = 0. Use equation (20.32) to compute prices for claims that pay the following:a. S2b.√Sc. S−2Compare your answers to the answers you obtained to
Suppose that ln(S) and ln(Q) have correlation ρ =−0.3 and that S(0) = $100,Q(0) = $100, r = 0.06, σS= 0.4, and σQ= 0.2. Neither stock pays dividends. Useequation (20.38) to find the price today
Suppose that X(t) follows equation (20.9). Use It^o's Lemma to verify that a solution to this differential equation is
Verify that equation (21.12) satisfies the Black-Scholes equation. What is the boundary condition for which this is a solution?
Suppose that a derivative claim makes continuous payments at the rate _. Show that the Black-Scholes equation becomes
What is the value of a claim paying Q(T )2S(T )? Check your answer using Proposition 20.4.
What is the value of a claim paying Q(T )−1S(T )? Check your answer using Proposition 20.4.
You are offered the opportunity to receive for free the payoff [Q(T ) − F0,T (Q)]× max[0, S(T ) − K]
An agricultural producer wishes to insure the value of a crop. Let Q represent the quantity of production in bushels and S the price of a bushel. The insurance payoff is therefore Q(T ) × V [S(T ),
Verify that ASaeÎ³ t satisfies the Black-Scholes PDE for
Use the Black-Scholes equation to verify the solution in Chapter 20, given by Proposition 20.3, for the value of a claim paying Sa.
Assuming that the stock price satisfies equation (20.20), verify that Ke−r(T−t) + S(t)e−δ(T−t) satisfies the Black-Scholes equation, where K is a constant. What is the boundary condition for
Verify that S(t)e−δ(T−t)N(d1) satisfies the Black-Scholes equation.
Verify that e−r(T−t)N(d2) satisfies the Black-Scholes equation.
Use the answers to the previous two problems to verify that the Black-Scholes formula, equation (12.1), satisfies the Black-Scholes equation. Verify that the boundary condition V [S(T), T ]= max[0,
Consider Joe and Sarah’s bet in Examples 21.2 and 21.3.a. In this bet, note that $106.184 is the forward price. A bet paying $1 if the share price is above the forward price is worth less than
Consider again the bet in Example 21.3. Suppose the bet is S − $106.184 if the price is above $106.184, and $106.184 − S if the price is below $106.184. What is the value of this bet to each
Let c be consumption. Under what conditions on the parameters λ0 and λ1 could the following functions serve as utility functions for a risk-averse investor? (Remember that marginal utility must be
Repeat the previous problem assuming that δ1= 0.05 and δ2 = 0.12. Verify that both procedures give a price of approximately $15.850.
Suppose there are 1-, 2-, and 3-year zero-coupon bonds, with prices given by P1, P2, and P3. The implied forward interest rate from year 1 to 2 is r0(1, 2) = P1/P2 − 1, and from year 2 to 3 is
Assume the same bonds and numeraire as in the previous question. Suppose that P1/P3 is a martingale following a geometric Brownian process with annual standard deviation σ1= 0.10, and that P2/P3 is
The box on page 282 discusses the following result: If the strike price of a European put is set to equal the forward price for the stock, the put premium increases with maturity. a. How is this
Under the social security system in the United States, workers pay taxes and receive a monthly annuity after retirement. Some have argued that the United States should invest the social security tax
Warren Buffett stated in the 2009 Letter to Shareholders: "Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds
Use a change of numeraire and measure to verify that the value of a claim payingKT if ST < K is Ke −rT N(−d2). (Note that this is the first term in the
Use a change of numeraire and measure to verify that the value of a claim paying ST if ST < K is SN(−d1).
Suppose that S1 and S2 follow geometric Brownian motion and pay continuous proportional dividends at the rates Î´1 and Î´2. Use the martingale argument to show that the value of a claim paying
Under the same assumptions as the previous problem, show that the value of a claim paying S2(T ) if S1(T) > KS2(T ) iswhere Ïƒ2, Î´1, and Î´2 are defined as in the previous problem.In the
In this problem we will use Monte Carlo to simulate the behavior of the martingale St/Pt , with Pt as numeraire. Let x0 = S0/P0(0, T ). Simulate the process xt+h= (1+ σ√ hZt+h)xtLet h be
We now use Monte Carlo to simulate the behavior of the martingale Pt/St , with St as numeraire. Let x0 = P0(0, T )/S0. Simulate the process xt + h= (1+ σ√hZt+h)xtLet h be approximately 1 day.a.
Suppose that the stock price follows a jump-diffusion process as outlined in Section 20.7. Let the jump intensity be λ = 0.75, the expected jump exp(αJ ), with αJ=−0.15, and let the jump
Suppose that S1 and S2 are correlated, non-dividend-paying assets that follow geometric Brownian motion. Specifically, let S1(0) = S2(0) = $100, r = 0.06, σ1 = 0.35, σ2 = 0.25, ρ = 0.40 and T = 1.
A collect-on-delivery call (COD) costs zero initially, with the payoff at expiration being 0 if S Let S = $100, K = $100, r = 5%, σ = 20%, T − t = 1 year, and δ = 0.a. Value a European COD call
Suppose an option knocks in at H1> S, and knocks out at H2 >H1. Suppose thatK < H2 and the option expires at T . Call this a "knock-in, knock-out" option. Here is an equation
Suppose the stock price is $50, but that we plan to buy 100 shares if and when the stock reaches $45. Suppose further that σ = 0.3, r = 0.08, T − t = 1, and δ = 0. This is a non cancellable limit
Covered call writers often plan to buy back the written call if the stock price drops sufficiently. The logic is that the written call at that point has little €œupside,€ and, if the stock
For the lookback call:a. What is the value of a lookback call as ST approaches zero? Verify that the formula gives you the same answer.b. Verify that at maturity the value of the call is ST − ST .
For the lookback put:a. What is the value of a lookback put if ST = 0? Verify that the formula gives you the same answer.b. Verify that at maturity the value of the put is ST − ST .
A European shout option is an option for which the payoff at expiration is max(0, S − K, G − K), where G is the price at which you shouted. (Suppose you have an XYZ shout call with a strike price
Consider the Level 3 outperformance option with a multiplier, discussed in Section 16.2. This can be valued binomially using the single state variable SLevel 3/SS&P, and multiplying the resulting
Consider AAAPI, the Nikkei ADR in disguise. To answer this question, use the information in Table 23.4.a. What is the volatility of Y , the price of AAAPI?b. What is the covariance between Y and x,
A barrier COD option is like a COD except that payment for the option occurs whenever a barrier is struck. Price a barrier COD put for the same values as in the previous problem, with a barrier of
Verify that equation (23.7) satisfies the appropriate boundary conditions for Pr(ST ≤ H and ST >K).
Verify that equation (23.14) (for both cases K > H and K < H) solves the boundary conditions for an up-and-in cash put.
Assume that S = $45, K = $40, r = 0.05, δ = 0.02, and σ = 0.30. Using the up rebate formula (equation (23.21)), find the value of H that maximizes (H − K) × UR(S, σ, r , T , δ), for T = 1, 10,
Verify in Example 23.12 that you obtain the same answer if you use x0Q0 as the stock price, δQ+ ρsσQ + r − rf as the dividend yield, r as the interest rate, and σQ as the volatility.
In this problem you will price various options with payoffs based on the Eurostoxx index and the dollar/euro exchange rate. Assume thatQ= 2750 (the index), x = 1.25 ($/=C), s = 0.08 (the exchange
The quanto forward price can be computed using the risk-neutral distribution as E(Yx−1). Use Proposition 20.4 to derive the quanto forward price given by equation (23.30).
In this problem we use the lognormal approximation (see equation (11.14)) to draw one-step binomial trees from the perspective of a yen-based investor. Use the information in Table
Using weekly price data (constructed Wednesday toWednesday), compute historical annual volatilities for IBM, Xerox, and the S&P 500 index for 1991 through 2004. Annualize your answer by
Compute January 12 2004 bid and ask volatilities (using the Black-Scholes implied volatility function) for IBM options expiring February 21.a. Do you observe a volatility smile?b. For which options
Compute January 12 2004 implied volatilities using the average of the bid and ask prices for IBM options expiring February 21 (use the Black-Scholes implied volatility function). Compare your answers
In this problem you will compute January 12 2004 bid and ask volatilities (using the Black-Scholes implied volatility function) for 1-year IBM options expiring the following January. Note that IBM
For this problem, use the implied volatilities for the options expiring in January 2005, computed in the preceding problem. Compare the implied volatilities for calls and puts. Where is the
Suppose S = $100, r = 8%, σ = 30%, T = 1, and δ = 0. Use the Black-Scholes formula to generate call and put prices with the strikes ranging from $40 to $250, with increments of $5. Compute the
Explain why the VIX formula in equation (24.29) overestimates implied volatility if options are American.The following three problems use the Merton jump formula. As a base case, assume S = $100, r =
Using the Merton jump formula, generate an implied volatility plot for K =50, 55, . . . 150.a. How is the implied volatility plot affected by changing αJ to−0.40 or−0.10?b. How is the implied
Using the base case parameters, plot the implied volatility curve you obtain for the base case against that for the case where there is a jump to zero, with the same λ.
Repeat Problem 24.16, except let αJ = 0.20, and in part (b) consider expected alternate jump magnitudes of 0.10 and 0.50.The following two problems both use the CEV option pricing formula. Assume in
Using the CEV option pricing model, set β = 1and generate option prices for strikes from 60 to 140, in increments of 5, for times to maturity of 0.25, 0.5, 1.0, and 2.0. Plot the resulting implied
Compute daily volatilities for 1991 through 2004 for IBM, Xerox, and the S&P 500 index. Annualize by multiplying by √ 252. How do your answers compare to those in Problem 24.1?
Using the CEV option pricing model, set β = 3 and generate option prices for strikes from 60 to 140, in increments of 5, for times to maturity of 0.25, 0.5, 1.0, and 2.0. Plot the resulting
For the period 1999-2004, using daily data, compute the following:a. An EWMA estimate, with b = 0.95, of IBM's volatility using all data.b. An EWMA estimate, with b = 0.95, of IBM's volatility, at
Estimate a GARCH(1,1) for the S&P 500 index, using data from January 1999 to December 2003.
Replicate the GARCH(1,1) estimation in Example 24.2, using daily returns from on IBM from January 1999 to December 2003. Compare your estimates with and without the four largest returns.
Use the following inputs to compute the price of a European call option: S = $100,K = $50, r = 0.06, σ = 0.30, T = 0.01, δ = 0.a. Verify that the Black - Scholes price is $50.0299.b. Verify that
Use the same inputs as in the previous problem. Suppose that you observe a bid option price of $50 and an ask price of $50.10.a. Explain why you cannot compute an implied volatility for the bid
Use the following inputs to compute the price of a European call option: S = $50,K = $100, r = 0.06, σ = 0.30, T = 0.01, δ = 0.a. Verify that the Black-Scholes price is zero.b. Verify that the vega
Compute January 12 2004 bid and ask volatilities (using the Black-Scholes implied volatility function) for IBM options expiring January 17. For which options are you unable to compute a plausible
a. What is the 1-year bond forward price in year 1?b. What is the price of a call option that expires in 1 year, giving you the right to pay $0.9009 to buy a bond expiring in 1 year?c. What is the
Verify that the price of the 12% interest rate cap in Figure 25.6 is $3.909.
Verify that the 1-year forward rate 3 years hence in Figure 25.5 is 14.0134%.
What are the 1-, 2-, 3-, 4-, and 5-year zero-coupon bond prices implied by the two trees?
What volatilities were used to construct each tree? (You computed zero-coupon bond prices in the previous problem; now you have to compute the year-1 yield volatility for 1-, 2-, 3-, and 4-year
For years 2€“5, compute the following:a. The forward interest rate, rf , for a forward rate agreement that settles at the time borrowing is repaid. That is, if you borrow at t ˆ’ 1 at the
You are going to borrow $250m at a floating rate for 5 years. You wish to protect yourself against borrowing rates greater than 10.5%. Using each tree, what is the price of a 5-year interest rate
Suppose that the yield curve is given by y(t) = 0.10 − 0.07e −0.12t , and that the short-term interest rate process is dr(t) = (θ(t) − 0.15r(t)) + 0.01dZ. Compute the calibrated Hull-White
Using Monte Carlo, simulate the process dr = a(b − r)dt + σdZ, assuming that r = 6%, a = 0.2, b = 0.08, φ = 0, and σ = 0.02. Compute the prices of 1-, 2-, and 3-year zero-coupon bonds, and
Repeat the previous problem, but set φ = 0.05. Be sure that you simulate the riskneutral process, obtained by including the risk premium in the interest rate process.
This problem builds on the previous problem using the same parameters, only valuing a call option instead of a bond. Using Monte Carlo, simulate the Vasicek process for 3 years. For each simulation
a. What is the 2-year forward price for a 1-year bond?b. What is the price of a call option that expires in 2 years, giving you the right to pay $0.90 to buy a bond expiring in 1 year?c. What is the
Using Monte Carlo, simulate the process dr = a(b − r)dt + σ√rdZ, assuming that r = 6%, a = 0.2, b = 0.08, φ = 0 and σ = 0.02. Compute the prices of 1-, 2-, and 3-year zero coupon bonds, and
What is the price of a 3-year interest rate cap with an 11.5% (effective annual) cap rate?
Suppose the yield curve is flat at 8%. Consider 3- and 6-year zero-coupon bonds.You buy one 3-year bond and sell an appropriate quantity of the 6-year bond to durationhedge the position. Any
Suppose the yield curve is flat at 6%. Consider a 4-year 5%-coupon bond and an 8-year 7%-coupon bond. All coupons are annual.a. What are the prices and durations of both bonds?b. Consider buying
Consider two zero-coupon bonds with 2 years and 10 years to maturity. Let a = 0.2, b = 0.1, r = 0.05, σVasicek = 10%, and σCIR = 44.721%. The interest rate risk premium is zero in each case. We
Construct a four-period, three-step (eight terminal node) binomial interest rate tree where the initial interest rate is 10% and rates can move up or down by 2%; model your tree after that in Figure
Verify that the 4-year zero-coupon bond price generated by the tree in Figure 25.5 is $0.6243.
Verify that the 1-year yield volatility of the 4-year zero-coupon bond price generated by the tree in Figure 25.5 is 0.14.
Consider the expression in equation (26.6). What is the exact probability that, over a 1-day horizon, stock A will have a loss?
Compute the 95% 10-day tail VaR for the position in Problem 26.8.In Problem 26.8.Compute the 95% 10-day VaR for a written strangle (sell an out-of-the-money call and an out-of-the-money put) on
Suppose you write a 1-year cash-or-nothing put with a strike of $50 and a 1-year cash-or-nothing call with a strike of $215, both on stock A.a. What is the 1-year 99% VaR for each option
Suppose the 7-year zero-coupon bond has a yield of 6% and yield volatility of 10% and the 10-year zero-coupon bond has a yield of 6.5% and yield volatility of 9.5%.The correlation between the 7-year

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