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1. Answer three parts of this question. Your answers for each part should be no more than two pages long. a. Describe the assumed process

1. Answer three parts of this question. Your answers for each part should be no more than two pages long. a. Describe the assumed process for the evolution of the underlying asset price in the Black-Scholes optionpricing model. b. Derive the lower bound for a European put option written on a non-dividend paying stock and explain how you could make a riskless profit if this bound is violated. c. American call options written on non-dividend paying stocks should never be exercised early. Is this statement true? Prove your answer. d. Describe how a Collateralized Debt Obligation (CDO) is created. Why is this derivative popular with the banking sector? e. Assuming that the reference entity defaults after 2 years and 3 months, describe the cashflows arising from a 3-year CDS contract, with a notional principal of 80 million and a credit default spread of 160 basis points that is initiated today. Premium payments are made semi-annually in arrears.

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