1. A bank has just sold a call option on 500,000 shares of a stock. The strike price is 40; the stock price is 40; the risk-free rate is 5%; the volatility is 30%; and the time to maturity is 3 months.

QUESTION 1.

a. What position should the company take in the stock for delta neutrality?

b. Suppose that the bank does set up a delta neutral position as soon as the option has been sold and the stock price jumps to 42 within the first hour of trading. What trade is necessary to maintain delta neutrality? Explain whether the bank has gained or lost money in this situation. (You do not need to calculate the exact amount gained or lost.)

c. Repeat part b) on the assumption that the stock jumps to 38 instead of 42.

Question 2.

1. Give an example of how a swap might be used by a portfolio manager.
2. Explain the nature of the credit risks to a financial institution in a swap agreement.

Question 4

1. Discuss the five inputs that are needed for the Black-Scholes estimations and shows its relevance to investors.
2. The current price of Kinston Corporation stock is $10. In each of the next two years, this stock price can either go up by $3.00 or go down by $2.00. Kinston stock pays no dividends. The one year risk-free interest rate is 5% and will remain constant. Using the binomial pricing model, calculate the price of a two-year call option on Kinston stock with a strike price of $9.