In the attached newspaper page advertising Citibanks Stock Index Insured Account, the bank promises Stock Market Returns. Zero Risk to Principal. In describing how it works, the advertisement explains that:

• The bank calculates the month-end average of the S&P 500 index average over the next five years, i.e. the average of 60 month-end S&P 500 index values.

• The bank takes the difference of the month-end average S&P 500 price and the value of the S&P 500 at the time of the deposit. If the difference is positive, i.e. the S&P has appreciated; the investor receives double the amount of the appreciation. If the difference is negative, i.e. the S&P has depreciated; the investor gets back the initial amount invested.

To make things simpler, assume that the bank simply offers to give the difference between the S&P 500 value at the end of five years and the initial index value if the S&P 500 appreciates (i.e. no averaging or doubling). If the S&P 500 depreciates, the investor gets back the initial principal.

1. Draw a picture representing the payoffs to the investor.

2. What is the cost to the investor for buying this product? For example, consider what the investor loses in comparison to a regular CD? Similarly, what does the investor lose in comparison to an investment in the S&P 500 Index Fund?

3. Explain why an investor might be interested in this product. Why would Citibank offer such a product?

4. What is the risk exposure to the bank from offering this product? How might the bank hedge this risk exposure?

5. Discuss the difference the option that truly underlies the CD and the simplified version of the option that I you have analyzed.