Part A (5 marks):

i. When valuing European Vanilla Options in the Black-Scholes-Merton Model, there is one source of uncertainty. What is this uncertainty? (3 marks)

ii. Why does a short call position in a European vanilla option typically have negative delta ()? (2 mark)

Part B (5 marks):

The current price of a non-dividend paying asset is $65, the riskless interest rate is 5% p.a. continuously compounded, and the option maturity is five years. What is the lower boundary for the value of a European vanilla put option on this asset with strike price of $80?

Part C (5 marks)

Two companies have investments which pay the following rates of interest:

Fixed Float

Firm A 6% Libor

Firm B 8% Libor + 0.5%

Assume A prefers a fixed rate and B prefers a floating rate. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B, what rates could A and B receive on their preferred interest rate? Show all working.

Assignment 2 Semester 2 2017 Assignment 2 (assessment worth 15%) Due Date 27th October at 4pm WST [Submission deadlines will be strictly observed. Please type your answers and make your submission via the electronic link on Blackboard] Part A (5 marks): i. When valuing European Vanilla Options in the Black-Scholes-Merton Model, there is one source of uncertainty. What is this uncertainty? (3 marks) Max 50 words. ii. Why does a short call position in a European vanilla option typically have negative delta ()? (2 mark) Max 75 words Part B (5 marks): The current price of a non-dividend paying asset is $65, the riskless interest rate is 5% p.a. continuously compounded, and the option maturity is five years. What is the lower boundary for the value of a European vanilla put option on this asset with strike price of $80? Part C (5 marks) Two companies have investments which pay the following rates of interest: Fixed Float Firm A 6% Libor Firm B 8% Libor + 0.5% Assume A prefers a fixed rate and B prefers a floating rate. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B. If an intermediary charges both parties equally a 0.1% fee and any benefits are spread equally between Firm A and Firm B, what rates could A and B receive on their preferred interest rate? Show all working. 1