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Question A.1 Briefly describe the model for stock prices that underlies the Black-Scholes option pricing analysis. Do you think it is a reasonable representation of real-world stock price movements? [Write no more than half of a page of A4] (6 marks) Question A.2 An underlying has a current price of $31. The premia on 3 month European put and call options on this underlying are $1 and $3 respectively. Both options have a strike price of $30. If the continuously compounded interest rate is 10%, is there an arbitrage opportunity here and, if so, how would you C exploit it? [Write no more than half of a page of A4] (6 marks) Question A.3 An option trader believes that, in the next month or so, trading conditions in an underlying are going to be very volatile. She thinks that there is a good chance that the underlying will rise significantly in value and a good, but somewhat smaller, chance that the underlying will fall significantly in value. She judges the chances of small movements in the underlying, either up or down, to be very small. Design an option position that the trader could build in order to profit from this view. [Write no more than half of a page of A4] (6 marks) Question A.4 Consider the pricing of a futures contract on copper. What would you expect to happen if storage costs rose? Explain the economics behind this effect. [Write no more than half of a page of A4] (6 marks) Question A.5 The one year spot interest rate is 4%. The two year spot rate is 5% and the three year spot rate is 6%. You are quoted a swap rate of 5.5% on a 3 year fixed-for-floating swap. Is this rate fair? Explain your response, and if it is not fair, derive the fair swap rate. [Write no more than half of a page of A4] (6 marks)