Question 1

(a) From the prices of the two T-bills, we can infer that the Canadian risk- free rate is
2.50% p.a. and the British risk-free rate is 3.00% p.a. Now, based on a (very
realistic) assumption that the bank can borrow or lend at the two risk- free rates, we
can calculate the forward price of British Pound in 6 months for the bank.

To calculate this forward price, note first that banks are not in the business of
speculating. They are there as financial intermediaries. Therefore, as soon as they
take a position in a derivative contract with one customer, they will have to hedge
themselves. They can do so in a few ways. The most obvious way is to find another
customer with an opposite position. However, since the contracts are highly
customized, it can be difficult to find another customer with exactly the same needs,
but on the opposite side. As a result, banks usually hedge themselves by synthetically
creating an opposite position.

In this question, the customer wants a short position. So the bank has to take a long
position in the real contract. To hedge itself, it then has to create a synthetic short. It
can do so by:

- borrow £0.9851. This is the the PV of £1.

- convert £0.9851 into C$2.4628 at the spot exchange rate
- lend C$2.4628 for 6 months at the Canadian risk-free rate.

At the end of 6 months, the bank has to repay its £ loan in an amount of £1. At
the same time, it will get back C$2.4628⋅e0.025(0.5) = C$2.4938 from its lending
transaction. Therefore, the forward price of £1 for the bank is C$2.4938.

1
 The bank will buy £1 from the customer under the real forward contract. This £1
will then be used to repay the £ loan. Since the bank has C$2.4938 and wants to
make a profit of C$ 0.0020 per Pound, it has to quote the forward price of
C$2.4918.

(b) The customer has a choice. He/she will compare the quoted forward price to the
forward price of Pound that he/she wants can create synthetically. Now, his/her
forward price will be different from the bank's cost. This is because the customer's
borrowing and lending rates are different from the bank's rates.

To create a synthetic short forward, the customer will have to:

- borrow £0.9827. This is the PV of £1 at the customer's borrowing rate for £.

- convert £0.9827 into C$2.4566 at the spot exchange rate
- lend C$2.4566 for 6 months at the customer's lending rate for C$. In 6
months, he/she will get C$2.4844 back.

Therefore, the customer's synthetic forward price is C$ 2.4844. Since the bank's
quoted forward price is C$2.4918, the customer should accept the bank's offer.

Question 2

The payoff of the bond is $1,000 + IT. We will replicate the bond’s payoff by a zero-
coupon bond and a long forward position on the index.

With the provided information, we can calculate the forward price. We will do that
later. For now, let’s just denote the forward price as F and remember that F is a
known value (i.e., known as soon as we calculate it). How, then, do we decompose
the bond’s payoff into a portfolio of zero-coupon bonds and an index forward? Note
that the bond’s payoff is:

2
 $1,000 + IT,

which can be rewritten as:

$1,000 + IT + F –F = [$1,000 + F] + [IT - F].

Note that we have managed to rewrite the bond’s payoff in two new terms. The first
term is the payoff of a zero-coupon bond with a face value of [$1,000 + F]. The
second term is the payoff of a long position in a one-year index forward contract.

Next, let’s calculate F.

F = S ⋅ e(r-q)T = 1,200 ⋅ e(0.05 – 0.02)(1)

= 1,236.5454.

Substituting the value of F into the bond’s payoff expression, we have the payoff as:

[$1,000 + F] + [IT - F]. = [$1,000 + 1,236.5454] + [IT – 1,236.5454]

= $2,236.5454 + [IT – 1,236.5454].

In other words, we can replicate the bond’s payoff by a portfolio of (i) a zero-coupon
bond with a face value of $2,236.5454; and (ii) a long position in a one- year index
forward contract. Because F is properly calculate, we know that the value of our long
forward position right now (i.e., when we enter into it) is zero. As a result, the
present value of the bond’s payoff is:

$2,236.5454 ⋅ e-0.05(1) = $2,127.4678.

When this question appeared in the midterm exam some years ago, many students
simply calculated F = 1,236.5454 and then added it to $1,000 to get $2,236.5454.

3
 They then discounted it back to get $2,127.4678. While the price of the bond that
they calculated was the right number, I did not accept this kind of answer without
further explanation. What they did was based on an implicit (and very wrong)
assumption that IT will be equal to F. This assumption was nonsense. The correct
price of the bond is $2,127.4678 because we can replicate it with a zero-coupon bond
and a forward contract (and not because we can see into the future and know what
IT will be).

Question 3

With the assumed zero lease rate, the formula for forward prices is:

F0,T = S 0 ⋅ e (r + u )T .

For the maturity of 3 months, the forward price is 7.0748. That is:

F0,0.25 = 7.0748 = S 0 ⋅ e (0.04 +u ) 0.25 . (1)

For the maturity of 6 months, the forward price is 7.1503. That is:

F0,0.5 = 7.1503 = S 0 ⋅ e (0.04+ u )0.5 . (2)

Dividing (2) by (1), we have:

7.1503 S 0 ⋅ e (0.04 +u ) 0.5 (0.02+ 0.5u − 0.01− 0.25u )

= +
=e .
7.0748 S 0 ⋅ e ( 0 . 04 u ) 0 . 25

Solving for u, we get u = 0.2461% p.a.

4
Question 4

The first choice is a sure stream of payments of $10,500 per year for three years, with the
first payment starting one year from now. The PV of this choice is $28,594.1043
(calculations omitted).

Alternatively, you can choose to receive 100 shares of your company's stocks per year for
three years, with the first payment starting one year from now. This is risky stream of
payments because no one knows what the share price will be in the future. Therefore, in
order to determine the value of this choice, you have to get rid of the risk and then
calculate the PVs of those three payments.

To get rid of the risk, you can short three forward contracts now. The first contract
matures in one year, and is for 100 shares. The second contract matures in two years, and
is for 100 shares. And so on. By shorting these contracts, you now have locked in the
prices at which you can sell the gold that you will receive. As a result, the stream of
payments is no longer risky. You now know for sure how much (in $ term) you will get
in years 1 – 5.

The one-year forward price (i.e., forward price for the one- year contract) is:

F0,1 = 98 · e(0.05 – 0.01) · 1 = $101.9995 per share.

By similar calculations, you can get the forward prices for the other two years.

F0,2 = $106.1621 per share

F0,3 = $110.4947 per share

As a result, the amounts of money you will get at the end at each year and their present
values are as follows:

5
 Dollar Amount of PV of the Dollar
Year
Shares Received Amount
1 10,199.9456 9,702.4884
2 10,616.2133 9,605.9470
3 11,049.4691 9,510.3662
28,818.8016

The present values are calculated using the risk-free rate because these amounts are sure
amounts. The sum of the PVs is $28,818.8016, which is higher than the PV of the cash
bonus. Therefore, you should choose the shares bonus scheme.

Again, when this question appeared in the midterm exam some years ago, most students
simply calculated the forward prices of the stock in the next three years and then discount
them back. Implicit in their solutions was an assumption that the stock price in each of
the next three years would be equal to the forward price that they calculated. I did not
accept this kind of thinking. It was completely wrong. Note that you'd need to enter
into three forward contracts in order to lock in the prices. I always mention in the
exam instructions that when the answers involve taking positions in securities or
lending/borrowing, all the relevant details have to be mentioned. Failure to do that
would make the answers incomplete and no point could be given.

6
Question 5

The payoffs of a long call and a short put with the same exercise price, K, are as follows:

ST < K ST > K
1) Long call 0 ST - K
2) Short put -(K - ST) 0
_______________ _______________
Total ST - K ST - K

As a result, the combined payoffs are similar to the payoff of a long forward where the
forward (i.e., delivery) price is K. We know from our discussion on the calculation of
forward prices that if the forward price, F, is properly calculated, then the forward
contract will have zero value when entered into. As a result, for the portfolio of a long
call and a short put to have zero value (or, equivalently, call price = put price), the
exercise price, K, must be the same as the properly-calculated forward price, F.