15.

437 Midterm Review

Michael Abrahams
MIT Sloan School of Management
miabraha@mit.edu
Fall 2014

Agenda
1)
2)
3)
4)
5)

Some Tips for the Midterm

Bonds
Swaps
Key Concepts + Exercises
Forwards
Options

Some Tips for the Midterm

Read each question very carefully!
Since this is an open book exam, dont expect simple
plug and chug type problems

Attempt to understand the intuition before focusing on

the equations
Expect to draw information from the whole course

It is important to explain your answers and show

intermediate steps for full (or partial) credit
Remember your calculator - laptops are not allowed

Bonds Key Concepts

Replication can allow you to price, hedge, or
build an arbitrage portfolio if it is mispriced
know how to do all of these!
Know the standard terminology and how the
different terms relate to each other:
a. Coupon bond
b.Zero coupon bond and zero coupon yield curve
c. Par bond and par bond yield curve
d.Forward rates
e. Floating-rate bond

Swaps Key Concepts

Know how to:

replicate and price both sides of a swap

find the fair value swap rate
value a swap with changing notional
value an existing swap position

Key result: value of individual floating

payment at time t is (Zt-1 Zt) per unit of
notional amount

Exercise 4.1
Exercise (Swap)
Consider a newly-issued 2-year swap with the following characteristics:
Notional values: $1M at period 1, $1.5M at 2, $2.0M at 3, and $2.5M at 4.
The fixed side pays every six months (i.e., at the end of 1,2,3, and 4).
The floating side makes a single payment at the end of period 4 (based on
the given notional).
What is the swap rate in this contract?
t (6-mth)
Zt

1
0.970

2
0.941

3
0.912

4
0.883

Forwards Key Concepts

Know how to:

find the forward price

replicate a forward contract
exploit arbitrage opportunities
value an existing forward position

Key result:
F = FVT[spot price] FVT [forgone cash flows]

Options Key Concepts

Learn the standard terminology (puts, calls, option
premium, strike price, American vs. European, etc.)
Put-Call Parity for European options:
S = C P + PV(K) if no intermediate cash flows on S
S = C P + PV(K) + PV(D) if there are dividends or other
intermediate cash flows

Options Key Concepts

Know how options relate to forward contracts
a. A call and put with strike equal to the forward price must
have the same premium
b. Rewrite put-call parity as S PV(D) = C P + PV(K). What
does S PV(D) look like? The present value of the forward
price (spot minus PV of forgone cash flows)! Thus, we also
have PV(F) = C P + PV(K), for any K.

Exercise 4.2
Exercise (Previous Exam Question)
A year ago your firm took a long position in a three-year forward contract on
100,000 pounds of copper. The forward price when the contract was initiated
was $3.20 per pound. The forward price for that delivery date has since risen to
$4.00 per pound.
Two-year European options, each covering 100 pounds of copper, are available
on the following terms:
Striking Price Call Put
350
80
35
400
52
52
450
30
75
The current price of a zero coupon bond maturing in two years is $.90. Your
counterparty on the forward contract has just offered your firm $70,000
to cancel the contract. Should your firm take this offer?

Exercise 4.3
Exercise (Previous Exam Question)
A firm has created a ten-year trust that holds one thousand shares of ABC stock.
This stock serves as collateral for three securities that the firm has issued. These
securities represent different claims on the stock.
The first security receives all of the dividends paid by the stock during the tenyear period. The residual value of the trust on the termination date is then
divided between the remaining securities. The second security receives any
capital appreciation the stock has experienced over the ten-year period. If the
stock has declined in value, the second security receives nothing. The third
security receives the full value left in the trust after the second security has been
paid.
The price of the stock when the trust was created was $100 per share. Show how
you could express the current value of each of the three securities in terms of the
current value of ABC stock, the current value of a zero coupon bond maturing
on the termination date of the trust, and the current value of European options
on ABC stock that expire on the termination date.

Exercise 4.4
Exercise (Forward on a Swap)
Consider a forward on a swap (distinct from a forward swap), that is, a
forward contract that requires you to buy an existing swap contract at a given
price in the future.
Specifically, determine the appropriate forward price on a 1-year forward on
a newly-issued, 2-year plain vanilla floating-for-fixed swap with notional of
$100. The forward matures just after the 1-year swap payment date. The
prices of 0.5, 1.0, 1.5, and 2.0 year zeros are 0.95, 0.90, 0.85, and 0.80
respectively. Assume that you will receive floating payments.