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# Econ 435-0201 - Problem Set 3.

## (Due date: December 2nd)

1. (Ch 16, problem 8) Rank the durations or effective durations of the following pairs of
bonds (and explain):
a. Bond A is a 6% coupon bond, with a 20-year time to maturity selling at par value.
Bond B is a 6% coupon bond, with a 20-year maturity time selling below par value.
b. Bond A is a 20-year noncallable coupon bond with a coupon rate of 6%, selling at par.
Bond B is a 20-year callable bond with a coupon rate of 7%, also selling at par.
2. (Ch 16, problem 12) You will be paying \$10,000 a year in tuition expenses at the end of
the next 2 years. Bonds currently yield 8%.
a. What is the present value and duration of your obligation?
b. What maturity zero-coupon bond would immunize your obligation?
c. Suppose you buy a zero-coupon bond with value and duration equal to your obligation.
Now suppose that rates immediately increase to 9%. What happens to your net position,
that is, to the difference between the value of the bond and that of your tuition obligation?
What if rates fall to 7%?
3. (Ch 16, problem 13) Pension funds pay lifetime annuities to recipients. If a firm will
remain in business indefinitely, the pension obligation will resemble a perpetuity. Suppose,
therefore, that you are managing a pension fund with obligations to make perpetual payments of \$2 million per year to beneficiaries. The yield to maturity on all bonds is 16%.
a. If the duration of 5-year maturity bonds with coupon rates of 12% (paid annually) is
4 years and the duration of 20-year maturity bonds with coupon rates of 6% (paid annually)
is 11 years, how much of each of these coupon bonds (in market value) will you want to hold
to both fully fund and immunize your obligation?
b. What will be the par value of your holdings in the 20-year coupon bond?
(Hint: Use the annuity factor and PV factor table provided. Note that the duration for
a bond portfolio is a weighted average of individual bonds durations, since duration is essentially the first derivative w.r.t. interest rate)
4. (Ch 20, problem 10) An investor purchases a stock for \$38 and a put for \$.50 with a
strike price of \$35. The investor sells a call for \$.50 with a strike price of \$40. What is
the maximum profit and loss for this position? Draw the profit and loss diagram for this
strategy as a function of the stock price at expiration.

5. (Ch 20, problem 12) In this problem, we derive the put-call parity relationship for European options on stocks that pay dividends before option expiration. For simplicity, assume
that the stock makes one dividend payment of \$D per share at the expiration date of the
option.
a. What is the value of a stock-plus-put position on the expiration date of the option?
b. Now consider a portfolio comprising a call option and a zero-coupon bond with the
same maturity date as the option and with face value ( X + D ). What is the value of this
portfolio on the option expiration date? You should find that its value equals that of the
stock-plus-put portfolio regardless of the stock price.
c. What is the cost of establishing the two portfolios in parts (a) and (b)? Equate the
costs of these portfolios, and you will derive the put-call parity relationship, Equation 20.2
(P = C S0 + PV(X) + PV(dividends)).
6. (Ch 20, problem 13)
a. A butterfly spread is the purchase of one call at exercise price X1 , the sale of two
calls at exercise price X2 , and the purchase of one call at exercise price X3 . X1 is less than
X2 , and X2 is less than X3 by equal amounts, and all calls have the same expiration date.
Graph the payoff diagram to this strategy.
b. A vertical combination is the purchase of a call with exercise price X2 and a put with
exercise price X1 , with X2 greater than X1 . Graph the payoff to this strategy.
7. (Ch 22, problem 14) The multiplier for a futures contract on a stock market index is
\$250. The maturity of the contract is 1 year, the current level of the index is 1,300, and the
risk-free interest rate is .5% per month. The dividend yield on the index is .2% per month.
Suppose that after 1 month, the stock index is at 1,320.
a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that
the spot-futures parity condition always holds exactly.
b. Find the holding-period return if the initial margin on the contract is \$13,000.
(Note: The multiplier being \$250 means that every 1 point increase in index futures gives
you \$250)
8. (Ch 22, problem 16) The S&P portfolio pays a dividend yield of 1% annually. Its current
value is 1,500. The T-bill rate is 4% annually. Suppose the S&P futures price for delivery
in 1 year is 1,550. Construct an arbitrage strategy to exploit the mispricing and show that
your profits 1 year hence will equal the mispricing in the futures market.

## 9.(bonus) (Ch 22, problem 19)

Consider this arbitrage strategy to derive the parity relationship for spreads:
(1) enter a long futures position with maturity date T1 and futures price F (T1 );
(2) enter a short position with maturity T2 and futures price F (T2 ); (3) at T1 , when the
first contract expires, buy the asset and borrow F (T1 ) dollars at rate rf ;
(4) pay back the loan with interest at time T2 .
a. What are the total cash flows to this strategy at times 0, T1 , and T2 ?
b. Why must profits at time T2 be zero if no arbitrage opportunities are present?
c. What must the relationship between F (T1 ) and F (T1 ) be for the profits at T2 to be
equal to zero? This relationship is the parity relationship for spreads.