Assignment 10

1. Do Chapter 21 Problem 34 in BKM P740

2. Do Chapter 21 Problem 36 in BKM P740

3. Do Chapter 21 Problem 37 in BKM P740

4. Do Chapter 21 Problem 38 in BKM P740

5. European options on Orange Conglomerate Co. with an exercise price of $100 and a maturity of one year, are selling for $10.95 if they are calls and $16.19 if they are puts. The one-year riskless interest rate is 5%.

a) What must be the price of Orange Conglomerate stock? [Hint: Your answer should be a number of dollars divisible by 10.]

b) Are the calls in the money or out of the money? By how much? Are the puts in the money or out of the money? By how much?

c) Now suppose that Orange Conglomerate stock follows a binomial model. A year from now the stock will either be up by $k or down by $k (assume that k > 0). Draw an event tree with two states of the world. In your event tree include the two possible values of the stock in terms of k and the two possible payoffs of the call option in terms of k.

d) What is k? [Hint: your answer should be another number divisible by 10.]

6. [Modified BKM Question] Firm ABC enters a 5-year swap with firm XYZ to pay LIBOR in return for a fixed 8% rate on notional principal of $10 million. Two years from now, the market rate on 3-year swaps is LIBOR in return for a fixed 6% rate. At this time, firm XYZ goes bankrupt and defaults on its swap obligation.

a) Why is firm ABC harmed by the default?

b) Assume that the yield curve is flat (all bonds have the same yield to maturity). What is the market value of the loss incurred by ABC as a result of the default?

c) Suppose instead that ABC had gone bankrupt. How do you think the swap would be treated in the reorganization of the firm?

Assignment 10