ECON2151-WE01
Financial Markets and Institutions
2022
1. (i) Demonstrate how a butterfly spread would be created using options and explain the circumstances under which a trader might construct the spread.
(ii) Use a numerical example to compare the potential payoffs and profits from a straddle and a strangle combination.
2. (i) A forward contract with 9 months to maturity is written on an underlying bond. The
market price of the bond is $95, and it is expected to pay coupons of $5 after 3 months and $5 immediately prior to maturity. The relevant riskless rate of interest is 3%. Calculate the theoretical forward price and initial value of the forward contract and explain the forward pricing relationship. (60 marks)
(ii) Provide a numerical example of an arbitrage strategy for situations where the forward is trading above, and below the theoretical forward price. (40 marks)
3. Demonstrate, numerically and by using diagrams, how a ‘plain vanilla’ interest rate swap is constructed to exchange fixed for floating payments. Explain the importance of the financial intermediary in the transaction and discuss the comparative advantage argument for the popularity of swaps.
4. (i) Demonstrate how the price and volatility of the underlying asset will influence the price of call and put options. (40 marks)
(ii) An option trader has short positions in call and put options written on an underlying
asset currently priced at $100. Numerically demonstrate the intrinsic values and moneyness ranges for the options using a range of plausible exercise (strike) prices and premiums. (60 marks)
5. (i) Discuss the key differences between forward and futures contracts. (30 marks)
(ii) Construct a numerical example of marking to market and discuss the relative risk exposure of corresponding futures and forward positions. (70 marks)
6. Explain how mortgage-backed securities, collateralised debt obligations and credit default swaps are constructed and evaluate their applications in financial markets.