# Essay on Derivatives Study Guide

2. Futures contracts are standardized; forward contracts are not. : True

3. The S&P500 index futures contract is a physical delivery contract. The pork bellies futures contract is a cash-settled contract. : False

4. An American option can be exercised at any time during its life. : True

5. A put option will always be exercised at maturity if the strike price is greater than the underlying asset price. : True

6. The fact that the exchange is the counter-party to every futures contract issued is important because it eliminates interest rate risk. : False

7. Index arbitrage is a strategy which exploits differences between actual index

futures

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3. Manchester United Corp. common stock is priced at $74.20 per share. The company just paid its $1.10 quarterly dividend. Interest rates are 6.0% (continuously compounded). A $70.00 strike European call, maturing in 6 months, sells for $6.50. How much arbitrage profit/loss is made by shorting the corresponding European put, which is priced at $2.50?Answer: No-arbitrage price of Put = C + Ke-r×T – (S0 – PV(D))

= 6.50 + 70 e(-0.06/2) – (74.20 – 1.10 e(-0.06/4) - 1.10 e(-0.06/2))

= 2.38

P/L = 2.50 – 2.38 = 0.12 profit

4. Suppose European put prices are given by

What no-arbitrage property is violated? What spread position would you use to effect arbitrage? Demonstrate that the spread position is an arbitrage.

Answer: The difference in put premiums is greater than the difference in strike prices. We could engage in arbitrage by selling the 55-strike put and buying the 50-strike put, which is a bull spread.

5. (10 points) Let S=40, K=40, r=8% (continuously compounded), σ=30%, =0, T=0.5 years, and number of binomial periods=2. Compute the prices of American call and put options.

Payoff for

Long