Answers Must Be In Excel Format And Include Formulas

Answers Must Be In Excel Format And Include Formulas Within The Spread

Answers Must Be In Excel Format And Include Formulas Within The Spread

ANSWERS MUST BE IN EXCEL FORMAT AND INCLUDE FORMULAS WITHIN THE SPREADSHEETS Week 10 Chapter 22: Problems 3(a-d), 5(a-d), 7(a-c), 10(a-b), and 12 Chapter 24: Problems 3(a-d), 6(a-c), 8(a-c), and 10(a-c)

Paper For Above instruction

This paper offers a comprehensive analysis and solution to the specified problems related to options pricing, portfolio management, and financial strategies as presented in the homework assignment. The focus is on translating these problems into structured Excel models with embedded formulas, enabling precise calculations and risk assessments. The objectives include exploring risk-neutral valuation, probability estimation in binomial models, Black-Scholes option pricing, and the evaluation of complex trading strategies such as straddles and butterfly spreads. Additionally, the paper discusses portfolio diversification, investment return calculations, fee structures, and asset allocation strategies.

Problem 3(a-d): Riskless Portfolio Composition and Probabilities for DEW Stock

The first problem involves constructing a riskless hedge for DEW Corp.'s stock over a one-year horizon using a binomial model. Given the stock price tree ($40, $42, $40.32, $38.71), the goal is to determine the initial portfolio composition of stocks and options, and the subsequent adjustments to maintain a riskless position. The process begins with identifying the up and down factors, calculating the risk-neutral probabilities, and establishing the hedge ratio for the options.

In constructing the riskless portfolio, we start by defining the possible price movements. The up and down factors (u and d) are derived as:

  • u = $42 / $40 = 1.05
  • d = $40.32 / $40 = 1.008

The risk-neutral probability (p) is calculated as:

p = (e^(r * Δt) - d) / (u - d), where r = 6%, Δt = 1 year.

Using Excel, formulas are entered to compute p, the delta of the option (which involves calculating the option's payoff in each node), and the initial number of shares and options to hold. To keep the portfolio riskless, dynamic rebalancing occurs at each node based on changing payoffs and asset prices.

Implementation in Excel:

- Cell A1: Initial stock price ($40)


- Cell A2: Up factor (calc: =42/40)


- Cell A3: Down factor (calc: =40.32/40)


- Cell A4: Risk-free rate (6%)


- Cell A5: Calculate p: =(EXP(A4) - A3)/(A2 - A3)


- Derive payoff at each node for options and stock


- Calculate hedge ratios (delta)


- Establish initial positions:


- Number of shares: based on delta


- Number of options: based on cost and hedge


- Adjust subsequent positions at each node for riskless replication

Such calculations are shown in the accompanying Excel spreadsheet, ensuring dynamic adjustment of the hedge ratios to replicate the option's payoff.

For the probability calculations, the binomial model's simplicity enables calculation of the likelihood of each terminal stock price, considering the number of up and down moves and their corresponding probabilities. The probabilities of reaching each terminal price are derived combinatorially, multiplied by the respective risk-neutral probabilities raised to the number of up/down steps.

Problem 5(a-d): Option Pricing on ARB Inc. Stock

This problem involves applying the Black-Scholes model to evaluate a European call and put options, accounting for dividends and dividend dates. The key challenge is adjusting the stock's spot price for upcoming dividends, which influences the expected stock price at expiration.

First, the stock's price is discounted for dividends. The effective stock price used in Black-Scholes is:

S* = S0 - PV(dividends)

where PV(dividends) is the present value of dividends to be paid before expiration.

Next, the parameters for the Black-Scholes formula are calculated, including volatility (20%), risk-free rate (9%), and time to expiration (91 days). The adjusted stock price (S*) is plugged into the Black-Scholes formula to compute the call value.

Similarly, the put price is derived from put-call parity, considering the dividends paid prior to expiration.

In Excel, the calculations involve:

  • Calculating d1 and d2: with formulas incorporating ln(S*/K), volatility, and interest rates.
  • Using NORM.S.DIST() for the cumulative normal distribution functions.
  • Adjustments for dividends at appropriate times.

Changes in volatility and risk-free rate are modeled by adjusting the respective parameters and recalculating option prices to observe their sensitivities.

Problem 7(a-c): Index Option Valuation and Implied Volatility

The valuation begins with calculating the theoretical call price using a Black-Scholes or a binomial model, considering an index level of 653.5, a dividend yield of 2.8%, and a volatility estimate of 16%. The continuous compounding rate of 5.5% is used to discount dividends and risk-free returns.

The implied volatility is obtained by solving the Black-Scholes formula for volatility given the observed market price ($17.40). This involves iteratively adjusting volatility inputs until the theoretical price matches the market price, which can be done using Excel's Goal Seek or Solver.

Discrepancies between theoretical valuation and market prices are discussed in terms of assumptions like constant volatility, liquidity, bid-ask spreads, and market sentiment.

Problem 10(a-c): Straddle and Alternative Strategies for Friendwork

Designing a straddle involves the combination of a long call and a long put at the same strike ($100) and maturity (1 year). The net payoff at maturity equals the absolute difference between stock price and strike, minus the total premium paid.

Using the provided option premiums ($9 for the call, $8 for the put), the breakeven points are calculated as:

  • Upper breakeven: $110 (strike + total premium)
  • Lower breakeven: $90 (strike - total premium)

Graphically, these payoffs are plotted to illustrate profitability across various stock prices at maturity.

The alternative butterfly spread combines long and short positions in calls or puts at different strikes, creating a profit window. The diagram shows maximum profit at the middle strike, with losses outside the bounds, and breakeven points derived from the net premium and strikes.

Problem 12: Creating a Butterfly Spread with Put Options

This involves constructing a butterfly profit diagram using puts on SAS stock, including specific contract positions at different strikes. For example, buy one lower strike put, sell two at a middle strike, and buy one higher strike put, all with the same expiration date.

Payoff calculations at expiration are performed for each position, and the combined payoff determines the profit structure. The Excel sheet shows the net payoffs at different stock prices, illustrating the characteristic butterfly shape.

Problem 3(a-d) (Chapter 24): Performance of a Closed-End Fund

Calculations include the investor's total return from buying at initial NAV, considering premiums or discounts, and selling at the end of the period. The growth rate of NAV is derived by solving the compound interest formula.

For the second investor, the focusing is on the return from the end-of-Period 1 to end-of-Period 2, including discounts and premiums. These are calculated using percentage changes in NAV and considering the timing of distributions.

Problem 6(a-b): Mutual Fund Returns and Tax Implications

The total return combines capital appreciation and distributions. For a tax-advantaged retirement account, taxes are deferred, and the total is simply the percentage increase. In taxable accounts, taxes reduce realized gains according to tax brackets, reducing net returns.

Reinvestment calculations are performed by dividing the distribution by the end-of-year NAV to determine the quantity of additional shares purchased, modeled in Excel formulas.

Problem 8(a-c): Fee Structures and Investment Horizon

Different fee schemes impact long-term investments. For each, formulas compute the future value of an initial investment over specified periods, including deductibles. For longer horizons, the cumulative effect of fees increases, favoring schemes with lower and deferred fees.

Excel models simulate the growth of $100,000 in each scheme over 3 and 10 years, demonstrating the impact of timing and fee structure on final wealth.

Problem 10(a-c): Portfolio Evaluation for the Muellers

The analysis reviews the diversification and risk profile based on sector, beta values, and asset types. Calculations include weighted averages of beta origins, assessments of sector diversification, and asset class allocation relative to the overall portfolio, informing on the portfolio's risk-return tradeoff and stability.

References

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  • Johnson, H., & Gibbons, M. (2019). Portfolio Management in Practice. CFA Institute Publications.
  • Tracy, J. (2017). Understanding the Greek Letters of Options. Financial Analysts Journal, 73(4), 50–62.
  • Merton, R. C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, 4(1), 141–183.
  • Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th ed.). McGraw-Hill Education.
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  • Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(3), 341–360.
  • Lee, S., & Patrick, C. (2020). Derivatives and Risk Management. Wiley Finance.

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