CED 6250: Derivatives and Alternative Investments

Test #2

Directions:

Please follow the directions in each section.

Part 1: Theory (10 points)

Select 10 of the 12 (1 point each).  Each of the following questions has the same point value; therefore, choosing question #2 vs #4 will not make any differences in the final points.

1) Why does the value of a put option decrease when the risk-free rate rises?

2) Why should you not exercise an American Call early?

3) Why is the Black Scholes model often criticized?

4) Why are hedge funds only available to sophisticated investors?

5) What is survivorship bias and why should we be concerned about it?

6) What is the goal or target of an active investor?

7) Why should returns be risk adjusted?

8) What is a fund of funds and why would an investor invest in it?

9) You are debating between investing in a hedge fund or a mutual fund; however, you know that you are an impulsive buyer and may need money at a moment’s notice. Which would you prefer?

10) Explain merger arbitrage.

11) Why is getting out or exiting such an important concept in the private equity world?

12) You want to invest in commodities, but do not want to own a precious metal or barrel of oil. What do you do?  

Part 2: Mathematics (10 points)

Please answer all the following questions.  All questions are worth 1 point unless marked.  

1) Using the Black-Scholes model and the following information, calculate the call option value (2 points):

a. Spot=45

b. Strike=40

c. Volatility=0.30

d. Risk free rate=3%

e. Time to Maturity=5 years

2) The up ratio, u, is 1.25 while the down ratio, d, is 0.80.  The risk-free rate is 4%. Assuming a spot price of 60 and a strike price of 55, how many shares must be purchased to hedge a short put?

3) Given the following, what is the cost of a put value:

a. Call value=5.25

b. Strike=75

c. Spot=82.50

d. Risk free rate (continuous)=4%

4) Company A has return of 11% and a volatility of 0.22. Company B has return of 13% and a volatility of 0.35.  If you are concerned about risk, which fund do you invest in and why? (2 points)

5) You are a general partner, and you had a great year.  You made a 17% return on a fund of 500 million USD.  Your fund uses a 2 and 20 strategy with a 14% hurdle rate. Calculate the fee you will make.

6) You are pricing a commodity future with a spot price of $120 with storage costs of $12 and a convenience yield of $4.80.  The risk-free rate is 4.25%.  What is the futures price?

7) Calculate the downside volatility of the following returns where the baseline hurdle rate is 3% (2 points):