McGill Desautels

Daniel Andrei, Financial Derivatives FINE 448, Winter 2022

Assignment #1

Due date: Thursday, Feb. 17, 5pm

This is an open book group assignment. While you are not allowed to copy from
different groups, you are encouraged to discuss conceptual problems with all your
colleagues.
No late assignments will be accepted, no exceptions. Please send the assignment
by email (PDF file) to [email protected] and [email protected].
Make sure your answers are clear and legible. Write down clearly the names of all
group members on the assignment. No need to send your codes.
Any appeal to your grade must be submitted in writing no later than one week
after the grades have been announced. A request for a re-grade will result in a full
second evaluation of all questions. The new outcome may be higher, the same, or
lower than the initial grade. For clarification questions about the assignment, please
consult with Nan Ma, the T.A. of the class. Alternatively, you can consult with me
during office hours.
No more questions will be answered 36 hours before the submission
deadline. Good luck!

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1 Equity Index Futures

a. Find information online about the NYSE FANG+ Index and answer. How is it
calculated? What are the current constituents of the index? What does FANG
represent? What is the difference between FANG and FANG+? Note that there
are two common versions of the index: price index (or price return index) and
total return index. What is the difference between these two versions?

b. Check the contract specifications of NYSE FANG+ Index futures on the web-
sites of the Intercontinental Exchange (ICE) and answer. What is the contract
size? How is the price quoted? What is the tick size? When was the last trad-
ing day for the September 2018 contract? Is there a daily price limit for this
contract? How is the contract settled? What is the final settlement price? Is it
based on the price index or the total return index?

c. Table 1 shows the daily settlement price, trading volume, and open interest
of September 2018 NYSE FANG+ Index futures between 23 July 2018 and 1
August 2018. What is the relation between daily trading volume and open
interest? Is it possible that the daily trading volume exceeds open interest?
What does this imply about the liquidity of the futures contract?

Table 1: Daily market data of September 2018 FANG+ Index futures and your ac-
count.
Date Settlement Volume Open interest P&L ($) Margin account ($) Margin call ($)
2018-07-23 2,936.9 1,873 1,274 -
2018-07-24 2,942.4 4,774 1,433 825
2018-07-25 3,012.6 2,879 1,424
2018-07-26 2,925.5 2,307 1,456
2018-07-27 2,822.3 1,911 1,435
2018-07-30 2,741.8 1,687 1,468
2018-07-31 2,755.4 1,851 1,468
2018-08-01 2,757.2 1,184 1,301
Source: Bloomberg

Alicia, an expert in computer science, is optimistic about the future development

of the high-tech industry. After some investigations about the financial market, she
decides to trade the NYSE FANG+ Index futures.

d. On 23 July 2018, Alicia takes a position in the September 2018 contract at the
settlement price and her profit and loss (P&L) on the next day is shown in the
table. How many contracts does she purchase or sell short? Does the clearing
house have a long or a short position corresponding to her trade? Assume that
the current maintenance margin of the September 2018 NYSE FANG+ Index
futures contract is $7, 574 per contract and that the initial margin for her is

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 10% more than her maintenance margin. What are the initial and maintenance
margin requirements for her position?

e. Alicia initially deposits an amount equal to her initial margin requirement in her
margin account when she opens the position and she will not add extra cash into
her margin account unless she has to. Complete the three columns of Table 1 in
blank: daily P&L, margin account balance right after daily settlement (prior to
margin call), and the variation margin if a margin call is received. How many
margin calls does Alicia receive?

f. Note that there was a large drop in the futures price (as well as the index level)
starting from July 25. What event triggered this plunge in FANG+ stocks?

g. Calculate the return on capital (ROC) of Alicia’s position between July 24 and
August 1. ROC is defined as the P&L divided by the amount of total investment
(ignoring the time value of money and opportunity cost for simplicity).

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 2 Exotic Options: The Log Contract
A log contract is an important building block in volatility derivatives and in the
calculation of the VIX. As you will see later during this course, the log contract allows
you to achieve pure exposure to fluctuations in volatility.
The payoff from a log contract at maturity T is simply the natural logarithm of the
underlying asset divided by the strike price, ln(ST /K). The payoff is thus nonlinear
and has many similarities with options. The value of this contract at time t = 0 for
a non-dividend paying asset is
     
−rT S0 1 2
L0 = e ln + r− σ T . (1)
K 2

In this exercise, you will find the price of a log contract using a binomial model.
We will consider a log contract that pays LT = 1000 ln(ST /K) (which is equivalent
with 1000 individual log contracts). Report answers with 4 decimal digits.
Consider the following inputs for a non-dividend paying stock

• The initial stock price S0

• The payoff function LT = 1000 ln(ST /K)

• The interest rate r

• The length of the period h

• The up and down factors u and d

• The number of periods n

a. Compute √the initial value

√ of a log contract with n = 4, r = 0.05, h = 1,
rh+σ h rh−σ h
u=e ,d=e , S0 = 100, σ = 0.3, and strike K = 90.
Show in a table the values of the log contract on all nodes of the tree. What is
the replicating portfolio at time 0?
What is the difference between the closed-form price (use Eq. (1)) and the initial
value of the log contract that you found above?

b. Compute the initial value of a log contract with n = 48, r = 0.05, h = 1/12,
√ √
u = erh+σ h , d = erh−σ h , S0 = 100, σ = 0.3, and strike K = 90. (I have
underlined the parameters that are different from the previous point.)
What is the replicating portfolio at time 0?
What is the difference between the closed-form price (use Eq. (1)) and the initial
value of the log contract that you found above?

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 3 Exotic Options: Asian Options
An Asian option is an option on the average price of the underlying asset. One
particular application of Asian options is hedging exchange rate risk. Asian options
are also popular in the energy OTC market and many commodity markets. Further-
more, because an Asian option is based on a price average, an attempt to manipulate
the asset price just before expiration will normally have little effect or no effect on
the option’s value. Asian options should therefore be of particular interest in markets
for thinly traded assets.
Consider the case of an Asian call option with discrete arithmetic averaging. An
option with maturity of T years and strike K has the payoff
( n )
1X
max S(ti ) − K, 0 (2)
n i=1

where ti = i × h and h = T /n. Notice that we do not include in the summation the
price of the asset today, i.e. S(t0 ).
Furthermore, assume S(t0 ) = 200, r = 0.02, σ = 0.20, K = 220, T = 1, n = 365.

a. Use Monte Carlo simulation to obtain one price path starting from S(t0 ) = 200
to S(tn ). To simulate the process, consider its values at each step:
√
  
1 2
S(ti+1 ) = S(ti ) exp r − σ ∆t + σ ∆tt (3)
2
where ∆t = T /n is the time interval, r and σ are given above, and t is a random
value drawn from a standard normal distribution.
Plot the resulting price path.
b. Build a second plot that has two lines:
(i) The price path from the previous point
(ii) The arithmetic average of the price path at each point in time ti , starting
from S(t0 ). That is, your second line on the plot should be:
Pn
S(t1 ) S(t1 ) + S(t2 ) S(t1 ) + S(t2 ) + S(t3 ) S(ti )
S(t0 ), , , , · · · i=1 (4)
1 2 3 n
What do you observe? Do you think the price of the Asian option should be
lower, equal, or higher compared with a similar standard option? Why?
c. Price the option by Monte Carlo simulation using 100 paths. Compute the price
of the option on each path with the formula
( n )
1 X
C0A = e−rT × max S(ti ) − K, 0 (5)
n i=1

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 What is the average of C0A over the 100 simulated prices? State the 95 percent
confidence interval of this average. (For this last question, you might need
to revisit statistical notions like “standard error of the mean” and “confidence
interval”).

d. Redo the previous point, but now with 100,000 paths. Compare the confidence
interval obtained in this case with the confidence interval from the previous
point.