Equity-linked note -- Chapter 04 – Quiz - YouTube

This final chapter, Chapter 4, contains 4 quiz questions to test your understanding

of the materials covered in this module.

With regard to the quiz, you should allow yourself about 30 minutes in total to complete

these questions.

Unless instructed otherwise, you should work with the same data as we have done throughout

the module, regarding stock price, volatility, interest rates, etc.

Each question is a multiple choice question with four possible answers.

You should click the PAUSE button while you are searching for the answer.

Answers and a discussion are provided after each question.

Question 1

The solution to Qn 1 appears on your worksheet Q1 Solution.

First of all, the price of a 3% 5-year bond appears in Cell E27 and amounts to $86.40.

The 300% participation rate, appearing in the Redemption formula , suggests that the

investor has bought 3 calls with a strike this time of 70, a number that also appears

in the redemption formula, but also has sold 3 calls at a higher strike given that there

is a cap of $172 under the redemption formula; 100 of that cap comes presumably from the

bond, so that the component representing the maximum payoff under the option combinations

is $72, which we divide by 3 to obtain $24.

We know that this $24 must represent the difference between the strike of the calls purchased

at 70, and the higher strike calls, which the investor has sold; this leads to the conclusion

that the strike of the calls sold must be 94.

The pricing grid indicates that the calls struck

at 70 cost $16.15 each, while calls struck at 94, which the investor is selling, earn

the investor $11.67 each, resulting in the call spreads from 70 to 94 costing the difference

between those two premia, that is to say $4.48.

Therefore, excluding the dealer profits, the package in total costs 86.40 for the bond,

plus 3 times the $4.48 premium for each call spread, a number which comes to $99.84.

This leaves 16 cents for the dealer profit, and therefore, the answer to this question

is (b).

Question 2

The solution to Question 2 appears on this Worksheet, Q2 Solution.

Since under the redemption formula, the investor collects the Contingent Payment if MSFT has

either risen or fallen by a certain amount, it follows that the investor has purchased

both calls and puts on MSFT, with strikes presumably of 130 for the calls, and 70 for

the puts.

The Worksheet shows the prices for these two options, with the call Cell E20-H20 costing

$9.75, while the put Cells E8, I8 costs only 0.79. and the vol to 20% if you are reproducing

this example in your own WS.]

The 150% factor in the redemption formula indicates that the investor has bought 1.5

units of each option.

Thus the total cost of all options purchased is $15.81, as indicated on this Row 22.

The principal protection requires the purchase of a 3-year bond, but this time carrying a

zero-coupon.

This is worth 83.37 as indicated in Cell E28.

Thus the fair value of the total package is 99.18, and therefore the correct answer

is (a).

Question 3

Solution to Qn 3 Hopefully you were able to realize that the

investor here, far from purchasing a call option, in fact has sold a put option.

The fact she has sold an option is hinted at by the unusually high coupon, which is

well above the 6.25% she would earn on a 1-year bank deposit.

The fact the option is a put is best recognized from observing that the issuer has the ability

to deliver shares instead of cash at maturity, a privilege the issuer would presumably exercise

if the share price has fallen below a certain level.

Specifically, the issuer would prefer to deliver 2 shares instead of $100 in cash if each share

is worth less than $50 at maturity; so the issuer appears to have bought, and the investor

appears to have sold, 2 puts on MSFT with a strike of $50.

The diagram you see here shows the equivalent values of the bargain struck by the two parties:

the investor has handed over $100 in cash, plus the two put options, in return for receiving

a note promising 117 dollars at maturity.

The PV of this note is reached by discounting the $117 at the 6.25% discount rate applicable

to the bank.

This comes to $110.12, as indicated in this bubble on the right; in turn this means that

each put is worth 110.12, minus 100, divided by 2, equals $5.06.

You should be able to confirm via Goal Seek and the Option Pricing worksheet used previously

that this is consistent with a volatility of 32%.

Thus the correct answer is (d).

Question 4

Q4 Solution, which is identical to Worksheet Greeks used previously, enables us to seek

the answer to this question 4.

The diminution in interest rates, modeled on Cells B143 to B133, increases the value

of the Bond , but reduces the value of the Option , since the forward price diminishes

along with the drop in interest rates.

Our discussion earlier showed that the Bond effect dominates the Option effect, so that

the ELN rises in value when rates diminish.

Turning to the passage of time: early in the life of the ELN, i.e. in Cells B208 to B204,

this passage of time also increases the value of the Bond ,

and reduces the value of the Option , due to time decay.

Our discussion earlier showed that, at least during those early quarters in the life of

the ELN, the Bond effect dominates by a small margin, so that the ELN rises in value when

time passes.

Thus both effects benefit the ELN’s value, and so the answer is (a).

This completes the quiz, and this entire module on the Equity-linked note.