A building society issues a one-year bond that entitles the holder to the return on a...

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A building society issues a one-year bond that entitles the holder to the return on a weighted-average share index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to the end of the year. (i) Explain how the building society can use a combination of call and put options to prevent making a loss on these bonds. [4] (i) The volatility of the ABC500 index is 30% pa and the continuously- compounded risk-free rate of return is 4% pa. Assuming no dividends, use the Black-Scholes pricing formulae to determine the value of x (to the nearest 1%) that the building society should choose to make neither a profit nor a loss. [6] [Total 10] A building society issues a one-year bond that entitles the holder to the return on a weighted-average share index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to the end of the year. (i) Explain how the building society can use a combination of call and put options to prevent making a loss on these bonds. [4] (i) The volatility of the ABC500 index is 30% pa and the continuously- compounded risk-free rate of return is 4% pa. Assuming no dividends, use the Black-Scholes pricing formulae to determine the value of x (to the nearest 1%) that the building society should choose to make neither a profit nor a loss. [6] [Total 10]

Answer rating: 100% (QA)

SOLUTION i To prevent making a loss on these bonds the building society can use a combination of call and put options to hedge against potential losses The bond guarantees a minimum level of return so ... View the full answer