N1559 Financial Derivatives 1. Accelerated Return Notes provide payoffs at maturity that depend on the value of an under lying stock and the notional N.Assume the stock pays no dividends.If the ending value of the underlying is below or at the starting value the note will pay starting value If the ending value is greater than the starting value then the payoff is given by starting value (a) Draw the payoff diagram for the Accelerated Return Note and explain the payoff profile in your own words. Use a notional of N=100 and an initial value of the underlying of 550. The maturity of the note is in one year. [8marks] (b If the only options traded on the underlying are European calls,how would you replicate the payoff? [6marks] c How would you replicate the note if only European puts were available? [4marks] d Now assume that the underlying stock has a volatility of 35% and the (continuously compounded risk-free rate is given by r=1%. What is the price of the note in the Black-Scholes-Merton model? [4marks] (e) Note: If you need values for any other parameters to answer the questions below, make reasonable assumptions and justify these. Simulate the payoff of the Accelerated Return Note in the Black-Scholes-Merton model. Use at least 10.000 simulations of the stock price. What is the average return of investing in the note, as well as the standard deviation of the returns [15marks] Page 2of 4 /Turn over N1559 Financial Derivatives f) Using your simulation output, is it more risky to invest into the note than to invest into the stock itself? Justify your answer using your simulation output. [4marks] g Using your simulation output.what is the probability that the return of the note is 20% 2of4 [4marks]