You are an investment banker sold a 3-year principal protected note tied to the S&P500...
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You are an investment banker sold a 3-year principal protected note tied to the S&P500 index point. The client who purchased the note for 3,000 will receive the S&P 500 index point in 3 years if the index finishes above 3,000 or 3,000 if the index finishes below 3,000. Suppose that the S&P500 index is at 3,000 and its volatility is 15%. The 3-year risk- free interest rate is 2% per annum with continuous compounding. Assume that S&P 500 pays a dividend yield of 2% per year. How should you hedge (or reproduce) the sold principal protected note and what would be the cost? Did you underprice, overprice, or correctly price the note? If you mispriced the note, by how much?
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