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Consider a forex debt covered by a call currency option; show graphically how this limits

the damage created by high exchange rates, without eliminating the potential of gains from low rates. 2. Briefly explain the dynamic asset allocation strategy of insuring the portfolio. Explain how time-variant delta can hedge the riskiness of the portfolio. 3. An investor believes that there will be a big jump in a stock price, but is uncertain as to the direction. Identify four different strategies the investor can follow and explain the differences among them. 4. What is implied volatility? It is often argued forward discount is the cost of hedging. Explain the fallacy behind this statement.
5. How do we measure the impact of credit shock and equity price shock on the CAR of a

6. In the case of investment assets, the future price is greater than the spot prices by an

amount reflecting the cost of carry. Explain the statement in terms of the following cost of carry model for an investment asset. Fo= SoacT 7. Give two reasons why the early exercise of an American call option on a non-dividend paying stock is not optimal? 8. The forward rate is the time t certainty equivalent of the future date- elucidate?
9. Where should forward rate be used in corporate financial management?

10. How can a forward purchase be represented by pay-off profiles of buy call and sell put options at expiration? 11. Explain why a bank is subject to credit risk when it enters into two offsetting swap contracts?

Explain carefully the difference between the Hedging, speculation and arbitrage.

Answer: Hedging is making an investment to reduce the risk of adverse price movements by taking an offsetting position in a related security. Hedging is used to reduce any substantial losses suffered by an individual or an organization. Speculation is the act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price from different markets. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. Options and futures are zero sum games. What do u think is meant by this statement?

Answer: Zero sum game means the profit of one party is equal to the loss of another party or every winner there is someone who loses an equal amount. Each futures or options contact requires two counterparties to the trade: long and short. In other words, for futures contracts to materialize there needs to be one buyer matched with one seller at a specific point in time, dealing in certain asset, at certain delivery point. For options, a writer has to sell their contract onto a holder, who purchases the option. Again, the deliverable is specified and strike price established. Futures contracts are marked-to-market daily, so that profit and loss on each position is calculated and added or remover from traders account. Therefore, one point gain on long position will equal one point loss on equivalent short position. The short pays long the daily difference in contract price changes via central counterparty. Reverse applies when prices go down, then short gains and long loses money; however, the difference will always be zero. The gain or loss to the party with a short position in an option is always equal to the loss or gain to the party with the long position. The sum of the gains is zero.

Explain how margins in futures protect traders against the possibility of default?

Answer: A margin is a sum of money deposited by an investor with his or her broker. It acts as a guarantee that the investor can cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level, the investor is required to deposit a further margin. This system makes it unlikely that the investor will default. A similar system of margins makes it unlikely that the investors broker will default on the contract it has with the clearinghouse member and unlikely that the clearinghouse member will default with clearinghouse.

Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to trade on a future exchange. Discuss the viewpoint.


Speculation can cause major shocks in the markets, where traders enter large bets based on their view of the future markets trends. This can lead to some outstanding gains; however, more often this is just a pure luck, which every gambler knows cannot be sustained for extended periods. Speculators assume price variability risk, thus making the transfer possible in exchange for the potential to gain. The interaction between speculators and hedgers is what makes the futures markets efficient. This efficiency and the accuracy of the supply-and-demand equation increase as the underlying contract gets closer to expiration and more information about what the marketplace requires at the time of delivery becomes available.

What are VAR and Stress testing? Why do we need stress testing in banks?

Answer: VAR or value at risk is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. Stress testing is a simulation technique used to determine the reactions of the different financial institutions under a set of exponential, but plausible assumptions through a series of battery of tests. It is an important risk management tool used by the FIs as a part of internal risk management to alert management to adverse unexpected outcomes related to variety of risks and provides an indication of how much vulnerable the liquidity position might be if large shocks occur. An analysis conducted under unfavorable economic scenarios which are designed to determine whether a bank has enough capital to withstand the impact of adverse developments. Stress tests can either be carried out internally by banks as part of their own risk management, or by supervisory authorities as part of their regulatory oversight of the banking sector. These tests are meant to detect weak spots in the banking system at an early stage, so that preventive action can be taken by the banks and regulators.

When is it appropriate for a trader to purchase a butterfly spread?


A butterfly spread involves a position in options with three different strike prices (k1, k2, k3). Butterfly spread leads to profit if the stock price stays close to k2 but gives rise to a small loss if there is a significant stock price movement in either direction. A butterfly spread should be purchased when the investor considers that the price of the underlying stock is likely to stay close to the central strike price k2.

If there is no basis risk, the minimum variance hedge ratio is always 1.0- Is this statement true? Explain your answer.

Answer: The statement is true. If the hedge ratio is 1.0, the hedger locks in a price of Fl + b2 . Since both Fl and b2 are known this has a variance of zero and must be the best hedge.

Why is a generalized wiener process not appropriate for stocks?

Answer: Generalized wiener process not appropriate for stocks because:

The price of a stock never falls below zero.

For a stock price we can conjecture that its expected percentage change in a short period of time remains constant, not its expected absolute change in a short period of time
We can also conjecture that our uncertainty as to the size of future stock price movements

is proportional to the level of the stock price.

Explain the no arbitrage and risk neutral valuation approach to valuing a European option using one-step binominal tree.

Answer: In the no-arbitrage approach, we set up a riskless portfolio consisting of a position in the option and a position in the stock. By setting the return on the portfolio equal to the risk-free interest

rate, we are able to value the option. In the risk-neutral valuation approach, we first choose probabilities for the branches of the tree so that the expected return on the stock equals the riskfree interest rate. We then value the option by calculating its expected payoff and discounting this expected payoff at the risk-free interest rate.

Give an intuitive explanation of why the early exercise of an American put becomes more attractive as the risk free interest rate increases and volatility decreases.

Answer: The advantage of early exercise is that a payoff is received now instead of at maturity. This advantage becomes larger if the risk-free rate is larger. A disadvantage of early exercise is that one does not profit from further decreases in the stock price. This is less likely if volatility is low. In the extreme case, if volatility approaches zero, it is always optimal to exercise immediately if the option is in the money.

A bank finds that its assets are not matched with liabilities. It is taking floating rate deposits and making fixed rate loan. How can swaps be used to offset the risk?

Answer: The bank is paying a floating-rate on the deposits and receiving a fixed-rate on the 1oans. It can offset its risk by entering into interest rate swaps (with other financia1 institutions or corporations) in which it contracts to pay at fixed rate and receive at floating rate.

What does it mean to asset that the delta of a call option is o.65? how can a short position in 1,000 call options be made delta neutral when the delta of each option is 0.65


A delta of .65 means that, when the price of the stock increases by a small amount, the price of the option increases by 65% of this amount. Similarly, when the price of the stock decreases by a small amount, the price of the option decreases by 65% of this amount. A short position of 1,000 options has a delta of -650 and can be made delta neutral with the purchase of 700 shares.