Case Studies in Financial Engineering

Case 8





TURBO EXTRA




















July 2012
2

TURBO EXTRA


Suppose you were selected by the board of Extra Bank to manage a portfolio of
warrants on the Dow J ones Eurostoxx 50 index.

Extra Bank issued on the 28th Sept.2007 a series of 3 million plain vanilla call warrants
with a 9-month maturity and a series of 5 million plain vanilla put warrants with a 15-
month maturity. On the 26th J une 2009, the board decided to issue two series of turbo
warrants expiring 6 months after. These turbo warrants are barrier options, being one of
the series a call up-and-in and the other a put down-and-out.

The warrants issued are detailed in the next table:

Series
Issuance
date
Quantity Expiry Date
Strike
Price
Barrier
/ Index
figure

Warrants
J un 2008
call 28-09-2007 3.000.000 27-06-2008 4.700 - 10
Warrants
Dec 2008
put 28-09-2007 5.000.000 29-12-2008 4.300 - 10
Turbo
Warrants
Dec 2009
call up and
in 26-06-2009 5.000.000 30-12-2009 2.700 3000 10
Turbo
Warrants
Dec 2009
put down
and out 26-06-2009 2.000.000 30-12-2009 2.500 2200 10

Note: consider the parity of the warrants as 0,01.

ISIN code of the DJ Eurostoxx 50 - EU0009658145SX5E; Datastream mnemonic:
DJ ES50I (more details on the DJ Eurostoxx 50 in http://www.stoxx.com)

Please answer to the following questions, considering the information provided:

1) What should be the issuance price of the plain vanilla warrants? To
estimate the future volatility use the model GARCH (1,1), considering
the returns in the last 30 trading days, or an adequate alternative. In order
to value the plain vanilla warrants use the Black-Scholes model.

2) With the purpose of hedging the risk of the plain vanilla warrants
portfolio, assume you decide to open a position in the futures contracts
on the Dow J ones Eurostoxx 50 expiring at J une 2008. Determine the
position to open in these futures contracts on the 28th Sept. 2007, aiming
at minimising the portfolio risk, using a delta hedging strategy for each
3
series of plain vanilla warrants (consider the Black-Scholes model in the
pricing of warrants).

3) What was the behaviour of the hedging portfolio considered in the
previous question (just for the plain vanilla warrants) between 28 Sept
2007 and 12 May 2008? Calculate the number of futures contracts used
to keep hedging positions opened. Proceed also with the cash portfolio
required for the margin account and its daily adjustments, adopting the
necessary assumptions.

4) Regarding the Turbo Warrants portfolio, propose the pricing of these
options on the issuance date (26 J une 2009), by using a closed formula
model (e.g. a Black-Scholes type model for barrier options).

5) In order to hedge the risk of the turbo warrants portfolio, consider that
you decide to open positions in futures contracts on the Dow J ones
Eurostoxx 50 index, expiring at Dec.2009. What would be the size of the
position to be opened on the 26
th
J une 2009, in order to minimise the
portfolio risk by using a delta hedging strategy for each series of Turbo
warrants. Discuss the performance of this hedging portfolio between 26
J un.2009 and 6 Nov.2009.

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APPENDIX


Dow J ones EURO STOXX 50 futures

Exchange Eurex

Settlement Cash settled

Trade Unit 10 multiplied by the value of the index

Point Value 10

Tick Value 10

Contract Months: Up to 9 months: The three nearest quarterly months of the March,
J une, September and December cycle.

Last Trading Day: Last Trading Day is the Final Settlement Day, which is the third
Friday of each maturity month if this is an exchange day; otherwise the exchange day
immediately preceding that day. Close of trading in the maturing futures on the Last
Trading Day is at the Beginning of the Xetraintraday auction starting at 12:00 CET.

Trading Hours: 7:50 am CET to 22:00 (10:00 pm) CET, except on last trading day,
when trading ends at 12:30 pm CET (Eurex operates in three trading phases: pre-
trading, trading and post-trading. The post-trading phase is further split in several
periods where different functions are available. Pre-trading begins at 7:30 am CET, and
post-trading ends at 22:30 (10:30 pm) CET, except on the last trading day, when trading
ends at 12:00 CET)

Ticker Symbol: FESX