Question Paper

Financial Risk Management – I (231) : October 2005

Section A : Basic Concepts (30 Marks)
• • This section consists of questions with serial number 1 - 30.
• • Answer all questions.
• • Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

< Answer
1. The risk-management process follows a series of logical steps to arrive at a result. These involve >
initially identifying the risks facing the firm. Which of the following represents the major difficulty that
arises in this identification process?
(a) There are insufficient data for the analysis
(b) Risks are ignored because they are seen as unimportant
(c) There is no consensus over which risks are to be included
(d) Some factors are included which are not risks
(e) Insufficient knowledge about available hedging instruments.
< Answer
2. An investor buys 100 shares of a stock at Rs.22 and buys a December 20 put at Re.1. This person’s >
maximum loss is
(a) Rs.300 (b) Rs.500 (c) Rs.1,500 (d) Rs.1,900 (e) Rs.2,000.
< Answer
3. It costs Rs. 1000/kg. p.a. to store platinum. The payment is to be made after every 3 months. If the spot >
rate is Rs. 1,20,000/kg and the risk-free rate of return is 10%, what should be the price of a three-month
futures contract for 1 kg of platinum?
(a) Rs. 1,16,750 (b) Rs. 1,20,000 (c) Rs. 1,23,250 (d) Rs. 1,28,070 (e) Rs. 1,32,000.
< Answer
4. If the time to expiration decreases, what will be the effect on the American call option premium and on >
the put option premium?
(a) Call option premium increases and put option premium decreases
(b) Call option premium decreases and put option premium increases
(c) Both call option premium and put option premium will increase
(d) Both call option premium and put option premium will decrease
(e) No change in the premiums at all.
< Answer
5. The strategy followed by the banks of entering into a swap with a party and hedging the interest rate >
risk till a counterparty is found is known as
(a) Arbitraging (b) Hedging (c) Warehousing
(d) Speculating (e) Swapping.
< Answer
6. An option has an intrinsic value of Rs.1.45 when the underlying asset price is Rs.35.00. However, this >
intrinsic value had completely disappeared when the asset price settled at Rs.42.00 the next day. This
position must be
(a) A call option with an exercise price of Rs.36.45
(b) A call option with an exercise price of Rs.33.55
(c) A put option with an exercise price of Rs.33.55
(d) A call option with an exercise price of Rs.34.45
(e) A put option with an exercise price of Rs.36.45.
< Answer
7. The discount yield on a 90 day T-bill futures of size $ 1,000,000 traded on 1MM at $992,420 is >
 (a) 2.95% (b) 3.03% (c) 3.06% (d) 3.20% (e) 3.25%.
< Answer
8. Combination of two fixed-floating currency swaps to form a fixed to fixed currency swap is called >
(a) Extendible swap (b) Forward swap (c) Vanilla swap
(d) Roller-coaster swap (e) Circus swap.
< Answer
9. Minimum price change allowed in the value of a stock futures index is 0.05. Lot size of the futures >
contract is 200. What is the tick size?
(a) Rs. 1.0 (b) Rs. 5.0 (c) Rs. 10.0 (d) Rs. 20.0 (e) Rs. 100.0.
< Answer
10. Which of the following is true about a callable swap? >
(a) The fixed rate payer has the right to terminate the swap at any time before its maturity
(b) Both fixed rate payer and receiver have right to terminate the swap at any time before its maturity
(c) The fixed rate receiver has the right to terminate the swap at any time before its maturity
(d) Both fixed rate payer and receiver have right to extend the swap beyond maturity
(e) The fixed rate payer has the right to extend the swap beyond maturity.
< Answer
11. Six months ago, an investor bought 100 shares of XYZ at Rs.38. Today the stock sells for Rs.47. The >
investor now writes an Rs.50 covered call at a premium of Rs.1.15. The most this person can lose of
their original investment is
(a) Rs.0 (b) Rs.1.15 (c) Rs.36.85 (d) Rs.39.15 (e) Rs.45.85.
< Answer
12. A Rs.5 million stock portfolio has a beta of 1.10 at a time when the BSE Sensex stands at 6400. You >
write 16 JUN BSE 6500 calls at a premium of Rs.50 each. At option expiration in June, the BSE Sensex
is 6520. What is the value of the total portfolio after option expiration? (Assume the lot size = 50)
(a) Rs.5,127,150 (b) Rs.5,125,250 (c) Rs.5,129,150
(d) Rs.5,130,850 (e) Rs.5,132,450.
< Answer
13. Which of the following equations is true? >
(a) Short underlying asset + long put = short call
(b) Long underlying asset + long call = short put
(c) Short underlying asset + long put = long call
(d) Short underlying asset + long call = long put
(e) Long underlying asset + short call = long put.
< Answer
14. Calculate the number of Eurodollar futures contracts that would delta-hedge a portfolio of a long >
position in swaps with a delta of $5,000 and a long position in a put option with a delta of -$2,300.
(a) Long 292 contracts (b) Short 108 contracts (c) Short 292 contracts
(d) Long 200 contracts (e) Long 108 contracts.
< Answer
15. Which of the following statements about stack hedging is false? >
(a) It is used by investors who would like to ensure the surety of their earnings for longer period of
time
(b) It implies buying various futures contracts, with different delivery dates
(c) Basis risk is more in this strategy
(d) Liquidity position is very good
(e) Both (c) and (d) above.
< Answer
16. Which of the following is not correct with respect to value at risk (VaR)? >
(a) VaR is important in identifying the effects caused by substantial future movements to the value of
the portfolio
(b) VaR relies on simplified assumptions which may not be applicable in complex situations
(c) The distribution of values need not be normal distribution for using VaR
(d) VaR is basically a statistical measure and not a managerial one
(e) VaR cannot measure accurately in extreme market conditions.
 < Answer
17. If you buy 100 shares of TTK at Rs.79 and simultaneously write a DEC 80 straddle for Rs.6. The break- >
even point and maximum gain from the strategy will be
(a) Rs.79 and Re.1 (b) Rs.80 and Rs.3 (c) Rs.78 and Rs.5
(d) Rs.76.5 and Rs.7 (e) Rs.80.5 and Rs.9.
< Answer
18. Which of the following statement about forward swaps is false? >
(a) The commencement date is set at a future date
(b) It works to the convenience of the fixed rate payer
(c) It is also termed as deferred swaps
(d) It provides the benefit from existing rate of interest
(e) It helps in locking the swap rates.
< Answer
19. Where is the fair value hedge included in FASB-133? >
(a) Current income (b) Comprehensive income
(c) Other comprehensive income (d) Comprehensive net income
(e) Current net income.
< Answer
20. XYZ Corporation sells for Rs.35 per share; the AUG option series has exactly six months until >
expiration. At the moment, the AUG 35 call sells for Rs.3 and the AUG 35 put sells for Rs.1.40. What
annual interest rate is implied in the option prices?
(a) 5.62% (b) 6.49% (c) 7.89% (d) 9.81% (e) 10.58%.
< Answer
21. Which of the following statements about Vega is false? >
(a) It declines as expiration approaches
(b) It will be highest for near the money option
(c) It tends to be zero for deep-out-of-money option
(d) Negative value indicates loss in theoretical value
(e) It is first derivative of an option price with respect to volatility of underlying stock.
< Answer
22. A portfolio has a gamma of –2400. The delta and gamma of a call option are 0.60 and 0.80 respectively. >
The position in call option that could lead to gamma neutral portfolio is
(a) Long 4000 (b) Short 4000 (c) Long 3000
(d) Short 3000 (e) Long 1920.
< Answer
23. A swap quote for US dollar interest rate swap fixed vs. LIBOR is 10/30 basis points over 3-year US T- >
bills. This quote can be interpreted as
(a) The ask rate is 20 basis points over yields on the US Treasury Bills versus LIBOR
(b) The ask rate is 10 basis points over yields on the US Treasury Bills versus LIBOR
(c) The bid rate is 30 basis points over yields on the US Treasury Bills versus LIBOR
(d) The bid rate is 20 basis points over yields on the US Treasury Bills versus LIBOR
(e) The bid rate is 10 basis points over yields on the US Treasury Bills versus LIBOR.
< Answer
24. The VaR of one asset is Rs.300 and the VaR of another asset is Rs.500. If the correlation between the >
returns from two assets is 1/15, the combined VaR is
(a) Rs.425 (b) Rs.475 (c) Rs.525 (d) Rs.575 (e) Rs.600.
< Answer
25. A financial institution lent to a borrower $10 million at an interest of 10% p.a., FI also purchased a cap >
at 10% with face value of $10 million. If the rate of interest later rises to 11% p.a., the gain/loss for the
financial institution at the end of each quarter will be
(a) $1 million (b) $0.50 million (c) $0.25 million
(d) $0.025 million (e) Zero.
< Answer
26. Derivative Financial Instruments include which of the following off-balance sheet items? >
(a) Interest only obligations (b) Mortgage-backed securities
 (c) Note issuance facilities (d) Principal only obligations (e) Indexed debt.
< Answer
27. If the standard deviation of change in spot rupee-dollar exchange rate is 10% and standard deviation of >
change in rupee-dollar futures contract is 4%. The coefficient of correlation between the returns from
spot and futures is 0.80. The minimum variance hedge-ratio for hedging through futures contract should
be
(a) 0.20 (b) 1.00 (c) 1.50 (d) 2.00 (e) 2.50.
< Answer
28. Which of the following statements is false? >
(a) If a company expects the coming days to be very cold should buy HDD index in summer
(b) If a company expects the winter to be cold in future should buy call options on CDD in summer
(c) If a company expects the coming days to be hot should sell CDD index in summer
(d) If a company expects the coming days to be very cold should sell HDD index in winter
(e) If a company expects the coming days to be hot should buy HDD index in winter.
< Answer
29. If a day’s temperature is 55º F, then heating degree days is >
(a) –10 (b) –5 (c) 0 (d) 5 (e) 10.
< Answer
30. The situation in which one party transfers its rights and duties under an insurance contract to another >
party is called
(a) Indemnity (b) Nomination (c) Assignment
(d) Insurable interest (e) Doctrine of subrogation.

END OF SECTION A
 Section B : Problems (50 Marks)
This section consists of questions with serial number 1 – 5.
Answer all questions.
Marks are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
1. The shares of Maruti Udyog Ltd. is currently traded in the market at Rs.440. Next dividend expected on the stock
in 2 months time is Rs.20. The continuously compounded interest rate term structure is flat at 4%. The European
3-month call option on Maruti with a strike price of Rs.400 is quoted at Rs.50 and the European 3-month put
option on Maruti with strike price Rs.400 is traded in the market at Rs.22.
You are required to
a. Estimate the fair value of the 3-month European put option based on the call price.
b. If you ignore transaction cost, can you take advantage of the situation? If no, justify why not. If yes, what
strategies you will adopt to book profit. Also calculate the profit earned from the strategy.
(2 + 10 = 12 marks) < Answer >
2. A European call option on NIFTY with exercise price of 1750 has remaining maturity of two months. The current
value of NIFTY is 1770, the risk-free rate is 6% p.a., and the volatility of the index is 12% p.a. The annualized
dividend yield on NIFTY during the life of the option is 2%.
You are required to calculate the value of the European call option on NIFTY.
(Lot size is 100)
(10 marks) < Answer >
3. A treasurer of an American company in September 2005 realizes that it needs to raise $25 million zero-coupon
bond in February 2006 for a period of 6-months. Zero-coupon bond of similar quality is currently yielding 4%, a
cost that the treasurer finds acceptable. The treasurer is of the view that interest rate will rise before the company
will issue the debt, hence will increase the cost of debt. So to hedge the interest rate risk the treasurer decided to
hedge the risk using March 2006 Eurodollar futures contract. March 2006, 90-day Eurodollar futures contract are
currently trading at 96.25.
You are required to
a. Explain how treasurer can hedge the risk through Eurodollar futures contract? How many futures contracts
are required to hedge?
b. If the March futures contract in February closes either at 95.75 or 96.80, calculate the cost of the bond to the
company in each case.
(4 + 6 = 10 marks) < Answer >
4. A swap bank is looking at the following expected futures prices to determine the swap rate of a five-year swap:
Payment dates T-bill futures Eurodollar futures
(Years) price ($)* price ($)*
0.5 0.9756 0.9769
1.0 0.9624 0.9658
1.5 0.9445 0.9482
2.0 0.9362 0.9495
2.5 0.9235 0.9274
3.0 0.9179 0.9202
3.5 0.9043 0.9090
4.0 0.8826 0.8863
4.5 0.8695 0.8728
5.0 0.8443 0.8487 * Present value for the
 futures price of one dollar.
You are required to determine the break-even swap rate on a five-year swap, where the bank will receive fixed
payments and pay floating rate payments.
(8 marks) < Answer >

5. Mr. Ashish has invested in 200 stocks of Cadila at Rs.240 each and 300 stocks of JISCO at Rs.360 each. The
standard deviation of stocks of Cadila and JISCO are 9% and 12% per annum respectively. The correlation of
returns from the two stocks is 0.56.
You are required to
a. Find out the standard deviation of the portfolio.
b. Find out the benefit of diversification.
c. Find out the benefit of diversification if the correlation of return between the two stocks is – 1.
d. Calculate the Value at Risk (VaR) of the portfolio for the correlation of 0.56 at 95% confidence level.
(Assume 250 trading days in a year)
(3 + 2 + 2 + 3 = 10 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 6 - 7.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.

6. Derivative instruments have gained wide popularity as risk management tools. Discuss the features that make
derivative instruments widely accepted tools for risk management.
(10 marks) < Answer >
7. “An asset or a liability must satisfy certain criteria if it is designated as a hedging item.” What are the criteria on
the basis of which an asset or a liability is designated as a hedging item? Discuss.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Financial Risk Management – I (231) : October 2005
 Section A : Basic Concepts
1. Answer : (b) < TOP >

Reason : Lack of data for analysis is a common problem in risk assessment and qualitative
approaches can be used to get round the problem. Since the identification stage involves
finding out what risks the firm is facing, all risks should be included. Including factors that
might not be risks is preferable to leaving them out. They can always be dropped later.
Ignoring risks because they are seen as unimportant is, therefore, a major difficulty. The
firm's perception of the risk may be distorted and important risks excluded from the
analysis.
2. Answer : (a) < TOP >

Reason : Initial out flow = 100 x 22 + 100 x 1 = Rs.2300.

If prices fall below Rs.20, the put will be exercised and inflow from exercising put will be
Rs.2000.
So maximum possible loss will be = 2300 – 2000 = Rs.300.
3. Answer : (c) < TOP >

Reason :Rs. 1,20,000 + interest @ 10% for 3 months on 1,20,000 + Rs. 1,000 / 4 =
Rs. 1,23,250.
4. Answer : (d) < TOP >

Reason :As the time to expiration decreases, extreme outcomes are less likely to
occur and hence the option premiums reduce.
5. Answer : (c) < TOP >

Reason :Warehousing is the name of the strategy followed by banks to hedge their
interest rate risk till a counterparty is found. It is mostly done through
financial futures.
6. Answer : (e) < TOP >

Reason :At an asset price of Rs.35.00, an intrinsic value of Rs.1.45 could either
imply that this is a call option with an exercise price of Rs.33.55 (35.00 –
1.45) or a put option with an exercise price of Rs.36.45 (35.00+1.45).
However, once we are told that at an asset price of Rs.42.00, there is no
longer any intrinsic value, then we can conclude that this is the put option
with an exercise price of Rs.36.45.
7. Answer : (b) < TOP >

1, 000, 000 − 992, 420 360

x x100%
Reason :Discount Yield = 1, 000, 000 90 = 3.03%
8. Answer : (e) < TOP >

Reason :In circus-swap two fixed-floating currency swaps are combined to form a
fixed to fixed currency swap.
9. Answer : (c) < TOP >

Reason :Tick size is minimum price fluctuation. Here the lot size is 200 and
minimum change in the value of index is 0.05. So the tick size is 200 × 0.05
= 10.0.
10. Answer : (a) < TOP >

Reason :A callable swap gives the holder, i.e. the fixed rate payer, the right to
terminate the swap at any time before its maturity. Should the interest rates
fall, the fixed rate payer exercises his right and terminates the swap since
the funds will be available at a lower rate. Hence (a) is the answer.
11. Answer : (c) < TOP >

Reason :The covered call writing strategy is useful when you expect some
appreciation in the stock prices. If the price falls below the strike price the
strategy will give loss and the maximum possible loss could be (38 – 1.15)
= Rs.36.85.
12. Answer : (a) < TOP >

Reason : The index rises by 1.875%. Therefore, the portfolio should rise by (1.10)(1.875%) =
2.063%.
Stock: Rs.5 million x 1.02063 = 5,103,150
Option premium: 16 x 50 x Rs.50 = 40,000
Cash settlement: (6500 – 6520) x 50 x 16 = (16,000)
Value of portfolio = Rs.5,127,150
13. Answer : (d) < TOP >

Reason : Protective calls and puts combines an underlying position with an option position, the
resulting position is a synthetic option as under:
Short underlying + long call = long put
Long underlying + long put = long call.
A covered write involving a position in the underlying and the option can be
used to create synthetic option as follows:
Long underlying + short call = short put
Short underlying + short put = short call.
14. Answer : (b) < TOP >

Reason :Net delta position before hedging = $5000 - $2300 = $ 2700.

Number of Eurodollar futures required = $ 2700 / ( $ 25) = 108.
So, we have to sell 108 Eurodollar futures contract to have delta of $ 2700.
15. Answer : (b) < TOP >

Reason :Stack hedging implies buying various futures contracts which are
concentrated in the nearby delivery months.
16. Answer : (c)
Reason :To apply VaR approach, we require values in normal distribution.

17. Answer : (d) < TOP >

Reason :The strategy will give profit if the prices go up.

The break-even point will be Rs.76.5 since,
Initial inflow + gain from stock +Gain from put +Gain from call
= 6 + (-2.5) + (-3.5) + 0 = 0
 Maximum profit from the strategy will be when spot price is more than
Rs.80.. Suppose spot price is Rs.82, then
6 + 3 + 0 – 2 = Rs.7.
18. Answer : (b) < TOP >

Reason :Forward swaps are different from Deferred Rate Swaps. Deffered Rate
Swaps allow the fixed rate payer to enter into a swap at any time up to a
specified future date. Forward swaps are attractive to those who do not need
funds immediately but would like to benefit from the existing interest rates.
19. Answer : (e) < TOP >

Reason :In FASB-133, fair value hedge is included in current net income.
20. Answer : (d) < TOP >

Reason :C – P = S – K/(1+R)T
3 – 1.40 = 35 – 35/(1 + R)0.5
1.60 – 35 = -35/(1 + R)0.5
33.40 = 35/(1 + R)0.5
1.0479 = (1 + R)0.5
R = 9.81%.
21. Answer : (d) < TOP >

Reason :Vega measures the sensitivity of the option premium with respect to the
volatility of the asset provided other factors determining the option premium
are constant. Vega of call and put will always be identical and positive
because all options gain value with rising volatility.
< TOP >
22. Answer : (c)
Reason :For making gamma neutral portfolio a long position in traded option is
2, 400
= 3, 000.
needed to the extent of 0.80
< TOP >
23. Answer : (e)
Reason :The given quote can be interpreted as bid rate is 10 basis points over yields
on the US Treasury Bills versus LIBOR and ask rate is 30 basis points over
yields on US Treasury Bills versus LIBOR.
24. Answer : (e) < TOP >

Reason :VaR = {3002 + 5002 + 2 x 300 x 500 x 1/15}1/2 = Rs.600.

25. Answer : (e) < TOP >

Reason : FI is the buyer of cap. If interest rate goes above the cap strike rate of 10%, then FI will be
compensated by the cap writer by the difference amount.
1
So loss on loan for each quarter = $10 × (0.11 – 0.10) × 4 = $0.025
million
Gain from cap = $0.025 million
∴ Net gain/loss = $0.025 – $0.025 = 0.
26. Answer : (c) < TOP >

Reason :Derivative Financial Instruments include only note issuance facilities from
the given alternatives.
27. Answer : (d) < TOP >

s

Reason :Minimum variance hedge ratio, H = f

0.10
= 0.80 x 0.04

= 2.0
28. Answer : (a) < TOP >

Reason :If a company expects the coming days to be very cold should sell HDD
index in winter and buy CDD index in summer.
29. Answer : (e) < TOP >

Reason :HDD = 0 or, 65°F − 55°F, whichever is higher = 10.

30. Answer : (c) < TOP >

Reason :The situation in which one party transfers its rights and duties under a
insurance contract to another party is called assignment.
 Section B : Problems

1. a) Using put-call parity, the fair value of put

option = C – SO + Xe-rt + De-rt
Where, C = Rs.50
SO = Rs.440
X = Rs.400
D = Rs.20
T = 0.25 year
T = 0.167 year
R = 0.04
 Put value = 50 – 440 + 400 e-0.04x0.25 + 20e-0.04x0.167
= 50 – 440 + 396.02 + 19.87
= Rs.25.89
b) Fair value of put option is Rs.25.89, which is greater than the market put price of Rs.22.
Hence put is under-priced and we can make arbitrage profit by adopting following strategy:
In time t = 0
Assets Cash flow
1. Buy the put option - 22.00
2. Sell the call option + 50.00
3. Buy the stock - 440.00
4. Borrow 400e-0.04x0.25 + 396.02
5. Borrow 20e-0.04x0.167 + 19.87
Net inflow at t = 0 Rr. 3.89
In time t
= 0.167
Assets Cash flow
1. Dividend received + 20
2. Repay 2nd borrowing - 20
Net cash flow 0
A time t = 0.25,
the value of the portfolio is
 Assets ST <X ST>X
1. Value of long put 400 – ST 0
2. Value of short call 0 - (ST-400)
3. Value of stock ST ST
4. Repay 1st borrowing - 400 - 400
Net cash flow 0 0
So with this
strategy we can earn profit of Rs.3.89 immediately and payoffs at the maturity are equal to
zero.
< TOP >
-qt -rt
2. The value of call option, C = SO e N(d1) – Xe N(d2)
σ2
ln(S0 / X) + (r − q + )t
2
Where, d1 = σ t

d2 = d1 −σ t
Here, S0 = 1770
X = 1750
R = 0.06
σ = 0.12
T = 0.167
q = 0.02
 1770  0.122
ln   + (0.06 − 0.02 + ) 0.167
 1750  2
d1 = 0.12 0.167
0.01136 + 0.00788 0.01924
= = 0.3927
= 0.0490 0.0490

d2 = 0.3927 – 0.0490 = 0.3437

N (d1) = N(0.39) = 0.6517
N (d2) = N(0.34) = 0.6331
C = 1770e-0.02x0.167 × 0.6517 – 1750e-0.06x0.167 × 0.6331
= 1149.66 - 1096.88
= Rs.52.78
Therefore, one contract would cost Rs.5278 (52.78x100).

< TOP >

3. a. The treasurer can hedge the risk by selling Eurodollar futures contract. The short futures
position will lead to profit if interest rate rises, which will reduce the interest outflow on
debt.
 The contract price of March futures
90
= $ 1,000,000 [1- 0.0375 × ] 360

= $ 990,625
If the company issue debt now, it can realize
25, 000, 000
0.04
1+
= 2 = $ 24,509,804
The duration of the bond is twice that of Eurodollar deposit underlying the futures contract,
hence number of futures contract to be sold
$ 24,509,804
$990, 625
= × 2 = 49.48 = 50 contracts.
b. In February, Eurodollar futures contract is at 95.75, it means yield has risen to 4.25%, so it
can issue bond at 4.50%.
25, 000, 000
0.045
1+
 Company will realize = 2
= $ 24,449,878
Gain in futures market = (96.25-95.75) × 100 × 25 × 50
= $ 62,500
Total amount realized = 24,449,878 + 62,500
= $ 24,512,378
25, 000, 000 − 24,512,378 12
x
Cost of zero-coupon bond = 24,512,378 6

= 3.98%
If Eurodollar futures contract closes at 96.80, it means that yield has taken to 3.20%, so it
can issue bond at 3.45%.
25, 000, 000
0.0345
1+
 Company will realize = 2
= $ 24,576,063
Loss in futures market = (96.80 – 96.25) x 100 x 25 x 50
= $ 68,750
Net amount realized = 24,576,063 – 68,750
= $ 24,507,313
25, 000, 000 − 24,507,313 12
x
Cost of zero-coupon bond = 24,507,313 6 = 4.02%
< TOP >
4. Let the fixed rate to be received by the bank be ‘R’, and the notional principal be ‘P’.
At the first payment date, the fixed payment is = P x R x 0.5
The present value of above payment on zero date is got by multiplying T- bill futures prices for 0.5 year payment
date i.e. P x R x 0.9756 x 0.5
 The present value of fixed leg payments =
P x R x (0.9756 x 0.5 + 0.9624 x .5 + 0.9445 x 0.5 + 0.9362 x 0.5 + 0.9235 x 0.5 + 0.9179 x 0.5 + 0.9043 x 0.5 +
0.8826 x 0.5 + 0.8695 x 0.5 + 0.8443 x 0.5)
= P x R x 4.5804
Now consider the floating side of the swap. The pattern of payments is similar to that of a floating rate bond, with
the important provision that there is no principal payment in a swap. We know that on the date when interest
rate is reset, the bond sells at par value. Hence, at time 0, the present value of floating rate payments is the notional
principal, P. But, given that there is no principal payment the present value of principal repayment to be subtracted
(alternatively it can be added to present value of fixed payments).
So, present value of floating payments is = P - P x 0.8487 = P x 0.1513
Now value of the swap at inception should be zero, hence we will equate present value of fixed payments and
present value of floating payments.
P x R x 2.71235 = P x 0.1513
or, R = 5.58%
So the bank should receive 5.58% for paying LIBOR.
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5. (a)
ρ Var(Cadila) × Var(JISCO) =
Covariance between two stocks = 0.006048
Variance of (Cadila + JISCO) = Var(Cadila) + Var(JISCO) + 2 x Covariance(Cadila, JISCO) =
0.09 2 + 0.12 2 + 2 × 0.00605 = 0.034596
Standard deviation of the portfolio = 18.60%
(b)
S.D. of Cadila + SD of JISCO + Benefits of diversification = S.D. of (Cadila + JISCO)
or, 9 + 12 + Benefits of diversification = 18.6
or, Benefits of diversification = 18.6 - 9 - 12 = -2.40%
(c)

If ρ = −1
Covariance = -0.0108
Variance of (Cadila + JISCO) = Var(Cadila) + Var(JISCO) + 2 x Covariance(Cadila, JISCO) =0.0009
Standard deviation of the portfolio = 3.00%
Benefit of diversification = 3 - 9 - 12 = -18.00%
(d)
Total investment = Rs.156000
Standard deviation = 18.60%
18.6
=
Daily volatility = 250 1.18%
VaR of the portfolio = 156000 x 0.0118 x 1.645 = Rs.3028.11.
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Section C: Applied Theory

6. There are four important features that distinguish derivatives from underlying assets and make them useful for a
 variety of purposes:
a. Relation between the values of derivatives and their underlying assets.
b. It is easier to take short position in derivatives than in other assets.
c. Exchange traded derivatives are liquid and have low transaction cost.
d. It is possible to construct portfolio which is exactly needed, without having the underlying assets.
a. Relation between the values of derivatives and their underlying assets: When the values of underlying
assets change, so do the values of derivatives based on them. For some derivative instruments such as swaps
and futures, the relation between the underlying assets and the instrument is straight forward i.e. if the
product price changes the instrument price also changes. In a currency future contract, the price to be paid
when the currency delivered will be fixed by the future contract, the value of the currency delivered will
fluctuate depending on the movements of the underling currency. Thus, the value of the future contract
depends on the value of the underlying currency. The relation between values of the underlying asset and
option are more complicated, but the values of the option and underlying assets are still be related. Due to
this unique quality the derivatives appear similar to real commodities for many traders.
b. It is easier to take short position in derivatives than in other assets: As all transactions in derivatives take
place in future specific dates it is easy for the investor to sell the underlying assets i.e. in an asset if he is
obligated to deliver the asset in future. The short position means taking stand for selling the underlying asset,
with or without possessing the asset he can take view of the market or product which is not possible in any
other asset.
c. Exchange traded derivatives are liquid and have low transaction cost: Exchange traded derivatives are
more liquid and have lower transaction costs than other assets. They are more liquid because they have
standardized terms and low credit risk. Furthermore, their transaction costs are low due to high volume in
trade and due to high competition. In addition, margin requirement in the exchange traded derivatives is
relatively low, which reflects that the risk associated with this instrument is low.
d. It is possible to construct portfolio, which is exactly needed, without having the underlying assets:
Derivatives can be constructed or combined to closely match specific portfolio requirement. For example,
suppose a firm with a floating-rate loan needs to limit its exposure to sharp increases in the interest rate. The
firm can purchase a derivative called an interest rate cap. This derivative pays the firm the difference between
the floating rate of interest and a predetermined maximum called the cap rate whenever the floating rate
exceeds the cap. Similarly, the lender can protect the decrease in the interest rate by buying the floor. The
derivative product seller pays the lender the difference between a predetermined maximum rate called the
floor rate whenever the floating rate falls below the floor rate.

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7. An asset or liability must satisfy the following criteria if it is to be designated as a hedging

item:
I. The single item (or portfolio of similar items) must be specifically identified as hedging all
or a specific portion.
a. If similar items are aggregated and hedged, each item has to share the risk exposure
that is being hedged (i.e. each individual item must respond in a generally
proportionate manner to the change in fair value).
b. A specific portion must be one of the following:
i. A percentage of the total asset, liability or portfolio.
ii. One or more selected contractual cash flows: For instance, the present value of the
interest payments due in the first two years of a 4-year debt instrument;
iii. An embedded put, call, cap or floor that does not qualify as an embedded
derivative in an existing asset or liability;
iv. Residual value in a lessor’s net investment in a sales-type or direct financing
 lease.
II. The item has an exposure to fair value changes that could affect earnings.
III. The item is not:
a. Re-measured with changes reported currently in earnings, for example, a foreign
currency denominated item;
b. A minority interest;
c. A firm commitment to enter into a business combination or to acquire or dispose of a
subsidiary; a minority interest; an equity method investee; or
d. An equity method interest classified in stockholder’s equity.
IV. The item is not a held-to-maturity debt security unless the hedged risk is for something
other than for fair value changes in market interest rates or foreign exchange rates;
examples include hedges of fair value due to changes in the obligor’s creditworthiness, and
hedges of fair value due to changes in a prepayment option component.
V. If the item is a non-financial asset or liability (other than a recognized loan servicing right
or a non-financial firm commitment with financial components), the designated hedged
risk is the fair value change of the total hedged item (at its actual location, if applicable);
FASB-133 stipulates that the price of a different location cannot be used without
adjustment.
VI. If the item is a financial asset or a liability; a recognized loan servicing right or a non-
financial firm commitment with financial components, the designated hedge risk arises out
of changes in fair value in:
a. The total hedged item;
b. Market interest rates;
c. Related foreign currency rates;
d. The obligor’s creditworthiness; or
e. Two or more of the above other than a.
Prepayment risk for a financial asset cannot be hedged but an option component of a pre-payable instrument can
be designated as the hedged item in a fair value hedge. Embedded derivatives have to be considered also in
designating hedges. For instance, in a hedge of interest rates, the effect of an embedded prepayment option must
be considered in the designation of the hedge.

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