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This assignment is due on or before 4:00 PM, February 6, 2012. It needs to be physically delivered at S3-01C-89. Your answers should be typed and printed (no hand written assignment and no email submission allowed). Please make sure to write your full name and student ID on top of the assignment. This assignment is worth a total of 100 points (excluding bonus question).

Problem 1

Suppose that you enter into two short futures contracts to sell July silver for $10.20 per ounce on the New York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is $4,000 per contract, and the maintenance margin is $3,000 per contract. i. (5 points) What change in the futures price will lead to a margin call? ii. (5 points) What happens if you do not meet the margin call? Problem 2 Suppose that you enter into two long futures contracts to buy July silver for $10.20 per ounce on the New York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is $4,000 per contract, and the maintenance margin is $3,000 per contract. i. (5 points) What change in the futures price will lead to a margin call? ii. (5 points) What happens if you do not meet the margin call? Problem 3 A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. The stock price is $50, and the risk-free rate of interest is 8% per annum with continuous compounding for all maturities. An investor has just taken a short position in a 6-month forward contract on the stock. i. (5 points) What are the forward price and the initial value of the forward contract ii. (5 points) Three months later, the price of the stock is $48 and the risk-free rate of interest is still 8% per annum. What are the forward price and the value of the short position in the forward contract? Problem 4 A stock is expected to pay a dividend of $1 per share in 2 months and in 5 months. The stock price is $50, and the risk-free rate of interest is 8% per annum with continuous compounding for all maturities. An investor has just taken a long position in a 6-month forward contract on the stock. i. (5 points) What are the forward price and the initial value of the forward contract ii. (5 points) Three months later, the price of the stock is $52 and the risk-free rate of interest is still 8% per annum. What are the forward price and the value of the long position in the forward contract?

Problem 5 The current market price of T-bill maturing 110 days from now is 97.90 (out of par 100). The

cash price for 90-day T-bill futures contract expiring 20 days from now is 98.30. A 20day Tbill futures contract is also traded in the market. i. (5 points) Compute the risk free rate that rules out arbitrage opportunities. ii. (5 points) Suppose that the 20-day T-bill rate is in fact 8%. Show how to set up transactions in T-bill contract and the futures contract that guaranteed to make an arbitrage profit. Problem 6 It is now October 2004. A company anticipates that it will purchase 10 million pounds of copper in each of February 2005, August 2005, February 2006, and August 2006. The company has decided to use the futures contracts traded in the COMEX division of the New York Mercantile Exchange to hedge its risk. One contract is for the delivery of 25,000 pounds of copper. The initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The companys policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months into the future are considered to have sufficient liquidity to meet the companys needs. Devise a hedging strategy for the company. Assume the market prices (in cents per pound) today and at future dates are as follows:

i.

(10 points) What is the impact of the strategy you propose on the price the company pays for copper? ii. (5 points) What is the initial margin requirement in October 2004? Is the company subject to any margin calls? Problem 7 A bank offers a corporate client a choice between borrowing cash at 11% per annum and borrowing gold at 2% per annum. (If gold is borrowed, interest must be repaid in gold. Thus, 100 ounces borrowed today would require 102 ounces to be repaid in 1 year.) The risk-free interest rate is 9.25% per annum, and storage costs are 0.5% per annum. The interest rates on the two loans are expressed with annual compounding. The risk-free interest rate and storage costs are expressed with continuous compounding. i. (10 points) Discuss whether the rate of interest on the gold loan is too high or too low in relation to the rate of interest on the cash loan. Problem 8 A fund manager has a portfolio worth $50 million with a beta of 0.87. The manager is concerned about the performance of the market over the next 2 months and plans to use 3month futures contracts on the S&P 500 to hedge the risk. The current value of the index is 1250, one contract is on 250 times the index, the risk-free rate is 6% per annum, and the dividend yield on the index is 3% per annum. The current 3-month futures price is 1259. i. (5 points) What position should the fund manager take to eliminate all exposure to the market over the next 2 months? ii. (10 points) Calculate the effect of your strategy on the fund managers returns if the

level of the market in 2 months is 1,000, 1,300, and 1,400. Assume that the 1-month futures price is 0.25% higher than the index level in 2 months time.

Problem 9 You are in charge of the bond portfolio of Freeman Investments Inc. and have to buy $100 million of bonds on or after February 7, 2011 and on or before May 7, 2011. You are concerned that interest rate might fall between now (January 26, 2011) and May 7, 2011 and decide to use T-bond futures contract to set up the hedge. The current May 2011 T-bond futures are 95-04. On May 1, 2011 the average duration of the targeted bond portfolio will be 9.0 years. The cheapest to deliver T-bond futures contract expected to be 20 years, 8% coupon bond whose duration is 11.2 years at maturity of the futures contract. i. (5 points) Explain which risk you are exposed to if you do not set up the hedge. Separately consider the scenarios where interest rate rises and declines. ii. (5 points) Demonstrate the size and direction (short or long) of a position in May 2011 T-bond futures that would provide a hedge for the underlying bond portfolio.

Bonus Question (10 points) One of the key ideas from the discussion is that expectations about the appreciation of the underlying asset do not enter the futures pricing formula. Suppose that you meet someone (let's call him Joe) who really thinks that gold is going to appreciate over the next year. Joe thinks that the gold will go up in price by 50% over the next year. Since the current price of gold is $100 (and because he has not taken my class!), Joe is willing to enter into a futures contract with you at a fixed futures price of $150. That is, Joe is willing to buy (or sell) gold one year from today at $150. Further assume that the risk free rate of return is 10%, and that there are no carrying costs or other market frictions. The question is: How do you make money trading with Joe if there were no futures market?

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