OMS January 2006 Derivatives

FORM A
Solvay Business School A. Farber FINAL EXAM January 26, 2006

Question 1 You have been hired as a consultant at the London office of Chinas State Reserve Bureau to explain the mechanics of futures trading to new employees. They all have in mind the fate of Lui Quibing, an employee who disappeared after having shorted hundreds of thousands of tons of copper on the London Metal Exchange (LME). They hope for another destiny. You decide to work out the following example. The spot price of copper is 4,700 US$/tonne and the US$ risk-free interest rate (with continuous compounding) is 5%. The cost of storage of copper, as a proportion of the spot price, is 3% per annum. The trading unit of one copper futures contract on the LME is 25 tonnes and the margin requirement are: Initial margin: US$6,500 Maintenance margin: US$4,500 Consider a trader taking a short position on 10 contracts with 12 months to maturity. (1.1) Explain how margins protect investors against the possibility of default. (1.2) By how much should the futures price change in order to trigger a margin call? (1.3) Suppose that the convenience yield is zero. Calculate the 12-month futures price. Briefly explain the logic underlying your calculation. (1.4) On January 20, 2006, official prices on the LME were as follow: Cash 4,706 3-months 4,579 15-months 3,960 27-months 3,515 Do these price show that the market expected on that day the spot price of copper to drop in the future? Question 2 ABC Partners, the private equity group, has agreed to pay 500m for Belgowaste, a Belgian waste management company. To finance the acquisition, ABC will have to borrow 250 million euros from the end of June 2006 (in 5 months from now) until the end of September 2006. The usual borrowing rate of the company was EURIBOR + 80bp. You have been asked to analyze how the interest rate risk on this loan could be hedged by using the 3-month Euribor contract traded on LIFFE. The size of one contract is 1 million euros and the tick is 25 euros. The underlying rate is the 3-month Euribor rate (a simple interest rate). The current quotation for the June contract is 97.69 (2.1) What position should ABC take on the Euribor futures contract (long or short) and on how many contracts? Explain. (2.2) Suppose that, one month later, the futures quote is 97.00. Calculate the gain (or loss) on one contract for ABC. (2.3) Suppose that at maturity, the 3-month Euribor rate is 3.00%. Verify the effectiveness of the hedge. (2.4) Suppose now that the current five-month (June) and eight-month (September) Euro discount factors are 0.9892 and 0.9826 respectively. Would this create an arbitrage opportunity? Explain.

OMS January 2006

FORM A

Question 3 Discussions are underway between A and B regarding the sale by A of 100 shares of XYZ to B. The transaction will take place in 6 months. The current price of XYZ is 100 per share. The company does not pay dividends and the volatility is 25%. The risk-free interest rate (with continuous compounding) is 4% per annum. Both parties seem willing to fix the delivery price that will be paid when the transaction will take place. Various solutions are being discussed. (3.1) A and B agree on the delivery price with no upfront payment. What should be this delivery price? (3.2) The delivery price is set equal to the current spot price and an upfront payment is made by one party to the other. Who would pay what amount to whom? (3.3) A sells a call option to B with a strike price equal to the current spot price. A has calculated that the delta of this option is 0.58 and the risk-neutral probability of exercising the option is 0.51. How much should B pay for this option? Explain. (3.4) Suppose A sold a call option to B at the price that you calculate in question (3.3). If the stock price turns out to be more volatile than expected, who is happy, who is unhappy, who is indifferent? Question 4 Having completed your studies, you are about to face Stefan van Kasteel, chief executive officer of Corner Bank Asset Management (COBAM). Since the mid-1990s, COBAM has transformed its business into a major structure products house. We knew that we had to offer our clients capital protection said van Kasteel in a recent interview. You would like to convince van Kasteel to hire you as a financial engineer in the structured product department. You heard through friends that he likes to ask candidates how they would proceed to offer capital protection using a simple model based on the binomial option pricing model with one step per year and no transaction cost. A typical question would run as follow. Suppose that a client wishes to have a guarantee that, after 3 years, his portfolio will be worth at least 1 million. In addition, the client wishes to receive 80% of the increase in the DJ Euro Stoxx 50 index (with dividend reinvested). Assume that the volatility of the DJ Euro Stoxx 50 index is 22.31%. The risk free interest rate (with continuous compounding) is 4% (4.1) Draw a diagram showing the future value in 3 years of the portfolio as a function of the evolution of the DJ Euro Stoxx 50. Identify the option(s) hidden in this strategy. (4.2) How much should the client invest today in order to achieve its objective? (4.3) How should COBAM allocate the money between stocks and bonds? (4.4) What should COBAM do in year 1 if the DJ Euro Stoxx 50 index goes up? Question 5 Sophia Hera loves watching butterflies and vacationing in Greece. But her job as trader at Cronus Derivatives doesnt leave her much time for her passions. After attending a seminar on derivatives, Sophia realized that she might combine work and pleasure. One of the speakers introduced butterfly spreads. This sounds lovely, thought Sophia I should suggest it to my boss. A butterfly spread involves options with three different strike prices. It is created by buying a call with a low strike price K1; buying a call with a high strike price K3; and selling two call options with a strike price K2, halfway between K1 and K3.

OMS January 2006

FORM A

Suppose that we implement this strategy on a stock currently worth 100. All three options have 6 month to maturity and their strike prices are 90, 100 and 110 respectively. Sophia has calculated the following Call Call Call Strike price 90 100 110 Number +1 -2 +1 Call price 14.88 9.15 5.24 Delta 0.750 0.57 0.393 Gamma 0.015 0.019 0.018 Theta -8.548 -9.768 -9.175

(5.1) Draw a diagram showing the value of the butterfly spread at maturity as a function of the stock price (Hint: first fill in the numbers in the following table) 85 Call K = 90 Call K = 100 Call K= 110 (5.2) Compute the initial value of this strategy. What view on the market justifies being long on a butterfly spread? (5.3) What does the delta of an option measure? What is the delta of the butterfly spread? (5.4) What does theta measure? What is the theta of the butterfly spread? Explain. 90 Stock price at maturity 95 100 105 110 115