Practice Questions

QUESTION 1 Consider a European call option on a non dividend paying stock when the stock price is $25.00, the strike price is $28.00, the risk-free interest rate is 8% per annum, the volatility is 30% per annum and there is four years to maturity.
a) Find the current price of the option. Show your calculations. The price of the call option is $7.9827.

Now assume the stock price instantaneously changes to $25.50. b) Use the delta of the option to estimate the value of the option after the change. Show your calculations. The value of the option after the change is $8.352975. c) Use the delta and gamma of the option to estimate the value of the option after the change. Show your calculations. The value of the option after the change is $8.3556. d) What is the exact value of the option after the change? Show your calculations. The exact price of the call option is $8.354807.

QUESTION 2 Consider a forward contract on a non dividend paying stock with five months to maturity. Assume that each contract covers one share. The current stock price is $120 and the fivemonth risk free rate is 8% per annum.
a) Assume the current forward price is $150. What opportunities are there for an arbitrageur? Explain and show your calculations including payoffs. Sell 1 forward, Buy 1 share, Borrow amount equal to S The profit from these transactions is $25.93258 in five months time. b) Assume the current forward price is $90. What opportunities are there for an arbitrageur? Explain and show your calculations including payoffs. Buy 1 forward, Sell 1 share, Invest the proceeds from the sale The profit from these transactions is $34.067 in five months time.

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QUESTION 3 A company enters into a long futures contract to buy 10,000 bushels of corn for 100 cents per bushel. The initial margin is $5,000 and the maintenance margin is $4,000. What price change would lead to a margin call? Under what circumstances could the company withdraw $2,500 from the margin account? Show your calculations. A price change of $0.10 will lead to a margin call. $2,500 can be drawn if price rises by $0.25 QUESTION 4 Assume it is March 15. A company knows it will need to buy 200,000 pounds of copper on July 15. The current price of copper is $3.40 per pound and the current July futures price is $3.00 per pound. Assume that each contract is for the delivery of 20,000 pounds and the maturity date of the contract is July 15. (Ignore daily marking to market/settlement).
a) How can the company hedge its exposure? Explain and show your calculations. Enter 10 long futures contract now and hold until maturity. b) If the price of copper on July 15 is $3.15, what is the outcome (total cost) for the company? Show your calculations. The company pays $600,000 for the copper. c) If the price of copper on July 15 is $2.50, what is the outcome (total cost) for the company? Show your calculations. The company pays $600,000 for the copper.

QUESTION 5 What is meant by a perfect hedge? Does a perfect hedge always lead to a better outcome than an imperfect hedge? Explain. QUESTION 6 Fully explain the similarities and differences between forward and futures contracts on the same asset when both contracts have the same maturity. QUESTION 7 Consider a futures contract on stock XYZ. XYZ has no systematic risk. Assume risk-free rate for all the maturities are the same. It is June 15. The September futures price is $50, and the December futures price is $51. What is the markets expectation about the stock price in June next year? E(ST) = $53.0604

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QUESTION 8 A financial institution has the following portfolio of over the counter options on ABC Ltd. shares: Type Call Call Put Number Long 1,000 Short 300 Long 400 Delta 0.25 0.85 -0.40

The current ABC stock price is $30. An exchange traded call option with a delta of 0.60 currently sells for $6. Each option covers one ABC share.
a) How could the investor delta hedge his exposure using the stock? Show your calculations. Buy 165 shares of stock. b) How could the investor delta hedge his exposure using the exchange traded call? Show your calculations. Buy 275 calls.

QUESTION 9 Suppose the current price of ACME Ltd. shares is $20 and in 3 months it will be either $18 or $22. Assume that the ACME stock does not pay any dividends, the continuously compounded risk-free interest rate is 12% per annum and markets are frictionless. Assume you have a portfolio of 10,000 ACME shares and you want to use portfolio insurance to protect the value of the portfolio from falling below $21 per share in 3 months.
a) What steps should be taken now to protect the portfolio? Show your calculations. For 10,000 puts we need to short 7,500 shares and long $160,123 in risk free bonds. b) Show the cashflows on the insured portfolio now and in 3 months when the stock price is $18 or $22. Show your calculations. The minimum value of the portfolio should be $210,000 or $21 per share. T=0 cost should be -$10,123 or -$1.0123 per share and represents the cost of the portfolio insurance.

QUESTION 10 Assume the spot USD/JPY exchange rate is 1 USD = 96 JPY. The continuously compounded risk-free interest rate is 1% per annum in the US and 3% per annum in Japan. Assume that the volatility of the USD/JPY exchange rate is 25% per annum.
a) Find the current price of JPY value of a one-year European call option on one USD with an exercise price of JPY 90? Show your calculations. Call price = 13.4276 JPY

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b) Calculate the USD value of a one-year European put option on one JPY with an exercise price of USD 0.011. Show your calculations. (Hint: there is no need to use the Black-Scholes) Put price = 0.001554 USD

QUESTION 11 Explain the similarities and differences between forwards and futures on the same asset. You may want to consider (but not limited to) the following points for the differences.
a) b) c) d) How trade is conducted Liquidity Counter-party risk Flexibility

QUESTION 12 "Basis risk is often a problem in using futures contracts for hedging purposes". Discuss. QUESTION 13 Assume two companies, ABC Limited and XYZ Limited, can borrow $50 million at the following rates for five years: ABC Limited XYZ Limited Fixed Rate 4.75% 5.60% Floating Rate LIBOR + 0.5% LIBOR + 0.9%

Assume that ABC Limited wants to borrow floating and XYX Limited wants to borrow fixed.
a) Design a swap that will net a financial institution 0.2% per annum and will appear attractive to both parties. b) What is the annual % gain from the swap for both companies? c) What is the annual % net cost to ABC Limited? d) What is the annual % net cost to XYZ Limited?

QUESTION 14 (from the textbook) Company A wishes to borrow U.S. dollars at a fixed rate of interest. Company B wishes to borrow sterling at a fixed rate of interest. They have been quoted the following rates per annum (adjusted for differential tax effects):

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Company A Company B

Sterling 11.0% 10.6%

US Dollars 7.0% 6.2%

Design a swap that will net a bank, acting as intermediary, 10 basis points per annum and that will produce a gain of 15 basis points per annum for each of the two companies. The spread between the interest rates offered to A and B is 0.4% (or 40 basis points) on sterling loans and 0.8% (or 80 basis points) on U.S. dollar loans. The total benefit to all parties from the swap is therefore 80 -40 = 40 basis points. It is therefore possible to design a swap which will earn 10 basis points for the bank while making each of A and B 15 basis points better off than they would be by going directly to financial markets. One possible swap is below. Company A borrows at an effective rate of 6.85% per annum in U.S. dollars.

Company B borrows at an effective rate of 10.45% per annum in sterling. The bank earns a 10-basis-point spread. The way in which currency swaps such as this operate is as follows. Principal amounts in dollars and sterling that are roughly equivalent are chosen. These principal amounts flow in the opposite direction to the arrows at the time the swap is initiated. Interest payments then flow in the same direction as the arrows during the life of the swap and the principal amounts flow in the same direction as the arrows at the end of the life of the swap. Note that the bank is exposed to some exchange rate risk in the swap. It earns 65 basis points in U.S. dollars and pays 55 basis points in sterling. This exchange rate risk could be hedged using forward contracts. QUESTION 15 (From the textbook. Although this question is about the valuation of interest rate swaps (which is not examinable), the method used to find the value of the swap is similar to the one used for currency options) In an interest rate swap, a financial institution pays 10% per annum and receives threemonth LIBOR in return on a notional principal of $100 million with payments being exchanged every three months. The swap has a remaining life of 14 months. The average of Practice Questions (FNCE30007) Page 5

the bid and offer fixed rates currently being swapped for three-month LIBOR is 12% per annum for all maturities. The three-month LIBOR rate one month ago was 11.8% per annum. All rates are compounded quarterly. Find the value of the swap. The swap can be regarded as a long position in a floating-rate bond combined with a short position in a fixed-rate bond. The correct discount rate is 12% per annum with quarterly compounding or 11.82% per annum with continuous compounding. Immediately after the next payment the floating-rate bond will be worth $100 million. The next floating payment ($ million) is

0.118 100 0.25 = 2.95

The value of the floating-rate bond is therefore
102.95e 0.11822 /12 = 100.941

The value of the fixed-rate bond is

2.5e 0.11822 /12 + 2.5e 0.11825/12 + 2.5e 0.11828/12 +2.5e 0.118211/12 + 102.5e 0.118214 /12 = 98.678

The value of the swap is therefore

100.941 98.678 = $2.263million

As an alternative approach we can value the swap as a series of forward rate agreements. The calculated value is

(2.95 2.5)e 0.11822 /12 + (3.0 2.5)e 0.11825/12 +(3.0 2.5)e0.11828/12 + (3.0 2.5)e 0.118211/12 +(3.0 2.5)e 0.118214 /12 = $2.263million
which is in agreement with the answer obtained using the first approach.

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