Question Paper

Financial Risk Management-I (231)–January 2006

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. As per FASB 133, the accounting treatment accorded to a Foreign currency hedge is that >
(a) The changes are included in current income
(b) The changes are included in current net income
(c) The changes are included in other comprehensive income
(d) The changes are included in comprehensive net income
(e) The changes are included in earnings.
< Answer
2. Zydus Ltd. stock is priced at Rs.30 with a standard deviation of 30%. The risk-free rate is 5%. There >
are put and call options available at exercise prices of Rs.30 and a time to expiration of six months. The
call is priced at Rs.2.89 and the put costs Rs.2.15. There are no dividends on the stock and the options
are European. An investor constructed a covered call. What is the breakeven stock price at expiration?
(a) Rs.27.11 (b) Rs.29.89 (c) Rs.30.00 (d) Rs.32.89 (e) Rs.35.66.
< Answer
3. Consider two put options differing only by exercise price. The one with the higher exercise price has >
(a) The lower breakeven and lower profit potential
(b) The lower breakeven and greater profit potential
(c) The higher breakeven and greater profit potential
(d) The higher breakeven and lower profit potential
(e) The greater premium and lower profit potential.
< Answer
4. Which of the following statements is true about closing a long call position prior to expiration relative >
to holding it to expiration?
(a) The profit is greater at all stock prices
(b) The profit is greater only at low stock prices
(c) The profit is greater only at high stock prices
(d) The range of possible profits is greater
(e) Profit is lower at all stock prices.
< Answer
5. Early exercise imposes a risk to all but one of the following transactions. >
(a) A short call (b) A short put
(c) A protective put (d) An uncovered call
(e) A covered call.
< Answer
6. Which of the following participant of derivative market perform a valuable economic function by >
feeding information and analysis into the derivative markets?
(a) Arbitrageurs (b) Financial institutions
(c) Speculators (d) Banks (e) Hedgers.
< Answer
7. Ignoring transactions costs, whether the futures price is at a discount or premium to the spot price, >
equilibrium non-arbitrage conditions imply that at the futures delivery date the futures price and the spot
price will be equal. This result is referred to as the
 (a) Convergence principle (b) Delivery parity
(c) Expected futures price (d) Futures contract settlement
(e) Arbitrage pricing.
< Answer
8. Which of the following statements is true about the purchase of a protective put at a higher exercise >
price relative to a lower exercise price?
(a) The breakeven is lower
(b) The maximum loss is greater
(c) The insurance is less costly
(d) The insurance is more costly
(e) The put option with lower exercise price is more valuable.
< Answer
9. Which of the following statements is/are true regarding Coffee Future Exchange India Limited >
(COFEI)?
I. It aims at providing a hedging opportunity against price risk to all those within and outside coffee
industry.
II. COFEI permits trading in twelve contracts simultaneously covering 24 months forward.
III. The clearing house is an entity separate from COFEI.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer
10. What will be the optimal stock index futures hedge ratio if the portfolio is worth $2,400,000, the beta is >
1.15 and the S&P 500 futures price is 450.70 with a multiplier of 500.
(a) 10.65 (b) 12.25 (c) 15.84 (d) 6123.80 (e) 5325.05.
< Answer
11. Though a cross currency hedge has somewhat higher risk than an ordinary hedge, it will reduce risk if >
which of the following occurs?
(a) Futures prices are more volatile than spot prices
(b) The spot and futures contracts are correctly priced at the onset
(c) Spot and futures prices are positively correlated
(d) Futures prices are less volatile than spot prices
(e) Spot and future prices are negatively correlated.
< Answer
12. If you buy 100 shares of TTK at Rs.79, and simultaneously write a MAR 80 straddle for Rs.6. The >
break-even point will be
(a) Rs.76.5 (b) Rs.78 (c) Rs.79.5 (d) Rs.80.5 (e) Rs.85.
< Answer
13. If an investor buys a bullish vertical spread consisting of one July call of 270 with a premium of Rs.62 >
and a July call of 350 with a premium of Rs.12, what will be his profit or loss if spot price at expiration
is Rs.325?
(a) Rs. 5 (b) – Rs. 5 (c) – Rs. 20 (d) Rs. 20 (e) Rs.25.
< Answer
14. Which of the following statements is false? >
(a) Minimum value of an American call option is either zero or, S0 – X
(b) Maximum value of an American call option can be the value of underlying asset (S0)
(c) If two American call options have same exercise price, the option with longer maturity date will be
worth less than the other option with shorter maturity.
(d) An American call option can never be worth less than a European call option
(e) The price difference between two American puts cannot exceed the difference in exercise prices.
< Answer
15. According to put-call parity, writing a put is similar to >
(a) Buying a call, buying stock and lending
(b) Writing a call, buying stock and borrowing
(c) Writing a call, buying stock and lending
 (d) Writing a call, selling stock and borrowing
(e) Buying a call, selling stock and lending.
< Answer
16. Which of the following statements is/are true? >
I. Black – Scholes model of option – pricing assumes that volatility of the underlying instrument is
constant over the entire life of the option but is continuously compounded.
II. The price prediction under Black – Scholes model focuses both the magnitude and direction of
changes.
III. According to the smile effect volatility of options deeply in the money is less than for those at the
money.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (III) above (d) Both (II) and (III) above
(e) Both (I) and (II) above.
< Answer
17. Which of the following is true about a callable swap? >
(a) The fixed rate receiver has the right to terminate the swap at any time before its maturity
(b) The fixed rate payer has the right to extend the swap beyond maturity
(c) The fixed rate payer has the right to terminate the swap at any time before its maturity
(d) Both fixed rate payer and receiver have right to terminate the swap at any time before its maturity
(e) Both fixed rate payer and receiver have right to extend the swap beyond maturity.
< Answer
18. 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 bid rate is 30 basis points over yields on the US Treasury Bills versus LIBOR
(b) The bid rate is 20 basis points over yields on the US Treasury Bills versus LIBOR
(c) The bid rate is 10 basis points over yields on the US Treasury Bills versus LIBOR
(d) The ask rate is 10 basis points over yields on the US Treasury Bills versus LIBOR
(e) The ask rate is 20 basis points over yields on the US Treasury Bills versus LIBOR.
< Answer
19. Which of the following statements is/are not true? >
I. Collectively, swap facilitators are known as ‘Swap Banks’.
II. Swap brokers share the gain from a swap arrangement.
III. Swap dealers bear the financial risk associated with a swap deal.

(a) Only (I) above (d) Both (I) and (II) above
(b) Only (II) above (e) Both (II) and (III) above.
(c) Only (III) above
< Answer
20. Assume that there are two firms X and Y in need of $100 million and £50 million respectively. They can >
borrow these currencies at the following interest rates:
Firms Dollars Sterling
Firm X 10.5% 11.8%
Firm Y 8.5% 12.5% The quality spread differential is
(a) 0.7 (b) 1.3 (c) 2.0 (d) 2.7 (e) 3.8.
< Answer
21. Which of the following is not true? >
(a) Delta of a call option is always positive or zero
(b) Delta of a put option is always negative or zero
(c) Rho is a measure of the sensitivity of option value to changes in spot prices
(d) Gamma is the rate of change of the delta to the price of the underlying stock
(e) Vega of all options declines as the expiration date approaches.
< Answer
22. A portfolio has a gamma of –2700. The delta and gamma of a call option are 0.65 and 0.90 respectively. >
The position in call option that could lead to gamma neutral portfolio is
 (a) Short 3000 (b) Long 3000 (c) Long 5000 (d) Short 5000 (e) Short 1250.
< Answer
23. Which of the following correctly expresses the profit on a hedge? >
(a) The basis when the hedge is closed
(b) The change in the basis
(c) The spot profit minus the futures profit
(d) The futures profit minus the spot profit
(e) Change in the price on the last day.
< Answer
24. Which of the following statements regarding cash flow hedges is/are true? >
I. A non – derivative instrument can be designated as a hedging instrument for a cash flow hedge.
II. The effective portion of gain or loss on the derivative instrument is reported in other
comprehensive income for a cash flow hedge.
III. The portion of gain or loss on the derivative instrument is reported in earning for a cash flow
hedge.
(a) Only (I) above (b) Only (II) above
(c) Both (II) and (III) above (d) Both (I) and (II) above
(e) All (I), (II) and (III) above.
< Answer
25. Minimum tick size for a weather derivative in CME is >
(a) 1.00 degree day index point
(b) 1.25 degree day index point
(c) 2.00 degree day index point
(d) 3.00 degree day index point
(e) 5.00 degree day index point.
< Answer
26. Cooling degree days (CDD) index is used in >
(a) Winter months (b) Spring months
(c) Summer months (d) Autumn months
(e) Throughout the year.
< Answer
27. Which of the following statements regarding methods of calculating VAR is/are true? >
I. Under Monte Carlo Simulation method returns are expressed as a histogram of hypothetical
values.
II. The results obtained by Hybrid method are less precise as compared to the other methods of
calculating VAR.
III. Variance/Covariance Models are less flexible compared to other models.
(a) Only (I) above (b) Only (III) above
(c) Both (I) and (II) above (d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
< Answer
28. Bajaj share prices have exhibited an annual standard deviation of 28%. Assuming 30 days in a month, >
what would be the equivalent monthly standard deviation that may be used in the Black-Scholes model?
(a) 6.80% (b) 8.08% (c) 10.89% (d) 15.71% (e) 20.28%.
< Answer
29. Which of the following elements of an insurance contract gives a right to the insurer to stand in place of >
the insured, after settlement of a claim, so far as insured’s part of recovery from an alternative source is
involved?
(a) Utmost Good Faith (b) Indemnity (c) Warranties
(d) Assignment (e) Subrogation.
< Answer
30. Which of the following statements are true regarding different kinds of Fire Insurance Policies? >
I. Under Declaration policy, adjustments are sought to be made by periodical declarations by the
insured on the changing value of the goods.
II. Under Floating policy value of the policy would be lowest of the rates taken for each of the
locations calculated as if the policy is taken separately.
III. The reinstatement policy is not useful when the property to be insured is stock, merchandise or
materials.
IV. Declaration policy covers loss only over and above other policies whether affected by the insured
or any other person covering the stocks hereby insured.
(a) Both (I) and (II) above (b) Both (III) and (IV) above
(c) (I), (II) and (III) above (d) (I), (III) and (IV) above
(e) (II), (III) and (IV) above.

END OF SECTION A
 Section B : Problems (50 Marks)
This section consists of questions with serial number 1 – 6.
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. A bank in US owns a portfolio of options on the dollar-euro exchange rate. The delta of the
portfolio is 8604. The current exchange rate is $1.21/ €. The annual volatility of dollar-euro
exchange rate is 8%.
You are required to calculate the 10-day value at risk at 95% confidence level for the portfolio.
(Assume 250 trading days in a year)
(7 marks) < Answer >
2. Current dollar-Can$ spot rate is $0.8265/Can$. A speculator is expecting that in the next two-three months dollar
will not fluctuate much from the current spot rate against Can$. The following call options are available in the
market:
Strike price Premium
Option Maturity
($/Can$) ($)
Call 0.77 0.035 3 months
Call 0.80 0.022 3 months
Call 0.83 0.012 3 months
Call 0.86 0.005 3 months The speculator wants to make a
profit from his view by adopting an option strategy using all the four call options given above, and would like to
limit his maximum potential loss.
You are required to suggest a strategy to the speculator and prepare pay-off profile indicating maximum profit,
maximum loss, and break-even points. Also draw the pay-off diagram for the strategy.
(8 marks) < Answer >
3. Cavin Cally Ltd., a large export house from India entered into a five-year interest rate swap
with the ICICI Bank, under which it has contracted to pay 8% and receive six-month LIBOR
semi-annually, on a notional principal amount of US $ 25 million. This deal was set-up on April
01, 2003. On April 01, 2005, after the swap payments were settled, the Treasurer of Cavin
Cally suggested that the swap be cancelled as the rates in the market have dropped
considerably. He approached the bank, which agreed to cancel the deal at 6%, which is also the
current rate for the 3 years swap deal for fixed vs LIBOR.
You are required to find out the following:
a. If the deal was to be cancelled on April 1, 2005, what amount of money would be required
to be paid? By whom?
b. Instead of canceling the existing deal, if a new deal was made and allowed to run for 3
years (till the maturity of the original deal), what would be the cash flow on the fixed leg
of the new deal? (Assume that each period is exactly 6 months).
(6 + 1 = 7 marks) < Answer >
4. A fund manager has a well-diversified portfolio that mirrors the performance of the S&P 500
and is worth $360 million. The value of the S&P 500 is 1,200 and the portfolio manager would
 like to buy insurance against a reduction of more than 5% in the value of the portfolio over the
next six months. The risk-free interest rate is 6% per annum. The dividend yield on both the
portfolio and the S&P 500 is 3% and the volatility of the index is 30% per annum.
a. If the fund manager buys traded European put options for the insurance, how much would
the insurance cost?
b. Explain carefully alternative strategies open to the fund manager involving traded European call options such
that they lead to the same result.
(8 + 4 = 12 marks) < Answer >
5. On January 10, 2006, Black Berry Inc. (BBI), a US based firm is expecting $20 million from a
foreign subsidiary in the month of March. BBI intends to invest the funds in three month US T-
bills. Looking at the present economic scenario BBI expects the interest rates to decline further
in the near future. Therefore it decides to hedge through 3-month T-bill futures contracts. The
March T-bill futures are quoting at 96.24 at the time of entering into the hedge.
You are required to
a. Explain how BBI can hedge using T-bill futures.
b. Calculate the annualized yield, if in March T-bills futures are quoted at
(i) 95.65 and
(ii) 96.74.
(3 + 5 = 8 marks) < Answer >
6. Mr. Rajat, a trader in T-bill market, wants to invest in a 90-day T-bill which is trading at 8.25%. In order to finance
his purchase of the T-bill he will use 30-day money market interest rate of 8%. You are required to calculate
break-even discount rate on the 90-day T-bill after 30 days.
(8 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 7 - 8.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.

7. a. Explain how the option on the futures become the same as an option on the asset.
b. How are spread and arbitrage strategies forms of speculation? How can they be interpreted
as hedges?
(4 + 6 = 12 marks) < Answer >
8. FASB - 133 specifies recognition of all derivatives instruments in the balance sheet as assets or liabilities
measured at fair value. However there are certain contracts that are not subject to the requirements of FASB – 133.
Explain these contracts.
(10 marks) < Answer >
 END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Financial Risk Management - I (231) : January 2006
Section A : Basic Concepts
1. Answer : (d) < TOP >

Reason: For a fair value hedge, changes are included in current net income.
For a cash flow hedge, changes are included in other comprehensive
income.
For a foreign currency hedge, changes are included in comprehensive net
income as part of cumulative transaction adjustment.
Hence, option (d) is the correct answer.
2. Answer : (a) < TOP >

Reason: Break even price for the investor = So – P

Rs.30 – Rs.2.89
Rs.27.11
Hence, option (a) is the correct answer.
3. Answer : (c) < TOP >

Reason: Suppose there are two put options.

Put option A Put option B
Strike price Rs.100 Rs.120
Premium Rs.10 Rs.12
Break even prices will Rs.90 Rs.108
be
For put option the profit is maximum when the stock price is zero at the
expiration. So the maximum profit will be Rs.90 and Rs.108 respectively for
both the options. Thus, it can be concluded that the put option with the
higher exercise price has the higher breakeven price and greater profit
potential.
Hence, option (c) is the correct answer.
4. Answer : (a) < TOP >

Reason: Closing a long call position prior to expiration relative to holding it to

expiration will give greater profit at all stock prices, since for a given stock
price, the longer a call is held, the more time value it loses and lower the
profit.
Hence, option (a) is the correct answer.
5. Answer : (c) < TOP >

Reason: A protective put strategy involves buying a stock and buying a put option on
the same stock. Early exercise imposes a risk for option writer and not
option buyer. All other strategies except protective put involve writing call
or put options and hence involves risk of early exercise.
Hence, option (c) is the correct answer.
6. Answer : (c) < TOP >

Reason: Speculators has a view in the market and based on the forecast the
speculator would like to make gains by taking long and short positions on
the derivatives. They perform a valuable economic function by feeding
information and analysis into the derivative markets.
Hencew, option (c) is the correct answer.
7. Answer : (a) < TOP >

Reason: As future contract approaches maturity, the cash and future prices come
closer and ultimately, on maturity, both coincide to a particular price. This
process is called as convergence.
Hence, option (a) is the correct answer.
8. Answer : (d) < TOP >

Reason: Purchase of a protective put at a higher exercise price relative to a lower

exercise price will involve more outlay of funds as option premium. The
breakeven price for higher exercise price option will be higher and
maximum loss will be lower than option with lower exercise price.
Hence, option (d) is the correct answer.
9. Answer : (a) < TOP >

Reason: COFEI aims at porviding hedging opportunity against price risk to all
those within and outside coffee industry. Hence, statement (I) is true. COFEI
permits trading in nine contracts simultaneously covering 18 months
forward. Hence,statement (II) is false. The clearing house is a part of COFEI
itself and not a separate entity. Hence, statement (III) is false.
Hence, option (a) is the correct answer.
10. Answer : (b) < TOP
>
$24, 00, 000 × 1.15
Reason: Optimal stock index future hedge ratio = 450.70 × 500
12.25
 Hence, option (b) is the correct answer.
11. Answer : (c) < TOP
>
Reason: A cross hedge will reduce risk if spot prices and future prices are positively
correlated.
Hence, option (c) is the correct answer.
12. Answer : (a) < TOP
>
Reason: The strategy will give profit if the prices are goes 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
Hence, option (a) is the correct answer.
13. Answer : (a) < TOP
>
Reason: If spot price at expiration is Rs.325, then call with strike price 270 will be
exercised and call with strike price 350 will not be exercised.
Initial investment = 62 – 12 = Rs.50
Profit or loss = (325 – 270) + 0 – 50 = Rs.5.
14. Answer : (c) < TOP
>
Reason: If two American call options have the same exercise price, the option with
longer maturity date will be more than the other option with shorter
maturity, so alternative (c) is false. All other alternatives are correct.
15. Answer : (b) < TOP
>
Reason: A short put position is equivalent to a long asset position plus shorting a call.
To fund the purchase of the asset, we need to borrow. This is because the
value of call or put is small relative to the value of the asset.
16. Answer : (a)
Reason: Black – Scholes model of option – pricing assumes that volatility of the
underlying instrument is constant over the entire life of the option but is
continuously compounded. Hence, statement (I) is true. The price prediction
under Black – Scholes model focuses on the magnitude of changes and not
on the direction of changes. Hence, statement (II) is false. According to the
smile effect volatility of options deeply in the money is greater than for
those at the money. Hence, statement (III) is false.
Hence, option (a) is the correct answer.
17. Answer : (c) < 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 (c) is the answer.
18. Answer : (c) < TOP >
 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.
19. Answer : (b) < TOP >

Reason: Both the counterparties and not the swap brokers share the net gain from the
swap. Hence, statement (II) is false. All other statements are correct.
Hence, option (b) is the correct answer.
20. Answer : (d) < TOP >

Reason: Here, firm X has comparative advantage in Sterling market while firm Y has
comaparative advantage in Dollar market. Therefore, quality spread
differtial will be [(10.5 – 8.5) + (12.5 – 11.8)] = 2.7%.
Hence, option (d) is the correct answer.
21. Answer : (c) < TOP >

Reason: Rho is a measure of the sensitivity of option value to change in the interest
rates. All other statements are correct.
Hence, option (c) is the correct answer.
< TOP >
22. Answer : (b)
Reason: For making gamma nentral portfolio a long position in traded option is
2, 700
= 3, 000.
needed to the extent of 0.90

Hence, option (b) is the correct answer.

< TOP >
23. Answer : (b)
Reason: Profit on a hedge is expressed as change in the basis points over the hedge
period.
Hence, option (b) is the correct answer.
24. Answer : (c) < TOP >

Reason: A non - derivative instrument can not be designated as a hedging instrumnet

for a cash flow hedge. Hence, statement (I) is not true. All other statemnts
are true regarding cash flow hedges.
Hence, option (c) is the correct answer.
25. Answer : (a) < TOP >

Reason: Minimum tick size for a weather derivative in CME is 1.00 degree day
index point.
Hence, option (a) is the correct answer.
26. Answer : (c) < TOP >

Reason: Cooling degree days (CDD) index is used to measure warmth in summer
months.
Hence, option (c) is the correct answer.
27. Answer : (d) < TOP >
 Reason: The results obtained by Hybrid method are more precise as compared to the
other methods of calculating VAR. Hence, statement (II) is false. All other
statements are corrrect.
Hence, option (d) is the correct answer.
28. Answer : (b) < TOP >

Reason: Equivalent monthly σ = (σ yearl) / Number of months = 0.28/ 12 = 8.08%

29. Answer : (e) < TOP >

Reason: Doctraine of Subrogation refers to “the right of the insurer to stand in place
of the insured, after settlement of a claim, so far as the insured’s right of
recovery from an alternative source is involved”. Hence, option (e) is the
correct answer.
30. Answer : (d) < TOP >

Reason: Under Floating policy value of the policy would be highest of the rates taken
for each of the locations calculated as if the policy is taken separately.
Hence, statement (II) is false. All other statements are correct.
Hence, option (d) is the correct answer.
 Section B : Problems
1. Current Euro – Dollar Exchange rate = 1.21
Delta of the portfolio = 8604
Volatility = 0.08
The approximate relationship between daily change in the portfolio value ∆P , and the daily
change in the exchange rate ∆S , ∆P = 8604 ∆S
S
Proportionate change in the exchange rate in one day ∆X = 1.21
P  8604  X  1.21
P  10410.84  X
8%
Daily volatility in the exchange rate ( ∆X )= 250 = 0.51%
∆P = 10410.84  0.0051 = 53.10
10 days VAR at 95% confidence level = 53.10  1.645  10 = $276.22
So 10 days VAR is $276.22.
< TOP >

2. The condor spread strategy is a suitable strategy for the speculator. Condor spread can be
created by buying two
options at 0.77 and 0.86, and selling two options at 0.80 and 0.83.
Initial outflow = 0.035 + 0.005 - (0.022 + 0.012) = 0.006
Pay-off Profile
 Gain/loss
Spot Net
(+) C = (–) C = (–) C = (+) C = Initial
price gain/loss
0.77 0.80 0.83 0.86 outflow
0.75 0 0 0 0 -0.006 -0.006
0.76 0 0 0 0 -0.006 -0.006
0.77 0 0 0 0 -0.006 -0.006
0.78 0.01 0 0 0 -0.006 0.004
0.79 0.02 0 0 0 -0.006 0.014
0.80 0.03 0 0 0 -0.006 0.024
0.81 0.04 -0.01 0 0 -0.006 0.024
0.82 0.05 -0.02 0 0 -0.006 0.024
0.83 0.06 -0.03 0 0 -0.006 0.024
0.84 0.07 -0.04 -0.01 0 -0.006 0.014
0.85 0.08 -0.05 -0.02 0 -0.006 0.004
0.86 0.09 -0.06 -0.03 0 -0.006 -0.006
0.87 0.10 -0.07 -0.04 0.01 -0.006 -0.006
0.88 0.11 -0.08 -0.05 0.02 -0.006 -0.006
Maximum
profit $ 0.024
Maximum loss $ 0.006
Break-even $ 0.776 &
points $0.854

< TOP >

3. a. Principal amount = $25 million

Interest rate on fixed leg = 8%
Interest rate on floating leg = LIBOR
Present market quote for three year swap = 6% v/s LIBOR
In order to cancel the deal on April 01,2005 (after settling payments), the present value of
future cash flows would have to be paid. The discount rate applicable should be the current
 rate of interest in the market i.e. 6% p.a. or 3% for six months.
Present value of amount to be paid as per the original contract = 1
Value of Fixed leg of interest = 1 PVIFA3%.6  25  PVIF3%,6
= $26.3543 million
Value of Floating leg of interest = $25 million (as the interest is just paid)
Value of swap to Cavin Cally = 25 – 26.3543 = -$1.3543million
This amount is to be paid by the company to the bank.
b. The company should pay to the bank every six month = 25x0.06/2 = $0.75 million
< TOP >

4. The fund is worth $300,000 times the value of the index. When the value of the portfolio falls
by 5% (to $342 million), the value of the S&P 500 also falls by 5% to 1140. The fund manager
therefore requires European put options on the 300,000 times the S&P 500 with exercise price
1140.

a. S0 = 1200, X = 1140, r = 0.06, σ = 0.30, T = 0.50 and q = 0.03. Hence:

 1200   0.09 
ln    0.06  0.03   0.5
 1140   2 
 0.4186
d1 = 0.3 0.5

d2 = d1 – 0.3 0.5 = 0.2064

N(d1) = 0.6622; N(d2) = 0.5818
N(-d1) = 0.3378; N( -d2) = 0.4182
The value of one put option is
1140e-r (T-t) N(-d2) - 1200e-q(T-t) N(-d1)
= 1140e-0.06 x 0.5  0.4182 - 1200e-0.03 x 0.5  0.3378
= 63.34
The total cost of the insurance is therefore
300,000  63.34 = $19,002,000
b. From put-call parity.
S0e-qT + p = c + Xe-rT
or:
p = c - Soe-qT + Xe-rT

This shows that a put option can be created by selling (or shorting) e-qT of the index, buying
a call option and investing the remainder at the risk-free rate of interest. Applying this to
the situation under consideration, the fund manager should:
(i) Sell 360e-0.03 x 0.5 = $354.64 million of stock
(ii) Buy 300,000 call options on the S&P 500 with exercise price 1140 and maturity in six
months.
(iii) Invest the remaining cash at the risk-free interest rate of 5% per annum. This strategy
 gives the same result as buying put options directly.
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5. Investment = $20,000,000.00
Months = 3
March T- Bill future contract = 96.24
Number of contracts required = 20
a. As the company will invest funds for a period of 3 – months, so it will buy T-bill future
contract to lock – up a yield of (100 – 96.24) = 3.76%. If the yield on date of investment
i.e. in March declines, the loss in the spot market will be offset by gain in the future
market. In case the interest rate rises, profit on spot market will be offset in the loss in the
future market. Thus, by buying T-bill future contract BBI will be able to lock up yield of
3.76%.
b. If March future is at 95.65
 3 
$20, 000, 000 ×  1 − 0.0435 × 
Price of cash T – bill =  12  = $19,782,500

Loss in future = (96.24 – 95.65) ×20 × 25 × 100 = $29,500.

Effective purchase price = $19,782,500 + $29,500 = $19,812,000
20, 000, 000 − 19, 812, 000 12
× × 100
Annualized yield = 19, 812, 000 3 = 3.80%
If March future is at 96.74
 3
$20, 000, 000 ×  1 − 0.0326 × 
Price of cash T-bill =  12  = $19,837,000

Gain in future = (96.74 – 96.24) ×20 × 25 × 100 = $25,000

Effective purchase price = $19,837,000 – $25,000 = $19,812,000
20, 000, 000 − 19, 812, 000 12
× × 100
Annualized yield = 19, 812, 000 3 =3.80%
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6. The break-even price is computed as follows.

Let P be the price at which the trader has to sell the T-bill after 30 days so that he breaks even.
Let B be the current price of the bill.
Then,
æ 30 ö
B ´ ç1 +0.08 ´ ÷=P.
è 360 ø
æ 30 ö
If P >B ´ ç 1 +0.08 ´ ÷, the trader will have money left over.
è 360 ø
æ 30 ö
If P <B ´ ç 1 +0.08 ´ ÷, he will lose money.
è 360 ø
100 - B 360
d= ´ .
100 90
 Given the discount yield of d = 8.25%, B = 97.9375.
æ 30 ö
P =97.9375 ´ ç1 +0.08 ´ ÷=98.59042.
è 360 ø
The break-even price is
The discount yield of the 90-day T-bill after 30 days, which sells at a price of 98.59042 can be
computed as
d = [(100 – 98.59042)/100] × [360/60]
8.4575%
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Section C: Applied Theory

7. a. In an option on a futures contract, the underlying is a futures contract. Thus, if the holder
exercises a call option on futures it creates a long position in a futures contract, and if the
holder exercises a put option on a futures it creates a short position in a futures contract. As
in options on assets, an option on a future requires that the buyer pay the premium up
front. There are two expirations, the expiration of the option and the expiration of the
underlying futures, though for some contracts, these expirations are the same. In that case,
exercise of the option on the futures creates a futures contract that immediately expires,
thereby turning into the spot asset and making the option on the futures the same as an
option on the asset.
b. A spread strategy is a long position in one futures contract and a short position in another
futures contract. The prices of the two contracts are normally highly correlated so that the
gains on one contract are at least partially offset by the losses on the other. The objective is
to take a small amount of risk in the hope of a small profit. An arbitrage strategy involves a
near risk less transaction in one or more futures contracts and possibly a spot transaction.
Arbitrage trading is usually triggered by a deviation from the theoretical relationship
between the prices of two instruments.
Both transactions can be viewed as hedges. A hedge is a position in the spot market and an
opposite position in the futures market. Thus, it is similar to a spread in that the gain on
one position is at least partially offset by the loss on the other. Arbitrage is like hedging in
that it is designed to have low risk and it often involves a position in the spot market and
an opposite position in the futures market.
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8. The contracts that are not subject to the requirements of FASB-133 are:
1. Regular way security trades
Delivery of a security readily convertible into cash within the specific time period
established by marketplace regulations or conventions where the trade takes place rather
than by the usual procedure of an individual enterprise. For instance the trades that are
excluded are forward purchases or sales of to-be- announced securities and when issued,
as-issued or if-issued securities.
2. Normal purchases and normal sales
Contracts for future delivery of assets convertible into cash and for that there is no net
settlement provision and no market mechanism to ease the net settlement. Terms must be
consistent with normal transactions and quantities must be reasonable in relation to needs.
3. Certain insurance contracts
 Contracts where the holder is only compensated when an insurable event takes place and
the value of the holder’s asset or liability is adversely affected or the holder incurs a
liability. The contracts that are not considered to be derivative instruments are traditional
life insurance and traditional property and casualty insurance policies.
4. Certain financial guarantee contracts
Contracts that call for payments only to reimburse for a loss from debtor failure to pay
when due. But a credit-indexed contract requiring payment for changes in credit ratings
would not be an exception.
5. Certain contracts that are not exchange traded
a. Climatic or geologically other physical variable
b. Value or price involving a non-financial asset not readily converted into cash or a non-
financial liability that does not require delivery of an asset that is readily converted
into cash.
c. Specified volumes of revenue of one of the parties: examples are royalty agreements
or contingent rentals based on related sales.
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