Homework 3: Pine Street Capital (Part I)

FINA 4529: Derivatives (II) Undergrad, Spring 2013 Carlson School of Management University of Minnesota Professor Hengjie Ai O ce: 3-127 Phone: 612-626-7348 Email: hengjie@umn.edu

Homework 3 is due on April 16, Tuesday, at the beginning of the class.

Introduction and Instructions

Please read the HBS case 9-201-071 Pine Street Capital carefully, and answer the following questions.

II

Case Summary

Pine Street Capital (PSC) is a technology hedge fund located in San Francisco, California. PSC manages a fund that invests primarily in semiconductor companies that produce integrated circuits for broadband communications including wide and local area networks, optical components, and storage area networks. It is currently July, 2000 in the case, and the NASDAQ market (where most of the stocks that PSC invests in are traded) index reached a peak of over 5,000 a few months ago but has dropped considerably since then. In addition, the NASDAQ has experienced a historically unprecedented amount of volatility over the last several months, as shown in Exhibit 7 of the case. Due to the market drop and volatility, PSC s fund has experienced considerable problems in the last few months. Even though the fund has had a policy of hedging market risk, the fund has nevertheless experienced large losses on many days (sometimes on several consecutive days) in the last few months. This has created problems for the fund because of the leverage employed by the fund. Some of the losses that the fund had experienced had been large enough that the fund had come dangerously close to having its prime broker, a prominent Wall Street rm, liquidate the fund. Harold Yoon, a partner in the fund, now must evaluate the fund s market hedging program over the last few months to determine why the fund had experienced such large losses on many days.

III

Derivatives and Leverage (10 Points)

Consider the following binomial tree of the price movement of a non-dividend-paying stock, assume the time period is one year, and the eective one-year interest rate is 20%. % & Su = 140 Sd = 90

S0 = 100

1. Please calculate the return on the stock for both states of the world (Note that the return on the stock depends on the states of the world. You need calculate the return on the stock at both nodes, u and d.). 2. Consider an at-the-money European call option. Compute the the return on the call option at both nodes, u and d)? 3. Is the call option riskier than the stock? Why? Sometimes we say a call option is like a leveraged position on the underlying stock, comment on this. 4. Consider a futures contract on one share of the stock. What is the no-arbitrage futures price, F0;T ? 5. Assume a margin requirement of 8:33%. What is the return on a long position in the futures contract (Again, the realized return will depend on the state of the world. Also, note that balances on the margin account will earn risk-free return.)? What is the expected return on the futures contract under the risk-neutral probability? Is the futures contract riskier than the stock? 6. Can you invest in stocks and a risk-free bond to replicate the payo of the futures contact, how? (You need to take into account that investing in the futures contract involves an initial investment in the margins account.) Is the futures contract in the above example a leveraged position in the underlying stock? and B of the call

option. What is the return on a long position in the call option (Again, please calculate

IV
1
1

Hedging with Put Options (15 Points)

to estimate the volatility of the NASDAQ 100 index during the sample period.

1. Use the historical data on NASDAQ 100 index in the Excel le NASDAQ Index_PSC.xls
This can be downloaded from the course website.

Hint: You need to rst get the data series for ln

St+1 St

, and estimate the standard

deviation of the log return process (Recall that we assume the log return process is i.i.d. normal). Since you are using monthly data, you need to transform the monthly estimate into annual volatility. You can do so by using the following formula:
Annual

M onthly

12

2. Suppose on Jan 31, 2007, An at-the-money European call option on the NASDAQ 100 index with maturity of 1 year is traded at $121.9639. Assume the continuously compounded LIBOR is 5% per annum, and the continuously compounded dividend yield is 0%. What is the implied volatility of the NASDAQ 100 index (from the BlackScholes model)? 3. Please nd the data for the NASDAQ 100 index during Feb 2006 in the spread sheet named "Feb 2006" in the Excel le NASDAQ Index_PSC.xls. Consider an at-themoney European put option on one NASDAQ 100 index on Jan 31, 2006. The maturity of the option is one year (the option expires on Jan 31, 2008). Calculate the theoretical Black-Scholes prices of this put option for each day in Feb 2006 and ll in the column "BS Put Price". Please use the continuously compounded annual interest of 5% per year. Please use the implied volatility you obtained in part 2 when calculating the Black-Scholes prices. 4. Suppose you invested 1 million US dollar in the NASDAQ 100 index
2 3

on Jan 31,

2006. Suppose you want to use the above put option on NASDAQ 100 index (That is, the at-the-money put option on the index with one year maturity described in the last question) to hedge the risks of your investment. To construct a
2

neutral position,

how many put option contracts do you need to purchase on Jan 31, 2006 (Note that
Of course, trading the NASDAQ 100 index directly can be very costly. In practice, you will probably invest in a ETF that tracks the NASDAQ 100 index (the ticker symbol for the ETF that tracks the NASDAQ 100 is QQQQ). 3 A Short Note on ETF: You can think of an exchange-traded fund as a mutual fund that trades like a stock. Just like an index fund, an ETF represents a basket of stocks that re ect an index such as the S&P 500. An ETF, however, isn t a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF s price changes throughout the day, uctuating with supply and demand. It is important to remember that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or more dierence between the actual index s year-end return and that of an ETF. By owning an ETF, you get the diversication of an index fund plus the exibility of a stock. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. When buying and selling ETFs, you pay your broker the same commission that you d pay on any regular trade.

each put option contract on the index contains 100 put options on the index.)? 5. Suppose you rebalance your position in the put option everyday to maintain a neutral

position during Feb 2006. In the column "Number of Contracts", calculate the number of put option contracts you need to maintain in your portfolio on each day in Feb 2006. What is the theoretical return of your hedged portfolio (Again, please assume a continuously compounded risk free rate of 5% per year, and a dividend yield of 0. Please use the implied volatility you obtained in question 2 in your calculation. Assume also all assumptions of the Black-Scholes model hold.)?