1 Subject: Derivatives, Option & Future Instructions: Answer all the questions. Marks allotted 100.

Each Question carries equal marks. Word limit is 500 words per questions. General Instructions: The Student should submit this assignment in the handwritten form (not in the typed format) The Student should submit this assignment within the time specified by the exam dept Each Question mentioned in this assignment should be answered within the word limit specified The student should only use the Rule sheet papers for answering the questions. The student should attach this assignment paper with the answered papers. Failure to comply with the above Five instructions would lead to rejection of assignment Question: 1 A. What are derivatives? Why do companies hedge risks during derivatives? Ans:- A derivative is a financial contract which derives its value from the performance of another entity such as an
asset, index, or interest rate, called the "underlying". Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages). Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these such as caps, floors, collars, andcredit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurancecontracts have developed into a separate industry.

Hedging is used to deal with three areas of risk exposure: fair value risk, cash flow risk, and foreign currency risk. Let's look at some of the more common derivatives. A futures contract allows a firm to sell (or buy) a financial instrument at a designated future date, at today's price. The seller in a financial futures contract realizes a gain (loss) when interest rates rise (decline). The effectiveness of a hedge is influenced by the closeness of the match between the item being hedged and the financial instrument chosen as a hedge.

B. On January, 2011, an investor has portfolio consisting of four securities as shown below: Securit Price No. of Beta y Shares A 50 400 0.7 B 60 800 1.5 C 50 200 0.9 D 60 300 0.3 The investor fears a fall in prices of the shares in the near future. Accordingly, he approaches you for advice: a. Calculate the beta of this portfolio. b. Give any three advantages of currency futures over currency forwards. Ans:- Foreign currency forward contracts are used as a foreign currency hedge when an
investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the

foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount. By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost. For example, a U.S. exporter signs a contract today to sell hardware to a French importer. The terms of the contract require the importer to pay euros in six months' time. The exporter now has a known euro receivable. Over the next six months, the dollar value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. To mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to lock in the rate at which he will sell the euros and buy dollars in six months. To accomplish this, he hedges the euro receivable by locking in a forward. This arrangement leaves the exporter fully protected should the currency depreciate below the contract level. However, he gives up all benefits if the currency appreciates. In fact, the seller of a forward rate faces unlimited costs should the currency appreciate. This is a major drawback for many companies that consider this to be the true cost of a forward contract hedge. For companies that consider this to be only an opportunity cost, this aspect of a forward is an acceptable "cost". For this reason, forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount.

c. You are required to help the investor to protect his portfolio using nifty future which is 5500 and the lot size is 50. Please advise him how many futures contract should he sell or buy to bring down the beta to 0.2. C. Currently USD/INR is trading at Rs 45; it is known that at the end of this month it will be either Rs 40 or Rs 50. The risk free interest rate is 12% per annum with continuous compounding. Find the value of a one month European call option with an exercise price of Rs 45 with the help of Binomial model and Risk neutralization model. Question: 2 A. The price of Gold is currently $500 per ounce. The forward price for delivery in one year is $700. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. Ans:- The arbitageur could borrow money to buy 100 ounces of gold today and a short futures contract on 100 ounces of gold for delivery in one year. In particular gold is purchased for $500 per ounce plus $50 for interest. The gold is sold at $700 one year later for a prot of $150 per ounce, i.e. 100 (700 550) = $15, 000 per contract. This is a 150 550 = 27.3% return on investment! Buy as much as possible.

B. The current price of a stock is $94, and 3-month European call options with a strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is trying to decide between buying 100 shares, and buying 2,000 call options (=20 contracts). Both strategies involve an investment of $9,400. What advice would you give? How does the stock price have to rise for the option strategy to be more profitable? Ans:- The investment in call options entails higher risks but can lead to higher returns. If the stock price stays at $94, an investor who buys call options loses $9,400 whereas an investor who buys shares neither gains nor loses anything. If the stock price rises to $120, the investor who buys call options gains 2000 (120 95) 9400 = $40, 600 An investor who buys shares gains 100 (120 94) = $2, 600 C. A company enters into a short futures contract to sell 5,000 bushels of wheat for 250 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead to a margin call? Under what circumstances could $1,500 be with-drawn from the margin account? Ans:- The total notional is 5000 * $4.50 = $22500. If the initial margin is $3000 and the maintenance margin is
$2000, the total notional would have to fall by $1000 to hit the margin call. so that value would be $23500/5000 = $4.70. If the price went up to 470 cents a barrel you would get a margin call. In the second question that would be ($22500 - $ 1500)/5000 = $4.20. the price would have to fall to $4.20 for you to be able to withdraw $1500.

Question: 3 A. Describe and analyze the dangers of financial disaster that can accompany the following activities: a. The securitization of mortgages Ans:- The process of mortgage securitization involves combining individual mortgages of similar
characteristics in a pool and selling debt securities that draw interest on principal payments from the pool of mortgages. Securitization turns illiquid assets of individual mortgage loans into marketable securities that can be bought. sold and traded on the secondary markets.

b. Buying stock on margin Ans:- Margin means buying securities, such as stocks, by using funds you borrow from your broker. Buying stock on margin is
similar to buying a house with a mortgage. If you buy a house at a purchase price of $100,000 and put 10 percent down, your equity (the part you own) is $10,000, and you borrow the remaining $90,000 with a mortgage. If the value of the house rises to $120,000 and you sell, you will make a profit of 100 percent (closing costs excluded). How is that? The $20,000 gain on the property represents a gain of 20 percent on the purchase price of $100,000, but because your real investment is $10,000 (the down payment), your gain works out to 200 percent (a gain of $20,000 on your initial investment of $10,000).

Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money to increase your profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market. Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, it is negative net worth. Leverage is a double-edged sword.

c. Trading in options Ans:- All investors should have a portion of their portfolio set aside for option trades. Not only do options
provide great opportunities for leveraged plays; they can also help you earn larger profits with a smaller amount of cash outlay. Whats more, option strategies can help you hedge your portfolio and limit potential downside risk. No investors should be sitting on the sidelines simply because they dont understand options.

d. Short selling a financial asset Ans:- The sale of a security that is not owned by the seller, or that the seller has borrowed.
Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders who are familiar with its risks.

D. It is now July, 2011. A mining company has just discovered a small deposit of gold. It will take six months to construct the mine. The gold will then be extracted on a more or less continuous basis for one year. Futures contracts on gold are available on the New York commodity exchange. There is delivery months every 2 months from August 2011 to December 2012. Each contract is for the delivery of 100 ounces. Discuss how the mining company might use futures markets for hedging. Ans:- The mining company can estimate its production on monthly basis.It can then short future contracts to lock in the price received for the gold. Question: 4 A. Suppose that on October 24, 2010, you take a short position in an April 2011 live cattle futures contact. You close out your position on January 21, 2011. The futures price (per pound) is 61.20 cents when you enter into the contract, 58.30 cents when you close out your position and 58.80 cents at the end of December 2010. One contract is for the delivery of 40,000 pounds of cattle. What is your total profit? How is it taxed if you are a) a hedger and b) a speculator? B. A fund manager has a portfolio worth $500 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 3-month futures contracts on the S&P 500 to hedge the risk. The current level 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. a. What position should the fund manager take to eliminate all exposure to the market over the next months?

Ans:- The Portfolio Hedging Program is a managed hedge program which uses stock index futures
and/or options to transfer price risk associated with long equity positions. Instead of selling individuals stocks investors can create a substitute sale through a short position in index futures and/or options. To participate in such a program, determinations would need to be made as to how an investors stock portfolio correlates to a particular index. Once the beta, correlation of an individual stock or group of stocks to an index, is calculated, the proper hedge ratio can be determined as under: Number of contracts to hedge = Weighted beta of portfolio() x $ Value of portfolio(P) $ Value of index No. of contracts = 0.87 x $50,000,000 = 139.2 $1,250 x 250

Rounding to the nearest whole number, the investor should short 139 contracts to eliminate exposure to the market.

b. Calculate the effect of your strategy on the fund managers returns if the level of the market in 2 months is 1,000: 1,100: 1,200: 1,300: and 1,400. Assume that the 1-month futures price is 0.25% higher than the index level at this time. Ans:- Case I:
If the index in two month is 1,000 the 1-month future price which is 0.25% higher than the index level at this time can be calculated as under: Futures price = 1,000 * 1.0025 = 1,002.50. Thus the gain on the short futures position = (1,259 1,002.50) 250 139 = $8,913,375. The return on the index for the index value of 1000 can be calculated as follows: Return in the form of Dividend (3/6) 0.50% Return in the form of Capital Gains (1000-1250)/1250 -20.00% Total Returns -19.50% Risk free rate for two months (6%*2/12) 1.00% Returns in excess of risk free rate -20.50% Expected Return on portfolio in excess of risk free rate from CAPM (0.87*-20.5%) -17.835% Portfolio Return -16.835% The loss on the portfolio is 0.16835 $50,000,000 or $8,417,500. When this is combined with the gain on the futures the total gain is $495,875. The calculations for the return on index at other index levels are the same. The following table shows that the strategy has the effect of locking in a gain close to $490,000 at any level of the index. Index in two months 1,000 1,100 1,200 1,300 1,400 Futures Price 1,002.50 1,102.75 1,203.00 1,303.25 1,403.50 Gain on futures($) 8,913,375 5,429,688 1,946,000 (1,537,688) (5,021,375) Index Return -19.5 -11.5 -3.5 4.5 12.5 Excess Index return -20.5 -12.5 -4.5 3.5 11.5

Excess Portfolio Return -17.835 -10.875 -3.915 3.045 10.005 Portfolio return -16.835 -9.875 -2.915 4.045 11.005 Portfolio Gain($) (8,417,500) (4,937,500) (1,457,500) 2,022,500 5,502,500 Total Gain 495,875 492,188 488,500 484,813 481,125