Question Paper

Financial Risk Management - I (231) : July 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.
1. Mr. Amit has bought an April call option on July 280 call option. The premium for April call option is
Rs.2 and the premium for July 280 call option is Rs.10. The underlying asset for the July 280 call option
is shares of Rainbow Co. Ltd. currently priced at Rs.250. The April call option will be exercised
(a) In April always irrespective of the value of the compound option on exercise date
(b) In April only if the value of the compound option on that date is less than Rs.8
(c) In April only if the value of the compound option on that date is greater than Rs.10
(d) In April only if the value of the compound option on that date is greater than Rs.280
(e) In April only if the value of the compound option on that date is greater than Rs.8.
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2. A futures contract on US T-bonds is now selling at 95.20 and any of the following bonds can be
delivered under the contract. Which of the bonds is the cheapest to deliver?
Bond I II III IV
Quoted Price 99.50 110.50 120.75 136.00
Conversion factor 1.0401 1.0585 1.2600 1.3543
(a) I (b) II (c) III
(d) IV (e) Insufficient information.
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3. The quotation for a forward rate agreement in US dollars is as follows:
US $ 6/9 months 4.25%/4.50% p.a.
The quotation means that the interest rate on
(a) A 6 month US $ deposit made today is 4.25%
(b) A 9 month US $ deposit made today is 4.50%
(c) A 9 month US $ borrowing after six months is 4.50%
(d) A 3 month US $ deposit after six months is 4.25%
(e) A 3 month US $ deposit after six months is 4.50%.
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4. Which of the following statement is/are false?
I. Risk management has to be done in anticipation.
II. Risk management should aim at maintenance of risk at the minimal level.
III. No risk management can be complete in itself.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (II) above
(e) Both (II) and (III) above.
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5. Premium paid for insurance policies falls under which of the following type of cost of risk?
(a) Loss control costs (b) Residual uncertainity cost
(c) Social costs (d) Loss financing cost
(e) Risk identifying costs.
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6. A financial service company has interest income of Rs.50 million and its EVPE (Economic Value of
Portfolio Equity) is Rs.200 million. The annual volatility of interest income is 10%. At 95% confidence
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level the maximum reduction expected in the EVPE in a single day is
(a) Rs.0.01 million (b) Rs.0.31 million
(c) Rs.0.52 million (d) Rs.0.65 million
(e) Rs.2.09 million.
7. Which of the following statements is/are true with respect to put time spread strategy?
I. The maximum loss in put time spread strategy is the initial investment.
II. The break-even point for the put time spread strategy is the exercise price plus the initial
investment.
III. The investor adopting put time spread strategy will benefit most, if the stock remains above the
exercise price until the short put position expires.
(a) Only (I) above (b) Only (II) above
(c) Both (I) and (III) above (d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
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8. In the Black- Scholes model, which of the following changes would not increase the price of a call
option?
(a) Increase in volatility of the price of underlying asset
(b) Increase in risk less rate of interest
(c) Decrease in time to expiration
(d) Decrease in exercise price
(e) Increase in stock price.
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9. The intrinsic value of a put option is the maximum of
(a) Strike Price Spot Price Premium, or zero
(b) Strike Price Spot Price, or zero
(c) Spot Price Strike Price, or zero
(d) Spot Price Strike Price Premium, or zero
(e) Strike price, or zero.
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10. An investor bought a binary call option on a stock at strike price of Rs.100, at a premium of Rs.5. On
the expiration date the stock price turned out to be Rs.110. The pay-off would be
(a) Rs.5
(b) Zero
(c) Rs.10
(d) A fixed sum decided at the time of entering into the contract
(e) Insufficient information.
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11. Which of the following statements best describes the liquidity risk?
(a) It is the possibility of adverse effect on the value of a firms liabilities due to exchange rate
movements
(b) It is the risk of an adverse effect of interest rate movement on a firms profit and balance sheet
(c) It is the possibility of bankruptcy arising due to the inability of a firm to meet its financial
obligations
(d) It is the risk faced by a firm due to change in business environment
(e) It is the possibility of firm not being able to produce the budgeted quantity at the budgeted price
due to frequent machinery breakdown.
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12. Mr. Nikunj expects that the AUS$ may depreciate in comparison to the CHF. Under which of the
following situation he will make profit?
I. He sells AUS$ futures, buy CHF futures and both the AUS$ and the CHF depreciates in relation to
US$, but the CHF depreciates more.
II. He buys AUS$ futures, sells CHF futures and both the AUS$ and the CHF depreciates in relation
to US$, but the AUS$ depreciates more.
III. He sells AUS$ futures, buy CHF futures and both the AUS$ and the CHF appreciates in relation to
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US$, but the CHF appreciates more.
IV. He sells AUS$ futures, buy CHF futures, and CHF appreciates and the AUS$ depreciates, both in
relation to the US$.
(a) Only (II) above (b) Only (III) above
(c) Both (III) and (IV) above (d) Both (I) and (II) above
(e) (II), (III) and (IV) above.
13. If you buy a share of RK Ltd. at Rs.49, and simultaneously write a JULY 50 straddle for Rs.6, the
maximum possible loss from the strategy will be
(a) Rs.49 (b) Rs.50 (c) Rs.93
(d) Rs.133 (e) Rs.145.
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14. A reverse diagonal call spread can be formed by
I. Buying a short-term call option and writing a long-term call option with the purchased call
utilizing a higher exercise price.
II. Buying a call option with the higher exercise price and writing a call option with the lower
exercise price, both having same maturity period.
III. Buying a short-term call option and writing a long-term call option both having same exercise
price.
IV. Buying a long-term call option and writing a short-term call option with the purchased call
utilizing a lower exercise price.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Only (IV) above
(e) Both (I) and (IV) above.
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15. Which of the following strategies involves holding a short position on the stock coupled with a
synthetic long position?
(a) Calendar spread (b) Conversions (c) Reversals
(d) Ratio spread (e) Condor spread.
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16. Suresh is looking at a call option with an exercise price of Rs.25.00 which is currently valued at
Rs.3.22. The price of the underlying asset is Rs.24.75. If the price of the underlying asset appreciates to
Rs.25.50, and the delta of the option is 0.35, what will be the return from holding the call option?
(a) 11.35% (b) 9.55% (c) 8.15% (d) 6.45% (e) 5.43%.
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17. Max Pharma Ltd. (MPL) has Euro receivables. To hedge this exposure MPL enters into a forward
contract. MPL is managing the risk by which of the following tools?
(a) Risk avoidance (b) Loss control (c) Risk separation
(d) Risk combination (e) Risk transfer.
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18. Two parties A and B enters into an equity swap in which party A pays the returns on a stock index and
party B pays a fixed rate of 6%. The notional principal is Rs.10 million. The stock index starts off at
10,000 and is at 10551.50 at the end of the period. If, the interest payment is calculated based on 180
days in the period and 360 days in a year, what is the net payment on the swap?
(a) Party B pays Rs.8,51,500 (b) Party B pays Rs.48,500
(c) Party B pays Rs.2,51,500 (d) Party A pays Rs.2,51,500
(e) Party A pays Rs.8,51,500.
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19. On April 12, a firm was expecting $10 million from a foreign branch on June 12. The firm intended to
invest the amount in 3-month T-bills. On April 12, the 3-month T-bill discount yield was 7.40% and the
implied discount yield on the June T-bill futures was 7.10%. The firm decided to use T-bill futures to
hedge against possible fall in the interest rates. If on June 12, the 3-month cash T-bill had a discount
yield of 7.85%, what would be the annualized discount yield available to the firm?
(a) 7.10% (b) 7.23% (c) 7.40% (d) 7.85% (e) 8.79%.
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20. Which of the following statements are true with respect to the variations that exists for swaps?
I. An off-market swap is one in which the fixed rate payer pays an above market rate in exchange for
the floating rate payer making an upfront cash payment.
II. An accreting swap is one in which the notional principal rises during the life of the swap.
III. A basis swap is one in which both counterparties pay floating rate of interest, however the
benchmarks used to calculate the payments are different.
IV. Forward swaps are one in which future coupon payments are dependent upon existing forward
rates for those periods.
(a) Both (II) and (III) above (b) Both (II) and (IV) above
(c) Both (III) and (IV) above (d) (I), (II) and (IV) above
(e) (I), (II) and (III) above.
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21. A company expecting hot days in summer should
I. Buy CDD indices in winter.
II. Buy HDD indices in winter.
III. Sell CDD indices in summer.
IV. Sell HDD indices in summer.
(a) Only (I) above (b) Only (IV) above
(c) Both (I) and (II) above (d) Both (II) and (III) above
(e) Both (I) and (IV) above.
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22. A Rs.5 million stock portfolio has a beta of 1.10 at a time when the BSE sensex stands at 6400. You
write 16 JUN BSE 6500 calls at a premium of Rs.50 each. At option expiration in June, the BSE sensex
is 6520. What is the value of the total portfolio after option expiration?
(a) Rs.5,127,150 (b) Rs.5,125,250 (c) Rs.5,129,150
(d) Rs.5,130,850 (e) Rs.5,132,450.
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23. An investor expects that there will be a bullish trend in market in the near future and constructs a 3:2
ratio spread using Dec 840 put priced at Rs.6.2 and Dec 860 put priced at Rs.14.1. What will be the
break-even point for the strategy?
(a) Rs.830.4 (b) Rs.849.6 (c) Rs.850.4
(d) Rs.855.2 (e) Rs.858.07.
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24. When a transaction consists both a currency swap and an interest rate swap with LIBOR based pricing
for floating side of each, the swap is called
(a) A deferred swap (b) A rate capped swap
(c) Amortizing currency swap (d) Roller-coaster swap
(e) A circus swap.
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25. The date on which the interest accrual stops is called
(a) Trade date (b) Effective date (c) Reset date
(d) Maturity date (e) Value date.
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26. Which of the following contracts are subject to the requirements of FASB-133?
(a) Casualty insurance policies
(b) Contract that call for payments only to reimburse for a loss from debtor failure to pay when due
(c) 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
(d) Forward purchase or sale of as-issued or if-issued securities
(e) Credit-indexed contract requiring payments for changes in credit rating.
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27. Which of the following statements is not correct?
(a) Normally, theta is always less then zero
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(b) Delta of a call is always positive
(c) Rho will be higher for deep-in-the-money put
(d) Vega of call and put will always be identical
(e) Gamma of a put and call option is equal.
28. An investor goes short on Index futures contract at Rs.3,525. Initial margin is Rs.25,000 and
maintenance margin is 75% of the initial margin. If next day index closes at Rs.3,600, the margin call
would be, (Assume a multiple of 100)
(a) Rs.2,500 (b) Rs.3,750 (c) Rs.5,000 (d) Rs.7,500 (e) Rs.8,700.
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29. Which of the following statements are false with respect to various elements of an insurance contract?
I. When the legal heirs of the insured have a right to recover the perceived loss from a third party,
full amount of policy would be subrogated by the insurer.
II. The assignor has right to revoke the assignment after the assignment is made.
III. An insurer is liable for any loss proximately caused by a peril insured against.
IV. Both life insurance policies as well as general insurance policies can be assigned.
(a) Both (I) and (II) above (b) Both (II) and (III) above
(c) Both (III) and (IV) above (d) (II), (III) and (IV) above
(e) (I), (II) and (III) above.
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30. Which of the following statements is/are correct according to the smile effect in option prices?
I. Implied volatility of options deeply in-the-money is greater than those at-the-money
II. Implied volatility of options deeply out-of-the-money is greater than those at-the-money
III. Implied volatility of options deeply in-the-money is smaller than those deeply out-of-the-money.
(a) Only (II) above (b) Only (III) above
(c) Both (I) and (II) above (d) Both (II) and (III) above
(e) All (I), (II), (III) above.
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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. Mr. Niraj a risk-averse investor is looking at the following call and put options of Ivy Systems quoted at the
market:
Strike Price
(Rs.)
Call Premium
(Rs.)
Put Premium
(Rs.)
Expiration
325 15 10 1 month
350 5 20 1 month
The current stock price of Ivy Systems is Rs. 330. He has no definite view of the market movements in next 1
month, but thinks that above options are not correctly priced by the market.
You are required to suggest a risk-less spread strategy to him by using all the four given options to make profit
from his view. Show the pay off profile of the strategy if the spot price after 1 month ranges between Rs.300
Rs.375, taking an interval of Rs.5.
(9 marks) < Answer >
2. Ranka Metal Inc. of UK is holding 25 million on the spot market. To hedge against fall in the value of euro the
company also purchased put option on 25 million with a strike price of 0.6892/. The option premium paid is
312,500. The delta of the put option is 0.60, the annual volatility of the euro-sterling exchange rate is 10% and
the current exchange rate is 1.4470/.
You are required to calculate 10-days value-at-risk (VaR) at 99% confidence level for
a. Long position in euro
b. Long position in put
c. The combined position of long currency and long put.
(Assume 250 trading days in a year)
(3 + 3 + 3 = 9 marks) < Answer >
3. A US investor is planning to buy 1000 shares of Swissair stock. The current price of the stock quoted in Swiss
market is SFr950. The current exchange rate is SFr1.2139/$. The investor is interested in speculating on the stock
and wish to reduce its probable losses using SFr futures contract as dollar is expected to depreciate against Swiss
Franc in future. The holding period of the investor is six months. The appropriate SFr futures contract is currently
traded at $0.8234. The contract size of SFr futures is SFr125,000.
You are required to construct a position and evaluate how the investment will perform if after six months the
stock is traded at SFr936.50, the spot exchange rate is SFr1.2095/$ and the futures price is $0.8272. Also
determine the gain or loss from the combined position.
(6 marks) < Answer >
4. Consider a one-year put swaption, which has an underlying swap as a four-year swap. A put swaption gives its
buyer the right to enter into a swap as a floating rate payer and if he exercises the option, receives fixed rate from
the swap. The strike price of the put swaption is 9% and the notional principal is $10 million. At expiration of the
swaption, the spot rates on zero coupon bonds of various maturities turned out as below:
Year Yield on Zero Coupon Bond
1 7.5%
2 8.0%
3 8.4%
4 8.7%
You are required to calculate the payoff from the put swaption. (Assume 360 days in a year).
(10 marks) < Answer >
5. An Indian Bank has sold three-month European call option on $2 million with a strike price of Rs.45.10. The
current rupee-dollar exchange rate is Rs.45.30/$. The annual volatility of rupee-dollar exchange rate is 6%. The
91-day T-bill rate in India is 4% p.a. and 91-day US T-bill rate is 1% p.a.
You are required to find out the position the bank should take (using options) to make the position delta neutral.
(8 marks) < Answer >
6. Stock of HLL is currently trading in the market at Rs.220. The price of the stock is expected to go up or down by
15% in the first half year and by 5% in the second half year. The return on the Government security being traded
in the market for same maturity is 4% p.a.
You are required to calculate the value of a one-year American put option on HLLs stock with strike price of
Rs.250.
(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. The justification for exercising an American call early does not hold up when considering an American put.
Why?
b. What are the advantages and disadvantages of an interest rate collar over an interest rate cap? Explain.
(5 + 5 = 10 marks) < Answer >
8. For a futures contract, the futures exchange specify in detail the exact nature and terms of the agreement between
two parties. Discuss the various specifications of futures contracts.
(10 marks) < Answer >
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Financial Risk Management - I (231) : July 2006
Section A : Basic Concepts
1. Answer : (c)
Reason: Compound options are basically options on options. Few examples of compound options
are captions, floors, and swaptions. They can be exercised only on the first exercise date
and the value of the option on that date should be greater than the strike price i.e. premium
of underlying option. Here, the strike price for the April option is premium of July option
i.e.Rs.10. Therefore, the April option will be exercised only if the value of the option on
that date is more than Rs.10.
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2. Answer : (a)
Reason: Cheapest to deliver bond is the bond with the lowest cost of delivering.
Cost of delivering = Quoted price (Current Futures price x Conversion Factor)
Cost of bond I = 99.50 (95.20 x 1.0401) = 0.4825
Cost of bond II = 110.50 (95.20 x 1.0585) = Rs.9.7308
Cost of bond III = 120.75 (95.20 x 1.2600) = Rs.0.7980
Cost of bond IV = 136.00 (95.20 x 1.3543) = Rs.7.0706
Hence, bond I is the cheapest to deliver bond.
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3. Answer : (d)
Reason: The quote means deposit interest starting 6 months from now for 3 month is 4.25% and
borrowing interest rate starting 6 months from now for 3 month is 4.50%.
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4. Answer : (b)
Reason: Risk management should aim at maintenance of the risk at an acceptable level that need not
always be the minimum since the cost may exceed the benefits. Hence, statement (II) is
false. Risk management cannot be done after the happening of an event, it has to be done in
its anticipation. Hence, statement (I) is true. No risk management is complete in itself. A
firm has to ensure that it employs the most optimum mix of various risk management tools
and as also that of various internal and external hedging techniques. Hence, statement (III)
is true.
Hence, option (b) is the correct answer.
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5. Answer : (d)
Reason: Loss financing costs include insurance policies, hedging arrangements and other
contractual risk tranfers.
Hence, option (d) is the correct answer.
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6. Answer : (c)
Reason: Volatility = 10% p.a.
Daily volatility = 10/
250
= 0.6325%
Maximum reduction expected in the interest income is Rs.50 million x (1 1.65 x
0.006325) = Rs.49.48 million. Therefore, the EVPE will be Rs.200 million Rs.0.52million
= Rs.199.48 million. Thus, the maximum loss expected in EVPE for a single day is Rs.0.52
million.
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7. Answer : (c)
Reason: The break even point for put time spread strategy is realized if the stock is at a price
equivalent to the exercise price minus the initial investment. Hence, statement (II) is false.
All other statements are correct.
Hence, option (c) is the correct answer.
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8. Answer : (c)
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Reason: Decrease in time to expiration will decrease the price of a call option. All other alternatives
would increase the price of a call option.
Hence, option (c) is the correct answer.
9. Answer : (b)
Reason: Intrinsic value of a put option is max (0, X-S), where X= strike price and S=spot price.
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10. Answer : (d)
Reason: Binary options have discontinuous pay-offs. For instance, a cash or nothing if stock price is
below the strike price and pays a fixed amount if the stock price rises above the strike price.
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11. Answer : (c)
Reason: Liquidity risk refers to the risk of a possible bankruptcy arising due to the inability of the
firm to meet its financial obligations. It is possible that a firm may be very profitable but
may have a severe liquidity crunch because it has blocked its money in illiquid assets.
Liquidity risk also refers to the possibility of having excess funds, i.e. the risk of having
more funds than it can profitably deploy.
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12. Answer : (c)
Reason: If the market expects that the AUS$ may depreciate in comparison to the CHF, he can sell
AUS$ futures while simultaneously buying CHF futures, thus assuring a future exchange
rate between the two said currencies. The money manager will make real benefits only in
the following situation:
Both the AUS$ and the CHF depreciate in relation to US$, but the AUS$ depreciates
more.
Both the AUS$ and CHF appreciate in relation to the US$, but the CHF appreciates
more
The CHF appreciates and the AUS$ depreciates, both in relation to the US$.
Hence, option (c) is the correct answer.
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13. Answer : (c)
Reason: Maximum loss from the strategy could be when price of the stock falls to zero. Then the
put will be exercised and loss from put will be Rs.50, and call will not be exercised. So,
total loss will be = 49 50 + 6 = Rs.93.
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14. Answer : (a)
Reason: A reverse diagonal call spread can be formed by buying a short-term call option and writing
a long-term call option with the purchased call utilizing a higher exercise price. Hence,
statement (I) is true. A bearish vertical spread strategy using the calls involves purchase of
a call option with the higher exercise price and writing of another call option with the lower
exercise price, both having same maturity period. Hence, statement (II) is false. Reverse
time spread strategy using calls involves the purchase of a short-term call option and
writing of a long-term call option, both having same exercise price. Hence, statement (III)
is false. A diagonal call spread strategy involves buying a long-term call option and writing
a short-term call option with the purchased call utilizing a lower exercise price. Hence,
statement (IV) is false.
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15. Answer : (c)
Reason: Reversals involve a short position on the stock coupled with a synthetic long position. This
gives rise to arbitrage opportunities in case of mispriced stocks.
Hence, option (c) is the correct answer.
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16. Answer : (c)
Reason: Change in call price = (Delta) (Change in stock) = 0.35 (25.5 24.75) = 0.2625
% Return holding call option = 0.2625 / 3.22 = 8.15%.
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17. Answer : (e)
Reason: The exchange risk involved in holding foreign currency asset/ liabilities can be transferred
to another by entering into a forward contract. So MPL is managing the risk by Transfer.
Therefore (e) is the answer.
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18. Answer : (d)
Reason: An equity swap means an exchange of dividends earned and capital gains on a portfolio,
which is based on a stock index against periodic interest payments. In the given situation,
party A will pay return on the stock index i.e. [(10551.50 10,000) * 10 million /10,000] =
Rs.5,51,500 and will receive (Rs.10 million * 0.06 * 180 / 360 ) = Rs.3,00,000 from party
B. Hence, overall party A will pay Rs.5,51,500 Rs.3,00,000 = Rs.2,51,500 to party B.
Hence, option (d) is the correct answer.
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19. Answer : (a)
Reason: Price of cash T-bill on June 12= $10,000,000 x (1 0.0785/4) = $9,803,750
Future loss = (92.15 92.90) x 100 x 25 x 10 = $18,750
Effective price of the cash T-bill = $9,803,750 + $18,750 = $9,822,500
Annualized discount yield = $10,000,000 - $9,822,500/$10,000,000 x 12/3 x 100 = 7.10%
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20. Answer : (e)
Reason: Statement (IV) is incorrect because a forward swap is one in which the coupon payments
will commence at some pre-determined future date. All other statements are correct.
Hence, option (e) is the correct answer.
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21. Answer : (d)
Reason: A company which is expecting hot days in summer would either buy HDD indices in
winter or sell CDD indices in summer.
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22. Answer : (a)
Reason: The index rises by 1.875%. Therefore, the portfolio should rise by (1.10)(1.875%) =
2.063%.
Stock: Rs.5 million 1.02063 = 5,103,150
Option premium: 16 50 Rs.50 = 40,000
Cash settlement: (6500 6520) 50 16 = (16,000)
Rs.5,127,150
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23. Answer : (d)
Reason: The investor will buy 3 Dec 840 put options and sell 2 Dec 860 put options.
So, the intial investment will be as follows:
Initial outflow on 3 Dec 840 put options purchsed = 3 x 6.2 = Rs.18.6
Initial inflow on 2 Dec 860 put options sold = 2 x 14.1 = Rs.28.2
Hence, net initial inflow = Rs.9.6
At the sotck price of Rs.855.2, the Dec 840 put options will not be excercised but the Dec
860 option will be exercised by the option buyer.So the trader wil make a loss of Rs. 9.6
[(860 - 855.2 ) x 2] on 2 Dec 860 put options sold.
Thus, the over all position will be
Initial inflow = Rs.9.6
Loss on option = Rs.9.6
Net flow = 0
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24. Answer : (e)
Reason: When two fixed - floating currency swaps are combined to form a fixed to fixed currency
swap, it is known as circus swap. It can be created by combining a currency swap and an
interest rate swap with floating rate or both having LIBOR pricing.
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25. Answer : (d)
Reason: The date on which interest accrual stops is called maturity date.
Hence, option (d) is the correct answer.
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26. Answer : (e)
Reason: Traditional life insurance, traditional property and casualty insurance policies, forward
purchase or sell of as-issued or if-issued securities are not considered as derivative
instruments as per FASB-133 and as such are not subject to the requirement of FASB-133.
Contracts for the future delivery of assets convertible into cash and for that there is no
settlement provision and no market mechanism to ease the net settlement are also not
subject to the requirement of FASB-133. Contracts that call for payments only to reimburse
for a loss from debtor failure to pay when due are not subject to requirements of FASB-
133. However, a credit-indexed contract requiring payment for changes in credit rating
qualifies as a derivative instrument and hence subject to the requirement of FASB-133.
Thus. Option (a), (b), (c) and (d) are false and option (e) is the correct answer.
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27. Answer : (c)
Reason: Rho will be lower for deep-in-the-money put, hence ( c) is not correct. All the others are
correct.
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28. Answer : (d)
Reason: Initial margin = Rs.25,000
Maintenance margin = 0.75 25000 = 18,750
Index closes at 3600
Loss = (3600 3525) 100
= 7500
Margin call = Rs.7,500.
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29. Answer : (a)
Reason: When the legal heirs of the insured have a right to recover the perceived loss from a third
party, it cannot be subrogated irrespective of the status of the policy amount that has to be
paid by the insurer. No amount of policy would be subrogated by the insurer. Hence,
statement (I) is false. Once, the assignment is made, it cannot be revoked by the assignor
because he ceases to be the owner of the policy unless re-assignment is made by the
assignee in favour of the assignor. Hence, statement (II) is false. An insurer is liable for any
loss proximately caused by a peril insured against. Hence, statement (III) is true. Both life
insurance policies as well as general insurance policies can be assigned. Many of the loan
companies and housing finance companies grants loans to the individuals on assignment of
life insurance policies. Hence, statement (IV) is true.
Hence, option (a) is the correct answer.
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30. Answer : (c)
Reason: The smile effect in option pricing models shows that volatility of deep in-the-money and
deep out-of-the-money options are greater than those at-the-money options.
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Section B : Problems
1. The appropriate spread strategy for the investor is box spread, as it is combination of bull and bear spread with
calls and puts respectively. The pay-off from the box spread is difference between higher and lower strike price
less initial investment. So if initial investment is less than the difference in strike prices, this spread strategy will
always give profit irrespective of the maturity spot price.
Box spread can be created by buying call at Rs.325 and selling call at Rs.350, and buying put at Rs.350 and selling put at Rs.325.
Initial investment = (15 5) + (20 10)
= 10+ 10
= Rs.20
Pay off Profile
Spot
Gain / loss on
I.O.
Net
gain/loss
(+) C =
325
()C = 350 (+)P = 350 ()P=325
300 +50 25 20 5
305 +45 20 20 5
310 +40 15 20 5
315 +35 10 20 5
320 +30 5 20 5
325 +25 20 5
330 +5 +20 20 5
335 +10 +15 20 5
340 +15 +10 20 5
345 +20 +5 20 5
350 +25 20 5
355 +30 5 20 5
360 +35 10 20 5
365 +40 15 20 5
370 +45 20 20 5
375 +50 25 20 5
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2. Spot rate / = 1.4470
Long position in euro = 25,000,000
Put strike price / = 0.6892
Option premium paid = 3,12,500
Delta of put option = 0.60
Exchange rate volatility = 10%
a. Position value in sterling =
25, 000, 000
1.4470
= 17,277,125.09
Daily volatility =
250
Annualvolatility
=
10
250
= 0.6325%
Z-value for 99% confidence level is 2.33
Volatility for 10 days period = 0.6325 x
10
= 2.00%
VAR of the position = 17,277,125.09 x 2.33 x 0.02 = 805,114.03
b. Delta of the put position = 25,000,000 x 0.60 = 15,000,000
Therefore long put option has the same position of going short on the 15,000,000.
The VAR of the position for 10 days at 99% confidence level will be
15,000,000 x 1/1.4470 x 2.33 x 0.02 = 483,068.42
c. Buying put option on $25 million is equivalent to going short on $15 million.
Therefore, the combined position of long on euro and long on put = 25,000,000 15,000,000 = 10,000,000
VAR at 99% confidence level for 10 days will be = 10,000,000 x 1/1.4470 x 2.33 x 0.02 = 322,045.61
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3. Investment made = 1000 x 950 = SFr 950,000
= $950,000 x 1/1.2139 = $782,601.53
The investor needs to buy SFr futures since he will gain if SFr appreciates against US$.
Number of contracts required to be purchased = 950,000 / 125,000 = 7.6

8
So he will buy 8 futures contract at $0.8234.
After six months the gain from futures contract = (0.8272 0.8234) x 8 x 125,000 = $3,800
Value of stock in dollar = 1000 x 936.50 x 1/1.2095 = $774,286.90
Therefore loss on stock is $8314.63
Overall loss from the hedged position = $8,314.63 - $3,800 = $4,514.63
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4. We have to find the fixed rate on the swap. Let the fixed rate be R, and the notional principal be P.
We can get the present value of the fixed leg by multiplying (P x R) by the discounting factor we get from the
yield on Zero coupon bonds.
Term Rate Discounting Factor
1 year 7.5%
[ ] 1/ 1 0.075(360 / 360) +
= 0.9302
2 years 8.0%
[ ] 1/ 1 0.08(720 / 360) +
= 0.8621
3 years 8.4%
[ ] 1/ 1 0.084(1080 / 360) +
= 0.7987
4 years 8.7%
[ ] 1/ 1 0.087(1440 / 360) +
= 0.7418
The present value of fixed leg = P x R x (0.9302 + 0.8621 + 0.7987 + 0.7418)
= P x R x 3.3328
We know that at time 0, the present value of floating rate payments is the notional principal, P. But, given that
there is no principal payment the present value of principal repayment is to be subtracted from the notional
principal P.
So, present value of floating payment = P (P x 0.7418)
= P x 0.2582
Now, value of swap at the inception is zero, so
P x R x 3.3328 = P x 0.2582
Or, R = 7.75%
The put swaption is expiring in-the-money. So, we can exercise the option or can close the position by taking cash
settlement.
Pay off from swaption = (0.09 0.0775) x (0.9302 + 0.8621 + 0.7987 + 0.7418) x $10 million
= $0.4166 million.
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5. Here, So = 45.30, X = 45.10,

= 0.06, r = 0.04, rf = 0.01, t = 0.25

d1 =
2
2
So
In r rf t
k
t

+ +

1
_

1
,
]
=
2
45.30 (0.06)
0.04 0.01 0.25
45.10 2
0.06 0.25
In + +

1
_

1
,
]
=
[ ] 0.00442 0.0318 0.25
0.06 0.25
+

=
0.01237
0.03
= 0.4123
N(d1) = 0.6600
Delta of a short position in one call option is =
0.04 0.25
0.6600

e
= 0.6534

Delta of total short position is = 0.6534 x $2 million = $1.3068 million

To make the position delta neutral the bank should either take a long dollar position of $1.3068 million in
spot market or should buy call option having delta of 1.3068 million.
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6. The stock price is likely to be as follows:
The value of American put option at node D, E, F and G will be equal to the value of European put option on these
nodes, which is equal to their intrinsic value.
Value at node D = as the stock price is more than the strike price, the put has zero value.
Value at node E = 250 240.35 = 9.65
Value at node F = 250 196.35 = 53.65
Value at node G = 250 177.65 = 72.35
Using single period model, the probability of price increase in the second half year,
p =

R d
u d
=
1.02 0.95
1.05 0.95

= 0.70

Probability of price decrease = 1 p = 0.30

Using single period model, the value of put option at node B is,
P =
(1 ) +
u d
C p p C
R
=
(0 0.70) (0.30 9.65)
1.02
+
= 2.84
At node B, pay off from early exercise is 0.

Value of put option at node B is 2.84.

Now at node C, value of put option is
P =
(53.65 0.70) (72.35 0.30)
1.02
+
= 58.10
At node C, pay-off from early exercise is (250 187) = 63, which is higher than the value of put option using
single period model. So value of put option at node C is 63.
Probability of price increase in the first half year
P =
1.02 0.85
1.15 0.85

= 0.57

Probability of price decrease = 1 0.57 = 0.43

Using single period model, value of put option at node A is,
P =
(2.84 0.57) (63 0.43)
1.02
+
= 28.15
At node A, pay off from the early exercise is (250 220) = 30, which is higher than the value of put option using
single period model.
So, value of put option is Rs.30.
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Section C: Applied Theory
7 a. An American call is exercised early only to capture a dividend. When a stock goes ex-dividend, the call will
lose value as the stock drops. This will cause a loss in value to the holder of the call. The call holder knows
this loss will be incurred as soon as the stock goes ex-dividend. If the call were exercised just before the
stock goes ex-dividend, however, the call holder would capture the stock and the dividend, which might be
enough to offset the otherwise loss in the value of the call. For a put, however, dividends are not necessary
to make the argument that it might be optimal to exercise early. The holder of an American put faces a
situation in which the gains are limited to the exercise price. Since the stock price can go down only to zero,
early exercise of a put on a bankrupt firm would obviously be advisable. But the firm does not have to go
bankrupt. If the stock price is low enough, the gains from waiting for it to go lower are not worth the wait. If
dividends were added to the picture, however, they would discourage early exercise. The more dividends
paid, the lower the stock price is driven and the more valuable it is to hold on to the put.
b. An interest rate cap provides protection against increases in the interest rate over the exercise rate at the
expense of having to pay cash up front. By combining a short position in an interest rate floor, you obtain an
interest rate collar, which will provide the same protection, but the firm can pay for it in a different way.
When a party buys an interest rate floor, it obtains protection if rates fall below the floor exercise rate. By
selling a floor, a firm receives a premium up front as compensation for the possibility that it will have to
make payments to the floor holder if rates fall below the floor exercise rate. Thus, if the buyer of a cap sells a
floor with a lower exercise rate, the payment received up front from the floor can offset the payment made
for the cap. The disadvantage of a collar is that the gains from falling interest rates below the lower strike are
forgone. Typically the exercise rate on the floor is set such that the floor premium precisely offsets the cap
premium.
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8 A futures contract between two parties should specify in some detail the exact nature of the asset, price, contract
size, delivery arrangements, delivery months, tick size, limits on daily price fluctuation and trading unit.
The Asset
The delivery of the asset needs to be specified at the time of entering into a contract. When the underlying asset is
a commodity, there may be variations in the quality of what is available in the market. It, therefore, becomes
important to specify the grade of the commodity that is to be delivered. For example, on CBOT, one of the
specifications for corn futures contract, the standard grade is No.2 Soft red or Dark northern spring No.1, etc.
The Price
The price agreeable to the buyer and the seller at the time of delivery of the future contract is specified at the time
of agreement. The futures prices quoted are convenient and easy to understand. For example, corn prices on the
Chicago Mercantile Exchange (CME) are quoted per bushel. The treasury bonds and notes on futures on CBOT
are quoted in dollars with two decimals.
The Contract Size
This specifies the amount of the asset that has to be delivered under one contract. If the size of the contract is too
large, many investors cannot use the exchange for hedging or for speculative purposes. This is because speculators
may not wish to take large positions due to risk. However, if the contract size is too small, trading becomes
expensive due to the cost associated with trading.
Delivery Arrangements
The place for delivery needs to be specified at the time of the contract to avoid controversy. The location or place
of delivery becomes a major issue when the transportation costs are significant. However, if any alternative
delivery locations are specified, the price received by the seller is sometimes adjusted according to the place
chosen by him. Sometimes alternatives are specified for the grade of the asset that will be delivered or for the
delivery locations.
Delivery Months
A futures contract is referred to by its delivery month. For example, July corn, which means that contract is for
delivery in the month of July. The delivery months vary from one contract to the other depending upon the
underlying asset, and also on the needs of market participants. For certain contracts the delivery period will be
throughout the month. Trading on contracts generally ceases a few days before the last day on which the delivery
can be made. The date on which the contracts ceases to trade is specified by the exchange.
Tick Size
The contract also specifies the minimum price fluctuation or tick size. For example, in soybean contract, one tick
is 1/4 cent per bushel as the minimum size of contract for soybean is 5000 bushels, which gives a tick size of
$12.50 per contract.
Limits on Daily Price Movements
The daily price movement limits are specified by the exchange. If the price moves up by a limit, it is referred to as
limit up and if it moves down by a limit, it is referred to as limit down. The prime purpose of the daily price limits
is to prevent large price fluctuations that may occur due to excessive speculations and also to safeguard the
interests of genuine traders. The limits are set by the exchange authorities. However, the price limits become
artificial when the price of the underlying commodity is advancing or declining rapidly.
Trading Unit
This specifies the minimum number of units that are traded on the exchange. For example, the trading unit for
soybean oil is 60,000 pounds on CBOT exchange. Apart from the above general specifications, there are certain
definite specifications pertaining to each of the categories based on underlying assets.
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