Reference no: EM132957905

FIN7020 Derivatives Investments - Birmingham City Business School

Learning outcome 1: Assess derivative contracts and their appropriateness and suitability for investment and management of different risks.

Learning outcome 2: Construct derivative contracts to get exposure to investments in different markets & asset classes.

Learning outcome 3: Evaluate different risks associated with investments & financing and use derivative contracts to hedge the relevant risks.

Question 1

A) You are currently working as a junior trader at the Derivatives Trading desk for Lambert Financials. Your line manager, Ray Donald, CFA, has asked you to prepare a short report comparing different option trading strategies. Ray has asked you to consider the costs for each strategy and its potential payoffs. You are not very comfortable with option models and must first investigate how to properly price European style equity options. Ray has given you choice to use any available option pricing model that you understand and can apply to price European puts and calls.

In order to complete the assigned task, you decide to use BSM model for pricing European puts and calls on Microsoft's stock listed on the Chicago Board of Options Exchange (CBOE) . You have to choose exercises prices, expirations, risk free rate and measure of volatility to use as inputs in pricing the options.

Requirement:
I) Estimate prices of European puts and calls on Microsoft's stock with two different expirations and two different exercise prices of your choice using the BSM model. Provide details of your underlying assumptions and inputs with justifications of each.

II) Illustrate Put-Call parity using any pair of the estimated call and put prices. You will have to bootstrap the value of risk free bonds.

III) Explain straddle strategy and demonstrate its execution using the puts and calls on Microsoft's stock. Also calculate the following for the straddle assuming different spot prices for Microsoft's shares at expiration:

a. Maximum profit
b. Minimum profit
c. Breakeven price

IV) Evaluate the impact of different holding periods for the straddle constructed from options on Microsoft's shares.

B) On the 9th of February 2021, one of your institutional client has committed lending £300 million in 70 days i.e. on 20th April 2021 for 180 days due on 17th October 2021. Interest rate is set to be 180-day LIBOR + 100 bps. The client is worried about a fall in interest rates over the next 70 days. However, the client wants to keep the upside.

You suggest the client buy a £300 million interest rate put option on the 180-day LIBOR with an exercise rate of 5.00% expiring on 20th April, 2021. The put option is available at a premium of £52,500. The spot 180-day LIBOR on 9th February, 2021 is 5.25%. The client does as you suggest and buys the option and exercises the option on 20th April, 2021 when the 180-day LIBOR is 3.00%. The payoff from the exercise is received on 17th October, 2021. Your line manager has asked you to evaluate this hedging strategy and explain if it effectively hedged against the fall in interest rate.

Required:

Calculate the effective annual interest rate for the client's lending. Explain if the strategy effectively hedges the interest rate exposure of the client.

Question 2

A) Ray has been approached by a portfolio manager who is responsible for a £750 million investment portfolio. The portfolio manager has increasingly become more risk averse recently as it is anticipating a major announcement regarding monetary policy. To reflect the future expectations, it wishes to temporarily make the following changes to the existing portfolio:

i) reduce the portfolio's equity allocation and decrease the equity beta of the portfolio;
ii) increase the portfolio's bond allocation and decrease its modified duration.

The portfolio's current and target characteristics are provided here.

Portfolio Characteristics

Current Portfolio				Target Portfolio
Asset Class	Modified Duration	Equity Beta	Allocation ((£ mlns)	Asset Class	Modified Duration	Equity Beta	Allocation (£ mlns)
Equities	---	1.15	500	Equities	---	0.85	400
Bonds	6.80	---	250	Bonds	5.5	---	350

It wants to avoid high trading costs for any temporary reallocation and chooses to use the following future contracts to realise the target portfolio allocations:

Equity Futures - currently priced at £160,000 per contract (after accounting for the multiplier), with an equity beta of 0.92;

Bond Futures - currently priced at £99,000 per contract, with a modified duration of 7.20 and a yield beta of 1.00.

Required:

Determine the action (buy or sell) and the number of futures contracts required to achieve the:

1. Equity targets

2. Bond targets

B) Ray is also responsible for managing a family investment portfolio with £60 million in equity and £30 million in bonds. As a consequence of change in family circumstances, the Jackson is rebalanced using the transactions shown below.

Transactions for Rebalancing the Peterson Portfolio
Type of Futures Contracts	Action	Number of Futures Contracts to Buy/Sell	Price per Futures Contract (USD)
Equity futures contract	Buy	50	200,000
Bond futures contract	Sell	25	150,000

After three months of these transactions, the market value of the Jackson portfolio's equities has grown by 4.00%, and the market value of its bonds has reduced by 3.20%. The prices of the equity and bond futures contracts are now £205,000 and £147,750, respectively.

Required:

Calculate the profit or loss of the portfolio over the past three months. Show your calculations in detail and explain accordingly.

C) The initial investment for a bull spread created using calls is greater than the initial investment for a bull spread created using puts.
Required:
Explain why the bull spread with calls has higher initial investment than the bull spread created with puts using put-call parity.

D) Contango and Backwardation are features of price patterns in futures market. An understanding of both is important with respect to the pricing and valuation of different futures contracts.

Required:

Identify one market each that has been in contango or backwardation anytime over the last one to two years. What factors can explain the contango or backwardation of each market? Explain.

Question 3

In Ray's team, Khan and Anna manage interest rate and currency risk and you have been assigned to work with them over the next one month to develop skills and understanding of in these areas. John Wiley, an old friend of Khan and Anna in college, is the CFO of GSX Plc. John has requested them for some advice on how to approach the interest rate and currency risk management over the next year or so at GSX Plc. which has effectively grown to become a multinational over the last few years. Given the expected increase in the growth of global economy in the post-COVID world over the next one year, John expects a significant increase in sales and now plans to increase the capacity of GSX's factory in the UK as further expansion at a cost of £50,000,000. This expansion will be financed through borrowing at floating rate of LIBOR + 1% with quarterly payments over 5 years period. John has requested Khan and Anna to advise him informally on the risks involved and how to manage them more effectively. Both Khan and Anna have shared this with you and have suggested that you should get involved in this as this will help you develop your understanding of the risks and their management and at the same. Given the nature of the advice being informal, without any legal repercussions, you agreed.

Khan has shared this with you and he expects that GSX's expansion will begin in the next three months and will receive the £50,000,000 financing at that point in time. However, Khan is worried that over this period the interest rates may increase and therefore it will be better to convert the loan's floating interest rate to a fixed rate in the coming three months' time. Khan has subsequently evaluated the forecasted future swap fixed rates and the current terms of the various swaptions. These are given below where the swaptions are for a Swap of 5 years with LIBOR flat as the floating interest rate.

Fixed rate for payer's swaption that matures in three months                                   8.20%

Fixed rate for receiver's swaption that matures in three months                               8.30%

Projected Swap Fixed Rate in three months                                                             8.40%

Fixed rate for payer's swaption that matures in 5 years                                            9.10%

Fixed rate for receiver's swaption that matures in 5 years                                        9.20%

Projected Swap Fixed Rate in 5 years                                                                       9.70%

GSX has just recently opened a new factory in France to sell its products locally with a projected quarterly earning cash flows of €15,000,000. To convert these quarterly Euro cash flows into dollars, Anna has suggested that GSX use currency swap that does not involve the exchange of notional principal. Only the quarterly cash flow in Euro will be exchanged for dollars. Anna has received the following exchange rate and annual swap fixed interest rates from a currency swap dealer and shared with you.

Exchange rate (GBP per EUR)                                                          0.90

Swap interest rate in GBP (UK)                                                         5.20%

Swap interest rate in EUR                                                                  6.40%

These rates are for 3 months' cash flow exchange and approximately coincides with the quarterly Euro cash flows GSX will receive from its French operations. The swap has a maturity of 2 years as Anna is not confident in projecting the earning cash flows from the French operations beyond 2 years.

Required:

Both Khan and Anna has tasked you to write a report that cover the following (word limit 1300):

i. Compare Swaps and forward contracts and evaluate which will better suit GSX's requirements for interest rate and currency risk management and why.

ii. Given the interest rate forecast, what risk does GSX run and what is the most appropriate position you recommend to hedge the financing of the factory expansion. Provide detail justifications and calculations.

iii. Assume the firm buys the appropriate swaption and Khan's interest rate forecasts prove correct. Determine the net interest payment GSX will make on the factory expansion loan in three months.

iv. If Khan's interest rate forecasts prove correct, and the appropriate hedge is enacted, what happens to the cash flow risk and the market value risk of GSX i.e. increase or decrease in each? Explain.

v. Identify the risk that GSX runs with respect to the cash flows' from the French factory and determine the periodic cash flows resulting from GSX's hedge of the French factory sales.

vi. Suppose that GSX's currency swap can be structured with fixed or floating payments. If Khan's interest rate concerns are correct, which of the following would be the ideal position for GSX to take in the currency swap? From GSX's perspective, how should the swap be structured?

a. Fixed dollar interest rate and a floating euro interest rate or
b. Floating dollar interest rate and a fixed euro interest rate or
c. Floating dollar interest rate and floating euro interest rate

Note: You must provide detail explanation of your choice.

vii. Explain the risk(s) to which GSX is exposed in the currency swaps.

Attachment:- Derivatives Investments.rar