INTI INTERNATIONAL UNIVERSITY

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1 FIN4242 (F) / Page 1 of 6 INTI INTERNATIONAL UNIVERSITY BACHELOR OF BUSINESS (HONS) INTERNATIONAL BUSINESS FIN4242: DERIVATIVES MARKETS ANALYSIS FINAL EXAMINATION: JANUARY 2013 SESSION Answer any FOUR (4) questions in the answer booklet provided. All questions carry equal marks. Question 1 (a) A cocoa merchant holds a current inventory of cocoa worth $10 million at present prices of $1,250 per metric ton. The standard deviation of returns for the inventory is She is considering a risk-minimization hedge of her inventory using the cocoa contract of the Coffee, Cocoa and Sugar Exchange. The contract size is 100 metric tons. The volatility of the futures is For the particular grade of cocoa in her inventory, the correlation between the futures and spot cocoa is.85. (i) Compute the number of metric tons of cocoa currently held by the merchant. (3 marks) (ii) (iii) Compute the risk-minimization hedge ratio. Determine how many contracts she should trade. (b) Kumpulan Sime Derby (KSB) and Oriental Port Company (OPC) need to raise funds to pay for capital improvements at their manufacturing plants. KSB is a well-established firm with an excellent credit rating in the debt market; it can borrow funds either at 11% fixed rate or at LIBOR + 1% floating rate. OPC is a fledging start-up firm without a strong credit history. It can borrow funds either at 10% fixed rate or at LIBOR + 3% floating rate. (i) (ii) Is there an opportunity here for KSB and OPC to benefit by means of an interest rate swap? Why? Suppose you have just been hired at a bank that acts as a dealer in the swaps market, and your boss has shown you the borrowing rate information for your clients, KSB and OPC. Discuss, with the help of the box-arrow diagram, how you

2 FIN4242 (F) / Page 2 of 6 could bring these two companies together in an interest rate swap that would make both firms better off while netting your bank a 2.0% profit. (8 marks) Question 2 (a) A plantation company executive has argued: There is no point in our using crude palm oil (CPO) futures. There is just as much chance that the price of CPO in the future will be less than the futures price as there is that it will be greater than this price. Discuss the executive s viewpoint. (9 marks) (b) You are paired with the Chairman of Oracle Group to play golf in a tournament to raise money for the local children s hospital. After playing golf in the tournament, you learn that the Chairman of Oracle expects the price of his firm to increase by 6 percent per quarter if their new stores are successful in KLCC. If the stores are unsuccessful, he expects the stock price of Oracle to decrease 5 percent per quarter. After a quick check, you find that Oracle is currently trading at $30 per share. The current risk-free interest rate is 3 percent per annum, and you expect this rate to remain unchanged in the future. i) Calculate the price of a six-month European put option written on Oracle stock with $31 strike price using the two-period risk-neutral binomial pricing model. (10 marks) ii) If an equivalent call option exists for Oracle stock, compute the value of the call based on the put-call parity relationship. Question 3 Edward Tobin is the chief executive officer of Putrajaya Holdings (PJH). The board of directors has just granted Mr. Tobin 20,000 at-the-money European call options on PJH stock, which is currently trading at $50 per share. PJH stock pays no dividends. The options will expire in 4 years, and the annual variance of the continuously compounded returns on PJH s stock is Government securities that mature in four years currently yield a continuously compounded interest rate of 6% per annum.

3 FIN4242 (F) / Page 3 of 6 (a) Use the Black-Scholes Model to calculate the value of a call and the total value of Mr. Tobin s call options. (12 marks) (b) You are Mr. Tobin s financial advisor. He must choose between the previously mentioned stock option package and an immediate $400,000 cash bonus. If he is risk-neutral, explain which would you recommend? (3 marks) (c) Explain how would your answer to (b) change if Mr. Tobin were risk-averse and he could not sell the options prior to expiration? (d) Explain any two factors that would affect the value of the call options. Question 4 a) Clement Jackson is a fund manager of an investment house. He manages a portfolio worth $65 million with a beta of He is concerned about the performance of the stock market over the next two months and plans to use the three-month futures contracts on the Kuala Lumpur Composite Index (KLCI) to hedge the risk. The index currently stands at 1000 points, one KLCI futures contract is on 100 times the index, the risk free rate is 4 percent per annum and the dividend yield on the index is 3 percent per annum. i) What is the theoretical futures price for the three-month futures contract on KLCI? ii) What position and how many contracts should Clement take to eliminate all exposure to the market over the next two months? iii) Calculate the effect of the strategy on Clement s returns if the level of the market in two months is 1400 points. (8 marks)

4 FIN4242 (F) / Page 4 of 6 b) Explain basis and basis risk and its impact to a hedger s position if the basis weakened or strengthened unexpectedly. (8 marks) Question 5 Thomas Lee has recently performed a thorough analysis on the airline industry and one of his beliefs is that Prime Jet, a domestic airline company, would soon be negotiating with another airline company for the possibility of merger between the two. Thomas believes that if the merger takes place, it will be able to create huge synergy for Prime Jet. However, at the same time, Prime Jet is facing a major lawsuit for its negligence in the safety aspect. As a result, Thomas believes that there will be a big jump in the stock price of Prime Jet but is uncertain as to the direction. From the above scenario, identify any FIVE (5) different strategies involving options that Thomas can follow and discuss the differences among them. (25 marks) Question 6 You are a derivatives trading advisor for Kijang Funds, with expertise in forward and futures markets and contracts. You assist Kijang s portfolio managers to evaluate forward and futures contracts. Three managers have approached you with the situations described below. Some of your responses to the portfolio managers rely on the financial market information given in the table below: 3-month risk-free rate: 6-month risk-free rate: Broad equity index level: 6% p.a. with continuous compounding 6% p.a. with continuous compounding Current index point=1250 Broad equity index dividend yield: 3% p.a. with continuous compounding Japanese Yen 3-month risk-free rate: 1% p.a. with annual compounding Japanese Yen spot price: /$

5 FIN4242 (F) / Page 5 of 6 Manager A, an equity manager, has two concerns: 1. Six month ago, to hedge against the expected decline in the value of a common stock in which he held 100,000 shares, he entered into a forward contract to sell the underlying stock at a price of $80. The forward contract has three months to expiration and the stock is trading for $75. He wants to know the value of his current position on a per share basis. 2. He expects equities to go up and would like to take a long position in a 6-month forward contract on the Broad Equity Index, which a dealer has priced at He wants to know whether the forward contract is fairly priced. Manager B runs Kijang s Global Fund. The fund recently held a special shareholder s meeting during which the use of derivatives for hedging purposes was approved. Consequently, knowing that she will receive a yen dividend payment in 90 days, she wants to know at what forward price she can sell yen for dollars. Manager C is in charge of a fixed income portfolio and asks the following questions: 1. Do I understand correctly that, to prevent arbitrage, the futures price must converge to the spot price at expiration 2. Am I correct in believing that storage costs and any convenience yield act to increase the futures price while any cash flows from the underlying asset act to decrease the price? (a) Calculate the value of Manager A s short position in the stock forward contract. (b) Advise Manager A on whether forward contract on Broad Equity index is fairly priced. (c) Advice Manager B at what forward price she can sell yen for dollars. (d) Discuss whether Manager C is correct or incorrect with respect to the convergence of spot and futures prices at expiration? (e) Explain to Manager C whether he is correct or incorrect in his second question.

6 FIN4242 (F) / Page 6 of 6 Question 7 (a) Refer to the table below: Data on Futures Contracts, Thursday, February 12, 2009 Agriculture Futures: Corn (CBT) 5000 bu.; cents per bu. Open High Low Settle Chg. Open Interest March ,858 May ,040 Suppose today is February 12, 2009, and your firm produces breakfast cereal and needs 140,000 bushels of corn in May 2009 for an upcoming promotion. You would like to lock in your costs today because you are concerned that corn prices might go up between now and May. (i) How could you use futures contracts to hedge your risk exposure? What price would you effectively be locking in based on the closing price of the day? (ii) Suppose corn prices are $3.92 per bushel in May. What is the profit or loss on your futures position? Explain how your futures position has eliminated your exposure to price risk in the corn market. a) Late one Friday afternoon in March, an investor receives a call from her broker. Her broker tells her that the American style March options on Microsoft will expire in ten minutes, that Microsoft is currently trading at $94.50, and that the March 85 call is selling at $8. The investor tells her broker that he is mistaken and must have read his screen incorrectly. (i) (ii) (iii) Explain which individual, the broker or the investor, is correct. Supposing that the broker is in fact correct, state the transactions that the investor would undertake to take advantage of this situation. Suppose the broker tells the investor that these options are European options. Discuss the impact of the fact that the options are European options on the actions of the investor. -THE END- FIN4242 (F)/January2013/NSH