CIS March 2012 Diet Examination Paper 2.3: Derivatives Valuation Analysis Portfolio Management Commodity Trading and Futures Level 2
Derivative Valuation and Analysis (1 12) 1. A CIS student was making a presentation on futures, and makes the following statements: Statement 1: Futures are traded using standardized contracts. They require margin and incur interest charges on the margin loan. Statement 2: If the margin balance falls below the maintenance margin amount due to a change in the contract price for the underlying assets, the investor must add funds to bring the margin back up to the initial margin requirement. Given the above information, are the student s statements correct or incorrect? A. Both statements are correct. B. Neither statement is correct. C. Only statement 1 is correct. D. Only statement 2 is correct. 2. A stock is selling at N40, a 3-month put at N50 is selling for N11, a 3-month call at N50 is selling for N1, and the risk-free rate is 6%. How much, if anything, can be made on an arbitrage? A. N0 B. N0.28 C. N0.78 D. N0.82 3. What kind of swap should a financial institution enter into if it will be adversely affected by increasing interest rates over the next 2 years? The bank should: A. Pay floating and receive fixed interest rate swap. B. Enter into a currency swap. C. Pay fixed and receive floating interest rate swap. 4. $ Profit or or loss Loss 1,000 Stock Stock price at at expiration expiration The above diagram illustrates the payoff of which of the following strategies? A. Short straddle. B. Short strangle. C. Writing of a call option. D. Buying a put option. 5. Consider a non-dividend paying stock with a spot price of N50. A 6-month European call with a strike price of N50 costs N4. A European put with the same expiration date and strike price costs N3.50. The continuously compounded risk-free rate is 4% per annum. The volatility of the stock is 25% per year. What can you conclude? A. Nothing can be determined from this information. B. There is an arbitrage opportunity because the put is overpriced. C. There is an arbitrage opportunity because the put is underpriced. D. There is no arbitrage opportunity.
6. On the 1st of May, an investor takes a short position in 10 December gold futures contracts. The current futures price is N500, the contract size is 100 ounces, the initial margin is N2,000 per contract, and the maintenance margin is N1,500. At the end of May, the futures price has dropped to N498: This means that: A. The investor s margin balance increases by N2,000. B. The investor s margin balance decreases by N2,000. C. The investor receives a margin call. D. The broker automatically closes out the position. 7. You own one stock in your portfolio. Which strategy do you have to follow, in order to protect your stock on the downside, while still leaving upside potential? A. Buy an "at the money" call. B. Sell a straddle (sell a call and sell a put, both "at the money"). C. Buy an "at the money" put. D. Buy an "out of the money" call, and sell an "in the money" put. 8. An investor buys shares of XYZ Limited at N30 and immediately writes a call on them. If the call carries a premium of N2.50 and its exercise price is N30, at what price of XYZ shares will this investor break-even? A. N32.50 B. N30.00 C. N27.50 9. ABC Limited issues N100,000,000 par value, floating rate notes paying LIBOR plus 200 basis points every year. The term is 3 years and the underwriting fees amounted to N4,500,000. Simultaneously, ABC enters into an interest rate swap agreement with the following terms: Notional Principal: N100,000,000 Receive Float: LIBOR Pay Fixed: 6.2% Term: 3 years Payment Frequency: Annual In effect, what will be ABC's net interest payment at the end of the year, if LIBOR is 10%? A. 5.8% B. 4.2% C. 3.8% D. 8.2% 10. Which of the following statements is (are) true with respect to the market for forward contracts? I. While it does not cost anything to enter into a forward contract, a margin must be posted at its initiation. II. Most financial forward contracts are settled by physical delivery. III. In order to minimize the exposure faced with a forward contract, an investor may make offsetting trades in the futures markets. IV. A dealer is the end user of most forward contracts. A. I and II only. B. III only. C. I, III and IV only. D. II, III and IV only.
11. What does the Vega of a portfolio of derivatives measure? A. The rate of change of the value of the portfolio to the volatility of the underlying asset. B. The rate of change of the value of the portfolio with respect to the passage of time, all else remaining the same. C. The rate of change of the portfolio s delta with respect to the price of the underlying asset. D. The rate of change of the value of the portfolio to the price of the underlying asset. 12. What is the Delta of an European equity call with the following parameter? Strike: N52 Underlying spot price: N52 Volatility: 17% Risk free rate (continuously compounded): 2% Maturity: 182 days (no dividends paid). A. -0.5447 B. 0.4736 C. 0.5000 D. 0.5569 Portfolio Management (13 28) 13. The risk and return spectrum for private equity can best be described by which of the following statements? A. Leveraged buyouts are most risky and distressed debt is least risky. B. Venture capital is most risky and mezzanine debt is least risky. C. Leveraged buyouts are most risky and mezzanine debt is least risky. D. Venture capital is most risky and distressed debt is least risky. 14. You wish to evaluate a particular portfolio manager. You note that she earned 11% at a time when the market yielded 10% and Treasury bills yielded 5%. If the portfolio has a standard deviation of 22% and a beta of 1.2, where would it lie in relation to the SML? A. Above the SML. B. Below the SML. C. Inconclusive with the data given. D. On the SML. 15. You are the owner of a N4 million portfolio with a beta of 1.0. You would like to insure your portfolio against a fall in the index of magnitude higher than 12%. The index currently stands at 4200. Put options on the index are available at three strike prices. Which strike will give you the insurance you want? A. 3,696 B. 3,840 C. 3,870 D. 3,950 16. A 3-month call option on a single stock has an exercise price of N35 and a quoted price of N2.45. Suppose that you sell this call option and buy the underlying stock at a price X. At expiration, if the price of the underlying stock is N31.10 and your loss is N2.45, what is X? (Assume that the contract size is one and ignore the effect of interest rates in your calculation). A. N31.10 B. N32.55 C. N36.00 D. N37.45
17. Following the constant mix strategy: A. You buy high and sell low. B. You buy low and sell high. C. You don t enter any transactions. D. None of the above answers is correct. 18. Compared to investors with long investment time horizons, investors with short investment time horizon most likely require: A. Less liquidity and less emphasis on capital appreciation. B. More liquidity and less emphasis on capital appreciation. C. Less liquidity and greater emphasis on capital appreciation. 19. A primary motivation for investment in commodities is most likely the: A. Positive correlation of commodities with unexpected inflation. B. Positive correlation of commodities with stock and bond investments. C. Positive volatility of commodities relative to stock and bond investments. D. All of the above. 20. Given the following correlation matrix, a risk-averse investor would least prefer which of the following two-stock portfolios (all else the same)? Stock W X Y Z W +1 X -0.2 +1 Y +0.6-0.1 +1 Z +0.8-0.3 +0.5 +1 A. W and Y. B. X and Y. C. X and Z. D. Y and Z. Use the following data to answer questions 21 to 22. The following table summarizes the performances of the Y Fund, the B Fund, and the R Fund over the past 5 years. The average risk-free return was 4%: Y Fund B Fund R Fund Average return 0.12 0.14 0.16 Standard deviation 0.22 0.24 0.3 Beta 0.6 1.1 0.8 21. Rank the performances of the three funds using Sharpe s index from the best to the worst. I. Y Fund. II. B Fund. III. R Fund. A. II, III and I B. I, II and III C. I, III and II D. II, I and III
22. Rank the performances of the three funds using and Treynor s index from the best to the worst. I. Y Fund. II. B Fund. III. R Fund. A. II, III and I B. III, I and II C. I, III and II D. II, II and I 23. Assume the following data: Beginning Price Ending Price Cash Flow During the Year Analyst's portfolio N40 N41 N6.00 Risk-matched market portfolio N10 N11 N0.25 How does the analyst's portfolio performance compare to the risk-matched portfolio performance? A. Equal. B. Inferior. C. Superior. D. Slightly worse. 24. The January anomaly, the neglected firm effect, and the book value/market value ratio are studies examining which form of the efficient market hypothesis? A. Weak form of the EMH. B. Strong form of the EMH. C. Semistrong form of the EMH. D. Both the weak and semistrong forms of the EMH. 25. A portfolio manager is evaluating investments in mortgage securities as part of a portfolio to fund long term liabilities. If she wants to minimize prepayment risk in her portfolio she is most likely to invest in: A. Mortgage loans. B. Mortgage passthrough securities. C. Collateralized mortgage obligations. 26. The one characteristic that hedge funds as an asset class have in common is that they typically: A. Are highly leveraged. B. Seek absolute returns. C. Utilize some type of hedging strategy. 27. Compared to investors with long investment time horizons, investors with short investment time horizons most likely require: A. Less liquidity and less emphasis on capital appreciation. B. More liquidity and less emphasis on capital appreciation. C. Less liquidity and greater emphasis on capital. appreciation.
28. Which of the following statements with respect to CAPM and APT is true? A. The APT model can be thought of as a subset of the CAPM. B. The APT model has far more restrictive assumptions than CAPM. C. CAPM would have a greater predictive power in forecasting individual security returns than would an APT model. D. Both models state the market as a whole is a factor that will influence specific security returns. Commodity Trading and Futures (29 40) 29. Which of the following is an example of churning? A. A futures broker assures his customer that selling gold futures short is a "sure thing". B. An oil company that is long crude oil repeatedly repurchases its futures contracts. C. An inverted market converts to a normal market and back again within six months. D. A registered representative encourages a customer to make many futures transactions in order to increase commissions. 30. Which hedgers would most likely initiate a long hedge? A. An oil company that is looking at locking in the price of oil. B. A farmer that wants to sell his crop at the current asking price. C. A copper pipe manufacturer that needs to lock in their costs. D. A cattle rancher that wants to hedge his costs. 31. A silver miner decided to initiate a short hedge by shorting five (5) December Silver futures contracts for N1.50. The current price of silver is trading at N2.20. Several months later, he sells his silver for N1.30 and liquidates his futures contracts at N0.90. What was the miner's net sale price per ounce? A. N1.30 B. N1.50 C. N1.60 D. N2.20 32. The spread between the bid and the ask is typically higher when: A. There are fewer market participants. B. The market is extremely liquid. C. The market is efficient. D. It is easy for market participants to enter and exit. 33. Why do hedgers find futures contracts most useful? A. They can beat speculators in reacting to important market news. B. They can ensure that someone else pays for any losses they incur. C. They can bring a degree of certainty to their future cash flows. D. They can deal in and out quickly for profit at low dealing costs. 34. Which of the following would be the best description of a market that is in backwardation? A. The futures price is not trading at its fair value. B. It is possible to agree to buy the asset for delivery at a future date at a lower price than the asset is currently trading in the cash market. C. The price of the synthetic position is trading above the underlying asset leading to a risk-free profit opportunity through trading the reversal. D. The futures price is trading above the cash price. 35. What most affects the price of crude oil? A. The weather in the US. B. A shortage of oil tankers. C. Political factors. D. The demand for petrol.
36. A risk-averse speculator anticipating a fall in milling wheat prices might: A. Buy milling wheat future calls. B. Buy milling wheat future puts. C. Sell milling wheat future calls. D. Sell milling wheat future puts. 37. If you were to buy a June 95.00 call at 2.25 and sell a June 96.00 call at 1.70, what would be your maximum profit? A. 2.25 B. 1.70 C. 0.55 D. 0.45 38. If metal prices fall below the cost of production what will be the likely impact on supply of the metal? A. Supply will rise as producers aim to compensate for the falling prices by selling more product. B. Supply will fall because the cost of production is now in excess of the price of the metal and therefore mines will be shut down. C. Supply will stay the same. 39. Which of the following describes the risk/reward profile of a short put? A. Downside unlimited, upside limited to premium. B. Downside limited to premium, upside unlimited. C. Downside limited to strike minus premium, upside limited to premium. D. Downside limited to premium, upside limited to strike minus premium. 40. All of the following could be considered to be significant influences on commodity prices except? A. Weather. B. Quotas. C. Interest rates. D. Tariffs. Total = 40 marks
Question 2 Derivative Valuation and Analysis What do you understand by hedge ratio? How does it help in portfolio risk management? Question 3 Portfolio Management Discuss the objectives of portfolio performance evaluation. (4 marks) Question 4 Commodity Trading and Futures One of the main International Swaps and Derivatives Association (ISDA) documents supporting derivative activities in the commodities market is the Master Agreement. What do you understand by Master Agreement? What are its advantages? Question 5 Derivative Valuation and Analysis The NSE 30 Index is currently at N10,000 and the risk-free rate is 4% (annualized). Futures and options with the same underlying assets as the NSE 30 Index are traded. You have been assigned to manage a (diversified) stock portfolio with the same composition as the NSE 30 Index and a present value of N1 billion, and have been asked to add derivatives trading to boost investment returns. All futures and options mature 3 months from now and 1 trading unit is 1,000 times the NSE 30 Index. (That is, the cost of purchasing 1 trading unit of options is 1,000 times the option price). Options are European style. The strike prices of traded puts are N8,000; N9,000 and N10,000; the strike prices of calls are N10,000, N11,000 and N12,000. For the sake of simplicity, you may ignore dividends. Required: 5(a) Find the theoretical current futures price. 5(b) 5(c) The current price of a call option with a strike price of N10,000 is N665; a put option with the same N10,000 strike price has a current price of N545. You have found an arbitrage opportunity. Explain why this is an arbitrage opportunity, provide an example of an arbitrage trade showing how many units of what asset should be traded at the current point in time in order to profit from the arbitrage, and find the profit to be gained from the trade. (7 marks) The arbitrage opportunity described in 5(b) above quickly disappeared, but you are very bullish about the market with the expectation that there will be a large rise in the NSE 30 Index over the very near term. Provide a specific proposal for how many units of what kinds of options to trade to create a position that will allow you to profit maximally from these expectations, while minimizing the downside risk. Draw a payoff diagram for the position at maturity and explain why you expect to profit. (5 marks) Payoff Value of the NSE 30 Index at maturity
Question 6 Portfolio Management 6(a) You are the fund manager of the TopEquities Mutual Fund. Recent uncertainties in the financial markets have necessitated the need to protect your portfolios. Before proceeding with the implementation of the portfolio insurance plan, you analyze the performance of the Fund in the last 6 months. In particular, you focus on the stock composition of the managed portfolio that is 70% in value stocks and the remaining 30% in growth stocks on the Nigerian Stock Exchange (NSE). The total returns of the value stocks and the growth stocks over the period are respectively 6.5% and 8.2%. 6(a1) Compute the total return of the TopEquities Mutual Fund for the last six months. (4 marks) 6(a2) Would it have been better in terms of return performance to have had the portfolio wealth equally-weighted in the growth and value stocks? Justify analytically. 6(b) You would also like to use Treasury bond futures to hedge a bond portfolio over the next three months. The portfolio is worth N100 million and will have a duration equal to 4 years in three months time. The futures price is 122 and the futures contract size equals N100,000. The bond that is expected to be cheapest to deliver will have duration of 9 years at the maturity of the futures contract. 6(b1) What position in futures contract is required? (4 marks) 6(b2) What did you accomplish with the hedge in part (a) in terms of duration? What does it imply? 6(b3) What adjustments to the hedge are necessary if after one month the bond that is expected to be cheapest to deliver changes to one with a duration of 7 years? (4 marks) 6(b4) Suppose that all interest rates increase over the three months, but long-term rates increase less than short-term and medium-term rates. What is the effect of this on the performance of the hedge? (2 marks) Question 7 Commodity Trading and Futures 7(a) While each country has its own market regulator which sets out the rules for operating commodities trading, the objectives of regulation are similar all over the world. 7(b) Discuss the main purposes and aim of regulation in the commodities market. (6 marks) Two major benefits usually mentioned for the use of derivatives is income enhancement and risk management. Illustrate (using appropriate payoff diagrams) the benefits and risks of a trader who is in each of the following 3 positions: 7(b1) Short call. 7(b2) Long futures. 7(b3) Long put. (3marks)
1) FORMULAE Black and Scholes Options pricing model: ; ; 2) 2) General cost of carry relationship: 3) Continuous time cost of carry relationship: 4) Determinants of Options Price: 5) Correlation/Covariance: 6) Static portfolio insurance using put option: 7) Hedging with Stock Index Futures: 8) Risk adjusted performance measures: 9) Binomial Option Valuation Model: 10)