The University for business

and the professions

Cass Business School

MSc Quantitative Finance
Module Code
SMM254

Exam Title
Derivatives

Date

Time

15th January 2010

1430 -1645

Division of Marks:
Instructions to students:

All questions carry equal marks

Answer any THREE questions out of FIVE

Indicative marks (proportions) for each part of the question are given in
parentheses. It is important that you show clearly and legibly the steps used in
your answers. Use of briefly and indicate is intentional.
This paper contains FIVE questions and comprises FIVE pages including the title
page
Number of answer books to be provided: One
Calculators are permitted: Yes Casio FX-83 MS/ES or FX-85 MS/ES
Dictionaries are NOT permitted
Additional materials or tables to be provided: None
Exam paper can be removed from the exam room: No
Internal Examiner(s): Professor Keith Cuthbertson
External Examiner: Professor Mark Shackleton

QUESTION 1
a)

You are a US portfolio manager holding 100m in a diversified portfolio of

35, UK stocks and $200m in US, 10-year AA-corporate (plain vanilla
coupon) bonds. The US-Sterling exchange rate is S= 1.5$/. Using these
illustrative figures, carefully explain how you would estimate the 25-day
VaR using the variance-covariance method and what the limitations and
risks are in your approach.
(50%)

b)

You have a portfolio of 20 written (European) calls on stock-A, with

premium C= 15 and you are long 50 (European) puts of company-B, with
put premium P=10. For illustrative purposes assume all the calls and puts
have a strike price K = 100, maturity of 1 year, the risk free rate is r=5%
and the initial stock prices are SA = SB = 100. Assume the mean daily
return on each stock is 0% and the annual standard deviation is 20% pa
for stock-A and 25% for stock-B and the correlation between the stock
returns is = 0.75.
Briefly explain the risks in holding this portfolio and then carefully outline
the steps you would take to calculate the 10-day VaR (1st percentile) of
this portfolio using Monte-Carlo Simulation.
Your risk manager believes that this approach is almost identical to
calculating the VaR using a bootstrapping technique, with a sample size
of 600 daily observations. Explain to your risk manager how you would
use bootstrapping and whether it is likely to produce better estimates of
the VaR.
(50%)

QUESTION 2
a)

Briefly explain how (i) an interest rate swap and (ii) a currency swap may
be used to hedge an existing exposure. It is argued that (under certain
circumstances) there are gains in a swap to both parties explain this
statement (using illustrative figures if you wish).
(33%)

b)

Carefully explain how you would price both an interest rate and a currency
swap and briefly indicate why the value of a swap changes over time.
(33%)
cont

c)

Briefly explain the swap-rate curve.

A US swap dealer has a series of (net) floating (6-month) $-LIBOR interest
payments over the next 5 years, on a notional principal of $100m. The
same swap dealer is also an annual net payer of sterling (for US dollars)
in a currency swap over the next 7-years, with a notional principal of
200m. Explain how she might use futures contracts to hedge her position
in the two swaps. What are the risks in these hedges?
(34%)

QUESTION 3
Consider a two-period, binomial option pricing model, BOPM. Let the current
stock price be S= 100 and the risk-free rate be r = 5 percent (per period) . Each
period, the stock price can go either up by 10 percent or down by 10 percent. A
European put option expiring at the end of the second period has an exercise
price of K = 110.
a)

Sketch the stock price lattice. By creating a riskless portfolio at time zero,
algebraically derive an expression for the hedge ratio and indicate how the
put premium P at t=0 depends on the probabilities pu , pd and r. Show that
the price of the two-period put is around P = 5.4. Calculate the hedge
ratio at time zero.
Show how you can hedge 100 long puts at t=0, and how the hedge
portfolio earns the risk-free rate over the first period (i.e. along the path
from node t=0, either to node-D or to node-U). What would an investor do
if the put were underpriced at P= 5 ?
In pricing the option, briefly state how your calculation of the put premium
would change if the put is American rather than European.
(33%)

b)

In practice, explain what would happen if you were a trader who

purchased 100 of the above puts and then delta-hedged them, over small
intervals of time and the stock price happens to fall monotonically each
period ending at ST = 20. What is your overall position at maturity? (Note:
each put delivers one stock on the underlying asset).
(33%)

c)

You hold several calls and puts on Microsoft (stock) with an overall
position which results in a portfolio delta of 200, a gamma of -300 (minus
300) and a vega of 100. Carefully explain how you might hedge this
portfolio over the next 5 trading days.
(34%)

QUESTION 4
a)

Carefully explain how, in the real world, you might use stock index futures
to hedge a $10m diversified portfolio of US stocks with a portfolio beta of
1.5 and a $5m diversified portfolio of US stocks with a portfolio beta of
0.5. What determines the optimal number of futures contracts you
require?
Qualitatively, what will happen in the hedge if stock prices rise over the
hedge period and what are the risks in the hedge?
Briefly explain how your analysis of the number of futures contracts would
change if you were hedging three, future interest rate resets on a bank
loan linked to (6-month) LIBOR.
(50%)

b)

Carefully explain how futures contracts on a stock and/or stock index

(paying dividends) are priced using no-arbitrage (or cash-and-carry
arbitrage). Give an example of how arbitrage profits might arise. What
additional difficulties arise when using cash-and-carry arbitrage to price
futures contracts on commodities such as heating oil, natural gas or
agricultural produce such as wheat?
(50%)

QUESTION 5
a)

You run a gas fired power station in California and hence you purchase
natural gas and sell electricity. Fifty percent of your sales of electricity to
consumers over the next 2 years are at a fixed price and 50 percent at a
floating price (ie. at whatever the spot price for electricity is at that date),
whereas you purchase your natural gas (NG) in the spot market. You also
face the risk that electricity demand depends in the summer months on
the amount of air conditioning used and in the winter months on the
amount of heating used by consumers. Explain and critically appraise
how you would use derivatives to offset some or all of these risks to your
profitability from volume and price uncertainty.
(50%)

b)

How might a wealth manager use two types of exotic option to restructure the risk-return characteristics of his clients (international)
portfolio of stocks and bonds?
cont

Briefly explain how the pricing of exotics differs from that of plain vanilla
options?

Asset backed securities (ABS) and collateralised debt obligations

(CDOs), spread risk and give rise to credit enhancement, yet such
assets can be highly risky if some of the underlying borrowers default
(e.g. a relatively few mortgage payers). Explain this statement.
(50%)