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Derivatives and Risk Management

Assignment 1

Q1.30) The arbitrageur should borrow $1,000 at 10% interest rate and go short on
the forward contract to sell at $1,200. In this process he will gain 20% (or 10% i.e.
net of interest cost) on the delivery of the gold at expiration of the contract.
Q1.31) Downside and upside risk are both magnified in the case of options strategy.
Lets suppose the investor buys the 2000 call options with a strike price of $95 at
$4.70 each ($9,400) and price of the stock goes down to $90. The option is not
exercised and the investor loses $9,400. Under the same scenario, had the investor
bought 100 shares the loss would have been only $400. However the gains are also
magnified in the case of options strategy if price rises. Suppose the stock price rises
to $150. The profit for the options holder is as follows:
2000 * ($150-$95) - $9,400 = $100,600
The profit for the investor, had he bought 100 shares is as follows:
100 * ($150-$94) = 5,600
So if the investor has reasonable proof that the probability for the share price to go
up is high, he should invest in the option strategy to magnify his gains.
The options strategy will be more profitable than the share purchase strategy at
above the following price: X
2000 * (X-$95) - $9,400 = 100 * (X $94)
X = 100. So when the price is above $100, the options strategy is more profitable.

Q2.32) The standard deviation of golds future daily price changes is $15.2 or
$1,520 per contract. Hence at 1% risk, the maintenance margin should be
1,520*2*2.33 = $5,008 per contract. For 0.1% it should be set at 1,520*2*3.09 =
$6,642. For oil the standard deviation of daily future price change is $1.57 or $1570
per contract. For 1%, the maintenance margin should be set at 1570*2*2.33 =
$5173.3 and for 0.1% it should be set at 1570*2*3.09 = $6860.7
The exchange would be interested in this calculation so as to minimize the risk of an
investors account balance falling below zero i.e. become negative.
b) Oil Contract: Total 157 margin calls and 9 time negative balance.
Gold Contract: Total 81 margin calls and 4 time negative balance.

Q 3.28)

a) He should short the following number of S&P500 futures contracts:


*(VA/VB) = 0.87*(50,000,000/314,750) = 138.2 or 138 contracts
b) If the index level goes to 1,000 when futures price is 1.0025 * 1000 = 1,002.5
Gain on the short futures position = 138 * 250 * (1259 1002.5) = 8,849,250
Rf per 2 months = 6/6 = 1%
Dividend yield per 2 months = 3/6 = 0.5%
Return on Index = 1000/1250 -1 = -20%, where net of dividend is -19.5%
Expected return on portfolio = 1 + 0.87(-19.5 1) = -16.84%
Loss on portfolio = 50,000,000 * 0.1684 = 8,417,500
Net Gain = Gain on futures loss on portfolio
8,849,250 8,417,500 = $431,750

If index is at 1,100
Gain on futures = 138 * 250 * (1259-1102.75) = $5,390,625
Loss on index = -12% + 0.5% = -11.5%
Expected return on portfolio = 1 + 0.87*(-11.5 -1) = -9.87%
Hence loss on portfolio = - $4,937,500
Total Gain = 5,390,625 4,937,500 = $453,125

If Index is at 1,200
Gain on futures = 138 * 250 *(1259 1203) = 1,932,000
Loss on index = -3.5%
Expected return on portfolio = 1 + 0.87 * (-3.5 1) = -2.92%
Loss on portfolio = - 1,457,500
Total Gain = 1,932,000 1,457,500 = $474,500

If Index is at 1300
Loss on futures = 138 * 250 * (1259 1303.25) = -1,526,625
Gain on index = 4.5%
Expected return on index = 1 + 0.87 * (4.5 1) = 4.045%

Return on portfolio = 2,022,500


Total Gain = 2,022,500 1,526,625 = $ 495,875

If Index is at 1400
Loss on futures = 138 * 250 * (1259 1403.5) = -4,985,250
Gain in index = 12.5%
Expected return on portfolio = 1 + 0.87 *(12.5 -1) = 11.01%
Return on portfolio = 5,502,500
Total Gain = 5,502,500 4,985,250 = $517,250

Q 4.32)
(a) Zero rates:
6-Months
98er*0.5
er*0.5 = 1.0204
r*0.5 = ln(1.0204)
r

=
=

100
0.0404

1 Year
95er = 100
er = 1.0526
r
r = 0.0513

1.5 Years
Semiannual coupon = 3.1, hence
3.1e-0.0404*0.5 + 3.1e-0.0513*1 + 103.1e-r*1.5 = 101
5.983 + 103e-1.5r = 101
103e-1.5r = 95.017
e-1.5r = 0.9216
-1.5r = ln(0.9216)
r = 0.0544
2 Years
Semiannual coupon = 4
4e-0.0404*0.5 + 4e-0.0513*1 + 4e-0.0544*1.5 + 104er*2 = 104

ln(1.0526)

11.405
2r = ln(0.8903)
R= 0.05807

104er*2

104

b) Forward rates using formula (R2T2 R1T1)/ (T2 T1)


6-12 months: 6.22
12 18 months: 6.06
18 20 months: 6.9
c) Pay yields using formula c = (100 100d)m/A, where d = e -0.05807 * 2 and A is
the value of an annuity that pays one dollar on each coupon payment date.
6 months: 4.04%
12 months: 5.12%
18 months: 5.42%
24 months: 5.78%
d) Price of the bond:
3.5e-0.0404*0.5 + 3.5e-0.0513*1 + 3.5e-0.0544*1.5 + 103.5e-0.05807*2 = 102.1
The estimate of y that solves this equation is roughly 5.7%
Yield of the bond:
3.5e-y*0.5 + 3.5e-y*1 + 3.5e-y*1.5 + 103.5e-y*2 = 102.1
= The estimate of y that solves this equation is roughly
Q4.33)
a) The duration of a zero coupon bond is equal to its time to maturity.
Hence
Portfolio A
Present value of 1-year zero coupon bond = 2000e -0.10*1 = 1809.67
Present value of the 10-year zero coupon bond = 6000e -0.10*10 =
2207.27
Total value of portfolio = 4016.94
Weights = 0.549 and 0.450
Duration of Portfolio A = 0.549*(10) + 0.4505*(1) = 5.94
Portfolio B
Duration of the portfolio is 5.95. Hence both portfolios have the
same duration.
b) Value at Portfolio A = 4016.94. Value of portfolio after 0.1% increase
in yield is 2000e-0.101*1 + 6000e-0.101*10 = 1807.86 + 2185.31 =
3993.17. Hence, decrease in value is 3993.17/4016.94 -1 = 0.59%
Value of Portfolio B = 2757.81. After 0.1% increase in yield = 5000e 0.101*5.95
= 2741.45, hence decrease in value is 2741.45 / 2757.81 -1
= 0.59%
c) Value of (A) after 5% increase in yield = 2000e -0.15*1 + 6000e-0.15*10 =
1721.41 + 1338.78 = 3060.19, hence change value of portfolio is
3060.19/4016.94 -1 = 23.8%.

Value of (B) after 5% increase in yield = 5000e -0.15*5.95 = 2048.15.


Hence decrease in value is 2048.15/2757.81 = 25.73%
Q 3.29)
80% of 1,000,000 = 800,000. Hence contracts = 800,000/25,000 = 32
Strategy: In Oct 2010, buy one March 11 Futures to hedge for Feb 2011. Buy
one Sep 2011 to hedge Aug 11. Buy one Sep 11 and roll in Aug 11 into March
12 contract to ultimately hedge for Feb 12. Buy one Sep 11 and roll in Aug 11
into Sep 12 contract to hedge Aug 12. Initial margin is 128 contracts * 2000 =
$256, 000.
In Feb 2011, the company pays as follows: -3.72.30 + 369.10 = -3.2 (loss on
futures contract)
3.2+369 = 372.2 * 800,000 = 297,760,000 (effective price paid for 800,000
pound of copper)
200,000 * 369 = 73,800,000 (effective price paid for 200,000 pounds of
unhedged copper at spot price)
Hence total paid = 371,560,000/1,000,000 = 371.50 cents.
In Aug 2011, the company pays as follows: 372.80 + (365 364.80) = 373
(effective price for 800,000 pounds of copper)
800,000 * 373 = 298,400,000
200,000 * 365 = 73,000,000 ( effective price paid for 200,000 pounds at spot
price)
Hence total paid is 371,400,000/1,000,000 = 371.40
For the Feb 12 purchase, net price paid is as follows:
-372.80 + 364.80 = -8 cents (lost on sep 11 futures when rolled over into Mar
12 contract).
364.30 + (377 376.70) = 364.6 + 8 = 372.6 (effective price for 800,000
pounds of copper)
Hence 800,000 * 372.6 = 298,080,000
200,000 * 377 = 75,400,000 (effective price of 200,000 pounds of copper at
spot price)
Hence 373,480,000/1,000,000 = 373.48 cents
For the Aug 12 purchase, net price paid is as follows:
-372.80 + 364.80 = 8 cents lost on roll.
364.20 + (388 388.20) = 364 + 8 = 372 (effective price for 800,000 pounds
of copper)
Hence 372 * 800,000 = 297,600,000
200,000 * 388 = 77,600,000 (effective price for 200,000 copper at spot price)
Hence total paid = 375,200,000/1,000,000 = 375.20 cents.
There is a margin call for the Mar 2011 contract and to the Sep 11 contract
for the period Oct 2010 Feb 2011 and then for the period Feb 2011 Sep
2011.

Specifically: Price of Mar 2011 contract in Oct 2011 is 372 and in Feb 2011 it
is 369.10. That means there is 372 * 800,000 = 297,600,000 cents worth of
copper in Oct 2011. In Feb 2011 the worth falls to 800,000 * 369.10 =
295,280,000 cents. The fall in the period is 23,200 in dollar terms. Since the
maintenance margin is $1,500 per contract total maintenance margin
required is $48,000. Initial margin is 2000 * 32 = $64,000. Hence over this
period, margin has fallen to 64,000 23,200 = 40,800 which is below the
maintenance margin of $48,000. Hence there will be a margin call in this
period.
Following the same calculation we see that for the Sep 11 contract bought in
Oct 2010, the margin falls by $20,800 during Oct 2011 and Feb 2011, thereby
reducing its margin below 48,000. Hence a margin call. Then again, for the
same contract, between Feb 2011 and Aug 2011, the margin falls by $43,200
to $20,800 thereby reducing its margin below the required 48,000. Hence a
margin call.
For the other contracts the price never deviated enough to warrant a margin
call.

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