======SS 16=====

Wanda Brock works as an investment strategist for Globos, an international inves

tment bank. Brock has been tasked with designing a strategy for investing in der
ivatives in Mazakhastan, an Eastern European country with impressive economic gr
owth.
One of the first tasks Brock tackles involves hedging. Globos wants to hedge som
e of its investments in Mazakhastan against interest-rate and currency volatilit
y. After a bit of research, Brock has gathered the following data:
The U.S. risk-free rate is 5.5%, and most investors can borrow at 2% above that
rate.
The Federal Reserve Board is expected to raise the fed funds rate by 0.25% in on
e week.
The current spot rate for the Mazakhastanian currency, the gluck, is 9.4073G/$.
Annualized 90-day LIBOR is 7.6%.
Globos¡‾ economists expect annualized 90-day LIBOR to rise to 7.9% over the next
60 days.
In Mazakhastan, commodities can be bartered at no charge through an ancient and
informal trading system, but futures trades cost 3% of the contract value.
The Mazakhastan risk-free rate is 3.75%, and most investors can borrow at 1.5% a
bove that rate.
Using the above data, Brock develops some hedging strategies, and then delivers
them to Globos¡‾ futures desk.
Brock then turns her attention to Mazakhastanian commodities. Globos has acquire
d the rights to large deposits of copper, silver, and molybdenum in Mazakhastan
and suspects the futures markets may be mispriced. Brock has assembled the follo
wing data to aid her in making recommendations to Globos¡‾ futures desk:
Copper
Spot price: $3.15/pound.
1-year futures price: $3.54/pound.
Silver
Spot price: $12.75/pound.
1-year futures price: $12.82/pound.
Molybdenum
Spot price: $34.45/pound.
1-year futures price: $35.23/pound.
After making some calculations, Brock assesses the arbitrage opportunities in Ma
zakhastan and passes the information on to the futures desk. Shortly afterward,
she is informed that Globos¡‾ Mazakhastan subsidiary uses its silver holdings as
collateral for business loans, which allows the unit to obtain a favorable inte
rest rate.
Jonah Mason, one of Globos¡‾ traders, asks Brock for a few details about the Maz
akhastan financial markets. Brock sends Mason a short e-mail containing the foll
owing observations:
Mazakhastan¡‾s investors don¡‾t like relying on old valuation data because asset
values have changed rapidly in the past, so they generally use a mark-to-market
valuation system.
Standard & Poor¡‾s just raised Mazakhastan¡‾s sovereign debt to investment grade
.
Interest rates tend to move in the same direction as asset values.
New technological innovations and commercial expansion has substantially boosted
the income of the average Mazakhastanian.
Before Mason receives the e-mail, he turns his attention to a memo about a futur
es contract a subordinate is considering. Unfortunately, the memo arrives withou
t the summary page to the notes. Mason must deduce the nature of the hedge based
on its characteristics: The risk-free rate used in calculating the futures pric
e, and that price adjusted to account for individual future dividends.
Questions:
The price of a 75-day gluck future should be closest to:
----9.3750G/$

Based on the information he received from Brock, Mason can best conclude that:
----- futures prices are higher than forward prices in Mazakhastan.

Based on the two characteristics of the futures contract in Mason¡‾s memo, which
of the following does the contract refer to?
-------- Treasury bond futures-Yes -----------Stock index futures-No

Based on Brock¡‾s information, how should traders best take advantage of arbitra
ge opportunities in Mazakhastan?
----- Buy copper, sell silver, and do not trade molybdenum.

Assume that Globos has taken a position in the Eurodollar futures contract, it i
s now 60 days later and the contract is expiring. Globos interest rate forecast
for 90-day LIBOR was correct. The value of the futures contract at expiration is
closest to:
----- $980,250

Which of the following would be most likely to cause a contango situation with s
ilver futures in Mazakhastan?
------ A shortage of warehouse space that drives up rental rates.

================================================================================
=================
Monica Lewis, CFA, has been hired to review data on a series of forward contract
s for a major client. The client has asked for an analysis of a contract with ea
ch of the following characteristics:
A forward contract on a U.S. Treasury bond
A forward rate agreement (FRA)
A forward contract on a currency
Information related to a forward contract on a U.S. Treasury bond: The Treasury
bond carries a 6% coupon and has a current spot price of $1,071.77 (including ac
crued interest). A coupon has just been paid and the next coupon is expected in
183 days. The annual risk-free rate is 5%. The forward contract will mature in 1
95 days.
Information related to a forward rate agreement: The relevant contract is a 3 ¡Á
9 FRA. The current annualized 90-day money market rate is 3.5% and the 270-day
rate is 4.5%. Based on the best available forecast, the 180-day rate at the expi
ration of the contract is expected to be 4.2%.
Information related to a forward contract on a currency: The risk-free rate in t
he U.S. is 5% and 4% in Switzerland. The current spot exchange rate is $0.8611 p
er Swiss France (SFr). The forward contract will mature in 200 days.
Questions
Based on the information given, what initial price should Lewis recommend for a
forward contract on the Treasury bond?
------$1,070.02

Suppose that the price of the forward contract for the Treasury bond was negotia
ted off-market and the initial value of the contract was positive as a result. W
hich party makes a payment and when is the payment made?
------- The long pays the short at the initiation of the contract

Suppose that instead of a forward contract on the Treasury bond, a similar futur
es contract was being considered. Which one of the following alternatives correc
tly gives the preference that an investor would have between a forward and a fut
ures contract on the Treasury bond?
---------- The forward contract will be preferred to the futures contract.

Based on the information given, what initial price should Lewis recommend for th
e 3 ¡Á 9 FRA?
-------4.96%.

Based on the information given and assuming a notional principal of $10 million,
what value should Lewis place on the 3 ¡Á 9 FRA at time of settlement?
----------$37,218 paid from long to short.

Based on the information given, what initial price should Lewis recommend for a
forward contract on Swiss Francs based on a discrete time calculation?
--------$0.8656

==================SS 17=====================
Mark Washington, CFA, is an analyst with BIC, a Bermuda-based investment company
that does business primarily in the U.S. and Canada. BIC has approximately $200
million of assets under management, the bulk of which is invested in U.S. equit
ies. BIC has outperformed its target benchmark for eight of the past ten years,
and has consistently been in the top quartile of performance when compared with
its peer investment companies. Washington is a part of the Liability Management
group that is responsible for hedging the equity portfolios under management. Th
e Liability Management group has been authorized to use calls or puts on the und
erlying equities in the portfolio when appropriate, in order to minimize their e
xposure to market volatility. They also may utilize an options strategy in order
to generate additional returns.
One year ago, BIC analysts predicted that the U.S. equity market would most like
ly experience a slight downturn due to inflationary pressures. The analysts fore
cast a decrease in equity values of between 3 to 5% over the upcoming year and o
ne-half. Based upon that prediction, the Liability Management group was instruct
ed to utilize calls and puts to construct a delta-neutral portfolio. Washington
immediately established option positions that he believed would hedge the underl
ying portfolio against the impending market decline.
As predicted, the U.S. equity markets did indeed experience a downturn of approx
imately 4% over a twelve-month period. However, portfolio performance for BIC du
ring those twelve months was disappointing. The performance of the BIC portfolio
lagged that of its peer group by nearly 10%. Upper management believes that a m
ajor factor in the portfolio¡‾s underperformance was the option strategy utilize
d by Washington and the Liability Management group. Management has decided that
the Liability Management group did not properly execute a delta-neutral strategy
. Washington and his group have been told to review their options strategy to de
termine why the hedged portfolio did not perform as expected. Washington has dec
ided to undertake a review of the most basic option concepts, and explore such e
lementary topics as option valuation, an option¡‾s delta, and the expected perfo
rmance of options under varying scenarios. He is going to examine all facets of
a delta-neutral portfolio: how to construct one, how to determine the expected r
esults, and when to use one. Management has given Washington and his group one w
eek to immerse themselves in options theory, review the basic concepts, and then
to present their findings as to why the portfolio did not perform as expected.
Questions:

Which of the following best explains a delta-neutral portfolio? A delta-neutral

portfolio is perfectly hedged against:
--------- small price changes in the underlying asset.

After discussing the concept of a delta-neutral portfolio, Washington determines

that he needs to further explain the concept of delta. Washington draws the pay
off diagram for an option as a function of the underlying stock price. Using thi
s diagram, how is delta interpreted? Delta is the:
---------slope in the option price diagram.

Washington considers a put option that has a delta of ?0.65. If the price of the
underlying asset decreases by $6, then which of the following is the best estim
ate of the change in option price?
-------+$3.90

Washington is trying to determine the value of a call option. When the slope of
the at expiration curve is close to zero, the call option is:
-------out-of-the-money.

BIC owns 51,750 shares of Smith & Oates. The shares are currently priced at $69.
A call option on Smith & Oates with a strike price of $70 is selling at $3.50,
and has a delta of 0.69 What is the number of call options necessary to create a
delta-neutral hedge?
------- 75,000

Which of the following statements regarding the goal of a delta-neutral portfoli

o is most accurate? One example of a delta-neutral portfolio is to combine a:
-------long position in a stock with a short position in call options so that th
e value of the portfolio does not change with changes in the value of the stock.
==================================================
Jacob Bower is a bond strategist who would like to begin using fixed-income deri
vatives in his strategies. Bower has a firm understanding of the properties fixe
d-income securities. However, his understanding of interest rate derivatives is
not nearly as strong. He decides to train himself on the valuation and sensitivi
ty of interest rate derivatives using various interest rate scenarios. He consid
ers the forward London Interbank Offered Rate (LIBOR) interest rate environment
shown in Table 1. Using a rounded daycount (i.e., 0.25 years for each quarter) h
e has also computed the corresponding implied spot rates resulting from these LI
BOR forward rates. These are included in Table 1

Questions

Bower is a bit puzzled about how to use caps and floors. He wonders how he could
benefit both from increasing and decreasing interest rates. Which of the follow
ing trades would most likely profit from this interest rate scenario?
--------Buy at the money cap and at the money floor

Bower shorts the floating rate bond given in Table 2. Which of the following wil
l best reduce Bower's interest rate risk?
--------Shorting Eurodollar futures.

Bower has studied swaps extensively. However, he is not sure which of the follow
ing is the swap fixed rate for a one-year interest rate swap based on 90-day LIB
OR with quarterly payments. Using the information in Table 1 and the formula bel
ow, what is the most appropriate swap fixed rate for this swap?
-------5.75%

Bower would like to perform some sensitivity analysis on a one year collar to ch
anges in LIBOR. Specifically, he wonders how the price of a collar (buying a cap
and selling a floor) is affected by an increase in the LIBOR forward rate volat
ility. Using the information in Tables 1 and 2 which of the following is most ac
curate? The price of the collar will:
------ decrease.

Bower computes the implied volatility of a one year caplet on the 90-day LIBOR f
orward rates to be 18.5%. Using the given information what does this mean for th
e caplet's market price relative to its theoretical price? The caplet's market p
rice is:
-----undervalued.

For this question only, assume Bower expects the currently positively sloped LIB
OR curve to shift upward in a parallel manner. Using a plain vanilla interest ra
te swap, which of the following will allow Bower to best take advantage of his e
xpectations? Purchase a:
-----pay fixed interest rate swap.
Janet Bellows, a portfolio manager, is attempting to explain asset valuation to
a junior colleague, Bill Clay. Bellows explanation focuses on the capital asset
pricing model (CAPM). Of particular interest is her discussion of the security m
arket line (SML), and its use in security selection.
Bellows begins with a short review of the capital asset pricing model, including
a discussion about its assumptions regarding transaction costs, taxes, holding
periods, return requirements, and borrowing and lending at the risk-free rate.
Bellows then illustrates the SML, and explains how changes in the expected marke
t return and the risk-free rate affect the line. In an effort to learn whether C
lay understands the concepts she has explained to him, Bellows decides to test C
lay¡‾s knowledge of valuation using the CAPM.
Bellows provides the following information for Clay:
The risk-free rate is 7%.
The market risk premium during the previous year was 5.5%.
The standard deviation of market returns is 35%.
This year, the market risk premium is estimated to be 7%.
Stock A has a beta of 1.30 and is expected to generate a 15.5% return.
The covariance of Stock B with the market is 0.18.
The standard deviation of Stock B¡‾s returns is 41%.
Using this information, Clay must calculate expected stock returns and betas. Be
llows especially wants to know Stock A¡‾s required return, and whether or not th
e stock is a good buy.
Bellows then proposes a hypothetical situation to Clay: The stock market is expe
cted to return 12.5% next year. Clay questions that return estimate in the conte
xt of the data listed above, and Bellows responds with four possible explanation
s for the estimate:
The estimated risk premium is incorrect.
Interest rates are likely to fall 1.5% over the next year.
Given the data above, the return estimate is correct.
The market beta is expected to rise over the next year.
Then Bellows provides Clay with the following information about Ohio Manufacturi
ng, Texas Energy, and Montana Mining:

Questions:
Based on the stock and market data provided above, which of the following data r
egarding Stock A is most accurate?
---------16.1% Sell

The beta of Stock B is closest to:

-----1.47 (Beta = (covariance of stock B with the market) / (variance of the mar
ket portfolio)= 0.18 / (0.35)2 = 1.47

Which of the following represents the best investment advice?

-----Avoid Texas because its expected return is lower than its required return.

Assuming the market return estimate of 12.5% is accurate, which of the following
statements is the best explanation for the estimate?
-----The estimated risk premium is incorrect.

With regard to the capital asset pricing model, relaxing assumptions about:
-----homogeneous expectations will result in the SML appearing more as a band in
stead of a line.

If the market risk premium decreases by 1%, while the risk-free rate remains the
same, the security market line:
-----becomes flatter.