EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies

Problem Set 2

This problem set is to be turned in by Friday, February 10th 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF.

1. Hedging Using Futures

A trader owns 55,000 units of a particular asset and decides to hedge the value of her position with futures
contracts on another related asset. Each futures contract is on 5,000 units. The standard deviation of the
change in the spot price of the asset is 0.43. The standard deviation of the change in futures price of the
related asset is 0.40. The correlation coefficient between the spot price change and futures price change is
0.95.

(a) What is the minimum variance hedge ratio?

(b) Should the hedger take a long or short futures position?

(c) What is the optimal number of futures contracts?

1 Instructor: Yongjin Kim

EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

2. Zero-Rates and Bond Valuation

Consider the following term-structure of spot rates (with continuous compounding):

Maturity (years) Interest rate (%)

1 3.0
2 4.0
3 4.6

We have a 3-year corporate bond that will pay $50-coupon each year and pay the face value of $1,000 in
year 3. What is the present value of the bond?

3. Forward Rates
Consider the following term-structure of spot rates (with continuous compounding):

Maturity (years) Interest rate (%)

1 3.0
2 4.0
3 4.6
4 5.0

(a) What is the forward rate r0 (3, 4) implied in the term structure?

(b) Consider an imaginary asset providing the return of the forward rate, r0 (3, 4), such that investors pay
$1 in year 3 and receive er0 (3,4) in year 4. Show that we can construct this imaginary asset by combining
two zero-coupon bonds.

2 Instructor: Yongjin Kim