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- Assignment 10

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MSc in Quantitative Finance

Module Code

SMM254

Date

14th January 2011

Division of Marks:

Instructions to students:

Exam Title

Derivatives

Time

1430 - 1645

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 GT+, Casio FX-85 GT+, Casio

FX-83 MS , Casio FX-83 ES, Casio FX-85 MS, and Casio FX-85 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 investor. You hold a diversified portfolio of around 30 stocks in US and

UK companies with a current market value of $30m and 20m, respectively. The

dollar-sterling spot rate is S = 1.6 ($ per ).

i) Carefully indicate the steps you would take to calculate the 10-day VaR for this

portfolio (a the 1% left tail probability) using the variance-covariance approach.

ii) How would you test the adequacy of your VaR model?

iii) Briefly explain what key parameters determine whether the portfolio VaR is large

or small?

iv) If you now also include a 2-year US coupon bond, $100m face value, 5% coupon

(paid annually) in your portfolio, briefly explain how this would be incorporated in

your VaR calculation?

(50%)

b)

You hold 100 European put options on stock-A and 200 European put options on

stock-B.

You also hold 20 stocks in company-A. For illustrative purposes assume the options

both have a strike price K = 100, maturity of 1 year 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.

Carefully, outline the steps you would take to calculate the 10-day VaR (at the 1% left

tail probability) of this portfolio using Monte Carlo Simulation (MCS).

Assume you have 1000 days of historic data on prices. How would you calculate

the 10-day (1% left tail) VaR of the above portfolio using a bootstrapping procedure?

Why might the bootstrap procedure and the MCS give different estimates of the VaR?

(50%)

Question 2

a)

Give practical examples and explain why an Asian option, a barrier option, and

an equity swap are useful for controlling risk.

Explain how one of the above options can be priced using the Binomial option pricing

model (BOPM) and Monte Carlo Simulation (MCS)

Choose two trading strategies using plain vanilla options and explain why they might

be used by speculators.

(50%)

b)

You run a large vehicle (car and lorry) plant in Ohio (USA) and your plant buys

natural gas and electricity from local energy firms, as you require it. Natural gas is

used to heat the plant and the electricity to power the machinery. Explain and

critically appraise how you would use weather derivatives to offset some or all of the

risks to your profitability from volume and cost/price uncertainty.

(50%)

Question 3

a)

In the futures market, briefly explain why the clearing house takes initial margin and

variation margin payments from both the buyer and the seller of futures contracts.

Briefly explain how arbitrage opportunities arise in futures markets and how you might

use them to make (near) riskless profits.

b)

(33%)

How can you use stock index futures contracts to hedge, over the next 6 months, a

portfolio of $10m consisting of 5 small-cap stocks, which have a portfolio beta of

1.5? The value of the S&P500 index is currently 1000 and the futures price (on the

S&P500 and with delivery in 1-year) is 1020.

Qualitatively, what will happen in the hedge if the S&P500 rises by 10% over the next

6 months? What are the risks in the hedge and how might you mitigate such risks?

Suppose that in 6 months time (after your successful hedge) you thought that the

stock market would rise substantially over the next 6 months as the economy

emerged from recession. How could you increase your exposure to this market rise

by using stock index futures?

(33%)

Cont overleaf

c)

It is January 1st and you are going to take out a 5-year US dollar loan in 6 months

time for $1.5m with payments linked to 180-day LIBOR + 100 basis points.

Carefully explain the steps you might take to hedge this position using a specific

futures contract and how you would calculate the optimal number of futures contracts.

(34%)

Question 4

a)

Consider the following data, where S= current stock price, K = strike price, r = (oneperiod) interest rate (decimal) and the stock price can move up or down by 10% each

period.

100

105

0.05

S(t=0)

K

r

1.1

0.9

U

D

Construct the stock price binomial tree over two periods. Show using the binomial

option pricing model (BOPM) that the price of a two-period put option is about P=

3.4.

If you

observed a similar option with a quoted price of P= 2, what trades would you do to

lock in a riskless arbitrage profit?

What concepts in the BOPM lead to the use of Monte Carlo simulation (MCS) in

pricing options?

(33%)

b)

You hold a Portfolio-A of options with delta, gamma and vega of:

a = -450

a = -6000

a = -4000

The following options are also available:

Option Z which has z = 0.6, z = 1.5,

Z = 0.8 and

Option Y which has y = 0.1, y = 0.5 and y = 0.6.

Describe how you can combine options A, Y and Z to give a portfolio which is

gamma, vega and delta neutral and briefly explain the meaning of this concept.

(33%)

Cont overleaf

c)

How would you dynamically delta hedge a long put option which you buy for P = 5

and K=100 and delta is minus 0.5?

Assume the stock price starts at S=100 and falls to 30 at maturity of the option.

(34%)

Question 5

a)

How are plain vanilla interest rate swaps priced, what determines the swap rate (and

swap rate curve). Why does the value of the swap change over its life? If interest

rates increase what is likely to happen to the value of a pay-fixed, receive-float

interest rate swap with a remaining maturity of (say) 10 years?

(33%)

b)

Clearly explain why and how a (non-financial) corporate might use (each of) a cap, a

floor, a collar and a swaption to manage interest rate risk.

(33%)

c)

Explain how credit derivatives such as mortgage backed securities (MBS), credit

default swaps (CDS), and collateralised debt obligations (CDOs) are used as

investment vehicles and in risk management.

(34%)

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