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The University for business

and the professions

Cass Business School

MSc in Quantitative Finance

Module Code
14th January 2011
Division of Marks:
Instructions to students:

Exam Title
1430 - 1645

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 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

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?


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

Question 2

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.


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.

Question 3

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.


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?

Cont overleaf


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.

What are the risks in the hedge?


Question 4

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




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=

What assumptions did you make in determining the option price?

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?

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.

Cont overleaf


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.

Question 5


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?


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.


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.