Review Guide for Midterm Exam 2 of BUS 172C

This guide has a limited amount of information for Midterm exam 1. The best preparation
requires studying all examples in Lecture notes, all HW assignments and all quizzes.

If any of the following topics are not covered in lectures, then ignore them: They will not on
the exam.

Reasons for no credit risk in Futures Trading?

Advantages and Disadvantages in spot – and futures hedge - trading

(Topic) Marking to market.

An investor purchases one December gold futures contracts from New Your Mercantile
Exchange (NYME). Now is June 5.

The contract size of one gold futures is 100 ounce.

The initial margin is $2000 per contract.
The maintenance margin is $1500 per contract.
This investor deposited $2000 in his margin account.

Suppose the current December futures price is $400 per ounce.

If the December futures price decreased to $390.0 in June 7, then what happen to his margin
account?
a. Nothing happen. He does not have to do anything about his margin account.
b. He has to deposit extra money to satisfy the maintenance margin.
c. He has to deposit extra money to satisfy the initial margin.

Answer) c.
P/L = ($393.3 - $400)1100 = - $1,000.
The balance of margin account = $2,000 - $1,000 = $1,000.
The balance of margin account ($1,000) < Maintenance margin ($1,500).
The difference between $2,000 and initial margin ($2,000) = $1,000 = margin call (variation
margin).

Another example
Topic) Margin account – minimum deposit to start futures trade

Suppose you purchased 2 contracts of e-mini S&P 500 index futures today. The purchase price of
the futures (index of S&P500) was 1200. The contract size of the futures per contract is 50. The
initial market requirement is $5,625 per contract for the futures. The maintenance margin for
the $2,800 per contract.

a. The minimum required deposit to start trading is $2,800.

b. The minimum required deposit to start trading is $5,600.
c. The minimum required deposit to start trading is $5,625.
d. The minimum required deposit to start trading is $11,250.
e. The minimum required deposit to start trading is $16,850
Answer) d.
The minimum required deposit = initial margin * number of contracts
= $5,625*2 = $11,250.

(Topic) P/L – basic computation – futures market

You expect the price of a certain underlying asset to rise and accordingly entered into the
corresponding two futures contracts. The futures price when you entered into the futures
contracts was $125. The contract size of the futures is 50. Suppose the price of the underlying
asset rose to $132 as you expected. Compute your profit from the price movement.
 a. Less than $500.
b. Larger than $500 but less than $650.
c. Larger than $650 but less than $750.
d. Larger than $750 but less than $850.
e. Larger than $850.

Answer) c.
(132-125)*2*50 = $700.

Settlement type
 Physical delivery - Foreign currency, Treasury bond futures, agricultural, metal, and
energy futures

 Cash settlement - stock index

When to use futures short hedge?

When to use futures long hedge?

Calculation of cash flows of an unhedged and a hedged position at termination

Topic) Hedge effectiveness

Short hedge or long hedge using futures can be imperfect.

a. True
b. False

Answer) a

Topic) Cross hedge

Suppose that you diversified your equity portfolio. Yet the measure of systematic risk (beta) of
your equity portfolio is not the same as the market portfolio, such as S&P500 portfolio. (Assume
that S&P500 stock index has the beta of one.) Now you decided to hedge your portfolio using
stock index futures. Which of the following is always true?
a. The value of beta of your hedged portfolio decreases.
b. The value of beta of your hedged portfolio increases.
c. The value of beta of your hedged portfolio converges to 0.
d. The value of beta of your hedged portfolio converges to 1.

Answer) c.
Topic) Basis Risk
Consider an underlying asset U. There is no futures contract on U. Hence, you are going to use
other futures contract instead to hedge the risk of adverse price movements in the underlying
asset U. Your assistant provided four candidate futures contracts, F, G, H and L with the correlation
coefficients of prices to U:
 Correlation coefficient between U and F = 0.
 Correlation coefficient between U and G = -0.9.
 Correlation coefficient between U and H = -1.
 Correlation coefficient between U and L = 0.8.

Answer) H.

Topic) Effective Buy/Sale price

It is May 1. A U.S. company expects to receive 100 million Japanese Yen at the end of July. The U.S.
Company, of course, wants to have U.S dollar, not the Japanese Yen. In other words, it will need
to sell Japanese Yen at the end of July. The company worries about the uncertainty in the sale
price of Japanese Yen. Hence it decided to enter into a position of futures contracts on Japanese
Yen today (May 1). Japanese Yen futures contracts on the CME have delivery months of March,
June, September, and December. Quotes available in May 1 are:
 June futures price = 0.74 cents per yen (Each contract delivers 12.5 mil yen.)
 September futures price = 0.76 cents per yen (Each contract delivers 12.5 mil yen.)
 December futures price = 0.78 cents per yen (Each contract delivers 12.5 mil yen.)
Suppose the spot and futures prices at the end of July are 0.74 and 0.745. Compute the effective
sale price of yen for the company at the end of July.

a. Effective sale price < 0.74 cents.

b. 0.74 cents ≤ effective sale price <0.75.
c. 0.75 cents ≤ effective sale price <0.76.
d. 0.76 cents ≤ effective sale price <0.77.
e. 0.77 cents ≤ effective sale price

Answer) c
Effective sales price = F0 – Ft + St = 0.76 – 0.745 + 0.74 = 0.755
Topic) Optimal number of option contracts for cross hedge.
It is the end of May 2010. United Airline (UA) Company expects to need 1,700,000 gallons (1.7
million) of Jet oil at the end of October 2010. On May 28, 2010, jet oil is trading at the price of
$4.1 per gallon. The UA expects jet oil prices to be much higher by the end of October 2010. To
protect itself against the rising price, the UA decides to hedge using heating oil futures since
there are no futures contracts on jet oil. The May 28 heating futures closing price is $2.3 per
gallon (in NYMEX, 1 contract of heating oil = 42,000 gallons of heating oil). The UA decides to
place the heating oil futures contracts on May 28, 2010. To place the orders, UA needs to
determine the number of heating oil futures contracts necessary to offset 1.7 million gallons of
jet oil. The UA knows the following information. What is the optimal number of futures contract
on heating oil to hedge the risk in the adverse movement of jet oil price?
 The correlation between the price changes of jet oil and heating oil (ρ) = 0.7.
 The standard deviation of the price change of jet oil (σ∆S) = $1.2.
 The standard deviation of the price change of heating oil (σ∆F) = $0.5.

a. Optimal number < 20.

b. 20 ≤ optimal number < 30
c. 30 ≤ optimal number < 40
d. 40 ≤ optimal number < 50
e. 50 ≤ optimal number

Answer) e
HR = ρ(σ∆S/ σ∆F) = 0.7($1.2/$0.5) = 1.68
N* = 1.68 ×(1,700,000/42,000) = 68
Hedging effectiveness = ρ2 = (0.7)2 = 0.49.
You are the manager of a stock portfolio. Today, your holdings consist of the five stocks listed in
the following table, which you intend to sell in three months. You are concerned about a market
decline over the next three months. The number of shares, their prices, and the betas are shown
in the table. Today, you decide to execute a hedge using a particular stock index futures
contract, which has a $50 multiplier. The six-month maturity futures price is $37.62 today.
Calculate the optimal number of index futures contracts for the hedge.

Market
Stock #share Beta Price value Weight
STOCK1 100 1 19.63 1,963.0 0.092
STOCK2 62 1.05 31.38 1,945.6 0.091
STOCK3 158 1.8 49.38 7,802.0 0.367
STOCK4 89 0.9 55.38 4,928.8 0.232
STOCK5 110 0.85 42.13 4,634.3 0.218
Total 21,273.7 1.000

a. 0
b. larger than 0 but less than 20
c. larger than 20 but less than 40
d. larger than 40 but less than 60
e. larger than 60
Answer)

Market
Stock #share Beta Price value Weight W*beta
STOCK1 100 1 19.63 1,963.0 0.092 0.092
STOCK2 62 1.05 31.38 1,945.6 0.091 0.096
STOCK3 158 1.8 49.38 7,802.0 0.367 0.660
STOCK4 89 0.9 55.38 4,928.8 0.232 0.209
STOCK5 110 0.85 42.13 4,634.3 0.218 0.185
Total 21,273.7 1.000 1.242

beta (portfolio) 1.241

Portfolio value (Oct) 21273.72

Futures price (Oct) 37.62
Contract size 50
Value of one futures
contract (Oct) 1881

Optimal NF 14.046
Nearest NF 14
  Which type of interest rate swap in a single currency does not exist?

a. Fixed for variable payments

b. Fixed for fixed payments
c. Variable for fixed payments
d. Variable for variable payments

(Answer) B

(Answer) B

 Net settlement in IRS

Consider the annualized floating rate of three-month LIBOR of 6% and the notional
amount of $20 million with quarterly reset frequency and the fixed rate of 4%, actual/360
and actual/365 day counting, respectively. The actual number of days for the quarter is 90.
What is the payment made?

(Answer)
90 90
6% × $20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × ( ) − 4% × $20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × ( )
360 365
= $102,739.73 is paid by the floating rate payer to
the fixed rate payer

 IRS and Liability management

Answer
  Transformed interest rate by a swap

ABC Company has a ten-year floating rate loan of $50 million at LIBOR plus 240 basis
points from a bank and fears a rise in interest rates.
A swap dealer is willing to receive fixed payments at 5.6% and make floating payments at
LIBOR. What is the transformed interest rate for ABC Company through the interest rate
swap?

(Answer)

Original interest rate = 𝐿𝐼𝐵𝑂𝑅 + 240𝑏𝑝

Transformed interest rate= 5.6% − 𝐿𝐼𝐵𝑂𝑅 + (𝐿𝐼𝐵𝑂𝑅 + 240𝑏𝑝)

= 8% fixed
  Interest cost saving with a swap contract using comparative advantage

5 year loans FB BABA

Fixed rate 3.0% 6.0%
Floating rate LIBOR + 50 bp LIBOR + 570 bp
Currently, the 5-year swap rate is 2.1%.

(1) In which market FB and BABA have respective comparative advantage in the fixed
and floating rate mrkets?
(2) How much can FB save using the interest rate swap?
(3) How much can BABA save using the interest rate swap?
(4) How much is the sum of individual interests under the comparative advantage?
(5) How much is the sum of individual interests under the comparative disadvantage?
(6) What is the difference in the total interest rates in the above (3) and (4).

(Answer)

o FB has the advantage in floating rate; BABA fixed rate.

5 year loans FB BABA If FB borrows instead of BABA
Fixed rate 3.0% 6.0% 3%-6%=-3% (3% saving)
Floating rate LIBOR + LIBOR + LIBOR + 50 bp –( LIBOR + 570 bp)=
50 bp 570 bp -520 bp = -5.2% (5.2% saving)

o FB borrows at LIBOR + 50; BABA borrows at 6%; and then swap.

o To take advantage of cost saving, get into a swap contract. Then, the transformed
interest for FB = Libor + 50bp – Libor + 2.1% = 2.6%
o If FB had to borrow from the fixed rate market, then it had to pay 3.0%. Hence,
comparing the transformed interest rate of 2.6%, FB saves = 3% - 2.6% = 0.4%
 o Similarly, the transformed interest for BABA = 6% –2.1% + Libor = Libor + 3.9%.
Hence, BABA saves = Libor + 570 bp – (Libor + 3.9%) = 1.8%
o Total interest rates under comparative advantage = Libor + 50 bp + 6% = Libor +
650bp
o Total interest rates under comparative disadvantage = 3% + Libor + 570 bp = Libor
+ 870bp
o Difference in the total interest rates in comparative advantage in disadvantage =
Libor + 870bp – (Libor + 650bp) = 220bp = 2.2%  same as the individual sum of
savings (0.4% + 1.8%).

 The expected NPV of a swap contract at inception = ?

 Swap pricing

Notional amount=200
million
360 year basis
Period Quarter 1 Quarter 2 Total
Libor (%) 4.3
Eurodollar futures price 88
Annualized forward rate (%) 12
Number of days 92 92

Periodic rate (%)

DF
=0.03067x$200 million =
Periodic floating payment $6.134 million
Periodic fixed payment SR*200m*184/360 Total
PV of periodic floating
payments 2.174 m= 0.98913*$2.198 5.887 m=0.9597*$6.134 m 8.061 m
 SR*98.103 m =
PV of fixed floating SR*200m*184/360
payments *(0.9597) SR*98.103 m

 Swap valuation

One day after determining the swap rate of 8.22% for the 6-month swap agreement, the
Eurodollar futures price changed from 88 to 94. What is the value of the swap for fixed
payer and for floating payer, respectively?

(Answer)
Swap value for fixed payer = -3.024 million.
Swap value for floating payer = +3.024 million