UNIVERSITY OF CAPE TOWN

FINANCIAL ANALYSIS & PORTFOLIO MANAGEMENT

Final Examination - 30 June 2018
Futures, Options and Derivatives: ECO 4108Z
Maximum Time: 3 Hours

Maximum Marks: 100

INSTRUCTIONS TO CANDIDATES

i. Answer ALL questions

ii. Show all calculations

iii. Write legibly

ADDITIONAL MATERIAL

• Statistical tables

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1. Explain how margin protect futures traders against the possibility of default [ 5 marks]

2. (a) Explain why the daily settlement of the contract can give rise to cash flow problems,
when a futures contract is used for hedging. [3 marks]

(b) Suppose that there are no storage costs for crude oil and the interest rate for
borrowing or lending is 7% per annum. How could you make money if the January
and June futures contracts for a particular year trade at R809.22 and R880.17,
respectively. [4 marks]

[Total: 7 marks]

3. Suppose Ms Lulu Mbatha, a recent FAPM graduate is considering trading on six-month

JSE Single Stock Futures (SSFs). The current price (S ) is 66,000 cents and the futures
price(F ) = 68,000 cents. Lulu has also observed that the six-month T.Bill rate (r ) is
7%; and the yield curve is flat.
Suppose that total transactions costs = R20, for a complete arbitrage with one contract.
(a) If no dividend is paid on this stock during the next six months:
(i) What is the theoretical futures price?
(ii) Discuss the specific arbitrage opportunities for Ms Mbatha.
[2; 3 marks]
(b) Now suppose a divided is paid on this stock in 6 months, just prior to expiration
of the contract. The present value of this dividend payment is 9000 cents.
(i) What is the theoretical futures price?
(ii) Discuss the specific arbitrage opportunities for Ms Mbatha in this case.
[2; 3 marks]
(c) Consider again the situation in (a). above (no divided during the next six months).
Suppose that, on day 1, she buys one SSFs contract with K = 68, 000 cents. Then,
after 3 months the spot price increases to S = 67, 500 cents, while the 6-month
T.Bill rate is at 7%.
(i) What is the new theoretical futures price?
(ii) What is the value of her futures contract?
[2; 3 marks]
[Total: 15 marks]

4. Suppose you have been recently employed by a local investment company, as an investment
adviser. On May 1, Ms Awande Tsivenda, an investor who holds 500,000 shares of XYZ
Ltd stock, a company listed on the JSE, with a market price of 70,000 cents (or R700)
per share. Awande is interested in hedging against movements in the market over the

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next month and decides to use the July JSE Top 40 Index futures contract. The index
is currently 50,580 with a contract size of R10 per index point. The beta of the stock is
0.85.
(a) Advise Awande on the investment strategy that she should follow. [3 marks]

(b) Under what circumstances will this strategy be profitable? [2 marks]

[Total: 5 marks]

5. (a) Suppose Tiger Manufacturing, a Botswana manufacturer, which relies on raw material
imports from South Africa, wishes to borrow South Africa Rand at a fixed rate of
interest. Limpopo Co, a South African company with subsidiaries in a number
of countries in the SADC region is considering expansion on one of their existing
factories in Botswana. The management of Limpopo Co. wants to borrow Pula at
a fixed rate of interest. The two companies have been quoted the following rates
per annum (adjusted for differential tax effects):
BW Pula RSA Rand
Tiger Manufacturing 11.0% 7.0%
Limpopo Co. 10.6% 6.2%
Design a swap that will net a bank, acting as intermediary, 10 basis points per
annum with the rest shared equally between the two companies. [6 marks]

(b) Suppose that the term structure of risk-free interest rates is flat in the South Africa
and Namibia. The South African interest rate is 7% per annum and the Namibian
rate is 9% per annum. The current value of the Namibian rand (NAD) is 0.62 ZAR.
Under the terms of a swap agreement, a financial institution pays 8% per annum
in NAD and receives 4% per annum in ZAR. The principals in the two currencies
are 12 million ZAR and 20 million NAD. Payments are exchanged every year, with
one exchange having just taken place. The swap will last two more years. What
is the value of the swap to the financial institution? Assume all interest rates are
continuously compounded. [6 marks]
[Total: 12 marks]

6. Consider an exchange-traded put option contract to sell 500 shares with a strike price
K = R900. Explain how the terms of the contract will change when there is :
(a) a 10% stock dividend [2 marks]
(b) a 10% cash dividend [2 marks]
(c) a 5-for-4 stock split [2 marks]
(d) an announcement of increased earnings [2 marks]
[Total: 8 marks]

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7. Suppose Bongani Ntiya, a manager at Laboratory Equipment Sales (LES) a leading

supplier of laboratory equipment in the Western Cape Province, received 10,000 shares
of company stock as part of his compensation package. The stock currently sells at R400
a share. Ntiya would like to defer selling the stock until the next tax year. In January,
however, he will need to sell all his holdings to provide for a down payment on his new
house. Ntiya is worried about the price risk involved in keeping his shares. At current
prices, he would receive R4,000,000 for the stock. If the value of his stock holdings falls
below R3,500,000, his ability to come up with the necessary down payment would be
jeopardized. On the other hand, if the stock value rises to R4,500,000, he would be able
to maintain a small cash reserve even after making the down payment. Ntiya considers
three investment strategies:

(a) Strategy A is to write January call options on the LES shares with strike price
R450. These calls are currently selling for R30 each.
(b) Strategy B is to buy January put options on LES with strike price R350. These
options also sell for R30 each.
(c) Strategy C is to write the January calls and buy the January puts (Note: this
would involve zero initial cost)

Evaluate each of these strategies with respect to Ntiya’s investment goals, and advise
him on which strategy to adopt. [15 marks]

8. Suppose you are given the following regarding the stock of BJW, a company listed on
the JSE

• the stock price is currently selling for 50,000 cents (or R500)
• one year from now it will either sell for 40,000 cents or 55,000 cents
• the stock pays dividends continuously at a rate proportional to its price. The
dividend yield is 10%
• the continuously compounded risk-free rate is 7%

While reading the business section of a national newspaper, you notice that a one-year
at-the-money European call written on BJW is selling for R20. You wonder whether this
call is fairly priced. Using the binomial option pricing model determine if an arbitrage
opportunity exits and identify the possible transactions that you should enter into to
exploit the arbitrage opportunity(if it exists). [6 marks]

9. Consider an option on a non-dividend-paying stock when the stock price is R500, the
exercise price is R490, the continuously compounded risk-free rate of interest is 5% per
annum, the volatility is 25% per annum, and the time to maturity is six months.
(a) Calculate the price of the option using the Black-Scholes formula, if the option is
a European call. [5 marks]

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(b) Determine the price of the option if it is an American call. [1 mark]

(c) Calculate the price of the option if it is a European put. [3 marks]

(d) Determine how the prices of the contracts in parts (a) to (c) would change in the
case of a dividend-paying underlying stock. [Note that you do not have to perform
any further calculations.] [3 marks]

[Total:12 marks]

10. A non-dividend paying share currently trades at S0 = R100. An investor is considering

buying a European call option on the share with a strike price of R120 and expiry in
five years. The continuously compounded risk-free rate of interest is 4% p.a.
(a) Determine lower and upper bounds for the price of the call option at time 0. [2 marks]

The call option is currently priced at R15.00. The assumptions of the Black-Scholes
model apply.
(b) Calculate the implied volatility of the share. [6 marks]

(c) Determine the corresponding hedging portfolio in shares and cash for 100 call
options. [2 marks]

[Total: 10 marks]

11. Consider a call option with price ct at time t (in years) written on an underlying
nondividend-paying asset with price St at time t and volatility σ. Using Taylor’s
expansion, it can be shown that the change in value of the option is approximately
given by:

dct = delta × dSt + 0.5 × gamma × (dSt )2 + theta × dt + vega × dσ

At time t = 0, the underlying asset price is R530 and the volatility is 20% per annum.
The option is priced at R61.70 and has the following properties:

• delta = 0.622
• vega = 0.104
• theta = -0.655
• gamma = 0.033

At time t = 1, the security price has fallen to R500 and its volatility is now 15% per
annum.

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(a) Estimate the value of the call option at time t = 1. [2 marks]

(b) The delta of a call option is always positive, whilst the delta of a put option is
always negative. Justify this result. [2 marks]

(c) The vega of both call and put options is always positive. Justify this result. [1 mark]

[Total: 5 marks]

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