MAN 308 Investment Analysis

2011

Individual Assignment

1. Format: A4 Page, Font Size 12, Single Spacing

Written Pages will not be accepted

Hand-drawn diagrams are permitted.

2. Random Questions are drawn to reflect your two assignment marks.

Deadline: 21/22 September 2011

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Question 1 Futures Hedging, Synthetic Option Strategies (Difficult)

Today is 15 September 2011. Dr. Mkhize is an equity portfolio manager. His primary
responsibility is looking after the equity portfolios of two wealthy clients, Mr. Chen and Mrs. Li.
Dr. Mkhize expects investor sentiments to be weak over the next 3 months due to the downgrade
of U.S. Treasury by Standard & Poor coupled with the contagion of the European debt crisis. Dr.
Mkhize’s annual bonus depends on the values of the clients’ portfolios on 15 December 2011.

* Mr. Chen has a well-diversified portfolio with current value of R20 million. The historical
volatility of Mr. Chen’s portfolio is estimated at 30% while the historical volatility of the
ALSI 40 index is 20%. The correlation between Mr. Chen’s portfolio and the ALSI 40 index
is estimated at 0.80. ALSI 40 has a dividend yield of 4% and the 90-day Treasury bill rate is
6%. ALSI 40 is currently 25 000 points.

* Mrs. Li has two investments. The first investment consists of 500 000 shares in ARC Ltd.
The company has done very well recently and the share price is expected to extend its
momentum over the next 3 months. Mrs. Li would like to sell all her ARC Ltd shares when
the share price reaches R63 per share. Mrs. Li has no desire to profit from additional price
appreciation above R63 per share as she would like to sell as many of her ARC Ltd shares as
possible by 15 December.

* Mrs. Li’s second investment consists of 500 000 shares in Tangent Ltd.

Option Contracts 15 September 2011 Contract Size: on 100 shares

Underlying Spot Month Strike Premium (per contract in rands)
Call Put
ARC 60 Dec 2011 57 1059 450
ARC 60 Dec 2011 60 906 582
ARC 60 Dec 2011 63 771 729

Tangent 30 Dec 2011 27 500 168

Tangent 30 Dec 2011 30 453 222
Tangent 30 Dec 2011 33 327 447

(a) Assume ALSI 40 index futures are trading at their fair value. Calculate the number and
type of ALSI 40 futures contracts Dr. Mkhize has to trade in order to completely hedge
against the exposure of Mr. Chen’s portfolio.

(b) Synthesize an option strategy that will satisfy Mrs. Li’s objective regarding her
investment in ARC Ltd. Include in your answer:

* complete profit/loss diagrams with all key points labelled (your diagram should be
based on one ARC Ltd share).

* complete option algebra attached to your profit/loss diagrams.

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 * estimations of profit/loss for the overall synthetic option strategy when the share
prices of ARC Ltd are R55, R61, R68 respectively.

(c) Construct a bear spread strategy for Mrs. Li’s investment in Tangent Ltd by adding in-
the-money call options and in-the-money put options to the existing investment in
Tangent Ltd. Include in your answer:

* complete profit/loss diagrams with all key points labelled (your diagram should be
based on one Tangent Ltd share).

* complete option algebra attached to your profit/loss diagrams.

* estimations of profit/loss for the overall synthetic option strategy when the share
prices of Tangent Ltd are R25, R29 and R35 respectively.

Question 2 Synthetic Option Strategies (Difficult)

Suppose you executed the following strategy on ABT Ltd using four exercise prices
R95/R100/R105/R110 that expire on 15 December 2011:

Long One ABT Call (X = R95 ; Premium per option = R10)

Short Two ABT Call (X = R100 ; Premium per option = R7)
Long One ABT Call (X = R105 ; Premium per option = R6)

a) What is the cost of initiating this strategy?

b) Graphically depict fully-labelled Profit/Loss diagrams of the strategy highlighting all key
points with full option algebra attached to your diagrams.

c) What is the strategy known as (do some research to find the answer)?

d) What is the profit/loss of the strategy at expiration if:

(i) St = R109
(ii) St = R115
(iii) St = R125

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Question 3 Futures Pricing (Easy)

Today is 15 June 2011. The JSE All Share Index is 32 000 points. The weighted average dividend
yield is 3% p.a. the 3-month Treasury bill rate is currently 6% p.a. and the initial margin required
for ALSI index futures is at 10% of the transaction value.

(a) What is the cost of carry for the ALSI index futures contract that closes out on 15
December 2011?

(b) What is the fair value for one ALSI index futures contract that closes out on 15 December
2011

(c) You sold 5 ALSI index futures contracts today at their fair values. What will be the
profit/loss and margin account levels for your positions on 16 June 2011 and 17 June
2011 if ALSI index futures are 33 000 and 32 000 respectively.

Question 4 Hedging Fixed-Income Portfolio Using Futures (Easy)

I am holding 20 fixed-coupon bonds with a nominal value of R1 000 000 (Coupon Rate of 10%
and 8 years to maturity). The bond is priced at YTM of 60 point above a tradable bond with
nominal value of R1 000 000 with a coupon rate of 8% and 4 years to maturity. The tradable
bonds are currently trading at their par value. How many futures contracts on tradable bonds do I
need to sell short to cover the exposure in my fixed-income bond portfolio? The duration for my
bond portfolio and for the tradable bonds are 11.57 years and 7 years respectively.

Question 5 Option Greeks (Easy)

(a) A portfolio of 6 000 shares held long requires 8 000 call options on the same share held
short to result in a perfect hedge. Estimate the following:
(i) hedge ratio for this operation;
(ii) call option delta;
(iii) put option delta; and

(b) I want to hedge a portfolio of 5 000 Naspers shares using a protective put strategy. If the
current share price of Naspers is R300 per share and Dec call option delta on Naspers
shares is equal to 0.50. Answer the following questions:
(i) R1 decrease in Naspers share price will result in R________ (profit/loss) in one
short Dec Naspers call option positon;
(ii) The hedge ratio using short Dec Naspers call option is ________;
(iii) Delta for Dec Naspers put option is ________;
(iv) The hedge ratio using long Dec Naspers put option is ________;
(v) The number of Dec Naspers put option contracts required to hedge my
investment in Naspers shares is equal to ________; and

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 (vi) The Dec Naspers call option is (in/out-of/at) -the-money and the Dec Naspers put option
is (in/out-of/at) -the-money.

Question 6 Performance Evaluation (Moderate)

The following data are available relating to the performance of Everlasting Equity Fund and the
market proxy:

Everlasting Market
Average Return 24% 15%
Standard Deviation of Return 20% 16%
Residual Standard Deviation 2% 0%

The risk-free return during the sample period was 6%.

Correlation between Everlasting return and market return = 0.96

(a) Calculate the following for Everlasting Equity Fund and the Market Portfolio
respectively:

* Information Ratio;
* Sharpe ratio;
* Treynor Ratio;
* Jensen’s Alpha; and
* M2 Measure

(b) Plot Everlasting Equity Fund and the Market proxy against the security market line.
Label all relevant points in your diagram.

(c) Plot Everlasting Equity Fund and the Market proxy against the capital market line. Label
all relevant points in your diagram.

Question 7 Performance Attribution (Easy)

Perform a complete performance attribution for Apex Ltd based on the following information

Bogey Portfolio Benchmark Component

Component Weight Return
Equity 0.60 18%
Bonds 0.20 8%
Cash 0.20 5%

Apex Portfolio Benchmark Component

Component Weight Return
Equity 0.50 14%
Bonds 0.30 12%
Cash 0.20 6%

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Question 8 Swaps (Moderate)

ARC Ltd is holding 10 semi-annual fixed coupon (10%) bond maturing in 36 months (face value
= R1m). The next interest receipt is in exactly 180 days. ARC Ltd would like to hedge the interest
rate exposure using interest rate swaps over the next 12 months. ARC Ltd can either enter into an
agreement with the swap dealer as a fixed-rate payer at 11% in exchange for a floating-rate
receipt of 180-day JIBAR + 1%, or as a floating-rate payer at 180-day JIBAR + 2% in exchange
for 12% fixed-rate receipt on notional principal required. The 180-day JIBAR rates are forecasted
as follows:

Current: 9%
In 180 days: 10%
In 360 days: 12%

a) What is ARC Ltd’s current exposure regarding the fixed coupon bond holding?

b) Construct the swap design to assist ARC Ltd in managing its interest rate exposure.

c) Demonstrate the payments/receipts schedule for the swap design in part (b).

d) Based on the interest rates forecasted, compute the expected net receipts/payments (from
the bond holding and the swap transaction) over the desired hedging period.

e) Would you advise ARC Ltd to go through the swap agreement based on the forecast?

Question 9 Hedging Fixed-Income Portfolio (Easy)

I am holding 15 untradable bonds with a nominal value of R 1,000,000 with a coupon of 15% and
5 years to maturity. The bond is priced at a premium YTM of 20 points above a tradable bond
with nominal value of R 1,000,000 with a coupon rate of 12% and 4 years to maturity. The
tradable bonds trades at YTM of 9%. How many future contracts do I need to sell short to cover
my long position in the untradable bond? Both bonds pay coupons semi-annually and the duration
for the untradable and tradable bond is given as 7.66 and 6.66 years respectively (assume the
contract size for the futures is R100,000).

Question 10 Option Pricing (Moderate)

What are the factors that influence an option's value? State whether each factor has a positive or
negative effect on both a call and a put option's price. Motivate your answers. Draw a distinction
between an option’s ‘intrinsic’ and ‘time’ value and mention which of the aforementioned factors
affect each. In your answer graphically depict the upper and lower bounds to the value of a call
option before expiration and use it to illustrate ‘intrinsic’ and ‘time’ values.

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Solution

Question 1

(a) F0 = 25000 x (1 + 0.06 – 0.04)3/12 = 25124 (Contract worths 251240)

Beta = (0.3/0.2) x 0.8 = 1.2
(20m x 1.2) / (251240 x 1) = SF 96 contracts

(b) SC63 provides Mr. Chen an automatic obligation to sell shares at R63 whenever share price reaches R63.

Profit/loss
LA ( 1 ; 1 )

60 63
ST

-60

Profit/Loss

7.71

63 70.71 ST

SC63 ( 0 ; -1 )

Profit/Loss

10.71 SP ( 1 ; 0 )

52.29 63 ST

-52.29

ST: R55 R61 R68

Profit/Loss: 2.71 8.71 10.71

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(c)
LA ( 1 ; 1 ; 1 )
Profit/Loss

27 30 33 ST

-30

Profit/Loss
28.53

27 28.53 33 ST
-4.47
LP33 ( -1 ; -1 ; 0 )

Profit/Loss

ST
27 32 33

SC27 ( 0 ; -1 ; -1 )

Profit/Loss

3.53

27 30.53 33 ST

-2.47
Bear ( 0 ; -1 ; 0 )
27,33

ST: R25 R29 R35

Profit/Loss: 3.53 1.53 -2.47

Question 2 (a) -10 + 7 + 7 – 6 = -2

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(b) Profit/Loss
95 100 105
LC95 (0 ; 1 ; 1 ; 1)

105 ST

-10

Profit/Loss

7 SC100 (0 ; 0 ; -1 ; -1)

107 ST

Profit/Loss

7 SC100 (0 ; 0 ; -1 ; -1)
107

ST
Profit/Loss

LC105 (0 ; 0 ; 0 ; 1)

111

ST
-6

+3
(c)
97 103 Long (0 ; 1 ; -1 ; 0)
ST Butterfly
95,100.105
-2

(d) ST: R25 R29 R35

Profit/Loss: 3.53 1.53 -2.47

Question 3

(a) Cost of Carry = (1 + 0.06 – 0.03)6/12 – 1 = 1.49%

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(b) 32 000 * (1.03)6/12 * 10 = R324 765

(c) Initial Margin (5 SF) = 5 * 0.10 * 324 765 = R162 383

Loss on 16 June 2011 (F = 33 000) = -R26 150 [(32477-33000) * 5 * 10]
Margin on 16 June 2011 = R136 233
Profit on 17 June 2011 (F = 32 000) = R50 000 [(33000-32000) * 5 *10]
Margin on 17 June 2011 = R186 233

Question 4

S(Untradable) F(Tradable)
FV: 1000000 FV 1000000
C: 50000 C 40000
N: 16 N 8
1/Y: 4.3 1/Y: 4
R 1 000
PV: R 1 079 790.21 PV: 000.00
S: R 21 595 804.18 F: R 100 000.00

MD: 11.09 MD: 6.73

N= 355.92
356 SF contracts

Question 5

(a)
(i) HR = 8000 / 6000 = 1.333
(ii) Delta (Call) = 1 / 1.333 = 0.75
(iii) Delta (Put) = 0.75 – 1 = -0.25

(b)
(i) R1 decrease in Naspers share price will result in R0.50 profit in one short Dec
Naspers call option;
(ii) The hedge ratio using short Dec Naspers call option is _2_;
(iii) Delta for Dec Naspers put option is _-0.5_;
(iv) The hedge ratio using long Dec Naspers put option is _2_;
(v) The number of Dec Naspers put option contracts required to hedge my
investment in Naspers shares is equal to _100 _; and
(vi) The Dec Naspers call option is at-the-money and the Dec Naspers put option is at-the-
monney.

Question 6

(a)
Beta (Everlasting) = (0.2/0.16) x 0.96

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 = 1.2

Alpha (Everlasting) = 0.24 – [0.06 + 1.2 x (0.15-0.06)]

= 0.24 – 0.168
= 7.2%

Alpha (Market) = 0%

Information Ratio (Everlasting) = -0.036 / 0.02

= -1.8

Information Ratio (Market) = 0

Sharpe Ratio (Everlasting) = 0.18 / 0.2

= 0.9

Sharpe Ratio (Market) = 0.09 / 0.16

= 0.5625

Treynor Ratio (Everlasting) = 0.18 / 1.2

= 0.15

Treynor Ratio (Market) = 0.09

M2 (Everlasting) = [(0.16 / 0.20) x 0.24] + [(1 – 0.16/0.2) x 0.06] – 0.15

= [0.8 x 0.24] + [0.2 x 0.06] – 0.15
= 5.4%% ( or (0.9 - 0.5625) x 0.16)

M2 (Market) = 0%

(b)

Return SML

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 Everlasting
24%
Alpha = 7.2%

16.8%

15% Market

Rf = 6%

0 1.00 1.2 Beta

(c)

Return CAL(Everlasting)

Everlasting
24% CML

H (80% E; 20% Rf)

20.4%
5.4%
15%

Rf = 6%

0 16$ 20% Stdev

Question 7

Bogey Portfolio Benchmark Component Bogey

Component Weight Return Return

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Equity 0.60 x 18% = 10.8%
Bonds 0.20 x 8% = 1.6%
Cash 0.20 x 5% = 1%
13.4%

Bogey Portfolio Benchmark Component Portfolio

Component Weight Return Return
Equity 0.50 x 14% = 7%
Bonds 0.30 x 12% = 3.6%
Cash 0.20 x 6% = 1.2%
11.8%

Excess Return = -1.6%

Component wp wb Excess w Rb Contribution

Equity 0.5 - 0.6 = -0.1 x 18% = -1.8%
Bonds 0.3 - 0.2 = 0.1 x 8% = 0.8%
Cash 0.2 - 0.2 = 0.0 x 5% = 0%
Contribution for Asset Allocation = -1%

Component Rp Rb Excess R wp Contribution

Equity 0.14 - 0.18 = -0.04 x 50% = -2%
Bonds 0.12 - 0.08 = 0.04 x 30% = 1.2%
Cash 0.06 - 0.05 = 0.01 x 20% = 0.2%
Contribution for Asset Allocation = -0.6%

Total Contribution = -1.6%

Question 8

a) Exposure = increase in interest rates.

b) Convert fixed-rate receipt to floating-rate receipt!

11%
ARC Ltd Swap Dealer/Counterparty
(Fixed-Rate Payer) (Floating-Rate Payer)
J + 1%

10%

Fixed-Coupon Bond
Issuer (Borrower)

Effective IR Receipt = 10% - 11% + (J+1%) = JIBAR

c)

10% 10%

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 J+1% J+1%

180days 360 days

11% 11%

d) Net Receipt in 180 days:

0.10 * (180/360) * 10m = 500k
((0.09 + 0.01) – 0.11) * (180/360) *10m = -50k
= 450k

Net Receipt in 360 days:

0.10 * (180/360) * 10m = 500k
((0.10 + 0.01) – 0.11) * (180/360) * 10m = 0k
= 500k

e) No.

Question 9

S(Untradable) F(Tradable)
FV: 1000000 FV 1000000
C: 75000 C 60000
N: 10 N 8
1/Y: 4.6 1/Y: 4.5
PV: R 1 228 344.74 PV: R 1 098 938.29
S: R 18 425 171.06 F: R 109 893.83

MD: 7.32 MD: 6.37

N= 192.65

Question 10

FACTOR CALLS PUTS

Current price of the underlying asset + -

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 Exercise price of the option - +
Time to expiration + +
Risk-free rate + -
Variance of returns of the underlying asset + +

 "intrinsic" - the value of an option at the moment the option is exercised

 "time" - the excess of the current price of the option over its intrinsic value
 the current price of asset and exercise price determine the intrinsic value, since IV is the
difference between the two
 the other three factors determine time value

Option value

Current price of the call value of the option if

option exercised
= intrinsic value
= ST - X

Time value

ST
0
X

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