Assignment 1 (MGFC30, Fall 2022)

SOLUTIONS

1.
a) Total loss by day 2: $9,250 + $8,475 = $17,725, which is the margin call amount
(MM – 6,725) + 17,725 = IM = 1.2MM è MM = $55,000
Therefore, IM = 1.2MM = $66,000.

b) Futures prices can be backed out from daily gain/loss, and margin balance and margin
call can now be worked out too since we know the two margin levels.

Margin
Futures Daily Account
Day Price Gain / Loss Balance Margin call
0 $2,000.00 $66,000 $0
1 $2,018.50 -$9,250 $56,750 $0
2 $2,035.45 -$8,475 $48,275 $17,725
3 $2,028.36 $3,545 $69,545 $0
4 $2,066.08 -$18,860 $50,685 $15,315
5 $2,044.88 $10,600 $76,600 $0
6 $2,075.04 -$15,080 $61,520 $0
7 $2,088.64 -$6,800 $54,720 $11,280

c) The price needs to move down

500(2,000 - p) = 1,500 è p = $1,997

2.
a) S = 100(40 + 75 + 66) = $18,100
D1 = 100×0.9[e–0.03(1/12) + e–0.03(7/12)] = $178.214
D2 = 100×1.85[e–0.03(2/12) + e–0.03(8/12)] = $365.4141
D3 = 100×1.5[e–0.03(4/12) ] = $148.5075

PVD = D1 + D2 + D3 = $692.14

F = (S - PVD)erT = (18,100 – 692.14)e0.03(9/12) = $17,803.98

b) Since the actual forward price of $16,987.55 is lower than = (S - I)erT, we should long
futures and short stocks and invest in T-bill.

Today, time 0 Cash flow

- long futures no cash flow
- short stocks $18,100
- buy T-bill – $18,100
Total 0

1
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
 9 months later, time T
- buy stocks according to contract – $16,987.55
and cover the short position
- return dividends (692.14e0.03(9/12)) – $ 707.89
- T-bill (18,100e0.03(9/12)) $18,511.87
Total $ 816.43
(same as $17,803.98 – $16,987.55 = $816.43)

3. F= Se(r + u - y)T
F7= Se(r + 0.01 – 0.065)(7/12)
F12= Se(r + 0.01 – 0.065)(12/12)

F12/ F7 = e(r + 0.01 – 0.065)(5/12) = 14.0715/14.2485

ð r = 2.5%

Substitute r = 2.5% back into either equation above, we have

ð S = $14.5/bushel

Therefore, F15 = Se(0.025 + 0.01 – 0.065)(15/12) = $13.9663.

Since the actual forward price of $14.55 is higher, we apparently should short forward
and long the spot. However, since you are an arbitrager, you don’t enjoy the convenience
yield. So we should instead use F= Se(r + u )T to test for arbitrage. Plug the numbers in, we
have F = $15.1485. Since the actual forward price is lower than this, but above $13.9663,
we don’t have arbitrage.

If you really short forward and long spot, you need to borrow money and buy1000 SeuT =
1,012.58 bushels of soybeans, which is 14.5(1,012.58) = $14,692.39.

At maturity,
- sell 1,000 bushels of soybeans $14,550
- loan: $14,692.39e0.025(15/12) - $15,148.46
Total - $ 598.46

ð Lose money.

4. Bond A: 16 years and 9 months

- 16(2) + 1 = 33 half years
- 2.1 + 2.1(PVIFA3%, 33) + 100(PVIF3%, 33) = $83.4108
- $83.4108/1.030.5 = $82.1871
- subtract accrued interest: $82.1871 – $2.1/2 = $81.1371
- conversion factor = 0.8114
- (130 + 16/32)(0.8114) = $105.8839
- Difference: $(109+14/32) – $105.8839 = $3.5536
(this is an extra cost)

2
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
 Bond B: 19 years and 2 month
- round down to 19 years
- 19(2) = 38 half years
- 1.8(PVIFA3%, 38) + 100(PVIF3%, 38) = $73.009
- conversion factor = 0.7301
- (130 + 16/32)(0.7301) = $95.2768
- Difference: $(94+26/32) – $95.2768 = –$0.4643 (this is a saving)

Bond C: 24 years and 11 months

- 24(2) + 1 = 49 half years
- 1.4 + 1.4(PVIFA3%, 49) + 100(PVIF3%, 49) = $60.5973
- $60.5973/1.030.5 = $59.7083
- subtract accrued interest: $59.7083 – $1.4/2 = $59.0083
- conversion factor = 0.5901
- (130 + 16/32)(0.5901) = $77.0059
- Difference: $(82+14/32) – $77.0059 = $5.4316
(this is an extra cost)

Therefore, Bond B is the cheapest to deliver.

5. a)
It must be the implied forward rate to avoid arbitrage, which is
[3.95%(2.5) – 2.35%(0.75)]/(2.5 – 0.75) = 4.6357%

Therefore the contract rate is, e0.046357 – 1 = 4.7448%.

b)
T1 = 0.25 years
T2 = 2.00 years
For CIBC, the contract value is V = L(RK – RF)(T2-T1)e–R2*T2

RF = [2.95%(2.00) – 2.00%(0.25)]/(2.00 – 0.25) = 3.0857%

therefore, e0.030857 – 1 = 3.1338%

V = 250,000,000(0.047448 – 0.031338)*(2.00 – 0.25)*e-0.0295(2.00)

= $6,644,315 (Depending on how many decimal places you carry for the interest
rates, the answer may be a bit off, which is OK.)

The overall interest rates have gone down, and the relevant forward rate has also gone
down (from 4.6357% to 3.0857%). Therefore, the FRA brings a gain to the lender since it
has locked into a higher rate.

3
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
Solution to Extra Exercise Questions

1. Problem 2.11

There is a margin call if more than $1,500 is lost on one contract. This happens if the
futures price of frozen orange juice falls by more than 10 cents to below 150 cents per lb.
$2,000 can be withdrawn from the margin account if there is a gain on one contract of
$1,000. This will happen if the futures price rises by 6.67 cents to 166.67 cents per lb.

2. Problem 2.15

The clearinghouse member is required to provide 20 ´ $2, 000 = $40, 000 as initial margin
for the new contracts. There is a gain of (50,200 - 50,000) ´ 100 = $20,000 on the
existing contracts. There is also a loss of (51, 000 - 50, 200) ´ 20 = $16, 000 on the new
contracts. The member must therefore add
40, 000 - 20, 000 + 16, 000 = $36, 000
to the margin account.

3. Problem 2.19

Speculators are important market participants because they add liquidity to the market.
However, contracts must be useful for hedging as well as speculation. This is because
regulators generally only approve contracts when they are likely to be of interest to
hedgers as well as speculators.

4. Problem 3.16

The optimal hedge ratio is

1.2
0.7 ´ = 0.6
1.4
The beef producer requires a long position in 200000 ´ 0.6 = 120, 000 lbs of cattle. The
beef producer should therefore take a long position in 3 December contracts closing out
the position on November 15.

5. Problem 3.18

A short position in
50, 000 ´ 30
1.3 ´ = 26
50 ´1, 500
contracts is required. It will be profitable if the stock outperforms the market in the sense
that its return is greater than that predicted by the capital asset pricing model.

4
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
6. Problem 4.10

The equivalent rate of interest with quarterly compounding is R where

4
0.12 æ Rö
e = ç1 + ÷
è 4ø
or
R = 4(e0.03 - 1) = 0.1218

The amount of interest paid each quarter is therefore:

0.1218
10, 000 ´ = 304.55 or $304.55.
4
7. Problem 4.11

The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price is
2e-0.04´0.5 + 2e-0.042´1.0 + 2e-0.044´1.5 + 2e-0.046´2 + 102e-0.048´2.5 = 98.04

8. Problem 4.14

The forward rates with continuous compounding are as follows:

Year 2: 4.0%
Year 3: 5.1%
Year 4: 5.7%
Year 5: 5.7%

9. Problem 4.15

The 3-year risk-free interest rate is 3.7% with continuous compounding. From equation
(4.10), the value of the FRA is therefore
[1, 000, 000 ´ (0.055 - 0.05) ´1]e-0.037´3 = 4, 474.69 .

10. Problem 5.9

a) The forward price, F0 , is given by equation (5.1) as:

F0 = 40e0.1´1 = 44.21
or $44.21. The initial value of the forward contract is zero.

b) The delivery price K in the contract is $44.21. The value of the contract, f , after six
months is given by equation (5.5) as:
f = 45 - 44.21e-0.1´0.5
= 2.95

i.e., it is $2.95. The forward price is:

5
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
 45e0.1´0.5 = 47.31or $47.31.

11. Problem 5.10

Using equation (5.3) the six month futures price is

150e(0.07-0.032)´0.5 = 152.88or $152.88.

12. Problem 6.10

The cheapest-to-deliver bond is the one for which

Quoted Price - Futures Price ´ Conversion Factor
is least. Calculating this factor for each of the 4 bonds we get
Bond 1 : 125.15625 - 101.375 ´ 1.2131 = 2.178
Bond 2 : 142.46875 - 101.375 ´ 1.3792 = 2.652
Bond 3 : 115.96875 - 101.375 ´ 1.1149 = 2.946
Bond 4 : 144.06250 - 101.375 ´ 1.4026 = 1.874
Bond 4 is therefore the cheapest to deliver.

13. Problem 6.11

There is no need to pay attention to the “cheapest to deliver” part. No one would identify
the cheapest bond that early. The whole point of the question is to figure out the quoted
futures price given the quoted price of the delivery bond and the conversation ratio.

There are 176 days between February 4 and July 30 and 181 days between February 4
and August 4. The cash price of the bond is, therefore:
176
110 + ´ 6.5 = 116.32
181
The rate of interest with continuous compounding is 2 ln1.06 = 0.1165 or 11.65% per
annum. A coupon of 6.5 will be received in 5 days (= 0.01366 years) time. The present
value of the coupon is
6.5e-0.01366´0.1165 = 6.490
The futures contract lasts for 62 days (= 0.1694 years). The cash futures price if the
contract were written on the 13% bond would be
(116.32 - 6.490)e0.1694´0.1165 = 112.02
At delivery there are 57 days of accrued interest. The quoted futures price if the contract
were written on the 13% bond would therefore be
57
112.02 - 6.5 ´ = 110.01
184

Taking the conversion factor into account the quoted futures price should be:
110.01
= 73.34
1.5

6
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto
 7
______________________________________________________________________________
Professor Jason Z. Wei, University of Toronto