Supplementary exercises before the midterm

with solutions
Important remarks:

1. These exercises are taken from very old exams for which access to class notes and computers
were allowed.

2. This is no longer the case for your midterm and final exams i.e. you won't have access to your
class notes or your computer. You have access to a formula sheet provided at the end of the
exam questionnaire.

3. Therefore, some of the questions below are not fully representative of what you might be
asked. However, these questions remain excellent exercises to prepare you for the exam

Question 1

An investor takes a short position in a forward contract with a one-year maturity where the underlying is
a non-dividend-paying stock. The stock price is $40 and the annual risk-free interest rate with continuous
compounding is 10%.

1. What is the forward price and the initial value of the forward contract?

2. Eight months later, the stock is priced at $33 and the risk-free rate is 8%. What is the value of the
forward contract? What would be the forward price associated with a new forward contract that
would have the same due date as the previous contract?

Suggested solution:

1.
𝐹 = 40 × 𝑒 0.1×1 = 44.21

𝑓=0

2. For a long position, the value of the contract is:

4
𝑓 = 33 − 44.21𝑒 −0.08×12 = −10.05

which gives +10.05 for a short position. The forward price would be:

𝐹 = 33 e0.08 x 4/12 = 33.89

Very old midterm exam questions with solutions Page 1 de 21

Question 2

The annual risk-free rate (continuous compounding) is 10% and the ABC Inc. stock, which pays no
dividends, is currently trading at a price of $500. You receive an offer to enter (at zero cost) with a long
position in a forward contract for the delivery of ABC Inc. in a month, at a forward price of $300.

a) Without writing a number, only with words, explain why this is a "very" good offer.

b) Explain, with supporting figures, the arbitration strategy that could be carried out to obtain a risk-
free profit.

Suggested solution:

1. This is an attractive offer because it allows, in one month and at a price of $300, the purchase of a
security currently worth $500.

2. In order to take advantage of this offer, we use the reverse cash and carry strategy:

𝒕=𝟎 𝒕 = 𝟏month
1
Borrow −500 Capital + interest: 500 𝑒 0.10×12 = 504.18
ABC short sale: 500 Purchase of ABC: −300.00
Long forward: 0
0 204.18
Total :

Thus, even if ABC's stock was worth $0 in one month, there would be a positive profit of $204.18

Question 3

On January 1, an investor holds a portfolio of securities worth $1 000 000. This investor wishes to guard
against changes in the value of the portfolio due to changes in the market by using a futures contract on
the S&P 500 Index. This contract expires in six months and ensures the delivery of $500 multiplied by the
value of the index. Knowing that the risk-free rate is 10% per year with continuous compounding, that
the dividend yield of the S&P 500 is 4% per year with continuous compounding, that the portfolio beta is
1.2 and that the value of the S&P 500 Index is 200:

1. What position (short or long) and how many futures contracts will be needed to cover market
risk? Explain why.

2. What position (short or long) and how many futures contracts would change the portfolio beta
from 1.2 to 2.0 (Intuitively explain why this allows you to change the beta)

Very old midterm exam questions with solutions Page 2 de 21

Suggested solution:

a) A short hedge is appropriate. If the price of the portfolio is correlated with futures prices, then a short
position ensures a profit if there is a decrease in the value of the portfolio

𝑉𝐴
𝑁∗ = 𝛽 ×
𝑉𝐹

• 𝑉𝐴 = 1 000 000$
• 𝑉𝐹 = 200 𝑒 (0.10−0.04)×0.5 × 500 = 206.09 × 500 = 103 045.45
• 𝛽 = 1.2

1 000 000
𝑁 ∗ = 1.2 × = 11.64 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
103 045.45

Which is rounded to 12, the nearest integer.

b) Long hedge

To increase the beta, we need to increase the sensitivity of our portfolio to market fluctuations. To do
this, we can take a long futures position and incorporate these securities into our portfolio

The number of contracts required is

1 000 000
𝑁 ∗ = (2.0 − 1.2) × = 7.76 contrats
103 045.45

which is rounded to 8, the nearest integer.

Question 4

Here is a table representing transactions in a margin account for a possible sequence of futures gold prices
from June 5, 20xx to June 26, 20xx. The position is opened on June 5 and closed on June 26. Here is some
information about the table:

• Several contracts are held by the investor

• The size of a contract is for 100 ounces of gold
• The initial margin is $1 500 per contract
• The maintenance margin is $1,000 per contract.
• The futures price shown in the table is for an ounce of gold
• The numbers displayed in the other columns are calculations for all contracts

Very old midterm exam questions with solutions Page 3 de 21

 Date Futures Gain (loss) Gain (loss) Margin Margin
price cumulative account call
400 $ 3 000
5 juin 397.00 (600) (600) 2 400
⋮ ⋮ ⋮ ⋮ ⋮
12 juin 395.40 (269) (920) ???? ????
13 juin 393.30 (420) (1 340) 1 660 ????
⋮ ⋮ ⋮ ⋮ ⋮
19 juin 387.00 (1 140) (2 600) 2 740 ????
⋮ ⋮ ⋮ ⋮ ⋮
25 juin ????
26 juin 392.30 260 ???? 5060

a) Does the investor has a long or short position? Explain your answer.

b) How many futures contracts does the investor have? Explain your answer.

c) What was the futures price as of June 25?

d) How much $$ should be found in the margin account on June 12 knowing that there were no
margin calls or withdrawals prior to that date? Explain your answer.

e) When was the first margin call and how much did the investor had to put into the account?

f) What figure should be displayed in the "Gain (loss) cumulative” column for June 26? Explain your
answer.

Suggested solution:

a) The investor is long because the $$ in his margin account decreases when the futures price
decreases

b) 2 contracts, because each contract is for 100 ounces and the futures price displayed is for one
ounce of gold. Thus, a change in the futures price of $3 results in a change of 3 × 2 × 100 =
$600 in the margin account.

c) The price was $391.00 since there was a gain of $260 i.e. $392.30 − $260/200).

d) $2 080 since the cumulative loss on that date is $920.

e) June 13, as the margin account is less than the maintenance margin of $1 000 per contract i.e. $
2 000 in total. The investor had to put 3000 − 1660 = 1340.

f) 1 540 = (392.30 − 400) × 200

Very old midterm exam questions with solutions Page 4 de 21

Question 5

On July 30, 2003, the cheapest-to-deliver bond associated with a Treasury bond futures contract maturing
in September 2003, has coupons of 13% paid on February 30 and August 30 each year. The date of delivery
of the bond on the futures contract is assumed to be September 30, 2003. The risk-free interest rate is
10% annual with continuous compounding for all maturities. The conversion factor for the bond to be
delivered is 1.5 and the quoted price is $110. Calculate the futures price quoted by this contract.

To simplify the calculations associated with the number of days between key dates, assume that each
month of the year has exactly 30 days and that a year has 360 days in total.

Suggested solution:

150
• Accrued interest = 6.5 × 180 = 5.42

• Cash bond price = 110 + 5.42 = 115.42

1
• 𝐼 = 6.5𝑒 −0.1×12 = 6.446
2
• 𝐹 = (𝑆 − 𝐼)𝑒 𝑟× 𝑇 = (115.42 − 6.446)𝑒 0.1×12 = 110.81

110.81 = quoted price × 1.5 + 6.5 × 30/180

quoted price = 73.15

Very old midterm exam questions with solutions Page 5 de 21

Question 6

It is January 1, 2004. You consider entering with a long position in a forward contract whose underlying is
a stock that will provide a dividend of $5 in 3 months. The forward contract has a maturity of 9 months,
i.e. the maturity date is October 1, 2004, the forward price is $110 and the following term structure
prevails for the risk-free interest rates:

Term structure of interest rates

Maturity (in years) 0.2500 0.5000 0.7500 1.0000 1.2500
Spot rate (continued capitalization) 0.0320 0.0410 0.0480 0.0520 0.0490

a) What is the price of the underlying asset as of January 1, 2004?

b) Six months later, on July 1, 2004, the spot price for the stock is $115. Knowing that the term
structure of spot rates (continuous compounding) is horizontal at 3.5%, calculate the value of the
forward contract.

Suggested solution

a) The expression linking the forward price and the price for an asset providing income in $ is given by:

𝐹0 = (𝑆0 − 𝐼)𝑒 𝑟𝑇

where 𝐼 representing the current value of income. Using the information provided in the problem
we find:

𝐼 = 5𝑒 −0.032×0.25 = 4.96

and:
110
110 = (𝑆0 − 4.96)𝑒 0.048×0.75 ⇒ 𝑆0 = + 4.96 = 111.07
𝑒 0.048×0.75

b) The value of the forward contract will be given by

𝑓 = 𝑆0 − 𝐾𝑒 −𝑟×𝑇 = 115 − 110𝑒 −0.035×0.25 = 5.96

Very old midterm exam questions with solutions Page 6 de 21

Question 7

You work as an arbitrager at a major financial institution. For a 3-month to maturity, the risk-free interest
rates are 1.29% and 2.50% for the United States and Canada respectively. On your screens, you see
displayed the price of the CAD/USD cash exchange rate (spot) at 1.3314 and the forward (which promises
the delivery of 1 USD in 3 months) to 13074. However, according to the theoretical relationship, the
forward exchange rate should be 1.3354. Is there an arbitration opportunity? If so, make it clear what
transactions to make to take advantage of this opportunity.

Suggested solution

Reverse cash and carry strategy (for a loan of 10 000 USD):

Transaction 𝒕=𝟎 𝒕 = 𝟑/𝟏𝟐

Borrow 10 000 USD at 1.29% for 3 months 10 000 USD Repayment of

and conversion to 13 314 CAD. 0.0129×3/12
10 000𝑒 = 10 032.30 USD
with the USD purchased from the forward
contract

Loan of 13 314 CAD to 2.5% for 3 months -13 314 CAD 13 314𝑒 0.025×3/12 = 13 397 CAD

--
Long forward for purchase of 10 032.30 Buy 10 032.30 USD x 1.3074 CAD/USD
USD in 3 months to 1.3074 CAD/USD = 13 116.23 CAD

Note: The 10 032 USD will be used to

repay the 10 000 USD loan, which will be
valued at 10 032 USD at 𝑡 = 3/12.

Profits 0 (13 397.00 – 13 116.23) CAD

Very old midterm exam questions with solutions Page 7 de 21

Question 8

A company active in the exploitation of magnesium mines has just carried out an exploratory drilling on a
new territory. The results of the study show that this deposit would obtain 100 000 tons of magnesium.
The duration of the project would be one year, and the 100 000 tons of magnesium would be sold on the
markets on that date. The president of the company would like to hedge against the risk associated with
changes in magnesium prices. Unfortunately, there are no futures contracts on magnesium. The only
contract available is a futures contract on manganese, a metal similar to magnesium.

Knowing that each futures contract is for 100 tons of manganese and that the following historical data are
available for futures manganese prices (expressed for one ton) and the price of magnesium:

Futures prices on Price per tons of

Semester manganese magnesium
(for a ton)
1 1872 2215
2 1840 2264
3 1860 2308
4 1828 2318
5 1830 2395
6 1854 2476
7 1864 2506
8 1895 2491
9 1928 2548

a) Calculate the minimum variance hedge ratio?

b) Indicate whether a long or short position is appropriate and calculate the optimal number of
contracts required to cover 100 000 tons of magnesium.

Suggested solution

a) WARNING: The question below requires calculating a standard deviation from a price sample. Since
the computer is no longer allowed for examination, such calculations will not be required.

We must first calculate the series of annual price changes since the horizon of our hedge is one year:

Very old midterm exam questions with solutions Page 8 de 21

 Annual changes in futures Annual changes in
Observation manganese prices magnesium prices
1 1860 − 1872 = −12 2308 − 2215 = 93
2 1830 − 1860 = −30 87
3 34 111
4 64 42

The standard deviations and correlation coefficient must then be estimated from the price changes
calculated:

𝜎𝑆 = 29 and 𝜎𝐹 = 43, 𝜌 = −0.51

The estimate of the minimum variance hedge ratio is then calculated with

𝜎𝑆 29
ℎ∗ = 𝜌 = −0.51 × = −0.35
𝜎𝐹 43

b) When you plan to sell an asset, you want to protect yourself from price declines i.e. you want to make
a profit in futures markets if the prices of the asset to be covered fall.

Since there is a negative correlation between the series of price changes, a negative change in the
spot prices of magnesium implies a positive change in futures manganese prices. Thus, a long futures
position will provide profits in the event of a drop in magnesium prices.

The optimal number of contracts will be given by:

ℎ∗ 𝑄𝐴 −0.35 × 100 000

𝑁∗ = = = −350
𝑄𝐹 100

The negative sign tells us that, contrary to the regular situation where price changes are positively
correlated, a long position in futures contracts must be taken.

Very old midterm exam questions with solutions Page 9 de 21

Question 9

It is December 17, 2003 at the end of the day, after the closure of the futures markets. You have recently
been hired as an assistant to the treasurer of ABC Inc. You were going to leave after a full day of work
when the treasurer, Mr. Roy, tells you that you will have to work some extra time tonight. Indeed, the
company plans to borrow in 1 year, 15 000 000$ for 3 months to finance the purchase of machinery. Mr.
Roy, who has just been informed of a major announcement from the Bank of Canada, is concerned that
interest rates will have risen sharply when he has to borrow. He would like to hedge against this potential
rate increase and would like your advice on this issue.

You immediately mention to Mr. Roy that it is possible to hedge against this kind of risk by means of
futures contracts on banker’s acceptances of 3 months (a form of zero coupon bonds in Canada) which
are traded on the Montreal Stock Exchange (the BAX contract). This BAX contract is the Canadian
equivalent of the futures Eurodollar contract. You provide the following quotes by telling him that these
contracts are very simple to use:

Maturity 17/12/2003 17/03/2004 16/06/2004 15/09/2004 15/12/2004

Futures
0 3 6 9 12
(number of months)

Closing price
96.7872 94.9686 93.7517 93.5485 96.2828
(settlement prices)

Mr. Roy is obviously very interested in your proposal and gives you a list of questions for which he would
like answers first thing in the morning on his desk:

a) What are the spot rates (annual, continuously compounded) for maturities of 3, 6, 9, 12 and 15
months.

b) What contract should be chosen (what maturity) and what position (long or short) should be taken
in the BAX market? Explain.

c) How many contracts should be taken?

d) Check that the cost associated with the covered loan (interest costs + futures profits (loss)) at the
end of the loan is the same, under 2 scenarios of interest rate changes in 1 year:

Scenario 1: borrowing rate on 15/12/2004 equal to 5% (quarterly compounding)

Scenario 2: borrowing rate on 15/12/2004 equal to 2.5% (quarterly compounding).

Make sure that this cost of borrowing is consistent with the forward rate that was associated with
the BAX contract used in the hedging strategy.

Very old midterm exam questions with solutions Page 10 de 21

Suggested solution

a) To estimate spot rates from futures prices on BAX, one must follow the procedure below:

i. Extract forward rates from futures prices using:

(100 − 𝑄)
𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠 =
100

ii. Convert these rates from semiannual compounding into continuously compounded rates with

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠
𝑅𝐹 = 4 × ln (1 + )
4

Use the forward rate valuation equation in a recursive manner to obtain spot rates, i.e.:

𝑅2 𝑇2 − 𝑅1 𝑇1 𝑅𝐹 × (𝑇2 − 𝑇1 ) + 𝑅1 𝑇1
𝑅𝐹 = → 𝑅2 =
𝑇2 − 𝑇1 𝑇2

This recursion begins by fixing 𝑅1 = 0.0320, i.e. equal to the forward rate calculated from the
futures contract with a maturity of 0 months. (This forward rate is a spot rate of 3 months.)

For example, for the 3-month maturity:

(100 − 𝑄) 100 − 96.7872

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠, 𝑚𝑜𝑛𝑡ℎ 0 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 3 = = = 0.03212
100 100

0.0321
𝑅𝐹, 𝑚𝑜𝑛𝑡ℎ 0 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 3 = 4 × ln (1 + ) = 0.03197
4

𝑅3 𝑚𝑜𝑛𝑡ℎ𝑠 = 𝑅𝐹, 𝑚𝑜𝑛𝑡ℎ 0 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 3 because for the shortest maturity, the forward rate is
equal to the spot rate

For example, for the 6-month maturity:

(100 − 𝑄) 100 − 94.9686

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠, 𝑚𝑜𝑛𝑡ℎ 3 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 6 = = = 0.05031
100 100

0.05031
𝑅𝐹, 𝑚𝑜𝑛𝑡ℎ 3 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 6 = 4 × ln (1 + ) = 0.04999
4

0.04999 × (6/12 − 3/12) + 0.03197 × 3/12

𝑅6 𝑚𝑜𝑛𝑡ℎ𝑠 = = 0.04098
6/12

Very old midterm exam questions with solutions Page 11 de 21

 For example, for the 9-month deadline:

(100 − 𝑄) 100 − 93.7517

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠,𝑚𝑜𝑛𝑡ℎ 6 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 9 = = = 0.06248
100 100

0.06248
𝑅𝐹 𝑚𝑜𝑛𝑡ℎ 6 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 9 = 4 × ln (1 + ) = 0.06199
4

0.06199 × (9/12 − 6/12) + 0.04098 × 6/12

𝑅9 𝑚𝑜𝑛𝑡ℎ𝑠 = = 0.04798
9/12

By proceeding this way for the other deadlines, and rounding to the 4th digit, we get the table below:

Maturity
(number of months) 3 6 9 12 15

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠 0.0321 0.0503 0.0625 0.0645 0.0372

𝑅𝐹 0.0320 0.0500 0.0620 0.0640 0.0370

𝑅𝑇 0.0320 0.0410 0.0480 0.0520 0.0490

b) We want to hedge a loan with a maturity of 3 months in 1 year. Therefore, the contract that expires
in one year would have to be taken.

Since we want to borrow at a futures date, we would like to hedge against rate increases, i.e. we
would like to take a futures position that would provide us with profits in the event of a rate increase
(lower bond prices). As futures prices vary as bond prices, a short position will have to be taken (rate
increase leads to lower bond prices, which lead to lower futures prices, which lead to increase in
profits if short position).

c) The appropriate number of contracts will be given by:

𝑃𝐷𝑃 15 000 000 × 0.25

𝑁∗ = = = 15.14
𝑉𝐹 𝐷𝐹 990 707 × 0.25

because the duration of the loan and the forward are both 0.25 and the value underlying the forward
contract is calculated with:

𝐹 = 10 000 × (100 − 0.25 × (100 − 96.2828)) = 990 707

d) This strategy would ensure a borrowing rate equal to 0.0372 (the rate 𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠,𝑚𝑜𝑛𝑡ℎ 12 𝑡𝑜 𝑚𝑜𝑛𝑡ℎ 15)

Very old midterm exam questions with solutions Page 12 de 21

 Scenario 1: 5% rate

0.05
• Interest paid after 3 months:15000000 × = 187 500
4

• Futures profit: Since this futures product is kept until maturity and is "cash settled", the contract
price at exit can be calculated with the spot rate of the scenario i.e.

𝐹𝑒𝑥𝑖𝑡 = 10 000 × (100 − 0.25 × (100 − 95.00)) = 987 500

𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 = 15 × (990707 − 987500) = 48105

• 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 187500 − 48105 = 139395

Scenario 2: rate at 2.5%

0.025
• Interest paid after 3 months:15000000 × = 93 750
4

• Futures profit: Since this futures product is retained until maturity and is "cash settled", the
contract price can be calculated with the spot rate of the scenario i.e.

𝐹𝑒𝑥𝑖𝑡 = 10 000 × (100 − 0.25 × (100 − 97.50)) = 993 750

𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 = 15 × (990 707 − 993 750) = −45 645

• 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 93 750 − (−45 645) = 139 395

The total cost for each scenario is consistent with the rate associated to the futures contract. This rate
was 0.0372 on an annual basis. This rate can be found from the cost:

139 395
×4 = 0.0372
15 000 000

Very old midterm exam questions with solutions Page 13 de 21

Question 10

It is January 1, 2005. You work for Orgest Inc., a gold mine company in Abitibi. Three months ago, to cover
the risk associated with the change in the price of gold, the company adopted a short position in a forward
contract. This contract promises the sale of 20 000 ounces of gold on July 1, the amount the executives
expect to extract from the mine for the first six months of 2005. The delivery price for this contract is set
at $400 per ounce.

a) Explain why a short position is appropriate for such a situation.

Due to the collapse of some of the mine's galleries, the production had to be halted and will not be able
to resume for another year. The forward contract is no longer necessary. The spot price of an ounce of
gold is currently $400 and the annual continuously compounded interest rate is 6% for all maturities. The
cost of storing gold is zero.

As you explained to your bosses, it is impossible to terminate the futures contract. However, it is possible
to cancel the effect of this contract by taking a position in another forward contract. This obviously does
not involve any money out today since it is a forward contract.

b) What position should be taken for this new forward contract? Explain and specify the maturity
and quantities, in ounces of gold, that should be associated with the contract.

c) What will be the futures price associated with this new contract?

d) What would be the value of your net position, the total value of the two forward contracts,
knowing that the price in c) was used for the new forward contract?

Your supervisor is worried. Indeed, he believes that it will be difficult to find a counterparty for a forward
contract with a long position on 20,000 ounces of gold for July 1. You then mention to him that another
strategy that would deliver perfectly equivalent results is possible. This strategy involves: i) borrowing or
lending money at the risk-free rate; and (ii) buying or selling gold today. This strategy would have the
same effect as taking a forward contract today with long position on 20,000 ounces of gold for delivery in
6 months.

e) Reassure your supervisor about this strategy by using the following steps:

i. A clear description of the strategy.

ii. Calculate the profit or loss that would be incurred in 6 months for this strategy. Be sure to
include the amount received for the delivery of gold associated with the first forward contract.

iii. Show how this loss or profit is equivalent to the net position calculated in d).

You finally receive an offer from a company ready to enter as a counterparty for the new forward contract.
This offer mentions a forward price of $450 per ounce for a 6-month term and 20,000 ounces of gold.

f) Is there an arbitration opportunity for such a price? If so, explain how it would be possible to take
advantage of this risk-free profit opportunity and calculate its profit.

Very old midterm exam questions with solutions Page 14 de 21

Suggested solution:

a) Without a forward contract, a drop in the price of gold would lead to a drop in revenues on July
1. A short position in a forward contract would allow a profit in case the price of gold decreases.
This would compensate for the loss on the spot market.

b) It will be required to take a long position for a forward contract on 20 000 ounces of gold in order
to cancel the short position of the existing contract. A long position on 20 000 ounces of gold for
a 6-month maturity will guarantee the delivery of the 20 000 ounces of gold associated with the
first contract.

c) The futures price associated with this new contract will be

𝐹 = 𝑆0 𝑒 𝑟𝑇 = 400𝑒 0.06×0.5 = 412.18

d) The value of the net position will be the sum of the values of the two contracts. The value of the
new contract is zero since the price in c) has been used. The value of the existing contract to
which a delivery price of $400 is attached is

𝑓 = 𝐾𝑒 −𝑟𝑇 − 𝑆0 = 400𝑒 −0.06×0.5 − 400 = −11.8217

for an ounce of gold. The value of the net position for 20,000 ounces of gold will therefore be

−11.8217 × 20 000 = −236 434

e)

i. The strategy is to borrow $8 000 000 for 6 months to buy 20 000 ounces of gold today.
This will allow fulfill the terms of the first forward contract i.e gold delivery in 6 months
at a price of $400 per ounce. The amount obtained for the sale of gold will be used to
repay (in part) the loan.

Very old midterm exam questions with solutions Page 15 de 21

 ii. This strategy would have resulted in the following loss:

Transaction 𝒕=𝟎 𝑻 = 𝟎. 𝟓 Year

loan 400 × 20000 −8 000 000 𝑒 0.06×0.5

= 8 000 000 $ = −8 243 636 $

Buy −8 000 000 $ Delivery of gold for

20,000 ounces of gold The first contract:

20 000 × 400 = 8 000 000 $

Profit 0 −243 636 $

iii. This loss is equivalent (in current value) to the net position calculated in c). Indeed

243636 × 𝑒 −0.06×0.5 = 236 435

By borrowing to buy the gold to be delivered, a portfolio replicating the cash flows of a
forward contract is created i.e. a synthetic foward is created.

f) Yes, such a forward price is too high and allows for arbitration opportunities. The appropriate
strategy is the cash and carry strategy that is described in the table below

Transaction 𝒕=𝟎 𝒕 = 𝟎. 𝟓 Year

loan 400 × 20000 −8 000 000𝑒 0.06×0.5

= 8 000 000 $ = −8 243 636 $

Buy
20 000 ounces of gold −8 000 000 $ Delivery of gold

Short Forward sur 0

the new contract 450 × 20 000
= 9 000 000 $

Profit 0 756 364 $

Very old midterm exam questions with solutions Page 16 de 21

Question 11

On November 1, 2001, a company expects to receive $5 million on January 1, 2002. The company's
treasurer expects to keep the money until April 1, when the funds will be used to complete an investment
project. The Treasurer therefore wishes to place this money in the bank in a three-month term deposit
providing a rate equal to the rate on three-month banker’s acceptances. These interest payments are paid
in a single instalment at the end of the three-month period. Currently, three-month to maturity bankers’
acceptances yield a rate of 5%. The company would like to hedge against changes in rates using the BAX
contract, a futures contract on banker’s acceptances seen in class (contract identical to that of Eurodollar
futures). The following data are available on November 1, 2001:

Bankers’ Bankers’ Banker’s

acceptance acceptance acceptance
rate rate rate
1 month 3 months 6 months BaX contract settlement price
Date (Maturity June 15, 2002)

Nov. 1 2001 5,070 % 5,000 % 4,950 % 95,31

a) Does the company has to hold long or short positions? Explain.

b) Calculate the value underlying the futures BAX contract, (contract price), as well as the futures rate
of the BAX contract. Interpret this rate.

c) Calculate the optimal number of contracts to hold.

Here is the history of futures interest rates and settlement prices for the contract:

Bankers’ Bankers’ Bankers’

acceptance acceptance acceptance
rate rate rate
1 month 3 months 6 months BAX contract Settlement price
Date (Maturity June 15, 2002)

2001-12-01 5,030 % 5,020 % 5,010 % 95,16

2002-01-01 5,060 % 5,090 % 5,100 % 94,75
2002-02-01 4,810 % 4,830 % 4,900 % 95,33
2002-03-01 4,800 % 4,790 % 4,850 % 95,47
2002-04-01 4,700 % 4,840 % 4,970 % 95,20

d) Calculate the amount of interest earned by the company as of April 1, 2002.

e) At what date should the futures positions be closed? Calculate the profit or loss associated with those
positions.

f) Calculate the total income (borrowing and hedging strategy) and compare this income to the amount
of interest provided by the futures rate calculated in b) and applied to the $5 million. Explain why the
two amounts are different? Under what conditions could they have been equal?

Very old midterm exam questions with solutions Page 17 de 21

Suggested solution:

a) The company must hold long positions because it is afraid of a rate decrease i.e. higher bond
prices. It must therefore hold a futures position providing profits should such a situation arise.

b) The underlying value of the futures contract (contract price) is given by

𝐹 = 10000(100 − 0.25 × (100 − 95.31)) = 988 275

𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠 = 100 − 95.31 = 4.69 %

The rate 𝑟𝑓𝑢𝑡𝑢𝑟𝑒𝑠 is the rate that could be guaranteed today (keeping the BAX contract until
maturity) for a three-month investment beginning at the end of the BAX.

c) The optimal number of contracts is given by

𝑃𝐷𝑃 5 000 000 × 0.25

𝑁= = = 5.059
𝑉𝐹 𝐷𝐹 988275 × 0.25

which is rounded to the nearest integer (5contracts).

d)
3
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 = 5 000 000 × 0.0509 × = 63 625
12

e) The futures positions taken on November 1, 2001 must be closed on January 1, 2002, when the
amount will be deposited. To calculate the profit on these positions, one must calculate the
contract price on exit. This price is given by:

𝐹𝑒𝑥𝑖𝑡 = 10 000 × (100 − 0.25 × (100 − 94.75)) = 986 875

The profit on futures positions will therefore be

𝑝𝑟𝑜𝑓𝑖𝑡 = 5 × (𝐹𝑒𝑥𝑖𝑡 − 𝐹𝑒𝑛𝑡𝑟𝑦 )

= 5 × (986 875 − 988 275) = −7 000

f) Total income (interest income and futures position):

3
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 5000000 × 0.0509 × = 63625
12

𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 = 63 625 – 7 000 = 56 625 $.

Interest income with the futures rate of November 1 would have been:

3
5 000 000 × 0.0469 × = 58 625
12

Very old midterm exam questions with solutions Page 18 de 21

Several factors can cause differences:

• In this case, the end date of the hedge is different from the expiry date of the BAX contract i.e.
there is a basic risk. The hedge provided by the futures contract is therefore not guaranteed to be
perfect, even if the underlying BAX (three-month bankers’ acceptance rate) is the same as the
rate to be hedged (banker’s acceptance rate for three-month).

• Rounding the optimal number of contracts (5.059 rounded to 5)

• Non-parallel variations in the term structure. Indeed, the optimal number of contracts was
obtained using durations. These measures work well when there are parallel shifts in term
structures.

To have equal amounts, it would have required:

• The two amounts would have been equal if the $5 million had been deposited (for three months)
on the expiry date of the BAX contract. In such a case, the ending date of the hedge and the ending
date of the contract would have been the same i.e. no basic risk. A position hedged with the BAX
contract would then have provided a total income (interest and futures profits) equal to that
specified by the futures BAX rate as of November 1.

• If we could have taken 5.059 contracts

• If the changes in the term structure would have been parallel.

Very old midterm exam questions with solutions Page 19 de 21

Question 12

It is January 1, 2005. You work for an airline planning to buy 100 000 kerosene barrels in six months. You
want to cover yourself for this purchase by adopting long positions in futures oil contracts. Each contract
is for 1 000 barrels of oil. Currently, the price of a barrel of kerosene is $50. The standard deviation from
semiannual changes in oil prices is 0.75. The standard deviation from semiannual changes in kerosene
prices is 1.5. The correlation between these two variables is 0.83. You plan to take positions in 100 futures
contracts.

a) Calculate the variance of your hedged position for a kerosene barrel

A friend tells you that this number of futures contracts is probably not optimal and that it would be
possible to have a number of contracts that allows for a lower variance.

b) This affects the number of contracts that minimize the variance in your covered position.

c) Calculate the variance of your covered position for a kerosene barrel with the contract number
calculated in b).

Suggested solution:

a) The variance for a barrel is given by

𝜎𝑠2 + ℎ2 𝜎𝐹2 − 2ℎ𝜌𝜎𝑠 𝜎𝐹

where 𝜎𝑆 is the standard deviation of changes in the prices of kerosene, 𝜎𝐹 is the standard deviation
of changes in oil prices, 𝜌 is the correlation, and ℎ is the hedge ratio. For 100 futures contracts,
the ratio is 1 because each contract is for 1 000 barrels and the number of barrels to be covered is
100 000.

The variance is therefore

𝜎𝑠2 + ℎ2 𝜎𝐹2 − 2ℎ𝜌𝜎𝑠 𝜎𝐹 = variance

1. 52 + 12 × 0.752 − 2 × 1 × 0.83 × 1.5 × 0.75 = 0.945

b) To find the number of contracts minimizing variance, we have to first find the minimum variance
hedge ratio that is given by

𝜎𝑆 1.5
ℎ∗ = 𝜌 = 0.83 × = 1.66
𝜎𝐹 0.75

The number of contracts is then given by

ℎ∗ 𝑄𝐴 100000
𝑁∗ = = 1.66 × = 166
𝑄𝐹 1000

c) The variance becomes

Very old midterm exam questions with solutions Page 20 de 21

 𝜎𝑠2 + ℎ2 𝜎𝐹2 − 2ℎ𝜌𝜎𝑠 𝜎𝐹 = 1. 52 + 1.662 × 0.752 − 2 × 1.66 × 1.5 × 0.75 = 0.699

Very old midterm exam questions with solutions Page 21 de 21