Investment Management Problem Sheet 7 Autumn Term 2016

True/false

1. The forward price of an asset will increase as interest rates fall, provided that the spot
price of the asset and its yield over the life of the contract remain unchanged.

2. As a forward contract approaches maturity, the spot price and the forward price
converge.

3. Whenever there is a positive correlation between interest rates and changes in futures
prices, the fair futures price will exceed the forward price.

4. If you bought a FTSE index future some time ago and now want to eliminate all
exposure to future share price movements, you need to find the trader who sold you
the future and negotiate to cancel the contract.

5. A futures contract is not much use for hedging unless you happen to want to hedge a
position until exactly the date on which the contract expires.

Substantive problems

1. You are intending to move to New York in three years time, and have an eye on a
$600,000 apartment. You do not want to put up the cash now, but are worried that
property prices will rise so you do not want to just wait. Assuming that dollar interest
rates are 4% annually compounded, and the rental of an apartment in New York on a
three year lease is $36,000/year paid annually in advance, what would be a fair
forward price? What would you do if the quoted forward price were higher or lower
than fair value?

2. You have a diversified portfolio of UK equities. They have a value of 60 million, and
a beta of 0.9. Their volatility is 30%, while the volatility of the FTSE index is 15%.
You are concerned that the market will drop in the next couple of months, and have
decided to hedge using a FTSE index futures contract. The FTSE-100 index future
that expires in three months is trading at 5758. The value of 1 contract is 10/index
point. The cash index is at 5747. Three month LIBOR is 4.40%.
(a) Compute the implied dividend yield on the FTSE100 index. Describe the strategy you
would follow if you believed that the actual dividend yield was likely to be lower than
this.
(b) Suppose that you decide to hedge away all market risk, how many futures contracts
would you buy or sell?
(c) Estimate the volatility of the hedged portfolio. How is the hedge likely to affect the
Jensens measure of performance?
3. Today the FTSE (cash) index closed at 6640.0, down 86.3 points on the previous
close. The three month FTSE future closed at 6658.0, down 84 points on the previous
close.
(i) Why was the futures price above the spot price? Would you expect it to be so in
general?
(ii) What explanations might there be for the difference in the price change on the futures
and the cash index?