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Section A : Basic Concepts (30 Marks)

• • This section consists of questions with serial number 1 - 30.

• • Answer all questions.

• • Each question carries one mark.

• • Maximum time for answering Section A is 30 Minutes.

< Answer

1. A trader is likely to prefer an options contract to a futures contract on an asset, if >

(a) He is uncertain but thinks it more likely that the price of the asset will fall than rise

(b) He thinks the price of the asset will remain unchanged

(c) He thinks the price of the asset will certainly rise

(d) He thinks the price of the asset in the underlying market will certainly fall

(e) He is uncertain but thinks it more likely that the price of the asset will rise than fall.

< Answer

2. The daily limit of a commodity futures contract is the maximum >

(a) Amount by which the maintenance margin can change per day

(b) Percentage by which the futures price can increase from the previous day

(c) Number of contracts allowed to be traded that day

(d) Price increase or decrease relative to the settlement price of the previous day

(e) Open interest permitted on any trading day.

< Answer

3. Which of the following are characteristics of the intrinsic value of a call option? >

I. The intrinsic value is obtained by subtracting the per-share exercise price of an option from

the market price of a stock.

II. The intrinsic value is obtained by subtracting the market price of a stock from the per-share

exercise price of an option.

III. The intrinsic value is the maximum price that an option will command when a stock’s market

price is below the exercise price.

IV. The market price of an option will approach its intrinsic value at expiration.

(a) Both (I) and (III) above

(b) Both (I) and (IV) above

(c) Both (II) and (III) above

(d) Both (II) and (IV) above

(e) All (I), (III), and (IV) above.

< Answer

4. Which of the following must be according to the no-arbitrage principle? >

(a) A stock option must cost at least as much as its intrinsic value

(b) An American option must cost at least as much as a European option

(c) A call option must cost no more than the underlying stock

(d) Both (a) and (c) above

(e) All (a), (b) and (c) above.

< Answer

5. Which of the following is/are true? >

(b) Buying a put creates the same exposure as writing a call

(c) Writing a put has unlimited downside risk

(d) Writing a call has unlimited downside risk

(e) Both (a) and (d) above.

< Answer

6. An investor buys a stock for Rs.150, and sells a call for Rs.25 premium. The break-even stock price is >

Rs.125. What is the call option’s strike price?

(a) Rs.100 (b) Rs.120 (c) Rs.125 (d) Rs.150 (e) Rs.175.

< Answer

7. An investor buys a block of 100 stocks for Rs.35 each. The same investor buys put to cover the stock. >

The option premium paid is Rs.5 for each share and the strike price is Rs.30. At expiration stock price is

Rs.25 per share. The profit from the strategy is

(a) Rs. 500 (b) – Rs. 500 (c) Rs.1000 (d) – Rs.1000 (e) Rs.0.

< Answer

8. An investor buys 100 baskets of the NSE 50 stock index for Rs.1540 each. He protects the portfolio by >

buying put options. What will be the effect of put option relative to the uncovered position?

(a) The upside risk of the covered portfolio is truncated and the downside risk is reduced relative to

the uncovered portfolio

(b) The downside risk of the covered portfolio is truncated and the upside return of the insured

portfolio is lower relative to the uncovered portfolio

(c) The upside potential and downside risk both are truncated

(d) The covered portfolio does better than the uncovered portfolio wherever the market declines

(e) Both (b) and (c) above.

< Answer

9. A 90-day US T-bill futures expires in 100 days. Spot price of the 190-day T-bill is $98. A 100-day risk- >

free interest rate is 3.5% p.a. The yield on the futures contract is

(a) 2.25% (b) 2.45% (c) 3.35% (d) 4.35% (e) 4.55%.

< Answer

10. Which of the following is true about a callable swap? >

(a) The fixed rate receiver has the right to terminate the swap at any time before its maturity

(b) The fixed rate payer has the right to extend the swap beyond maturity

(c) The fixed rate payer has the right to terminate the swap at any time before its maturity

(d) Both fixed rate payer and receiver have right to terminate the swap at any time before its maturity

(e) Both fixed rate payer and receiver have right to extend the swap beyond maturity.

< Answer

11. Which of the following equations is true? >

(b) Short underlying asset + long put = long call

(c) Long underlying asset + short call = long put

(d) Short underlying asset + long put = short call

(e) Long underlying asset + long call = short put.

< Answer

12. In a single period binomial option-pricing model, the underlying stock is currently selling for Rs.60 and >

will rise or fall by 15% over the next six-month. The risk-free rate is 5% p.a. A call option with an

exercise price of Rs.65 would have a premium of

(a) Zero (b) Rs. 2.28 (c) Rs. 4.00 (d) Rs. 9.00 (e) Rs.14.00.

< Answer

13. Where is the fair value hedge included in FASB-133? >

(c) Current net income (d) Other comprehensive income

(e) Comprehensive net income.

< Answer

14. Currently, the BSE SENSEX is at 4850 and the annualized risk free rate is 4.5%. If the annualized >

dividend on the index is 1.46%, what should be the futures price on the current 6-month index futures?

(a) 4889.52 (b) 4896.38 (c) 4916.84 (d) 4923.72 (e) 4953.46.

< Answer

15. Suresh is looking at a call option with an exercise price of Rs.25.00 which is currently valued at >

Rs.3.22. The price of the underlying asset itself is Rs.24.75. If the price of the underlying asset

appreciates to Rs.25.50, and the delta of the option is 0.35, what will be the return from holding the call

option?

(a) 11.35% (b) 9.55% (c) 8.15% (d) 6.45% (e) 5.43%.

< Answer

16. The risk involved in speculation using derivative instruments is a >

(c) Static risk (d) Dynamic risk

(e) Both (a) and (b) above.

< Answer

17. The difference between the swap rate and the rate on a Treasury security of the same maturity is called >

the

(a) Swap spread (b) Risk premium (c) Swap basis

(d) Settlement spread (e) LIBOR.

< Answer

18. If the initial margin is $5,000, the maintenance margin is $3,500 and your balance in margin account is >

$3,100, how much must you deposit?

(a) 0 (b) $400 (c) $1500 (d) $1,900 (e) $5400.

< Answer

19. Risk sharing approach of risk management is a combination of >

(a) Risk avoidance and separation (b) Combination and risk transfer

(c) Loss control and risk retention (d) Risk avoidance and risk retention

(e) Risk retention and risk transfer.

< Answer

20. Which of the following is not a goal of the risk management process? >

(c) Bringing risk to optimal level (d) Reactive risk management

(e) Proper mix of risk management techniques.

< Answer

21. Which of the following statements is/are true? >

(a) Buyer of a call swaption has the right to enter into a swap as a floating rate payer

(b) Buyer of a put swaption has the right to enter into a swap as a floating rate payer

(c) Buyer of a put swaption has the right to enter into a swap as a fixed rate payer

(d) Writer of a call swaption becomes the fixed rate payer

(e) Both (a) and (d) above.

< Answer

22. A US bank is quoting Floating/Fixed rate swap as 25/50 basis points over 10-year >

US T-bonds, which are yielding 4.25%. It means

(a) Bank will pay Floating + 25 bp and receive 4.25%

(b) Bank will receive Floating + 50 bp and pay 4.25%

(c) Bank will pay Floating and receive 4.50%

(d) Bank will receive Floating and pay 4.50%

(e) Bank will receive Floating + 25 bp and pay 4.75%.

< Answer

23. The value of a forward contract at delivery date is equal to >

(a) Zero

(b) Current spot price – Forward price

(c) Forward price – Current spot price

(d) Spot price at the date of initiation – Forward price

(e) Bid-ask spread.

< Answer

24. Which of the following statements is/are true? >

(b) Delta is positive for all call option positions

(c) Gamma is always opposite in sign to theta

(d) Common stock has a delta of zero

(e) Both (a) and (b) above.

< Answer

25. As per FASB-133, which of the following is not a criterion to be designated as a hedging item? >

(a) The item has to share the risk exposure that is being hedged

(b) The item has an exposure to fair value changes that could affect earnings

(c) The item is re-measured with changes reported currently in earnings

(d) An embedded put, call that does not qualify as an embedded derivative

(e) Residual value in a lessor’s net investment in a direct financing lease.

< Answer

26. The shares of X Ltd. are being traded for Rs.50 and a call option on its share is available for a premium >

of Rs.5. Delta of this call option is 0.4. If the share price increases to Rs.60, the premium on its call

option would be

(a) Rs.4 (b) Rs.6 (c) Rs.8 (d) Rs.9 (e) Rs.15.

< Answer

27. In normal distribution, what percentage of values lies within plus/minus 1 standard deviation of mean? >

(a) 65.5% (b) 68.3% (c) 90.0% (d) 95.5% (e) 99.7%.

< Answer

28. Which of the following methods of calculation of VaR is better suited for a shorter period of study? >

(a) Monte Carlo Simulation (b) Hybrid Method

(c) Variance / Covariance models (d) Historical pattern of observations

(e) Both (a) and (b) above.

< Answer

29. In a survey, in the city of Hyderabad, the average age of CEOs is found to be 50 years with standard >

deviation of 5 years. In the survey 400 CEOs are contacted. How many observations from the given

sample are expected to fall in the range of 40 to 60 years?

(a) 273 (b) 298 (c) 342 (d) 382 (e) 398.

< Answer

30. Which of the following types of fire insurance policy is based on the principle that variation in the value >

of insured stock results in under-insurance or over-insurance?

(a) Declaration policy (b) Floating policy

(c) Reinstatement value policy (d) All of the above

(e) Both (a) and (c) above.

END OF SECTION A

Section B : Problems (50 Marks)

• This section consists of questions with serial number 1 – 6.

• Answer all questions.

• Marks are indicated against each question.

• Detailed workings should form part of your answer.

• Do not spend more than 110 - 120 minutes on Section B.

1. An American investor is holding 25 US T-bonds of remaining maturity 18 years. Underlying interest on the bond

is 5.5% and the bond is currently quoted in the market at 90-12.

The interest rates in the American economy are set to rise in near future, so the investor wants to hedge its holding

of bonds through T-bond futures. The investor has decided to protect his holding for 6-months and identified the

following T-bond futures for hedging:

T-bond futures price 94-24

Underlying coupon rate 6% p.a.

You are required to

a) Advise the investor how to hedge the holding through T-bond futures, and how many futures contract

required for perfect hedge?

b) Calculate the annualized return earned on the holding for the protection period, if T-bond price and futures

price after 6-months closes at

i. 92-26, 97-08

ii. 88-06, 92-22

(5 + 7 = 12 marks)< Answer >

2. The current rupee-dollar exchange rate is Rs.46.00 /$. The annual volatility of the rupee-dollar exchange rate is

5%. The risk free interest rate in India is 5% p.a. and risk free interest rate in US is 1.5% p.a.

You are required to calculate the value of a 6-month call option on dollar for the strike price of Rs.46.50.

(8 marks)< Answer >

3. XYZ Inc. an American company has a receivable of C$ 5 million maturing 4 months from now. The company is

trying to evaluate whether the exposure should be hedged through futures market or a money market cover. Six-

month futures on Canadian dollar are currently trading at US $ 0.7443 and the current C$/$ exchange rate is

1.3283. The 4 month interest rate for dollar is 2.00%/2.50% p.a. The size of Canadian dollar futures is C$ 100,000.

You are required to

(a) Calculate the inflow to the company, if after four months futures contract trades at 0.7449 and the spot C$/$

rate is 1.3346.

(b) Calculate the borrowing interest rate on Canadian dollar, so that the company should be indifferent between

the futures hedge and money market cover?

(2 + 6 = 8 marks)< Answer >

4. Current Yen - dollar exchange rate is Yen 105.6525 /$. A speculator is expecting that after 3-months time yen-

dollar exchange rate will be extremely volatile, but he is not sure of which direction it will move. The speculator

wants to adopt some option strategies to make profit from his views and also wants to limit his downside potential.

The speculator has identified the following options trade in the market.

Strike price Option Premium Option Premium Expiration

($ / Yen) ($ / Yen) ($ / Yen)

0.0098 Call 0.00011 Put 0.00025 3 months

0.0091 Call 0.00035 Put 0.00005 3 months

You are required to suggest an appropriate option strategy, and prepare pay-off profile, indicating maximum

possible profit, maximum possible loss and break-even point(s), if spot rate after 3 months ranges between 0.0088

– 0.0101 $/yen.

(8 marks)< Answer >

5. The borrowing requirements of two companies APCO Ltd. and PATCO Ltd. as well as the lending terms available

to them in different markets are given as under:

Lending term available

Firm Objective Fixed Floating interest Maturity

interest

APCO US$ 100 mln. at fixed rate 9% 6m LIBOR + 0.75% 5 years

PATCO US$ 100 mln. at floating rate 8% 6m LIBOR + 0.25% 5 years You are

required to

a. Explain how to go about a swap in order to reduce their borrowing cost. Show the same with a diagram.

b. What are the risks involved in this swap?

(6 + 2 = 8 marks)< Answer >

6. An investor has short sold 100 shares of ICICI Bank at a price of Rs.250 per share. To hedge against any rise in the

stock value the investor also purchased call option on 100 shares with strike price of Rs.240. The premium is

Rs.12 for each share. The delta of call option on ICICI’s stock is 0.70, and the standard deviation of the price of

ICICI stock is 18% p.a.

You are required to calculate 15-day VaR at 95% confidence level for

i. The short position in the stock

ii. The long position in the call

iii. The combined positions of short stock and long call.

(Assume 250 trading days in a year).

(2 + 2 + 2 = 6 marks)< Answer >

END OF SECTION B

• This section consists of questions with serial number 7 - 8.

• Answer all questions.

• Marks are indicated against each question.

• Do not spend more than 25 -30 minutes on section C.

7. Use of option based investment strategies can produce risk return pattern suited to the unique requirements of the

investor. Discuss the important factors that need to be considered while evaluating option-based strategy.

(10 marks) < Answer >

8. “A swap bank has to entail certain risks, which are inherent to the swap business and are interrelated”. Explain the

risks involved in the swap business.

(10 marks) < Answer >

END OF SECTION C

Suggested Answers

Financial Risk Management - I (231) : October 2004

1. Answer : (e) < TOP >

Reason : A trader is likely to prefer an options contract to a futures contract on an asset if he is uncertain but

thinks it more likely that the price of the asset will rise than fall.

2. Answer : (d) < TOP >

Reason : The daily limit of a commodity futures contract is the maximum price increase or decrease relative to

the settlement price of the previous day.

3. Answer : (b) < TOP >

Reason : The intrinsic value of a call option is zero until the market price of the underlying stock reaches the

strike price; after that point, the intrinsic value is computed by subtracting the strike price from the

market price of the stock. At expiration, the option can no longer have a time premium, so its value is

equal to its intrinsic value.

4. Answer : (e) < TOP >

Reason : If any of the given alternatives are not true, arbitrage would be possible. If the option costs less than its

intrinsic value, the arbitrage would be to buy the option immediately, exercise it and then sell the

underlying stock. If a European option cost more than a corresponding American option, the arbitrage

would be to write the European the European option and buy the American option, and then hold both

until expiration. If an option costs more than the underlying asset, the arbitrage would be to buy the

stock and write the option.

5. Answer : (d) < TOP >

Reason : The buying a call and selling a put have very different payoffs. Similarly, writing a call and buying a put

have very different payoff diagrams. The downside risk from writing a put is limited to the strike price.

As observed in the short call’s payoff diagram, the downside risk is unlimited.

6. Answer : (c) < TOP >

Stock loss + Short call profit = 0

So, (ST – S0) + (X – ST + C0) = 0 or, X – S0 + C0 = 0 or, X = S0 – C0 = 150 – 25 = Rs. 125.

7. Answer : (d) < TOP >

Reason : Since the stock fell below the strike price, the investor will exercise the puts, selling the stocks at Rs.30

per share. Profit = 3000 – 3500 – 500 = – Rs.1000.

8. Answer : (b) < TOP >

Reason : The long position in index is covered by the long position in put options, so the downside risk is limited

since the put strike price sets a floor below which the portfolio cannot fall. The upside potential is

unlimited, but since the put option costs initially, the profit on upside is always less than the uncovered

portfolio by the original put option price.

9. Answer : (d) < TOP >

This price is equivalent to yield of (100/98.94)4 – 1 = 4.35%.

10. Answer : (c) < TOP >

Reason : A callable swap gives the holder, i.e. the fixed rate payer, the right to terminate the swap at any time

before its maturity. Should the interest rates fall, the fixed rate payer exercises his right and terminates

the swap since the funds will be available at a lower rate. Hence (c) is the answer.

11. Answer : (a) < TOP >

Reason : Protective calls and puts combines an underlying position with an option position, the resulting position

is a synthetic option as under:

Short underlying + long call = long put

Long underlying + long put = long call.

A covered write involving a position in the underlying and the option can be used to create synthetic

option as follows:

Long underlying + short call = short put

Short underlying + short put = short call.

12. Answer : (b) < TOP >

Reason : The price after six-month can be either Rs. 69 or Rs. 51. The call option with exercise price of Rs. 65

will be in-the-money by Rs. 4 if price is 69 and out-of-the-money if price is 51.

Probability of price rise = (1.025 – 0.85)/(1.15 – 0.85) = 0.583

Value of call with exercise price 65 = {0.583 x 4 + 0.417 x 0}/1.025 = Rs.2.28.

13. Answer : (c) < TOP >

14. Answer : (d) < TOP >

(6/12)(1.46%) (4850) = 35.41

So Future Price F = 4850{1+(4.5%)(180/360)} – 35.41 = 4923.72.

15. Answer : (c) < TOP >

Reason : Change in call price = (Delta) (Change in stock) = 0.35 (25.5 – 24.75) = 0.2625

% Return holding call option = 0.2625 / 3.22 = 8.15%.

16. Answer : (d) < TOP >

Reason : The risk involved in speculating using derivative is a dynamic risk as dynamic risks depend on the

changes in scenario, which will effect loss or gain from speculation. In pure risks, outcome tends to be a

loss with no possibility of gain. Non-acceptable risks are risks not acceptable to a firm. Static risk does

not depend on various scenarios.

17. Answer : (a) < TOP >

Reason : The difference between the swap rate and the rate on a Treasury security of the same maturity is called

the swap spread.

18. Answer : (d) < TOP >

19. Answer : (e) < TOP >

Reason : Risk sharing techniques is a combination of risk retention and risk transfer. Under this technique, a

particular risk is managed by retaining a part of it and transferring the rest to a party willing to bear it.

20. Answer : (d) < TOP >

Reason : The risk management process is always done at the anticipation of risk, hence, reactive risk

management is not a goal. Others are the goals of risk management process.

21. Answer : (b) < TOP >

Reason : Buyer of put swaption has the right to enter into a swap as a floating rate payer and the buyer of call

swaption has the right to enter into swap as a fixed rate payer.

< TOP >

22. Answer : (d)

Reason : The swap quote implies that the bank will receive floating and pay 4.50% (4.25 + 0.25) and the bank

will pay floating and receive 4.75% (4.25 + 0.50).

< TOP >

23. Answer : (b)

Reason : The value of a forward contract at delivery date is spot price on delivery date less the forward price.

The value of a forward contract is zero at its initiation. Forward price after discounting for time value less

current spot price is the value of the forward at any date after initiation and before delivery date.

24. Answer : (c) < TOP >

Reason : The correct statement is (c), all others are not correct.

25. Answer : (c) < TOP >

Reason : As per FASB-133, if a hedging item is re-measured with changes reported currently in earnings, is not

designated as a hedging item.

26. Answer : (d) < TOP >

P −5

0.4 =

60 − 50

Reason :

Or, P = 0.4 x 10 + 5 = Rs. 9.

27. Answer : (b) < TOP >

Reason : In normal distribution, 68.3% of values lie within plus or minus 1 standard deviation of mean.

28. Answer : (c) < TOP >

Reason : Variance/Covariance models are best suited to calculate VaR for shorter period of study.

29. Answer : (d) < TOP >

60 − 50 40 − 50

5 5

Reason : Z-value = = +2 and Z-value = = -2

As this range is equivalent to average ± 2 standard deviations, so the number of observations within the

range 40 to 60 years is 95.5% of the total observations. Therefore number of observations is 400 ×

0.955 = 382.

30. Answer : (a) < TOP >

Reason : Declaration policy is based on the principle that variation in the value of insured stock results in under-

insurance or over insurance.

Section B : Problems

1. a. As the investor is expecting a rise in interest rate so value of the holding is expected to reduce. To hedge the

falling value of the bonds the investor should sell the T-bond futures, as the rise in interest rate will reduce

the futures price, and hence he can make profit by buying at lower price thus booking gain. This gain will

reduce the loss in holdings value.

To find out the number of futures required for perfect hedge, we have to find out the conversion factor of T-

bonds.

Present value of cash flows from the bond

36

∑ 2.75 100

i= 1 (1.03)i (1.03)36

= + = 2.75 x 21.832 + 100x0.345 = 94.538

Face value of futures contract

= x Conversion factor

$ 2, 500, 000

x 0.94538 =23.63 ; 24 contracts

$100, 000

=

b. Value of the holding at the time of entering hedge

12

90 32

100

= $ 2,500,000 = $ 2,259,375

i. After six months,

26

92 32

100

bond value = $ 2,500,000 = $ 2,320,313

Change in basis points in futures = 80 bs

Loss in futures – 80 x $ 31.25 x 24 = $ 60,000

6

12

Accrued interest for six months = $ 2,500,000 x 0.055 x

= $ 68,750

(2, 320, 313 −60, 000 +68, 750) −2, 259, 375 12

X

2, 259, 375 6

Annualized return =

69, 688 12

x

2, 259,375 6

=

= 6.17%

ii. After six months,

6

88 32

100

bond value = $ 2,500,000 = $ 2,204,688

Change in basis point in futures = 66 bp

Gain in futures = 66 x $ 31.25 x 24 = $ 49,500

Accured interest = $ 68,750

(2, 204, 688 + 49, 500 +68, 750) −2, 259, 375 12

X

2, 259, 375 6

Annualized return =

63, 563 12

x =5.63%

2, 259, 375 6

=

< TOP >

2. The value of call option is given by

C = SOe-rft N(d1) – Xe-rt N (d2)

Where, SO = 46.00

X = 46.50

r = 0.05

rf = 0.015

σ = 0.05

t = 0.50

σ2

ln (SO / x) + (r − rf + )t

2

σ t

d1 =

σ t

d2 = d1 -

2

46.00 0.05

ln + (0.05 − 0.015 + 2 ) 0.50

46.50

0.05 0.50

d1 =

−0.01081 +0.01813 0.007315

= = 0.21

0.03536 0.03536

=

d2 = 0.21 – 0.03536 = 0.17

N (d1) = 0.5832

N (d2) = 0.5675

Call value = 46 x e-0.015x0.50 x 0.5832 – 46.50 x e-0.05x0.50 x 0.5675

= 26.627 – 25.737

= Rs.0.89

< TOP >

3. a. The company is long on Canadian dollars, So it should sell C$ futures.

It should sell 50 C$ - futures contracts.

Loss on the futures contract = (0.7443 – 0.7449) x 50 x 100,000

= $ 3000

1

1.3346

Inflow in the spot market = $ 5,000,000 x

= $ 3,746,441

Net inflow = $ 3,746,441 – $ 3000

= $ 3,743,441

b. If the company is indifferent between the futures cover and money market cover, the inflow from money

market should also be $ 3,743,441.

Let the borrowing interest rate on C$ be x.

Money market hedge can be structured as : borrow C$,

Convert into $ at spot market and invest for 4 months.

5, 000, 000

today

(1 + x)

So, borrow C$

5, 000, 000

(1 + x) (1.3283)

Sell at spot market to get $ and

5, 000, 000x1.0067

(1 + x) (1.3283)

Investment proceeds after 4 months $

For indifferent situation,

5, 000, 000 x 1.0067

(1 + x) (1.3283)

= 3,743,441

or, 1 + x = 1.01229

or, x = 1.229 % for 4 months.

12

4

Hence, annualized rate = 1.229 × = 3.69%

< TOP >

4. The appropriate strategy for the speculator is strangle. Strangle is created by buying call with higher strike price

and put with lower strike. So the speculator will buy call at 0.0098 and buy put at 0.0091.

Initial outflow = 0.00011 + 0.00005 = $ 0.00016.

Spot Gain / loss on Gain/loss on Initial Net

($ / Yen) (+) C = 0.0098 (+) P = 0.0091 outflow gain/loss

0.0088 – + 0.0003 0.00016 0.00014

0.0089 – + 0.0002 0.00016 0.00004

0.0090 – + 0.0001 0.00016 – 0.00006

0.00894 – + 0.00016 0.00016 0

0.0091 – – 0.00016 – 0.00016

0.0092 – – 0.00016 – 0.00016

0.0093 – – 0.00016 – 0.00016

0.0094 – – 0.00016 – 0.00016

0.0095 – – 0.00016 – 0.00016

0.0096 – – 0.00016 – 0.00016

0.0097 – – 0.00016 – 0.00016

0.0098 – – 0.00016 – 0.00016

0.00996 + 0.00016 – 0.00016 0

0.0099 + 0.0001 – 0.00016 – 0.00006

0.0100 + 0.0002 – 0.00016 0.00004

0.0101 + 0.0003 – 0.00016 0.00014 Maximum

profit = unlimited

Maximum loss = – 0.00016 Yen / $

Break-even points = 0.00894 and 0.00996.

< TOP >

Firm Objective Available Available Comparative in advantage

Fixed Interest Floating Interest

APCO Fixed Rate 9% LIBOR + 0.75% Floating Rate

PATCO Floating Rate 8% LIBOR + 0.25% Fixed Rate

Absolute advantage of PATCO 1% 0.5%

Thus, we can

see that while PATCO Ltd. has absolute advantage in both fixed and floating markets, APCO has comparative

advantage in the floating market. So, the advantage to both the parties will be 50 bp ( 075% - 0.25% ) and that

both share the benefit equally, without paying any intermediary commission. Hence APCO will borrow at floating

rate and PATCO will borrow at fixed rate.

APCO will borrow fund from floating rate market at LIBOR + 0.75% and will lend that to PATCO at LIBOR.

PATCO will borrow fund from the fixed rate market at 8% and will lend that to APCO at same 8%.

The net costs of funds to both the parties will be :

Paid to Received from Paid to the

Firm Net Cost Savings

counter party counter party market

LIBOR +

APCO 8% LIBOR 8.75% 9% – 8.75% = 0.25%

0.75%

LIBOR

LIBOR + 0.25% –

PATCO LIBOR 8% 8%

(LIBOR) = 0.25%

b. The risks in this swap are:

i. PATCO is at a risk of LIBOR rising in near future.

ii. APCO is at a risk of opportunity loss in the event of a fall in LIBOR.

iii. Both are at a default risk from each other.

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Volatility = 18% p.a.

18

250

Daily volatility = = 1.1384

15

= 4.41%

Value at risk at 95% confidence level for 15 days

= 25,000 × 0.0441 × 1.96

= Rs.2160.90

ii. Delta of call option = 0.70

Delta of call option position = Rs.240 × 100 (0.70) = – Rs.16,800

So, the long call option has the same risk of going long on the stock of size Rs.16,800.

Value at risk 90% confidence level for 15 days

= 16,800 × 0.0441 × 1.96

= Rs.1452.12

iii. As the buying call option on 100 shares of ICICI is equivalent to going long on the shares of size Rs.16,800.

∴ The combined position of short stock and long call

= – Rs.25,000 + Rs.16,800

= – Rs.8200

So, the combined VaR at 90% confidence level for 15 days

= 8200 × 0.0441 × 1.96

= Rs.708.78

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Section C: Applied Theory

7. The use of option based investment strategies can produce risk-return patterns suited to the unique requirements

of investors. Following factors need to be accounted while calculating the pay offs associated with these strategies.

i. i. Transaction Costs: In fact, most of the strategies result in substantial brokerage commissions

because brokerage has to be paid on multiple legs. For example, while executing a long straddle strategy

commissions have to be paid on buying a call and buying a put. In fact, many clients do complain that the

brokerage houses have pushed these strategies on them to generate additional commissions.

ii. Bid-Ask Spreads: There are bid-ask spreads for each option and the consideration of spread is important

because an investor buys an option at the higher asked price and sells an option at the lower bid price.

Therefore, bid-ask spread is a cost of trading which has to be reckoned while calculating the pay-off

associated with a complex strategy.

iii. Dividends: Options are not dividend protected and we have ignored the possibility of dividends being

declared on the underlying stock prior to the expiration date.

iv. Margin Requirements: We have also ignored the margin requirements applicable to writing of options and

we have assumed that investors receive the full amount of written options.

v. Early Exercise: The most important point we have ignored is the possibility of early exercise. We have

wished away this possibility by assuming that the options are of the European type, but the fact remains that

most of the equity options that are traded are of the American type. A written American put or a written

American call that is in-the-money can be exercised early (prior to the date of expiration). Therefore, the

investor executing a complex investment strategy like a bearish vertical spread using calls faces a higher risk

than what we have assumed.

vi. Timing of Cash Flows: We have also ignored the timing of the different cash flows which, of course, is not

very significant, when the initial cash flow and the expiration day cash flows occur within a period of one

year. The above caveats have to be borne in mind before an investor actively pursues any of the complex

investment strategies outlined in this note. These investment strategies can appeal to investors with very low

trading costs and in the Indian context these strategies can be profitably employed by institutional investors

that can trade in the exchange either directly or through a stock broking subsidiary.

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8. While the earnings of the swap bank are from the bid-ask spread of swaps and the fees charged (upfront fees), it

has to entail the following risks, which are inherent to the swap business and are mostly inter-related:

i. i. Interest Rate Risks: Interest rate risk arises mostly on fixed rate legs of swaps. While the floating rate

interest can be periodically adjusted to the prevailing interest rates, the fixed rate in the market not

accompanied by a change in the yield of debt instruments of the same time period as the interest rates will

entail interest rate losses to the bank. Unless the swap bank is fully hedged, losses will be incurred.

ii. ii. Currency Exchange Risk: Currency exchange risks happen when there is an exchange rate

commitment given to one party and there is a steep change in the exchange rate between the currencies in the

swap. If the swap bank is not able to match the counterparty well in time, it will incur losses due to the

exchange rate difference.

iii. iii. Market Risks: Market risks occur when there is difficulty in finding counterparty to a swap. Usually,

longer maturity swaps have less takers and vice versa. Lower the number of takers, higher the risks of losses.

iv. iv. Credit Risks: Credit risks are those risks which the swap bank has to bear in case the counterparty to a

swap defaults on payment due to bankruptcy or any other defaults, legal or otherwise. The bank continues to

the obliged to pay the other party of the swap, irrespective of the fact whether the former party defaulted or

not. Market risks and credit risks together amount to default risks of the bank.

v. v. Mismatch Risk: Mismatch risks take place when the swap bank comes across mismatches in the

requirements of both counterparties to the swap. Usually, banks have a pool of swaps and have no difficulty in

finding matches, but if no party is found, the risk of mismatch losses is there. This risk is further aggravated in

case one of the parties defaults.

vi. vi. Basis Risks: Basis risks take place mostly in floating-to-floating rate swaps, when both the sides are

pegged to two different indices the sides are pegged to two different indices and both the indices are

fluctuating and there is no proper correlation between both.

vii. vii. Spread Risk: Spread risks happen when the spread changes over the time period the parties are

matched. The spread risk is not the same as interest rate risk, as spreads may change as a result of change in

basis points, while the interest rate may still remain constant.

viii.viii. Settlement Risk: Settlement risks take place when the payments of currency swaps are made at

different times of the day mainly because of different settlement hours in capital markets of two countries

involved in the currency swap. If a limit on the size of the settlement is placed for each day, this risk is

minimized.

ix. ix. Sovereign Risk: Sovereign risks are those risks that can take place if a country changes its rules

regarding currency deals. It mostly happens in the underdeveloped or developing countries which tend to

have more political instability than the developed world.

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