Chester Midway Case ScenarioChester Midway, CFA, is a portfolio manager for Pacific Capital, a hedge fund which invests in debt, equity and related derivatives securities. Midway is reviewing several investment recommendations from his research staff with respect to Yorktown Carrier Corporation. Midway believes that Yorktown’s stock price will increase over the next six months, but he does not want to purchase the stock today. In order to protect against the stock price rising over the next six months, Midway is considering a forward purchase. Yorktown’s common stock currently trades at $100 per share and is expected to pay quarterly dividends of $0.75 per share with the next dividend payment expected 90 days from today. To evaluate this transaction, Midway uses the data provided in Exhibit 1. Exhibit 1 Risk Free Interest Rates Maturity Rate 3 months 0.50% 6 months 0.50% 1 year 1.00% Michael Edwards, an equity analyst at Pacific, believes that call options are an alternative approach to establishing a long position in Yorktown stock. The current market price of a six month put option with a strike price of $100.00 is $5.35. Midway asks Edwards if there are ways to measure the risk of option positions. Edwards responds by stating that numerical risk measures such as delta and gamma are used by investors to monitor the price relationship between a call option and the underlying stock. Edwards makes the following statements: Statement 1: “A smaller gamma limits the effectiveness of delta hedging.” Statement 2: “A negative delta indicates that the call option price and the stock price will move in opposite directions.” Statement 3: “A larger gamma means that there is more uncertainty as to whether the call option will expire out-of-the-money.” Midway has analyzed Yorktown’s recent price history and estimates that historical volatility is 30%. He uses the Black-Scholes option pricing model to observe that the volatility implied by the market prices of Yorktown options is 20%. Midway’s forecast is that Yorktown’s price volatility will remain at 30%. Midway recommends buying put options and selling call options in order to profit from his view on the volatility for Yorktown’s stock relative to the market consensus. Jim Frank is Pacific’s fixed income analyst. He has analyzed Yorktown’s balance sheet, and is meeting with the company’s treasurer. He asks the treasurer if Yorktown’s stock price may be adversely affected by rising interest rates given the high level of floating rate debt within its capital structure. Frank, however, believes that interest rates will not rise. The treasurer tells him that Yorktown could consider interest rate swaptions which hedge against a rise in rates but which simultaneously provides the flexibility to not engage in the swap should rates not rise. Frank has evaluated Yorktown’s senior debt and its credit default swaps (CDS). Frank has a positive outlook regarding Yorktown’s credit condition over the next two years but is concerned about Yorktown’s longer term (5 years) credit outlook based on secular trends within Yorktown’s industry. 7. The six month forward price on Yorktown stock that Midway should expect to pay is closest to: A. $98.50. B. $98.75. C. $99.00. 8. Based on Exhibit 1 and put-call parity, the price of a 6-month call option with a strike price of $100.00 on Yorktown stock is closest to: A. $5.10. B. $5.60. C. $5.85. 9. Which of Edward’s statements to Midway regarding options is mostly likely correct: A. Statement 1. B. Statement 2. C. Statement 3. 10. Holding all of the other components of the Black-Scholes model constant, Midway’s put and call strategy to exploit volatility is most likely incorrect because: A. both puts and calls will increase in value. B. both puts and calls will decrease in value. C. puts will decrease in value while calls will increase in value. 11. Which interest rate hedge instrument is most suitable for Yorktown given Frank’s assessment of Yorktown’s interest rate exposure and his view on interest rates: A. Payer Swaption B. Receiver Swaption C. Plain Vanilla Swap 12. Given Frank’s credit evaluation of Yorktown, which CDS strategy is most appropriate for Pacific? A. Sell 2-year CDS. B. Sell 2-year CDS and buy 5-year CDS. C. Buy 2-year CDS and sell 5-year CDS. Chester Midway Case Scenario Chester Midway, CFA, is a portfolio manager for Pacific Capital, a hedge fund which invests in debt, equity and related derivatives securities. Midway is reviewing several investment recommendations from his research staff with respect to Yorktown Carrier Corporation. Midway believes that Yorktown’s stock price will increase over the next six months, but he does not want to purchase the stock today. In order to protect against the stock price rising over the next six months, Midway is considering a forward purchase. Yorktown’s common stock currently trades at $100 per share and is expected to pay quarterly dividends of $0.75 per share with the next dividend payment expected 90 days from today. To evaluate this transaction, Midway uses the data provided in Exhibit 1. Exhibit 1 Risk Free Interest Rates Maturity Rate 3 months 0.50% 6 months 0.50% 1 year 1.00% Michael Edwards, an equity analyst at Pacific, believes that call options are an alternative approach to establishing a long position in Yorktown stock. The current market price of a six month put option with a strike price of $100.00 is $5.35. Midway asks Edwards if there are ways to measure the risk of option positions. Edwards responds by stating that numerical risk measures such as delta and gamma are used by investors to monitor the price relationship between a call option and the underlying stock. Edwards makes the following statements: Statement 1: “A smaller gamma limits the effectiveness of delta hedging.” Statement 2: “A negative delta indicates that the call option price and the stock price will move in opposite directions.” Statement 3: “A larger gamma means that there is more uncertainty as to whether the call option will expire out-of-the-money.” Midway has analyzed Yorktown’s recent price history and estimates that historical volatility is 30%. He uses the Black-Scholes option pricing model to observe that the volatility implied by the market prices of Yorktown options is 20%. Midway’s forecast is that Yorktown’s price volatility will remain at 30%. Midway recommends buying put options and selling call options in order to profit from his view on the volatility for Yorktown’s stock relative to the market consensus. Jim Frank is Pacific’s fixed income analyst. He has analyzed Yorktown’s balance sheet, and is meeting with the company’s treasurer. He asks the treasurer if Yorktown’s stock price may be adversely affected by rising interest rates given the high level of floating rate debt within its capital structure. Frank, however, believes that interest rates will not rise. The treasurer tells him that Yorktown could consider interest rate swaptions which hedge against a rise in rates but which simultaneously provides the flexibility to not engage in the swap should rates not rise. Frank has evaluated Yorktown’s senior debt and its credit default swaps (CDS). Frank has a positive outlook regarding Yorktown’s credit condition over the next two years but is concerned about Yorktown’s longer term (5 years) credit outlook based on secular trends within Yorktown’s industry. 7. The six month forward price on Yorktown stock that Midway should expect to pay is closest to: A. $98.50. B. $98.75. C. $99.00. Answer = B “Derivative Markets and Instruments,” Don M. Chance 2011 Modular Level II, Vol. 6, pp. 26-31 Study Session 16-60-b Calculate and interpret the price and the value of an equity forward contract, assuming dividends are paid either discretely or continuously. B is correct because Forward Price = (Stock Price – Present value of dividends over life of contract) X (1+r)T 98.75 = (100 - .7491 - .7481) × (1.005) (180/360) Where: PV D1 = (.75) / (1+.005)90/360 = .7491 PV D2 = (.75) / (1+.005)180/360 = .7481 8. Based on Exhibit 1 and put-call parity, the price of a 6-month call option with a strike price of $100.00 on Yorktown stock is closest to: A. $5.10. B. $5.60. C. $5.85. Answer = B “Derivative Markets and Instruments,” Don M. Chance 2011 Modular Level II, Vol. 6, pp.171-176 Study Session 17-62-a Calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic bond, and synthetic underlying stock, and infer why an investor would want to create such instruments. B is correct: Call value = Short Bond + Put + Stock = -$100/(1.005) (180/360) + $5.35 + $100.00 = $5.60 208. 213. Midway’s put and call strategy to exploit volatility is most likely incorrect because: A. Chance 2011 Modular Level II. both puts and calls will increase in value. B. Statement 3. Receiver Swaption C. Which interest rate hedge instrument is most suitable for Yorktown given Frank’s assessment of Yorktown’s interest rate exposure and his view on interest rates: A.or out-of-the-money. 214 Study Session 17-62-d Explain how an option price. B. Statement 1. 6 pp 203-206 Study Session 17-62-f Explain the gamma effect of an option’s price and delta and how gamma can affect a delta hedge. C. as represented by the Black-Scholes-Merton model. Chance 2011 Modular Level II. since both will increase in value should Implied Volatility rise to match the level of historical volatility. Answer = A “Derivative Markets and Instruments.” Don M. Answer = C “Derivative Markets and Instruments. 212.” Don M. 209. Payer Swaption B. Holding all of the other components of the Black-Scholes model constant. puts will decrease in value while calls will increase in value.9. A is correct because Pacific will want to purchase Call Options and Put Options. is affected by each of the input values (the option Greeks). 6 pp. Vol. Statement 2. C is correct because Gamma is larger when there is more uncertainty about whether the option will expire in. C. Vol. 11. 10. both puts and calls will decrease in value. Plain Vanilla Swap Answer = A . Which of Edward’s statements to Midway regarding options is mostly likely correct: A. 202. “Derivative Markets and Instruments. 6 p. 6.Yorktown owns the option to enter into a pay fixed swap should rates increase but it may choose not to enter into the pay fixed swap should rates not increase. Answer = B “Derivative Markets and Instruments. p. C. and how they are used by hedge funds and other managers. . B. which CDS strategy is most appropriate for Pacific? A. 283 Study Session 17-63-f Explain and interpret the characteristics and uses of swaptions. A is correct because entering into a Payer Swaption provides a simultaneous benefit . CFA 2011 Modular Level II. Buy 2-year CDS and sell 5-year CDS.” Don M.” George Spentzos. Given Frank’s credit evaluation of Yorktown. B is correct because Pacific will collect CDS income over the first three years (when creditworthiness is projected to be OK) but will benefit from owning credit protection via the CDS between year 3 and 5. Sell 2-year CDS.361 Study Session 17-65. 12. Chance 2011 Modular Level II. including the difference between payer and receiver swaptions. This strategy is known as a steepener. Sell 2-year CDS and buy 5-year CDS.d Discuss credit derivatives trading strategies. Vol. Vol. Novatel’s managers feel that the current interest rate on the loan is high and they also believe that interest rates are poised to decline.53 270 2. KPS wants to increase the equity exposure to the U. The final meeting is with KPS Financial Services. The notional principal on the swap will be $250.12 2.86 1. All rates shown are annualized. market in one of its portfolios by $100. Whitney advises Novatel to enter into a one-year pay floating LIBOR receive fixed interest rate swap with quarterly payments.34 1.84%. an independent advisory firm. Grand manufacturing is currently able to borrow Euros at an interest rate of 3. Whitney will be meeting with three clients who need advice on structuring and implementing swap programs to manage their interest rate exposures.000. a U.42 2.87 Note: LIBOR is the London Interbank Offer rate. Whitney outlines three options: Option 1: A cash settlement with the counterparty. Exhibit 1 Current Term Structure of Rates (%) Days LIBOR EURIBOR HIBOR 90 1. The current exchange rate is HK$11.Meredith Whitney Case Scenario Meredith Whitney is a senior consultant in the Swaps Advisory Group of DCM Capital. HIBOR is the Hong Kong Interbank Offer rate. For her meetings.000 one-year bridge loan to fund operations in Germany.32% and receive HK$ at a fixed rate of 1. Option 2: Enter into a payer swaption Option 3: Enter into a receiver swaption. EURIBOR is Euro Interbank Offer Rate.S. Next. Whitney’s first meeting is with Novatel.42 per €1.000.70 360 3. Whitney meets with Grand Manufacturing.S. Novatel has asked Whitney to provide recommendations on how it can terminate the swap.22 180 1.75%.84 2.000.42 1. Whitney advises Grand to borrow in HK$ and enter into a one-year foreign currency swap with quarterly payments to pay Euro’s at a fixed rate of 2.000 that carries a 5. This client is based in Hong Kong but requires a €25. based asset manager. but wonders if there is a less expensive alternative.000.S. based company that currently has an outstanding loan of $250.000. Whitney plans to use the data presented in Exhibit 1 below.24 1. a U. Whitney advises KPS to .11 1.15% fixed interest rate.000. -$2.08 2.15% 8.94 1.62 3.03 2.95 180 2. -$2. Each client follows Whitney’s advice and immediately implements the recommended position. Forty five days have passed since Whitney’s initial meetings and in the interim a worldwide financial crisis has caused interest rates to rise dramatically. -$718. HIBOR is the Hong Kong Interbank Offer rate.750 .S. 7. Using data in Exhibit 1. 5.22% B.875. All rates shown are annualized.enter into a one-year equity swap with quarterly payments to receive the return on a U.15 3.250.70 360 4.85 Note: LIBOR is the London Interbank Offer rate. she notes that the exchange rate for the Hong Kong dollar is HK$9. 2.S. Whitney’s clients have asked to meet with her to review their positions. EURIBOR is Euro Interbank Offer Rate.000 B. 3. In addition. stock index is 925. Using data in Exhibit 2.45 270 3.96 per €1 and the U. Exhibit 2 Term Structure of Rates 45 Days Later (%) Days LIBOR EURIBOR HIBOR 90 2.36% C.92 4.21 2. In order to prepare for the meeting Whitney has obtained updated interest rate data that is presented in Exhibit 2.S stock index and pay a floating LIBOR interest rate. The current value of the U. the market value of Novatel’s swap after 45 days is closest to: A. stock index is at 905.73 3.000 C. the annualized fixed rate of the swap recommended by Whitney for Novatel is closest to: A. 9.000 11.000 B. HK$1.232.000 C.313. Using data in Exhibit 2. 10.000 C. -$2. option 2. Using data in Exhibit 2.300 B. the market value of KPS Financial Services’ swap after 45 days is closest to: A. option 3. C. HK$36. Middle C. option 1. At what point in the swap’s life is the credit risk with respect to KPS Financial Services’ swap position most likely the highest? A. B. the market value of Grand Manufacturing’s swap after 45 days is closest to: A. -$2.000 12.402.162. End B. Whitney is least likely correct with respect to: A. With regard to the recommendations for the termination of Novatel’s swap position. Beginning .500. HK$35.372. -$4. 000.34 1.000.11 1. Whitney’s first meeting is with Novatel.42 2.42 1.S. market in one of its portfolios by $100. Whitney advises KPS to .000 one-year bridge loan to fund operations in Germany. Exhibit 1 Current Term Structure of Rates (%) Days LIBOR EURIBOR HIBOR 90 1.S.000.Meredith Whitney Case Scenario Meredith Whitney is a senior consultant in the Swaps Advisory Group of DCM Capital. Novatel’s managers feel that the current interest rate on the loan is high and they also believe that interest rates are poised to decline.32% and receive HK$ at a fixed rate of 1. KPS wants to increase the equity exposure to the U.53 270 2. All rates shown are annualized. based company that currently has an outstanding loan of $250. Whitney outlines three options: Option 1: A cash settlement with the counterparty. HIBOR is the Hong Kong Interbank Offer rate. based asset manager. Whitney meets with Grand Manufacturing.15% fixed interest rate. This client is based in Hong Kong but requires a €25.75%. Whitney plans to use the data presented in Exhibit 1 below. Whitney advises Grand to borrow in HK$ and enter into a one-year foreign currency swap with quarterly payments to pay Euro’s at a fixed rate of 2. Whitney will be meeting with three clients who need advice on structuring and implementing swap programs to manage their interest rate exposures.24 1.000 that carries a 5. but wonders if there is a less expensive alternative.22 180 1. an independent advisory firm. Grand manufacturing is currently able to borrow Euros at an interest rate of 3.87 Note: LIBOR is the London Interbank Offer rate.S.000. Whitney advises Novatel to enter into a one-year pay floating LIBOR receive fixed interest rate swap with quarterly payments.000.84 2. a U. For her meetings.70 360 3.42 per €1.84%. The current exchange rate is HK$11. The final meeting is with KPS Financial Services. Option 2: Enter into a payer swaption Option 3: Enter into a receiver swaption.000.12 2. EURIBOR is Euro Interbank Offer Rate.86 1. a U. The notional principal on the swap will be $250. Next. Novatel has asked Whitney to provide recommendations on how it can terminate the swap. All rates shown are annualized.15% Answer = B “Swap Markets and Contracts. In addition.45 270 3.96 per €1 and the U.73 3. 7.” Don M. 3. The current value of the U.03 2. In order to prepare for the meeting Whitney has obtained updated interest rate data that is presented in Exhibit 2. Whitney’s clients have asked to meet with her to review their positions.15 3. pp.enter into a one-year equity swap with quarterly payments to receive the return on a U. 2.S.21 2.08 2. Vol.22% B. Chance 2011 Modular Level II. stock index is at 905. 5.85 Note: LIBOR is the London Interbank Offer rate. stock index is 925.62 3. the annualized fixed rate of the swap recommended by Whitney for Novatel is closest to: A. Each client follows Whitney’s advice and immediately implements the recommended position. Using data in Exhibit 1.92 4. Forty five days have passed since Whitney’s initial meetings and in the interim a worldwide financial crisis has caused interest rates to rise dramatically.94 1. .95 180 2. Exhibit 2 Term Structure of Rates 45 Days Later (%) Days LIBOR EURIBOR HIBOR 90 2.70 360 4. 265-267 Study Session 17-63-c Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market value of the swap during its life.36% C. she notes that the exchange rate for the Hong Kong dollar is HK$9. 6.S stock index and pay a floating LIBOR interest rate. HIBOR is the Hong Kong Interbank Offer rate.S. EURIBOR is Euro Interbank Offer Rate. 9669 For example.9965 Bo(180) 0.000. 225 and 315 days. Chance 2011 Modular Level II. B is correct.” Don M.750 Answer = B “Swap Markets and Contracts. -$718. 135.9772 + 0.0007 The market value of the pay floating receive fixed rate swap = $250. -$2.0084) × (0. 267-269 Study Session 17-63-c Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market value of the swap during its life. Vol.000 C. the market value of Novatel’s swap after 45 days is closest to: A. B0(90) is calculated as: Other present value factors are calculated in a similar manner.0084 × 4 = 0.000 .9917.0336 8.9844 Bo(360) 0.0007) = -$2. The fixed rate is calculated as follows: The annualized rate = 0.9972) = 1.000 B. Using data in Exhibit 2.0142 × 90/360) + 1) × (0.250. B is correct.9587) = 0. Per $1 of notional principal the present value of the fixed payments = (0.9587) + (1 × 0.875. Per $1 the present value of the floating payments = present value of first floating payment + the present value of future floating payments = ((. The appropriate present value factors are provided below: Bo(90) 0.9903 + 0.9972 + 0. pp. 6. -$2.9909 Bo(270) 0.9917 – 1. Note that the payments now occur in 45.000 × (0.250. and the foreign notional principal for a given domestic notional principal on a currency swap. C. the market value of Grand Manufacturing’s swap after 45 days is closest to: A. pp. B is correct.9976 + 0. pp. C is correct. Grand receives €25. Forty five days into the swap: Per HK$1 of notional principal the present value of the fixed payments received on the Hong dollar = (0. HK$1.500.0046) × (0. HK$36.9855 . Using data in Exhibit 2.313.9.84% on the Hong Kong dollar.9834 + 0.” Don M.9674) = 0. 270-275 Study Session 17-63-d Calculate and interpret the fixed rate. B. and determine the market values of each of the different types of currency swaps during their lives.500. Vol. Chance 2011 Modular Level II.42 per euro.000 C. 283. Answer = C “Swap Markets and Contracts. option 2. 10.300 B. HK$35. 6.9909 + 0. A receiver swaption cannot be used to terminate a pay floating receive fixed swap. if applicable.293 Study Session 17-63-f Explain and interpret the characteristics and uses of swaptions.000.000 Answer = B “Swap Markets and Contracts. option 3. With regard to the recommendations for the termination of Novatel’s swap position.000 and pays HK$285.000 based on the current exchange rate of HK$11. We are told that Grand will pay an interest rate of 2. option 1. Initially.32% on the euro and receive 1.” Don M.402. Chance 2011 Modular Level II. Vol. Whitney is least likely correct with respect to: A. including the difference between payor and receiver swaptions.9674) + (1 × 0. 6. 9650) = 0.present value of floating payment.0007) × $100.08649 The present value of euro fixed payments in HK$ = 0. 275-280 Study Session 17-63-e Calculate and interpret the fixed rate. At what point in the swap’s life is the credit risk with respect to KPS Financial Services’ swap position most likely the highest? A.000 Answer = B “Swap Markets and Contracts.9878 × 0.08757 = 0. End B.402.0058) × (0.500. Per €1 of notional principal the present value of the fixed payments paid on the euro = (0.000 B.96 = 0.000 = -$2.97838 – 1.8615) = HK$35.232. -$4.000 11. Vol. -$2. pp. Chance 2011 Modular Level II. the market value of KPS Financial Services’ swap after 45 days is closest to: A.9972) = 1. -$2. Value of $1 investment in equity = 905 ÷ 925 = 0.372.9963 + 0. if applicable.42 the actual notional principal = 1÷11.9650) + (1 × 0. Middle C.162.9811 + 0. The market value of the swap per $ notional principal = value of $1 investment in equity .000 C.8615 The market value of the swap = 285.9878 Note that based on the exchange rate of HK$11.08757 The present value of euro fixed payments = 0.000 × (0.000.97838 Per $1 the present value of the floating payments = present value of first floating payment + the present value of future floating payments = ((.” Don M. 6.0142 × 90/360) + 1) × (0. Beginning Answer = B . B is correct.232. Using data in Exhibit 2.08649 × 9.0007 Market value of swap = (0.9888 + 0. on an equity swap and the market values of the different types of equity swaps during their lives.42 = €0.000 12.9855 – 0. and illustrate how swap credit risk is reduced by both netting and marking to market. B is correct. credit risk is greater during the middle of the life of these swaps. distinguish between current credit risk and potential credit risk. p. . Therefore. 6. 288 Study Session 17-63-i Evaluate swap credit risk for each party and during the life of the swap. Vol. KPS Financial has entered into an equity swap. so the credit risk is higher during the middle of its life.2011 Modular Level II. Interest rate and equity swaps do not involve an exchange of principal. -based asset management firm. Statement 3: Delta is a more precise measure of the change in the option’s value when the gamma of the option is larger.S. to help him. Monk makes the following statements: Statement 1: “The delta of an out-of-the-money call moves towards 0 as expiration approaches even if the price of the underlying does not change. a U.Questions 49 through 54 relate to Derivative Investments. (ACT) Equity. Thomas Monk. Exhibit 2 provides current market prices and data of selected instruments related to ACT equity.” Baloo asks Monk to assist him in analyzing the following transactions: Transaction 1: Arbitrage Strategy on Acuriva Ltd.25 European put option on ACT equity $3.40 ACT equity price $33. Exhibit 1 Effect of Increasing Input Values on European Call Option Values Effect on Input Call Option Value Exercise price Decrease Risk-free rate Decrease Time to expiration Increase Volatility of the underlying Increase Monk wonders about the delta and gamma of a long call option position. Baloo is considering using derivatives to enhance returns and manage risk. Ravi Baloo Case Scenario Ravi Baloo is a portfolio manager with Springtree Investments. In Exhibit 1.66 Time to expiration of options 3 months . Monk summarizes the relationship between an increase in the value of each of the listed inputs and the value of a European-style call option. holding all else constant.or out-of-the-money. Exhibit 2 Current Market Prices and Data Security Price European call option on ACT equity $2. He asks his junior analyst. Statement 2: Gamma is smaller when there is more uncertainty about whether the option will expire in. 9691 620 0. Statement 5: The swaption fixes the rate that Springtree will pay on its swap.86 in 100 days and the term structure of interest rates is as presented in Exhibit 4.00% Monk determines that the value of a synthetic call option expiring in 3 months with an exercise price of $35.99 percent. Transaction 2: Purchase of a European put option on Tekvonix (TVX) equity. He asks Monk to explain how a swaption can be used to protect Springtree from an adverse change in interest rates.09 at the beginning of the swap and the notional principal of the swap is $100 million.0499 0. . The swap has annual payments.58. Monk uses a one- period binomial model to calculate the value of a one-year put option on TVX equity. Monk makes the following statements: Statement 4: “Springtree should purchase a payer swaption.00 is $2. Details of the put option are given in Exhibit 3.0442 0.9209 Note: Calculations are on a 360-day basis. Statement 6: A swaption can be settled in cash at expiration. The Russell 2000 Index is at 757. Transaction 4: Baloo expects to enter a pay-fixed position in a 4-year interest rate swap in six months. Exhibit 3 European Put Option on TVX Equity Time to expiration 1 year TVX equity price $52 Exercise price $45 Model predicted up move 15% Model predicted down move 20% Annualized risk-free rate 6. (T) = Discount factor of $1 from time T to the present. Exercise price of options $35.” Monk considers a scenario in which the Russell 2000 Index falls to 723. Exhibit 4 Term Structure of LIBOR Interest Rates 100 Days Later Days (T) (T) (T) 260 0.00% Transaction 3: Equity swap to gain exposure to the Russell 2000 index. Springtree enters into a two-year equity swap in which it will receive the rate of return on the Russell 2000 Index and will pay a fixed interest rate equal to 4. (T) = LIBOR rate to time T. T = Time to expiration.00 Annualized risk-free rate 6. Statement 2 C. Which of Baloo’s statements regarding the delta and gamma of a call option is correct? A. Which of the relationships shown in Exhibit 1 is incorrect? A. 52. Statement 1 B. selling the put option in the market and buying the equity. Statement 3 51. The value of the one-year put option in Transaction 2 is closest to: A. “The value of this equity swap is the amount of money that is exchanged on the annual payment date. the market value of Transaction 3 is closest to: A.000.070.910. $0. B.070. B. –$3.83. 53.38. C.Monk states. buying the put option in the market and shorting the equity. C. . -$1. selling the put option in the market and shorting the equity. C.70. Baloo’s arbitrage strategy in Transaction 1 should include: A.” 49.000. Risk-free rate C. –$5. Exercise price 50. Volatility B.000. $2. B. $1. Given Monk’s scenario. 54. Statement 4 B. Statement 5 C. Statement 6 . Which of the statements Monk makes with respect to Transaction 4 is incorrect? A. (ACT) Equity. He asks his junior analyst. holding all else constant. Ravi Baloo Case Scenario Ravi Baloo is a portfolio manager with Springtree Investments. Thomas Monk.-based asset management firm. In Exhibit 1. to help him.” Baloo asks Monk to assist him in analyzing the following transactions: Transaction 1: Arbitrage Strategy on Acuriva Ltd.Questions 49 through 54 relate to Derivative Investments. Monk makes the following statements: Statement 1: “The delta of an out-of-the-money call moves towards 0 as expiration approaches even if the price of the underlying does not change. a U.S. Exhibit 2 provides current market prices and data of selected instruments related to ACT equity.or out-of-the-money. Exhibit 1 Effect of Increasing Input Values on European Call Option Values Effect on Input Call Option Value Exercise price Decrease Risk-free rate Decrease Time to expiration Increase Volatility of the underlying Increase Monk wonders about the delta and gamma of a long call option position. Baloo is considering using derivatives to enhance returns and manage risk. Statement 2: Gamma is smaller when there is more uncertainty about whether the option will expire in. . Statement 3: Delta is a more precise measure of the change in the option’s value when the gamma of the option is larger. Monk summarizes the relationship between an increase in the value of each of the listed inputs and the value of a European-style call option. Exhibit 3 European Put Option on TVX Equity Time to expiration 1 year TVX equity price $52 Exercise price $45 Model predicted up move 15% Model predicted down move 20% Annualized risk-free rate 6. Exhibit 2 Current Market Prices and Data Security Price European call option on ACT equity $2. The swap has annual payments. Springtree enters into a two-year equity swap in which it will receive the rate of return on the Russell 2000 Index and will pay a fixed interest rate equal to 4. He asks Monk to explain how a swaption can be used to protect Springtree from an adverse change in interest rates.66 Time to expiration of options 3 months Exercise price of options $35. Monk uses a one- period binomial model to calculate the value of a one-year put option on TVX equity.00 is $2. Statement 5: The swaption fixes the rate that Springtree will pay on its swap.86 in 100 days and the term structure of interest rates is as presented in Exhibit 4.” Monk considers a scenario in which the Russell 2000 Index falls to 723.00% Transaction 3: Equity swap to gain exposure to the Russell 2000 index. Details of the put option are given in Exhibit 3.25 European put option on ACT equity $3. Statement 6: A swaption can be settled in cash at expiration.99 percent. Monk makes the following statements: Statement 4: “Springtree should purchase a payer swaption. .00% Monk determines that the value of a synthetic call option expiring in 3 months with an exercise price of $35. Transaction 4: Baloo expects to enter a pay-fixed position in a 4-year interest rate swap in six months. Transaction 2: Purchase of a European put option on Tekvonix (TVX) equity.58.40 ACT equity price $33.09 at the beginning of the swap and the notional principal of the swap is $100 million. The Russell 2000 Index is at 757.00 Annualized risk-free rate 6. 9691 620 0. as represented by the Black-Scholes-Merton model. pp. the value of a call option increases.” 49. Which of the relationships shown in Exhibit 1 is incorrect? A. Volume 6. “The value of this equity swap is the amount of money that is exchanged on the annual payment date. Monk states. Volatility B. Exhibit 4 Term Structure of LIBOR Interest Rates 100 Days Later Days (T) L0(T) B0(T) 260 0.0442 0. As the risk-free rate increases. Volume 6. T = Time to expiration. Exercise price Answer: B “Option Markets and Contracts.9209 Note: Calculations are on a 360-day basis. Statement 2 C.” Don M. 189-192 Study Session 17-62-f Explain the gamma effect on an option’s price and delta and how gamma can affect a delta hedge. . Which of Baloo’s statements regarding the delta and gamma of a call option is correct? A. 193-194 Study Session 17-62-d Explain how an option price. 50. is affected by each of the input values (the option Greeks). Statement 3 Answer: A “Option Markets and Contracts. Chance 2009 Modular Level II.” Don M. Chance 2009 Modular Level II. pp. L0(T) = LIBOR rate to time T.0499 0. Risk-free rate C. B0(T) = Discount factor of $1 from time T to the present. Statement 1 B. selling the put option in the market and buying the equity. selling the put option in the market and shorting the equity.” Don M. Baloo’s arbitrage strategy in Transaction 1 should include: A. the delta of an option changes as the option moves towards expiration. long underlying and short bond) is more expensive than the market price thus the call is under priced in the market. C. synthetic bond. The synthetic call (long put. pp. short the equity. Chance 2009 Modular Level II. Even if the price of the underlying does not change. Put-call parity: co + X/(1 + r)T = po + So co current price of call option with exercise price X. expiring in T years So current equity price . B. 51. Thus the correct arbitrage transaction (see put-call parity formula below) is to buy the call and sell the put. buying the put option in the market and shorting the equity. expiring in T years X exercise price r risk-free rate po current price of put option with exercise price X. The delta of an out-of-the-money call will move towards 0 as expiration approaches. Baloo should buy the call in the market and sell the synthetic call. and buy the bond. Answer: B “Option Markets and Contracts. synthetic put option. Using put-call parity. 157-163 Study Session 17-62-a Calculate and interpret the prices of a synthetic call option. and synthetic underlying stock and infer why an investor would want to create such instruments. Volume 6. 910.83 53.8 Sd=52*0.n.910.000 .7429 + - + (1.7427×$0 + 0. C. Answer: A “Option Markets and Contracts. –$3.83.000.38.40 – 0.000= -$5. B.9209-0.6 P+ = 0 P.8) = 0.09)-0. -$1. Given Monk’s scenario. if applicable. $0.8)/(1. Chance 2009 Modular Level II. Volume 6.070. Volume 6.15 – 0. The value of the one-year put option in Transaction 2 is closest to: A.” Don M. pp.86/757.m) Bt (h j ) S0 j 1 =((723. pp.6 = 3.0499*(0.000. –$5. C. ) /(1+r) ) = (0. $2.8 = 41. 249-254 Study Session 17-63-e Calculate and interpret the fixed rate.9691+0.52.= 45-41. 176 Study Session 17-62-b Calculate and interpret prices of interest rate options and options on assets using one.99 % (Given in vignette) Market value of a swap: n St t(hn) – FS(0.70. B. Answer: A “Swap Markets and Contracts.9209))*100.000. the market value of Transaction 3 is closest to: A.” Don M. $1.000.15 = 59.06 = $0.40)/1.and two-period binomial models The value of the one-year put is calculated as follows: Su= 52*1. Chance 2009 Modular Level II.2573×$3.070. on an equity swap and the market values of the different types of equity swaps during their lives Fixed rate on swap = 4. 166-170. 54. Chance 2009 Modular Level II. if it chooses. 249-254 Study Session 17-63-e Calculate and interpret the fixed rate. Volume 6. Statement 5 C. . Statement 6 Answer: B “Swap Markets and Contracts.” Don M. Statement 4 B. on an equity swap and the market values of the different types of equity swaps during their lives The exercise rate on a payer swaption is the fixed rate at which the holder can enter a pay- fixed position in a swap. pp. Which of the statements Monk makes with respect to Transaction 4 is incorrect? A. if applicable. Lawrence is conducting a training session for two recently hired analysts. and taking short positions in the stock and the bond. For example.30 Current Put Price $4. Wilma Kaplan and Anita Mehra.00 Days to Expiration* 60 Current Stock Price $128. if we find that the current call price is greater than the synthetic call price then we could earn an arbitrage profit by carrying out the following transactions: selling the call. Lawrence begins the meeting by stating: Statement 1: “You have both been asked to use the information provided in Exhibit 1 to perform certain calculations.70 Exercise Price $130. What are the other assumptions of this model?” Kaplan responds: . Lawrence states: “The Black–Scholes–Merton option pricing model is based on a number of assumptions. Exhibit 1 Stock and Options Data for Berkeley Corporation and Risk-Free Interest Rate Current Call Price $2. One of your tasks was to calculate the synthetic values of call and put options for Berkeley Corporation. “Deriving synthetic values enables us to determine whether it is possible to earn arbitrage profits. Kaplan and Mehra are asked questions about the Berkeley Corporation and are provided with the information in Exhibit 1. purchasing the put.55 Up Move on Stock 15% Down Move on Stock 10% Risk-Free Interest Rate 3% *Note: Assume a 365-day year.Robyn Lawrence Case Scenario Robyn Lawrence is a senior quantitative analyst in the Global Derivatives Group of Ridgeview Capital. there are no cash flows on the underlying. an investment management firm based in New York City. At the meeting. the risk-free rate is known and constant. and the options being priced are European options. including: underlying prices follow a lognormal probability distribution.” The discussion then moves on to the Black–Scholes–Merton option pricing model. Can one of you tell me why it is useful to construct and value synthetic calls and puts?” Kaplan responds. 88 C. Based on the information provided for the Berkeley Corporation in Exhibit 1. the value of a 60- day Berkeley Corporation call option with a strike of $130. is closest to: A. $5.52 8.00. . and the risk-free rate. option prices for European calls and puts are impacted by a number of variables. because traders can use this to construct hedges to offset the risks of their option positions. Assumption 3: The prices of the underlying asset follow a lognormal distribution.” Lawrence continues the discussion: “In the Black–Scholes–Merton model. incorrect with regard to purchasing the put. 9. the price of a synthetic 60-day call option with a $130. $8. Can one of you explain the effect of changes in these variables on the prices of European call and put options?” Mehra responds: “Call and put prices are higher when volatility is higher. B. Based on the information in Exhibit 1 and using a one-period binomial model. $3. volatility. Assumption 2: The volatility of the underlying assets change through time.25 B.” Lawrence ends the meeting with the following statement: Statement 2: “An important option Greek that you should be familiar with is the option delta.31. delta approaches 1 as the option moves toward expiration. put option prices can be higher or lower the longer the time to expiration. C. correct. However.” 7. $6. You should note that for in-the- money call and put options. incorrect with regard to taking a short position in the stock. and call and put prices are lower for higher risk-free rates. $3.67.“The other assumptions of the model are: Assumption 1: There are no taxes or transactions costs.00 strike price is closest to: A. Kaplan’s response to Lawrence’s Statement 1 is most likely: A. including time to expiration. while call options are higher for longer time to expiration. B. 10. No. the risk-free rate. B. time to expiration. 12. Is Statement 2 by Lawrence most likely correct? A. Mehra’s response to Lawrence is least likely correct with respect to the impact on call and put prices of: A. Assumption 2. C. C. Kaplan’s response to Lawrence regarding the assumptions of the Black–Scholes–Merton model is least likely correct with respect to: A. Assumption 3. Yes. B. . 11. volatility. she is incorrect with respect to puts. she is incorrect with respect to calls. Assumption 1. No. B. C. The discussion then moves on to the Black Scholes Merton option pr Black Scholes Merton option pricing model is based on a number of assumptions.30 Current Put Price $4. Kaplan and Mehra are asked questions about the Berkeley Corporation and are provided with the information in Exhibit 1. Exhibit 1 Stock and Options Data for Berkeley Corporation and Risk-Free Interest Rate Current Call Price $2. if we find that the current call price is greater than the synthetic call price then we could earn an arbitrage profit by carrying out the following transactions: selling the call. Can one of you tell me why it is arbitrage profits. there are no cash flows on the underlying. an investment management firm based in New York City. including: underlying prices follow a lognormal probability distribution. the risk-free rate is known and constant.70 Exercise Price $130.Robyn Lawrence Case Scenario Robyn Lawrence is a senior quantitative analyst in the Global Derivatives Group of Ridgeview Capital. For example. Lawrence is conducting a training session for two recently hired analysts. Wilma Kaplan and Anita Mehra. What are the other assumptions of this model? Kaplan responds: . and the options being priced are European options.55 Up Move on Stock 15% Down Move on Stock 10% Risk-Free Interest Rate 3% *Note: Assume a 365-day year.00 Days to Expiration* 60 Current Stock Price $128. Lawrence begins the meeting by stating: Statement 1: One of your tasks was to calculate the synthetic values of call and put options for Berkeley Corporation. At the meeting. Assumption 1: There are no taxes or transactions costs. $3. Lawrence continues the discussion: Scholes Merton model. $5. and the risk-free rate. B is correct. Vol. put Lawrence ends the meeting with the following statement: Statement 2: this to construct hedges to offset the risks of their option positions. including time to expiration.25 B. option prices for European calls and puts are impacted by a number of variables. and infer why an investor would want to create such instruments. However. 6. Assumption 2: The volatility of the underlying assets change through time. while call options are higher for longer time to expiration. pp.00 strike price is closest to: A. You should note that for in-the- 7. and synthetic underlying stock. The synthetic call option is constructed by going long the put and the stock and short the bond. Based on the information provided for the Berkeley Corporation in Exhibit 1. volatility. Can one of you explain the effect of changes in these variables on the prices of European Mehra responds: gher when volatility is higher. $3. 171 176 Study Session 17-56-a Calculate and interpret the prices of a synthetic call option.52 Answer = B 2012 Modular Level II. synthetic put option. . and call and put prices are lower for higher risk-free rates. the price of a synthetic 60-day call option with a $130.88 C. synthetic bond. synthetic put option. Answer = C 2012 Modular Level II. 9. and infer why an investor would want to create such instruments.00. 175 177 Study Session 17-56-a Calculate and interpret the prices of a synthetic call option. B. $9. The correct strategy is to sell the call option and then take long positions in the put and the stock and a short position in the bond (purchase the synthetic call). pp. Answer = C 2012 Modular Level II.and two- period binomial models. pp. $6.00. Vol. correct. incorrect with regard to purchasing the put.31. Based on the information in Exhibit 1 and using a one-period binomial model. . most likely: A. He incorrectly states that a short position should be taken in the stock.88. Vol. Synthetic call = = = $3.67. C. Kaplan is incorrect about the set of transactions that can be used to earn an arbitrage profit if the current price of the call option is greater than the synthetic value. 180 183 Study Session 17-56-b Calculate and interpret prices of interest rate options and options on assets using one. synthetic bond. C. incorrect with regard to taking a short position in the stock. it allows one to determine if it is possible to earn arbitrage profits. the value of a 60- day Berkeley Corporation call option with a strike of $130. However. 8. is closest to: A. Kaplan is correct about the reason for calculating synthetic option values. 6. $8. B. 6. and synthetic underlying stock. C is correct. least likely correct with respect to the impact on call and put prices of: A. Assumption 3. 11. B is correct. C. S.8325 S. 6. Answer = B 2012 Modular Level II.= 128. volatility. the risk-free rate.695 130] = 0 10. 115.8325 130] = 17. S+ X] = Max[0. Kaplan is incorrect. Assumption 1. The Black Scholes Merton model assumes that the volatility of the underlying asset is known and is constant. time to expiration. Scholes Merton model is least likely correct with respect to: A.15 = 147.00 given by: + S = 128. pp. C.90 = 115. Vol.= Max[0.X] = Max[0.55 × 1. C is correct. The value of the call option using the one-period binomial model is calculated as follows: = =$9. 198 199 Study Session 17-56-c Explain and evaluate the assumptions underlying the Black Scholes Merton model.55 × 0. Assumption 2. B.8325 c. 147.695 c+ = Max[0. Answer = B . B. C is correct. B is correct. 12. as the option moves toward expiration. delta approaches 1. she is incorrect with respect to calls. as represented by the Black Scholes Merton model. No. is affected by a change in the value each of the inputs. Yes. not 1. Answer = C 2012 Modular Level II. 202 204 Study Session 17-56-d. The price of a call option rises as the risk-free rate goes up. she is incorrect with respect to puts. is affected by a change in the value each of the inputs. however. as represented by the Black Scholes Merton model. . Vol. declines as the risk-free rate rises. pp. e Explain how an option price. The price of a put option. Explain the delta of an option and demonstrate how it is used in dynamic hedging. Is Statement 2 by Lawrence most likely correct? A. For in-the-money put options. B. 6. Study Session 17-56-d Explain how an option price. No. Mehra incorrectly states the relationship between the risk-free rate and the prices of call and put options. C. is planning to repatriate million from its British subsidiary. and that she wants to use the Eurodollar market to meet these.” Stahlberg mentions that Borealis will have ongoing U. Stahlberg has told Howell that she wants to protect Borealis against the possibility that the British pound depreciates against the euro before the funds are repatriated. stating: Statement 3: “Similar to a forward contract.S.S. and is very sensitive to the risk-free rate. a plain vanilla interest rate swap could convert it to a fixed rate obligation. Howell explains how swaps and swaptions can be used to address Stahlberg’s concerns. She intends to convert the British pounds to euros (the home currency for Borealis) in 90 days. dollar borrowing needs. yields before the FRN issuance date will increase her future borrowing costs (measured in U. . For example. She prefers to use floating rate debt. In particular.Questions 49 through 54 relate to Derivative Investments. Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk. Howell makes the following statements: Statement 1: “The call option price will decrease as the time to expiration decreases or the exercise price decreases. dollars).S. dollar denominated floating rate note (FRN). but has potential credit risk that will increase steadily over the life of the swap. if you issued a US$100 million FRN today that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. a plain vanilla interest rate swap can fix borrowing costs. Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is equivalent to a put option. the company treasurer for the Finnish-based Borealis Group Oyj. and a short position in a zero-coupon bond. Stahlberg is concerned that an increase in U.S. Statement 2: You can use 90-day call options on the euro with a strike price of current 90-day forward exchange rate is uropean call option on the euro can be created by combining a long put position on the euro. Howell suggests that Stahlberg consider the use of foreign currency options. Nicholas Howell is advising Stahlberg on these transactions. a European call option on euros will allow Borealis to hedge its foreign currency risk. Tarja Stahlberg Case Scenario Tarja Stahlberg. a short position in a forward contract on the euro. and is considering issuing a U. S. C.S. LIBOR 3. zero-coupon bond 51.S.90% n/a Fixed rate on swap n/a 4.9901 180-day discount factor 0. B.76%.35% Fixed rate on swaption 3. Given the information in Statement 3 and Exhibit 1. 1. Exhibit 1 U. C. The information in Statement 1 is correct with respect to: A. 4.32%. 3. . Statement 2 is incorrect with respect to which position? A. The data for this example is presented in Exhibit 1. You would want a European swaption with a notional principal amount of US$100 million and a 90-day expiry at the time of FRN issuance. time to expiration. put option B. 50. dollar LIBOR and Fixed Rates LIBOR.84%. and Swaption Today In 90 days Rates are Annualized 90-day U.50% 4. exercise price.32% 90-day discount factor 0. B.9913 0.00% 180-day U. risk-free interest rate. LIBOR 3.9787 49. the annualized fixed rate on the plain vanilla interest rate swap would be closest to: A.Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. forward contract C.85% 4. Swap.9811 0. correct with respect to both current credit risk and potential credit risk. Based on Statement 6 and Exhibit 1. C. correct with respect to potential credit risk only. correct with respect to both put option equivalency and pay floating position.725. C.961.52. the market value of the swaption at expiration would be closest to: A. 54. incorrect with respect to the put option equivalency. B. C.764. B. $206. B. correct with respect to current credit risk only. Statement 5 can be best characterized as: A. Statement 4 can be best characterized as: A. . $207. $208. 53. incorrect with respect to the pay floating position. Nicholas Howell is advising Stahlberg on these transactions. Statement 2: You can use 90-day call options on the euro with a strike price of current 90-day forward exchange rate is uropean call option on the euro can be created by combining a long put position on the euro. and is considering issuing a U. but has potential credit risk that will increase steadily over the life of the swap. a plain vanilla interest rate swap can fix borrowing costs. Howell makes the following statements: Statement 1: “The call option price will decrease as the time to expiration decreases or the exercise price decreases. Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk. Howell explains how swaps and swaptions can be used to address Stahlberg’s concerns.S. a European call option on euros will allow Borealis to hedge its foreign currency risk.S. Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is equivalent to a put option.Questions 49 through 54 relate to Derivative Investments. She prefers to use floating rate debt.” Stahlberg mentions that Borealis will have ongoing U. a short position in a forward contract on the euro. Tarja Stahlberg Case Scenario Tarja Stahlberg. She intends to convert the British pounds to euros (the home currency for Borealis) in 90 days. stating: Statement 3: “Similar to a forward contract. Stahlberg is concerned that an increase in U. For example. In particular. Howell suggests that Stahlberg consider the use of foreign currency options.S. Stahlberg has told Howell that she wants to protect Borealis against the possibility that the British pound depreciates against the euro before the funds are repatriated. dollar denominated floating rate note (FRN). and is very sensitive to the risk-free rate. .S. a plain vanilla interest rate swap could convert it to a fixed rate obligation. dollar borrowing needs. yields before the FRN issuance date will increase her future borrowing costs (measured in U. and that she wants to use the Eurodollar market to meet these. dollars). is planning to repatriate million from its British subsidiary. and a short position in a zero-coupon bond. if you issued a US$100 million FRN today that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. the company treasurer for the Finnish-based Borealis Group Oyj. the price of the option moves toward the payoff value of the option at expiration. a process known as time value decay. put option B.S.85% 4. LIBOR 3.50% 4. risk-free interest rate. zero-coupon bond Answer: B . The data for this example is presented in Exhibit 1.00% 180-day U. pp. as presented by the Black-Scholes-Merton model.90% n/a Fixed rate on swap n/a 4.S.9811 0. Exhibit 1 U. Swap. B. 50.195-197 Study Session 17-62-d Explain how an option price. The information in Statement 1 is correct with respect to: A. As expiration approaches.S. LIBOR 3. Don M. Statement 2 is incorrect with respect to which position? A.9787 49. Volume 6.9913 0. You would want a European swaption with a notional principal amount of US$100 million and a 90-day expiry at the time of FRN issuance. C. exercise price. Answer: B “Option Markets and Contracts”.Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR.32% 90-day discount factor 0. is affected by each of the input values (the option Greeks). time to expiration. dollar LIBOR and Fixed Rates LIBOR. and Swaption Today In 90 days Rates are Annualized 90-day U.35% Fixed rate on swaption 3.9901 180-day discount factor 0. forward contract C. Chance 2009 Modular Level II. n. 2009 Modular Level II. B.0 – ( ) ] / [ ( ) + ( ) ] .0 – ( ) ] / j ( ) where: FS(0.32%. 51.76%. pp.4. the annualized fixed rate on the plain vanilla interest rate swap would be closest to: A. Since Howell stated that F(0.84%. then this would be a short position in the zero-coupon bond. The fixed rate on a swap is calculated as: FS(0.n. 1. C. long the put option. Put-call-forward parity states that: Rearranging terms a synthetic call option is: That is you take a long position in the put. pp. 4. and long or short a zero-coupon bond.m) is the fixed payment on a swap starting at time 0 making n payments based on the m-day rate ( ) is the present value factor for the final notional payment ( ) is the sum of the present value factors for each payment Based on Howell’s third statement and the data in Exhibit 1: FS(0.T) > X. A synthetic call option is constructed by being long a forward. 3. Given the information in Statement 3 and Exhibit 1.90) = [ 1. 202-205 Study Session17-62-i Illustrate how put-call parity for options on forwards (or futures) is established. Chance 2009 Modular Level II. Don M. Volume 6. Answer: B “Swap Markets and Contracts”. Volume 6.m) = [ 1. a short bond position and a long forward position. 240-244 Study Session 17-63-c Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market value of the swap during its life. correct with respect to current credit risk only. A receiver swaption is equivalent to a call option. Don M. incorrect with respect to the pay floating position. including the difference between payer and receiver swaptions. While there is no credit risk at contract initiation.9811) / (0. Chance 2009 Modular Level II. B. pp. This is the quarterly rate and annualizing it (multiplying by four) leads to 3. Don M. Answer: A “Swap Markets and Contracts”. Volume 6. distinguish between current credit risk and potential credit risk. Chance 2009 Modular Level II. correct with respect to both put option equivalency and pay floating position. correct with respect to potential credit risk only. B. pp. Answer: B “Swap Markets and Contracts”.84%. 52.0 – 0.4. the potential credit risk of an interest rate swap is greatest at the middle of its life.0096. incorrect with respect to the put option equivalency.9811 Thus.90) = ( 1. Volume 6.9913 + 0. ( ) = 1 / [ 1 + 0.256-257 Study Session 17-63-f Explain and interpret the characteristics and uses of swaptions. C. correct with respect to both current credit risk and potential credit risk.9811) = 0. C. and illustrate how swap credit risk is reduced by both netting and marking to market. 262-263 Study Session17-63-i Evaluate swap credit risk for each party and over the life of the swap. Statement 5 is can be best characterized as: A. 53. FS(0. Statement 4 can be best characterized as: A. it does not increase throughout the life of the swap. .0385(180/360) ] = 0. 9787 ($105.n.000 * 0.3.764.000 ( ) = 1 / ( 1 + 0.9901 ( ) = 1 / ( 1 + 0.n. FS(0. B.9787) = $206.m) – x] * j (hj) Using the information in Exhibit 1 and Howell’s sixth statement: [4. $206.54. Based on Statement 6 and Exhibit 1.9901) + ($105. pp. Volume 6. 260-262 Study Session 17-63-h Calculate and interpret the value of an interest rate swaption on the expiration day The payoff of a payer swap in which the exercise price is x and the market rate on the underlying swap is FS(0. $207.0435*180/360) = 0. Chance 2009 Modular Level II.90%) * (90/360)]= $105. Answer: A “Swap Markets and Contracts”.725 .32% .000 * 0. Don M.m) is: Max[0.961. C.725. the market value of the swaption at expiration would be closest to: A.0400*90/360) = 0. $208. such as the CDX. The best way to do this is to buy CDX investment grade expiring in 5 years and sell CDX high yield expiring .000. The swap calls for quarterly payments.95 360 3. Vinay Jani and Zhong Geng.000. say 4 to 5 years. and Merinar asks Jani to determine its cash settlement using the term structure presented below in Exhibit 2.250. the S&P/ASX 300 index was 3. to review the performance of investments made by RRCA and to evaluate potential new investments.000. The value of the S&P/ASX 300 index today is 3. RRCA entered into a one-year equity swap 30 days ago. Under the terms of the swap. 30 days ago.42 150 1. Merinar wishes to determine the market value of the equity swap today using the current term structure of interest rates presented in Exhibit 1.84 240 2. as well as two potential new investments. to take advantage of this. Virginia.Tyra Merinar Case Scenario Tyra Merinar is a portfolio manager at Ridge Row Capital Advisors (RRCA). the fund would receive the return on the S&P/ASX 300 Metals & Mining Index and pay a fixed annual interest rate of 4.738. Onex should generate enough cash flow to improve credit quality to pre-acquisition levels. longer term. RRCA purchased a European receiver swaption that is exercisable into a two- year swap with semiannual payments. However. We could use forward contracts on a credit default swap (CDS) index. At this meeting they will discuss two recent investments. which are currently rated BBB. The swaption has just expired.000. At the time the swap was initiated. Merinar is meeting with two assistant portfolio managers.75% and a notional principal of $25.68 540 4. Exhibit 2 Term Structure of Interest Rates (%) Days LIBOR 180 1. Onex has just announced an acquisition that we believe will likely weaken its credit metrics over the next two years. an equity swap and a swaption.42 Three months ago. a hedge fund based in Charlottesville.65 strategy that invo have been evaluating bonds of Onex Corporation. Exhibit 1 Term Structure of Interest Rates (%) Days LIBOR 60 1. The swaption has a semiannual exercise rate of 2.12 330 3.11 720 4.8% on notional principal of $75. The annual risk-free rate is 3. she asks him to evaluate a futures contract on the S&P 400 Mid Cap stock index expiring in 145 days. Assuming a 365-day year. No. most likely appropriate? A.Merinar asks Jani to assess potential mispricing in equity futures markets with a view to implementing an investment strategy to take advantage of any mispricing. 44.71. .5%. 854. No.500. and the index is at 840 today. the appropriate strategy would be to buy 2-year CDS and sell 5-year CDS for Onex Corporation. $7.000.717. $9.500. the market value of the equity swap is closest to: A. the market value of the receiver swaption is closest to: A. the appropriate strategy would be to sell 2-year CDS and buy 5-year CDS for Onex Corporation.665.250. $7. 45. 848. B.500. C.997. the appropriate Merinar closes the meeting by asking if Geng and Jani can explain the relation between futures s prices are an accurate estimate of Expected spot prices are e 43. Using the information provided in Exhibit 1. C. B.15 per contract. $106. $495. Yes. C. C.85. Merinar explains the investment strategy to be implemented if the stock index futures contract e calculation. B. The accumulated value of dividends reinvested over the life of the futures contract is expected to be $3. Specifically. Using the information in Exhibit 2.11. $687. 46. the S&P 400 Mid Cap stock index futures price is closest to: A.508. 836. B. Jani B. the correct strategy would be to purchase the stock index and sell stock index futures. B. Geng C. Merinar . No.47. C. Yes. most likely correct? A. No. 48. Who correctly states the relationship between futures prices and expected spot prices? A. the correct strategy would be to only purchase stock index futures. to review the performance of investments made by RRCA and to evaluate potential new investments. to take advantage of this.000. a hedge fund based in Charlottesville. an equity swap and a swaption. The swap calls for quarterly payments.738. The best way to do this is to buy CDX investment grade expiring in 5 years and sell CDX high yield expiring . However. Merinar is meeting with two assistant portfolio managers.42 150 1. longer term.Tyra Merinar Case Scenario Tyra Merinar is a portfolio manager at Ridge Row Capital Advisors (RRCA).000. which are currently rated BBB.68 540 4. The swaption has just expired.65 strategy that involve have been evaluating bonds of Onex Corporation. and Merinar asks Jani to determine its cash settlement using the term structure presented below in Exhibit 2. We could use forward contracts on a credit default swap (CDS) index.75% and a notional principal of $25. The swaption has a semiannual exercise rate of 2. RRCA purchased a European receiver swaption that is exercisable into a two- year swap with semiannual payments. Under the terms of the swap. At this meeting they will discuss two recent investments. Merinar wishes to determine the market value of the equity swap today using the current term structure of interest rates presented in Exhibit 1.84 240 2.95 360 3. Exhibit 2 Term Structure of Interest Rates (%) Days LIBOR 180 1. The value of the S&P/ASX 300 index today is 3. Exhibit 1 Term Structure of Interest Rates (%) Days LIBOR 60 1. Vinay Jani and Zhong Geng.11 720 4.250. say 4 to 5 years. such as the CDX. Onex has just announced an acquisition that we believe will likely weaken its credit metrics over the next two years.8% on notional principal of $75. RRCA entered into a one-year equity swap 30 days ago.000. as well as two potential new investments. Onex should generate enough cash flow to improve credit quality to pre-acquisition levels. the S&P/ASX 300 index was 3.12 330 3.000. 30 days ago.42 Three months ago. Virginia. At the time the swap was initiated. the fund would receive the return on the S&P/ASX 300 Metals & Mining Index and pay a fixed annual interest rate of 4. if applicable.000.Merinar asks Jani to assess potential mispricing in equity futures markets with a view to implementing an investment strategy to take advantage of any mispricing.9696 For example. and the index is at 840 today.500. Merinar explains the investment strategy to be implemented if the stock index futures contract alculation. on an equity swap and the market values of the different types of equity swaps during their lives. $9. she asks him to evaluate a futures contract on the S&P 400 Mid Cap stock index expiring in 145 days. The annual risk-free rate is 3.5%. $7. Vol.997.15 per contract.9976 B30(180) 0.665.9861 B30(360) 0. C is correct. Answer = C 2012 Modular Level II. the appropriate Merinar closes the meeting by asking if Geng and Jani can explain the relation between futures rices are an accurate estimate of Expected spot prices are equa 43.000 = $9. 275 280 Study Session 17-57-e Calculate and interpret the fixed rate. the market value of the equity swap is closest to: A.717.500.500 The appropriate present value factors are provided below: B30(90) 0.000. The accumulated value of dividends reinvested over the life of the futures contract is expected to be $3. B. $7. the market value of the equity swap is calculated as follows: The market value of the swap = 0.9924 B30(270) 0. C. pp. Using the information provided in Exhibit 1.997. Specifically. Per $1 of notional principal. 6.1333 × $75. B30(90) is calculated as: . 44. B0(180) is calculated as: Other present value factors are calculated in a similar manner.9645 Bo(540) 0. (0. The fixed rate is calculated as follows: The annualized rate = 0.9419 + 0.508.0223 × 2 = 0. Answer = B Don M. 286 287 Study Session 17-57-h Calculate and interpret the value of an interest rate swaption at expiration. Chance 2012 Modular Level II. The market value of the receiver swaption is calculated as: Max [0.500. $106. Using the information in Exhibit 2.0149) × $25. B is correct. The appropriate present value factors are provided below: Bo(180) 0. $687. 268 269.9419 Bo(720) 0.9903 + 0.250. pp.0275 0. Vol.000.508.0223)] × (0. 6.0446 .000 = $495.9903 Bo(360) 0. C. the market value of the receiver swaption is closest to: A.9149 For example. B.9645 + 0. $495. 848. Vol. pp.45. and currency futures. stock index futures.11. and then strengthen over the longer term (five years).85. and explain how they are used by hedge funds and other managers. Answer = C rge Spentzos 2012 Modular Level II. the appropriate strategy would be to sell 2-year CDS and buy 5-year CDS for Onex Corporation. B is correct. No. Assuming a 365-day year. 836. Answer = B 2012 Modular Level II. the appropriate strategy would be to buy 2-year CDS and sell 5-year CDS for Onex Corporation.035)(145/365) 3. B. No. 46. Yes. The 2-year CDS would provide a hedge against short-term volatility. The S&P 400 Mid Cap futures price is: 840 × (1. C is correct.41 . 854. the appropriate strategy is to buy 2-year CDS and sell 5-year CDS. most likely appropriate? A.15 = 848. B. C. 6. pp. Vol. C. 6. and the sale of the 5-year CDS would partially fund the purchase of 2-year CDS. 114 120 Study Session 16-55-h Calculate and interpret the prices of Treasury bond futures.71. Since Geng expects credit ratings for Onex Corporation bonds to weaken over the near term up to two years. This is a flattener curve trade. 361 362 Study Session 17-59-d Describe credit derivatives trading strategies. the S&P 400 Mid Cap stock index futures price is closest to: A. Geng C. the correct strategy would be to only purchase stock index futures. Jani is correct. the expected spot price equals the futures price plus a risk premium. Answer = A 2012 Modular Level II. Merinar is correct. and currency futures. stock index futures. This strategy will effectively ensure that Merinar has borrowed money at the risk-free rate and repaid at a rate less than the risk-free rate. Jani B. Vol. Merinar Answer = A ts 2012 Modular Level II. 48. The futures price is equal to the expected spot price minus a risk premium. B. 6. 6. 99 100 Study Session 16-55-f Explain the relation between futures prices and expected spot prices. the correct arbitrage strategy would be to short the stock index and purchase stock index futures. Alternatively. C. the correct strategy would be to purchase the stock index and sell stock index futures. p. pp. If stock index futures are underpriced. No. Who correctly states the relationship between futures prices and expected spot prices? A. A is correct. No. Vol. A is correct. most likely correct? A. Yes. 116 Study Session 16-55-h Calculate and interpret the prices of Treasury bond futures.47. .