CIS March 2012 Diet
Examination Paper 2.3:
Derivatives Valuation Analysis
Portfolio Management
Commodity Trading and Futures
Level 2
Derivative Valuation and Analysis (1 – 12)
1.
A CIS student was making a presentation on futures, and makes the following
statements:
Statement 1:
Statement 2:
Futures are traded using standardized contracts. They require margin
and incur interest charges on the margin loan.
If the margin balance falls below the maintenance margin amount
due to a change in the contract price for the underlying assets, the
investor must add funds to bring the margin back up to the initial
margin requirement.
Given the above information, are the student’s statements correct or incorrect?
A. Both statements are correct.
B. Neither statement is correct.
C. Only statement 1 is correct.
D. Only statement 2 is correct.
2.
A stock is selling at N40, a 3-month put at N50 is selling for N11, a 3-month call at
N50 is selling for N1, and the risk-free rate is 6%. How much, if anything, can be
made on an arbitrage?
A. N0
B. N0.28
C. N0.78
D. N0.82
3.
What kind of swap should a financial institution enter into if it will be adversely
affected by increasing interest rates over the next 2 years? The bank should:
A. Pay floating and receive fixed interest rate swap.
B. Enter into a currency swap.
C. Pay fixed and receive floating interest rate swap.
D. None of the above.
4.
$Profit
Profit or or
loss Loss
1,000
Stock
price atat expiration
Stock
price
expiration
The above diagram illustrates the payoff of which of the following strategies?
A. Short straddle.
B. Short strangle.
C. Writing of a call option.
D. Buying a put option.
5.
Consider a non-dividend paying stock with a spot price of N50. A 6-month European
call with a strike price of N50 costs N4. A European put with the same expiration
date and strike price costs N3.50. The continuously compounded risk-free rate is 4%
per annum. The volatility of the stock is 25% per year. What can you conclude?
A. Nothing can be determined from this information.
B. There is an arbitrage opportunity because the put is overpriced.
C. There is an arbitrage opportunity because the put is underpriced.
D. There is no arbitrage opportunity.
6.
On the 1st of May, an investor takes a short position in 10 December gold futures
contracts . The current futures price is N500, the contract size is 100 ounces, the
initial margin is N2,000 per contract, and the maintenance margin is N1,500. At the
end of May, the futures price has dropped to N498: This means that:
A. The investor’s margin balance increases by N2,000.
B. The investor’s margin balance decreases by N2,000.
C. The investor receives a margin call.
D. The broker automatically closes out the position.
7.
You own one stock in your portfolio. Which strategy do you have to follow, in order
to protect your stock on the downside, while still leaving upside potential?
A. Buy an "at the money" call.
B. Sell a straddle (sell a call and sell a put, both "at the money").
C. Buy an "at the money" put.
D. Buy an "out of the money" call, and sell an "in the money" put.
8.
An investor buys shares of XYZ Limited at N30 and immediately writes a call on
them. If the call carries a premium of N2.50 and its exercise price is N30, at what
price of XYZ shares will this investor break-even?
A. N32.50
B. N30.00
C. N27.50
D. None of the above.
9.
ABC Limited issues N100,000,000 par value, floating rate notes paying LIBOR plus
200 basis points every year. The term is 3 years and the underwriting fees
amounted to N4,500,000. Simultaneously, ABC enters into an interest rate swap
agreement with the following terms:
Notional Principal:
Receive Float:
Pay Fixed:
Term:
Payment Frequency:
N100,000,000
LIBOR
6.2%
3 years
Annual
In effect, what will be ABC's net interest payment at the end of the year, if LIBOR is
10%?
A. 5.8%
B. 4.2%
C. 3.8%
D. 8.2%
10. Which of the following statements is (are) true with respect to the market for forward
contracts?
I.
While it does not cost anything to enter into a forward contract, a margin must
be posted at its initiation.
II. Most financial forward contracts are settled by physical delivery.
III. In order to minimize the exposure faced with a forward contract, an investor
may make offsetting trades in the futures markets.
IV. A dealer is the end user of most forward contracts.
A.
B.
C.
D.
I and II only.
III only.
I, III and IV only.
II, III and IV only.
11. What does the Vega of a portfolio of derivatives measure?
A. The rate of change of the value of the portfolio to the volatility of the underlying
asset.
B. The rate of change of the value of the portfolio with respect to the passage of
time, all else remaining the same.
C. The rate of change of the portfolio’s delta with respect to the price of the
underlying asset.
D. The rate of change of the value of the portfolio to the price of the underlying
asset.
12. What is the Delta of an European equity call with the following parameter?
Strike: N52
Underlying spot price: N52
Volatility: 17%
Risk free rate (continuously compounded): 2%
Maturity: 182 days (no dividends paid).
A.
B.
C.
D.
-0.5447
0.4736
0.5000
0.5569
Portfolio Management (13 – 28)
13. The risk and return spectrum for
following statements?
A. Leveraged buyouts are most
B. Venture capital is most risky
C. Leveraged buyouts are most
D. Venture capital is most risky
private equity can best be described by which of the
risky and distressed debt is least risky.
and mezzanine debt is least risky.
risky and mezzanine debt is least risky.
and distressed debt is least risky.
14. You wish to evaluate a particular portfolio manager. You note that she earned 11%
at a time when the market yielded 10% and Treasury bills yielded 5%. If the
portfolio has a standard deviation of 22% and a beta of 1.2, where would it lie in
relation to the SML?
A. Above the SML.
B. Below the SML.
C. Inconclusive with the data given.
D. On the SML.
15. You are the owner of a N4 million portfolio with a beta of 1.0. You would like to
insure your portfolio against a fall in the index of magnitude higher than 12%. The
index currently stands at 4200. Put options on the index are available at three strike
prices. Which strike will give you the insurance you want?
A. 3,696
B. 3,840
C. 3,870
D. 3,950
16. A 3-month call option on a single stock has an exercise price of N35 and a quoted
price of N2.45. Suppose that you sell this call option and buy the underlying stock at
a price X. At expiration, if the price of the underlying stock is N31.10 and your loss is
N2.45, what is X? (Assume that the contract size is one and ignore the effect of
interest rates in your calculation).
A. N31.10
B. N32.55
C. N36.00
D. N37.45
17. Following the constant mix strategy:
A. You buy high and sell low.
B. You buy low and sell high.
C. You don’t enter any transactions.
D. None of the above answers is correct.
18. Compared to investors with long investment time horizons, investors with short
investment time horizon most likely require:
A. Less liquidity and less emphasis on capital appreciation.
B. More liquidity and less emphasis on capital appreciation.
C. Less liquidity and greater emphasis on capital appreciation.
D. None of the above.
19. A primary motivation for investment in commodities is most likely the:
A. Positive correlation of commodities with unexpected inflation.
B. Positive correlation of commodities with stock and bond investments.
C. Positive volatility of commodities relative to stock and bond investments.
D. All of the above.
20. Given the following correlation matrix, a risk-averse investor would least prefer
which of the following two-stock portfolios (all else the same)?
Stock
W
X
Y
Z
A.
B.
C.
D.
W
+1
-0.2
+0.6
+0.8
X
Y
Z
+1
-0.1
-0.3
+1
+0.5
+1
W and Y.
X and Y.
X and Z.
Y and Z.
Use the following data to answer questions 21 to 22.
The following table summarizes the performances of the ‘Y’ Fund, the ‘B’ Fund, and
the ‘R’ Fund over the past 5 years. The average risk-free return was 4%:
‘Y’ Fund
‘B’ Fund
‘R’ Fund
Average return
0.12
0.14
0.16
Standard deviation
0.22
0.24
0.3
0.6
1.1
0.8
Beta
21. Rank the performances of the three funds using Sharpe’s index from the best to the
worst.
I. ‘Y’ Fund.
II. ‘B’ Fund.
III. ‘R’ Fund.
A.
B.
C.
D.
II, III and I
I, II and III
I, III and II
II, I and III
22. Rank the performances of the three funds using and Treynor’s index from the best to
the worst.
I. ‘Y’ Fund.
II. ‘B’ Fund.
III. ‘R’ Fund.
A.
B.
C.
D.
II, III and I
III, I and II
I, III and II
II, II and I
23. Assume the following data:
Beginning
Price
Ending
Price
Analyst's portfolio
N40
N41
Risk-matched market
portfolio
N10
N11
Cash Flow
During the Year
N6.00
N0.25
How does the analyst's portfolio performance compare to the risk-matched
portfolio performance?
A. Equal.
B. Inferior.
C. Superior.
D. Slightly worse.
24. The January anomaly, the neglected firm effect, and the book value/market value
ratio are studies examining which form of the efficient market hypothesis?
A. Weak form of the EMH.
B. Strong form of the EMH.
C. Semistrong form of the EMH.
D. Both the weak and semistrong forms of the EMH.
25. A portfolio manager is evaluating investments in mortgage securities as part of a
portfolio to fund long term liabilities. If she wants to minimize prepayment risk in her
portfolio she is most likely to invest in:
A. Mortgage loans.
B. Mortgage passthrough securities.
C. Collateralized mortgage obligations.
D. None of the above.
26. The one characteristic that hedge funds as an asset class have in common is that
they typically:
A. Are highly leveraged.
B. Seek absolute returns.
C. Utilize some type of hedging strategy.
D. None of the above.
27. Compared to investors with long investment time horizons, investors with short
investment time horizons most likely require:
A. Less liquidity and less emphasis on capital appreciation.
B. More liquidity and less emphasis on capital appreciation.
C. Less liquidity and greater emphasis on capital.
appreciation.
D. None of the above.
28. Which of the following statements with respect to CAPM and APT is true?
A. The APT model can be thought of as a subset of the CAPM.
B. The APT model has far more restrictive assumptions than CAPM.
C. CAPM would have a greater predictive power in forecasting individual security
returns than would an APT model.
D. Both models state the market as a whole is a factor that will influence specific
security returns.
Commodity Trading and Futures (29 – 40)
29. Which of the following is an example of churning?
A. A futures broker assures his customer that selling gold futures short is a "sure
thing".
B. An oil company that is long crude oil repeatedly repurchases its futures
contracts.
C. An inverted market converts to a normal market and back again within six
months.
D. A registered representative encourages a customer to make many futures
transactions in order to increase commissions.
30. Which hedgers would most likely initiate a long hedge?
A. An oil company that is looking at locking in the price of oil.
B. A farmer that wants to sell his crop at the current asking price.
C. A copper pipe manufacturer that needs to lock in their costs.
D. A cattle rancher that wants to hedge his costs.
31. A silver miner decided to initiate a short hedge by shorting five (5) December Silver
futures contracts for N1.50. The current price of silver is trading at N2.20. Several
months later, he sells his silver for N1.30 and liquidates his futures contracts at
N0.90. What was the miner's net sale price per ounce?
A. N1.30
B. N1.50
C. N1.60
D. N2.20
32. The spread between the bid and the ask is typically higher when:
A. There are fewer market participants.
B. The market is extremely liquid.
C. The market is efficient.
D. It is easy for market participants to enter and exit.
33. Why do hedgers find futures contracts most useful?
A. They can beat speculators in reacting to important market news.
B. They can ensure that someone else pays for any losses they incur.
C. They can bring a degree of certainty to their future cash flows.
D. They can deal in and out quickly for profit at low dealing costs.
34. Which of the following would be the best description of a market that is in
backwardation?
A. The futures price is not trading at its fair value.
B. It is possible to agree to buy the asset for delivery at a future date at a lower
price than the asset is currently trading in the cash market.
C. The price of the synthetic position is trading above the underlying asset leading
to a risk-free profit opportunity through trading the reversal.
D. The futures price is trading above the cash price.
35. What most affects the price of crude oil?
A. The weather in the US.
B. A shortage of oil tankers.
C. Political factors.
D. The demand for petrol.
36. A risk-averse speculator anticipating a fall in milling wheat prices might:
A. Buy milling wheat future calls.
B. Buy milling wheat future puts.
C. Sell milling wheat future calls.
D. Sell milling wheat future puts.
37. If you were to buy a June 95.00 call at 2.25 and sell a June 96.00 call at 1.70, what
would be your maximum profit?
A. 2.25
B. 1.70
C. 0.55
D. 0.45
38. If metal prices fall below the cost of production what will be the likely impact on
supply of the metal?
A. Supply will rise as producers aim to compensate for the falling prices by selling
more product.
B. Supply will fall because the cost of production is now in excess of the price of the
metal and therefore mines will be shut down.
C. Supply will stay the same.
D. None of the above.
39. Which of the following describes the risk/reward profile of a short put?
A. Downside unlimited, upside limited to premium.
B. Downside limited to premium, upside unlimited.
C. Downside limited to strike minus premium, upside limited to premium.
D. Downside limited to premium, upside limited to strike minus premium.
40. All of the following could be considered to be significant influences on commodity
prices except?
A. Weather.
B. Quotas.
C. Interest rates.
D. Tariffs.
Total = 40 marks
Question 2 – Derivative Valuation and Analysis
What do you understand by ‘hedge ratio’? How does it help in portfolio risk management?
(3 marks)
Question 3 – Portfolio Management
Discuss the objectives of portfolio performance evaluation.
(4 marks)
Question 4 – Commodity Trading and Futures
One of the main International Swaps and Derivatives Association (ISDA) documents
supporting derivative activities in the commodities market is the Master Agreement.
What do you understand by ‘Master Agreement’? What are its advantages?
(3 marks)
Question 5 – Derivative Valuation and Analysis
The NSE 30 Index is currently at N10,000 and the risk-free rate is 4% (annualized).
Futures and options with the same underlying assets as the NSE 30 Index are traded. You
have been assigned to manage a (diversified) stock portfolio with the same composition as
the NSE 30 Index and a present value of N1 billion, and have been asked to add
derivatives trading to boost investment returns.
All futures and options mature 3 months from now and 1 trading unit is 1,000 times the
NSE 30 Index. (That is, the cost of purchasing 1 trading unit of options is 1,000 times the
option price). Options are European style. The strike prices of traded puts are N8,000;
N9,000 and N10,000; the strike prices of calls are N10,000, N11,000 and N12,000. For
the sake of simplicity, you may ignore dividends.
Required:
5(a)
Find the theoretical current futures price.
5(b)
The current price of a call option with a strike price of N10,000 is N665; a put
option with the same N10,000 strike price has a current price of N545. You have
found an arbitrage opportunity. Explain why this is an arbitrage opportunity,
provide an example of an arbitrage trade showing how many units of what asset
should be traded at the current point in time in order to profit from the arbitrage,
and find the profit to be gained from the trade.
(7 marks)
5(c)
The arbitrage opportunity described in 5(b) above quickly disappeared, but you are
very bullish about the market with the expectation that there will be a large rise in
the NSE 30 Index over the very near term. Provide a specific proposal for how
many units of what kinds of options to trade to create a position that will allow you
to profit maximally from these expectations, while minimizing the downside risk.
Draw a payoff diagram for the position at maturity and explain why you expect to
profit.
(5 marks)
Payoff
Value of the NSE 30 Index at maturity
(3 marks)
Question 6 – Portfolio Management
6(a) You are the fund manager of the TopEquities Mutual Fund. Recent uncertainties in
the financial markets have necessitated the need to protect your portfolios. Before
proceeding with the implementation of the portfolio insurance plan, you analyze the
performance of the Fund in the last 6 months. In particular, you focus on the stock
composition of the managed portfolio that is 70% in value stocks and the remaining
30% in growth stocks on the Nigerian Stock Exchange (NSE).
The total returns of the value stocks and the growth stocks over the period are
respectively 6.5% and 8.2%.
6(a1) Compute the total return of the TopEquities Mutual Fund for the last six
months.
(4 marks)
6(a2) Would it have been better in terms of return performance to have had the
portfolio wealth equally-weighted in the growth and value stocks? Justify
analytically.
(3 marks)
6(b)
You would also like to use Treasury bond futures to hedge a bond portfolio
over the next three months. The portfolio is worth N100 million and will have
a duration equal to 4 years in three months time. The futures price is 122 and
the futures contract size equals N100,000. The bond that is expected to be
cheapest to deliver will have duration of 9 years at the maturity of the futures
contract.
6(b1) What position in futures contract is required?
(4 marks)
6(b2) What did you accomplish with the hedge in part (a) in terms of duration?
What does it imply?
(3 marks)
6(b3) What adjustments to the hedge are necessary if after one month the bond
that is expected to be cheapest to deliver changes to one with a duration of
7 years?
(4 marks)
6(b4) Suppose that all interest rates increase over the three months, but long-term
rates increase less than short-term and medium-term rates. What is the effect
of this on the performance of the hedge?
(2 marks)
Question 7 – Commodity Trading and Futures
7(a)
7(b)
While each country has its own market regulator which sets out the rules for
operating commodities trading, the objectives of regulation are similar all over the
world.
Discuss the main purposes and aim of regulation in the commodities market.
(6 marks)
Two major benefits usually mentioned for the use of derivatives is income
enhancement and risk management.
Illustrate (using appropriate payoff diagrams) the benefits and risks of a trader who
is in each of the following 3 positions:
7(b1) Short call.
(3 marks)
7(b2) Long futures.
(3 marks)
7(b3) Long put.
(3marks)
FORMULAE
1)
Black and Scholes Options pricing model:
;
2)
2)
General cost of carry relationship:
3)
Continuous time cost of carry relationship:
4)
Determinants of Options Price:
5)
Correlation/Covariance:
6)
Static portfolio insurance using put option:
7)
Hedging with Stock Index Futures:
8)
Risk adjusted performance measures:
9)
10)
Binomial Option Valuation Model:
;