CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.3
Derivatives Valuation Analysis
Portfolio Management
Commodity Trading and Futures
Professional Examination
March 2012
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
C
C
A
B
A
C
C
D
B
A
D
B
D
A
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
C
B
B
A
A
A
B
C
C
C
B
B
D
D
B
31
32
33
34
35
36
37
38
39
40
C
A
C
B
C
B
D
B
C
C
(40 marks)
x
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Derivative Valuation and Analysis
Hedge ratio is a ratio comparing the value of a position protected via a hedge with the
size of the entire position itself. For example, a ratio comparing the value of futures
contracts purchased or sold to the value of the cash commodity being hedged.
The hedge ratio is important for investors in futures contracts, as it will help to identify
and minimize basis risk.
Hedge ratios are calculated for options using the option’s delta (rate of change between
the option price and the underlying price of the stock or futures contract). For example,
a hedge ratio of 4 (4 options for each futures contract) would be needed if a N1/barrel
change in the underlying futures price led to a 25 cent per barrel change in the options
premium.
(3 marks)
2
Question 3 – Portfolio Management
The following are the objectives of portfolio performance evaluation:
i.
To measure portfolio returns by the calculation of rates of return for the portfolio.
ii.
To conduct performance attribution analysis of the rates of return to determine
the factors explaining how the return was achieved.
iii.
To appraise portfolio performance in terms of how good the performance was.
iv.
Overall to assess progress toward achievement of investment objectives, and to
assess portfolio management skill.
(4 marks)
Question 4 – Commodity Trading and Futures
The ISDA master agreement is a document agreed between two parties that sets out
standard terms that apply to all the transactions entered into between those parties.
Each time that a transaction is entered into, the terms of the master agreement do not
need to be re-negotiated and apply automatically. The Master Agreement is widely used
by a wide variety of counterparties.
(1 mark)
i.
Once a master agreement is signed, the documentation of future transactions
between parties is reduced to a brief confirmation of the material terms of the
transaction.
ii.
The master agreement aids in reducing disputes by providing extensive resources
defining its terms and explaining the intent of the contract, thereby
preventing disputes from beginning as well as providing a neutral resource to
interpret standard contractual terms.
iii.
The master agreement greatly aids in risk and credit management for the parties.
(1 mark each for any2 points)
(3 marks)
3
SECTION C: COMPLUSORY QUESTIONS
Question 5 – Derivative Valuation and Analysis
5(a)
F0 = S0 (1 + R) T
= 10,000 (1 + 0.04)3/12
= 10,098.53
Or, in the alternative (assuming continuous compounding)
F0 = S0er. T
F0 = 10,000. e0.04 (3/12)
= 10,100.50
(3 marks)
5(b)
SO + P = C + Ke -rt
10,000 + 545 = 665 + 10,000. e –0.04 x 3/12
10,000 + 545 = 665 + 9,900.50
10,545 is not equal to 10,565.50
Therefore, there is an arbitrage opportunity.
(3 marks)
To exploit the arbitrage opportunity, buy the relatively underpriced asset (the left
side of the equation) and sell the relatively overpriced asset ( the right side of the
equation) as demonstrated below:
(1 marks)
Now
Borrow the PV of the exercise price at the risk-free rate
(9,900.5 X 1,000)
Sell one unit of the call option (N665 X 1,000)
Cash flow generated
Buy 1 unit of the NSE 30 index (10,000 x 1000)
Buy 1 unit of the put (N545 X 1,000)
= N9,900,500
= N665,000
N10,565,500
=(N10,000,000)
=(N 545, 000)
N20,500
At maturity, the payoffs will offset each other to zero , and currently, an arbitrage
profit of N20,500 will be earned.
4
In 3 months
St < 10,000
St>10,000
Call option
0
(St-10,000)
Put option
10,000 - St
0
St
St
-10,000
-10,000
0
0
NSE 30 option
Loan repayment
Total
(3 marks)
7 marks
5(c)
Since you are bullish about the market, an appropriate option strategy that would
maximize payoff while minimising downside risk is the long call strategy.
Specifically, you could buy 1 unit of call option with 10,000 exercise price. The cost of
buying the call option to create the position is be (1000 x Ck).
There will be a loss if
the NSE 30 index drops below the current price, but a large rise will cause the price of
the in-the-money call option to rise, earning you a profit.
The diagram below illustrates the payoff at maturity. This position will be profitable if the
price of the underlying asset experiences a large move upwards, while the maximum
loss possible is limited to the cost of the call option,
(1000 x Ck), if the price of the
index drops below 10,000.
(5 marks)
Total = 16 marks
5
Question 6 – Portfolio Management
6(a1)
Total return = 70% (6.5%) + 30% (8.2%) = 4.55% + 2.46% = 7.01%
(4 marks)
6(a2)
If the portfolio was equally weighted in growth and value stocks, it means the proportion
of investment would be 50% each.
Total return would be: 50% (6.5%) + 50 %( 8.2%) = 3.25% + 4.1% = 7.35%
It would have been better to have value stocks and growth stocks in equal proportion as
the return of the fund would have been slightly higher by 0.34%.
(3 marks)
6(b1)
= - N100 million x 4
122 % x 100000 x 9
=
364
(4 marks)
6(b2)
The portfolio manager has effectively made the duration of the entire position zero. As a
result, the hedge eliminates portfolio sensitivity to any small parallel shift in the yield
curve.
(3 marks)
6(b3)
This increases the number of contract that should be shorted to 468.
= - N100 million x 4
122 % x 100000 x 7
=
468
(4 marks)
6(b4)
In this case the gain on the short futures position is likely to be less than the loss on the
bond portfolio. This is because the gain on the short futures position depends on longterm rates variations while the loss on the bond portfolio depends on medium-term rates
variations. Duration-based hedging implicitly assumes that the movements in the two
rates are the same.
(4 marks)
Total = 20 marks
6
Question 7 – Commodity Trading and Futures
7(a)
¾
To enhance market efficiency.
¾
To ensure transparency.
¾
To ensure professional conduct and behaviour by market participants.
¾
To prevent market failures.
(2 marks for each well-developed point)
(Maximum 6 marks)
7(b1)
Short call is an option strategy in which an investor sells a call on shares that are either
currently owned (covered call) or not yet owned (naked call). The two types of short
calls carry different risks.
A naked call strategy is inherently risky, as there is limited upside potential and
(theoretically) unlimited downside potential should the stock rise above the exercise
price of the options that have been sold.
As a result of the risk involved, only experienced investors who strongly believe that the
price of the underlying stock will fall or remain flat should undertake this advanced
strategy. The upside to the strategy is that the investor could receive income in the
form of premiums without putting up a lot of initial capital.
(3 marks)
7(b2)
The long futures position is an unlimited profit, unlimited risk position that can be
entered by the futures speculator to profit from a rise in the price of the underlying.
The long futures position is also used when a manufacturer wishes to lock in the price of
a raw material that he will require sometime in the future.
7
(3 marks)
7(b3)
Long put is an options strategy in which a put option is purchased as a speculative play
on a downturn in the price of the underlying equity or index. In a long put trade, a put
option is purchased on the open exchange with the hope that the underling stock falls in
price, thereby increasing the value of the options, which are "held long" in the portfolio.
The options can either be sold prior to expiration (for a profit or loss) or held to
expiration, at which time the investor must purchase the stock at market prices, then
sell the stock at the stated exercise price.
As illustrated below, the downside of the strategy is limited to the option premium paid
for the put, while the upside potential is maximized if the price of the underlying drops
to zero.
(3 marks)
Total = 14 marks
8