CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.3
Derivatives Valuation Analysis
Portfolio Management
Commodity Trading and Futures
Professional Examination
March 2011
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
C
B
D
B
D
B
D
C
D
A
D
D
D
B
D
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
D
C
B
A
B
B
D
B
B
B
D
C
D
A
C
31
32
33
34
35
36
37
38
39
40
B
B
A
B
B
B
C
D
D
C
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Derivative Valuation and Analysis
Derivative contracts allow a trader to control a relatively large amount of underlying
assets relative to the investment made. This quality could help magnify significantly the
return of the investor or erode his investment depending on market situations.
A trader who buys call options on a stock would generate higher return on investment
than another trader who buys the stock directly, if the price of the stock moves up after
the transaction. This is because with the same amount of investment, he enjoys the
returns on a larger number of shares.
Available funds = N5,000
ABC Share
= N20/share
Call option on one ABC shares = N4
Buying shares directly = N5,000/N20 = 250 shares
Buying the call option = N5,000/N4
= 1,250 shares
Total =3 marks
2
Question 3 – Portfolio Management
3(a)
An alternative asset is an investment product other than the traditional investments of
stocks, bonds, cash, or property. The term is a relatively loose one and includes tangible
assets such as art, wine, antiques, coins, or stamps and some financial assets.
Examples:
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
venture capital
private equity
real estate
commodities
art and antiques
precious metals
fine wines
rare stamps and coins,
sports cards and other collectibles
(2 marks)
3(b)
i. Diversification benefits - alternative assets generally exhibit low correlation
coefficients with both equities and fixed income. Therefore are great options for
diversification.
ii. Generally generate higher rate of return than bonds.
iii. They are generally not susceptible to market trends because of relatively low market
risk
(Any two points = 2 marks)
Total = 4 marks
Question 4 – Commodity Trading and Futures
i.
ii.
iii.
iv.
v.
vi.
Standardized contracts guarantee the quality and quantity of underlying product.
Reasonable market liquidity available for all major futures types.
Futures trading usually include simple and reasonably low commission fees and
plans.
By using futures contracts, traders can maximize profit or limit risk on trading
other funds, equities or commodities.
Availability of both standard and mini contracts helps traders to choose;
especially with modest accounts.
Increase in trading volumes thereby increasing National Income.
(1 mark each for any 3 points= 3 marks)
Total = 3 marks
3
SECTION C: COMPLUSORY QUESTIONS
Question 5 – Derivative Valuation and Analysis
5(a)
SO + P = C + Ke -rt
3712.61 + 214.60 = 296.60 + 3700. e –0.0325
3712.61 + 214.60 = 296.60 + 3631.12
3927.21 = 3927.77
x 208/360
(2 marks)
We can therefore conclude that put-call parity holds (rounding error of 0.56 is
insignificant).
5(b)
5(b1)
= 1.2 x N10,000,000 / (3712.61 X 1)
= 3232 put options
(3 marks)
5(b2)
This is simply the cost of the put options.
= 3232 put options x N214.60
= N693, 587
(2 marks)
5(c)
5(c1)
When a trader projects high levels of volatility in the market which could be in either
direction, then the most appropriate option strategies are:
i.
ii.
long straddle, or
long strangle
4
(2 marks)
5(c2)
Long straddle
A long straddle involves going long, i.e., purchasing, both a call option and a put option
on the index. The two options are bought at the same strike price and expire at the
same time. The owner of a long straddle makes a profit if the underlying price moves a
long way from the strike price, either above or below. This position is a limited risk, since
the most a purchaser may lose is the cost of both options. At the same time, there is
unlimited profit potential.
Long strangle
The long strangle involves going long (buying) both a call option and a put option of the
same underlying security. Like a long straddle, the options expire at the same time, but
unlike a straddle, the options have different strike prices. The owner of a long strangle
makes a profit if the underlying price moves far enough away from the current price,
either above or below. The risk here is also limited, since the most a purchaser may lose
is the cost of both options. At the same time, there is unlimited profit potential.
(Either of the above = 3 marks)
5(d)
•
The option is a put option as its delta is negative. The delta of a put option is
always negative.
•
The figure 0.357 means that for every N1 increase in the price of the underlying
asset, the value of the put option drops by N0.357
(3 marks)
Total = 15 marks
Question 6 – Portfolio Management
6(a)
Benefits of Investing in emerging markets
• Diversification benefits - by diversifying across nations whose economic cycles are
not perfectly in phase-investors in different parts of the world should be able to
reduce still further the variability of their returns.
• Attractive Investment opportunities – Emerging markets provide attractive
investment opportunities. Thus, investing in emerging markets might give foreign
investors better return compared to the investing only in their domestic markets.
5
Risks of Investing in emerging markets
•
•
•
•
•
Firstly, investing in emerging markets can be more expensive than investing in other
developed markets. In smaller markets, you may have to pay a premium to purchase
shares of popular companies.
In some emerging markets there are unexpected taxes and levies such as
withholding taxes on dividends. Moreover, transaction costs such as fees, broker’s
commissions, and taxes often are higher than in developed.
There are some legal and political barriers in emerging markets which could put
investment to risk.
Inadequate information flow – this may make it more difficult to take investment
decisions and monitor.
Weaker Regulation – Most emerging markets are relatively weakly regulated thereby
exposing investors to greater risks.
(1 mark each for any 6 points)
= 6 marks
6(b)
6(b1)
Current projected return = 10%
Desired return =10.5 +1.5 = 11.5%
Let W be the weight of European stock in the portfolio.
Therefore, 1- W = weight of Nigerian stocks in the portfolio.
10%.W + 15%. (1- W) = 11.5%
Solving for W, we have:
Proportion of European stocks = W = 0.7 = 70%
Proportion of Nigerian stocks = 1 - W = 30%
(2 marks)
6(b2) Assuming that Nigerian stocks are included in the portfolio as calculated in
6(b1) above, what will the standard deviation of your portfolio be?
{ w12
1
2
+ (w2 2
w1
w2
= 70%
= 30%
1
= 16%
2
= 30%
2
2
+ 2. w1 w2 1
2
ρ1,2 }
ρ1,2 = 0.3
6
=
{(0.7)2(0.16)2 + (0.3)2(0.3)2 + 2(0.7)(0.3)(0.16)(0.3)(0.3)}
= 0.1181 = 11.81%
(3 marks)
6(b3) How does the Sharpe ratio of the portfolio calculated in 6(b1) above
change compared to the case of investing only in developed countries?
Investing only in European Stocks
= 10 -3 /16
= 0.4375
Inclusion of Nigerian stocks
= 11.5-3/11.81
= 0.7197
The Sharpe ratio would improve by 0.7197- 0.4375 = 0.2822
(4 marks)
6(c)
6(c1)
•
•
•
•
•
Active management is more flexible in terms of choice of investment and
management strategies.
Active management is a vital ingredient for the efficiency of the market.
There is empirical evidence that some active managers have consistently overperformed the market over a long period.
There are market ‘anomalies’ which active managers could exploit in the market.
It is possible to obtain a higher Sharpe ratio using active management rather than
passive management.
(1 mark each for any three points = 3 marks)
6(c2)
Tracking error, also referred to as active risk, is a measure of how closely a portfolio
follows the index to which it is benchmarked. It is a measure of the deviation of the
returns of a portfolio from the benchmark.
(2 marks)
Total = 20 marks
7
Question 7 – Commodity Trading and Futures
7(a)
7(a1) Exchange traded vs OTC-traded products.
Exchange-traded products are instruments that are traded via specialized derivatives
exchanges or other exchanges, while Over the counter (OTC) products are products that
are traded (and privately negotiated) directly between two parties, without going
through an exchange or other intermediary.
(2 marks)
7(a2) Cost of carry vs Fair value of futures
The cost of carry is the cost of "carrying" or holding a position. The cost of carry model
expresses the futures price as a function of the spot price and the cost of carry.
Fair value on the other hand is the equilibrium price for a futures contract. This is equal
to the spot price after taking into account compounded interest (and dividends lost
because the investor owns the futures contract rather than the physical stocks) over a
certain period of time.
7(a3)
Basis vs Convergence.
(2 marks)
In the context of futures, basis can be defined as the difference between the spot price
and the futures price.
Convergence simply means a movement in the price of a futures contract toward the
price of the underlying cash commodity. As a futures contract nears expiration, the
futures price and the cash price converge to eventually become the same price.
(2 marks)
7(a4) Initial margin vs Maintenance margin
When you open a futures contract, the futures exchange will state a minimum amount of
money that you must deposit into your account. This original deposit of money is called
the initial margin.
Maintenance margin is the lowest amount an account can reach before needing to be
replenished. For example, if your margin account drops to a certain level because of a
series of daily losses, brokers are required to make a margin call and request that you
make an additional deposit into your account to bring the margin back up to the initial
amount.
(2 marks)
8
7(a5)
Reputational risk vs Default risk
Reputational risk is a type of risk related to the trustworthiness of business. Damage to a
firm's reputation can result in lost revenue or destruction of shareholder value, even if
the company is not found guilty of a crime.
Default risk on the other hand is the risk that companies or individuals will be unable to
make the required payments on their debt obligations. Lenders and investors are
exposed to default risk in virtually all forms of credit extensions.
(2 marks)
7(b)
7(b1)
This strategy is referred to as bull put spread. It involves the simultaneous purchase of
put with a lower exercise price and the sale of a put with a higher exercise price.
It is used when the investor expects moderate rise in the underlying commodity, but is
not overly sure.
(2 marks)
7(b2)
Profit
K1 = 11500
K2 =11,550
ST
(3 marks)
Total = 15 marks
9