CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.3
Derivatives Valuation Analysis
Portfolio Management
Commodity Trading and Futures
Professional Examination
September 2010
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
C
D
B
A
B
A
C
A
A
A
B
C
A
C
D
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
D
D
D
C
A
D
B
D
D
A
B
C
D
C
C
31
32
33
34
35
36
37
38
39
40
C
B
A
B
D
A
B
C
A
D
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Derivatives Valuation and Analysis
(r-q)T
, profit can be made by
If futures price F0 is greater than the theoretical price, S0e
buying the stocks underlying the index at the spot price and shorting futures contract.
(r-q)T
, profits can be made by doing the reverse. That
Conversely, if F0 is less than S0e
is, shorting the stock underlying the index and taking a long position in futures
contracts.
(3 marks)
Question 3 – Portfolio Management
3(a) He could use the following techniques:
i. Full replication- where all the securities in an index are purchased in
proportion to their weight in the index.
ii. Sampling – Here the portfolio manager buys only a representative sample of
stocks that make up the index
iii. Programming – involves using historical information on price changes and
correlation between securities to determine the composition of a portfolio that
would minimize tracking error, through computer programming.
Any two, 1 mark each (Maximum 2 marks)
2
3(b)
i. Event study – this involves examining market reactions to and the excess
market returns around a specific information event like acquisition
announcement or stock split.
ii. Portfolio study – a portfolio of stocks having an observable characteristic is
created and tracked over time to see whether it earns superior risk-adjusted
returns.
(2 marks)
Question 4 – Commodity Trading and Futures
4(a) Storage cost increase the cost of carry, which increases the future price of
commodities that are subject to storage costs.
The following pricing relationship clearly reflects this impact:
Fo = {So + PV(u)} er.T
From the above formula, we have to add storage costs to the spot price. This
makes the futures price higher.
(2 marks)
4(b)
Buyer power is the ability of a buyer or buyer group to reduce price profitably
below a supplier's normal selling price, or more generally the ability to obtain
terms of supply more favorable than a supplier's normal terms. This applies
particularly with respect to bringing pressure to bear on prices from the
suppliers/producers of a product.
(1 mark)
SECTION C: COMPLUSORY QUESTIONS
Question 5 – Derivative Valuation and Analysis
5(a)
i.
Number of contracts to be bought:
Nf =
(1.2-0.95) x (175,000,000)
( 0.98)
= 421.99 = Approx 422
(N105,790)
(3 marks)
ii.
The value of the portfolio is N175,000,000 (1+ 0.051) = N 183,925,000
The profit on the long futures position is 422(N111,500 –N105,790) =
N2,409,620
The overall value of the position (stock plus long futures) is N183,925,000
+ N2,409,620 = N186,334,620
(N186, 334,620) - 1 = 0.0648
(N175, 000,000)
The effective beta is 0.0648/0.055 = 1.18, which is approx equal to the
target beta of 1.2
(3 marks)
The overall rate of return is
3
5(b)
i.
•
•
•
•
•
•
•
•
Uses of Swaps
Interest rate exposure management - interest rate swaps are used to
hedge against or speculate on changes in interest rates.
To take speculative positions in relation to future movements in interest
rates.
Swap can be used to transform a fixed rate liability into a floating rate
liability or vice-versa
Swap can be used to transform the nature of an asset that provides a
fixed rate income to one that provides a floating rate income
To obtain lower cost funding
To obtain higher yielding investment assets
To create types of investment asset not otherwise obtainable
To implement overall asset or liability management strategies
Any four points (2 marks)
ii.
Credit risk
A swap contact is a private arrangement between two companies. Therefore
it entails credit risk- the possibility that one of the parties would default.
Credit risk on the swap comes into play if the swap is in the money or not. If
one of the parties is in the money, then that party faces credit risk of
possible default by another party.
The financial institution that serves as an intermediary usually bears the
credit risk if one of the parties gets into financial difficulty and defaults. This
is because it still has to honour the contract it has with the other party.
(2 marks)
iii.
Termination of swaps
A swap can be terminated by using any of the following methods:
•
•
•
•
5(c)
By entering into a separate and offsetting swap.
To agree a cash settlement based on market value.
By selling the swap to another party.
The use a swaption.
(2 marks)
The implication of the above scenario is that you are essentially holding a twoyear swap agreement that requires you to pay 7% in exchange for floating rate.
Since the current market rate for the same swap is 6.5%, if your counterparty
defaulted you would be able to replace the swap at a lower rate, thereby reducing
your obligation.
Thus, it would be to you benefit for your counterparty to default, and you would
realize an economic gain.
(3 marks)
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Question 6 – Portfolio Management
6(a)
Ayo
2010
Jan
Feb
Mar
Apr
Mav
Total
Aminu
Cost
lump sum
averaging
units
purchased
N
1,000
25,000
25,000
25,000
25,000
1,000
units
purchased
250.00
254.32
257.47
249.00
1,010.79
(4 marks)
6(b)
offer price(N)
Realized
Original
investment
Return
1,000
99.2
99,200
100,000
-0.80%
1010.79
99.2
100,270
100,000
0.27%
units
Ayo
Aminu
(3 marks)
6(c)
Naira cost averaging
(1 mark)
6(d)
i.
ii.
iii.
Stock X is not a growth stock. It has a low earnings growth. The high
dividend yield suggests it is generating significant cash with few reinvestment opportunities. Stock X is not a permitted investment for it
appears to be outside the Bloom fund's investment mandate.
(3 marks)
Stock Y has strong earnings growth, its PE is not high and it pays a
reasonable dividend of 3.2%. The stock may fit a growth stock at a
reasonable price strategy. Moreover, the beta is not high, and is likely to
lower the overall portfolio beta. This stock may well be early to mid stage
growth. Chika is likely to see this stock as a suitable prospect.
(3 marks)
Stock Z is a growth stock. It has strong earnings growth, but its PE is also
high and pays no dividend. No dividend payments are often associated with
fast growing firms reinvesting their own profits in the business. The price of
the stock and its high beta may deter Chika somewhat, but if the stock is at
an early stage of growth the price may be inexpensive. Chika is likely to see
this stock as a suitable prospect.
(3 marks)
5
6(e) The net asset value (NAV) of an investment company is its per share value. It equals
the total market value of the entire firm’ asset divided by the total number of fund
shares outstanding.
It is computed as follows:
NAV = (Total market value of fund portfolio) – (Fund expenses)
Total fund shares outstanding
(3 marks)
Question 7 – Commodity Trading and Futures
7(a)
i.
F0 = 100(1 +4%) = 104 X 1,000 = N104,000
(2 marks)
ii.
Stock price goes down to N93
New futures price = F0 = 93(1 +4% x 359/360) = N96.71 X 1000
=N96, 710
(2 marks)
iii.
The investor is long the contract so faces a loss:
(96.71 – 104) x 1,000 = N7, 290
(2 marks)
iv.
The initial margin required was 1,000 x N104 x 10% = N10,400
v.
With the stock decrease the margin account balance becomes:
(2 marks)
N10, 400 – N7, 290 = N3, 110
(2 marks)
r. T
Note: If the candidate assumes continuous compounding (F0 = S0e
relevant marks would be awarded in full as well.
),
7(b)
i. Economic Activities – If there is strong growth in GDP signifying increased
economic activities then it is likely that the price of crude oil will increase
accordingly. When there is economic downturn, the opposite should be
expected.
ii. Discovery of new reserves – As more oil fields are discovered, global supply of
crude oil increases. Higher volume of production will result in falling crude
prices.
iii. Improved Technology - The effectiveness of technology to prospect and retrieve
crude oil will affect pricing. As more effective, lower cost technologies are
developed, the price of crude oil will drop.
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iv. Possibility of substitution – As the world develops alternative to crude oil (such
as biofuel), as a source of power, prices of crude oil would drop.
v. Demand for refined products – Each refined product has its own unique
supply and demand dynamics which in some cases feed back into the crude oil
market.
vi. Investor activity – As oil price increases, the market becomes more attractive to
institutional investors. Given the volume of money flowing into the market, their
activities are often cited as being responsible for creating a self-reinforcing
circle.
vii. Movement in the USD – Crude oil is priced in the US dollars and so a weakening
of the currency should lead to an increase in the demand for the commodity
from the non-dollar users, as the cost is lower in terms of domestic currency.
viii. Activities of OPEC –OPEC sets production quota for member counties. Over the
years the activities of this Cartel has impacted global oil prices significantly.
Any 5 points (5 marks)
7