IIM BODH GAYA zrra warRT rrerrt FINANCIAL DERIVATIVES END TERM EXAMINATION TERM IV TIME : 1.5 HOURS MARKS : 50 CLOSED BOOK CASE IS COMPULSORY. ATTEMPT ANY THREE FROM FIRST SIX OUESTIQNS. ALL QUESTIONS CARRY EQUAL MARKS. 1. A speculator is expecting that in next two months rupee will not fluctuate much from the current spot rate against dollar. The current rupee-dollar spot rate is Rs.45.20 / $. The following call options are available in the market: Option Strike price (Rs / $) Premium (Rs.) Maturity (Months) Call 44.75 0.60 2 Call 45.00 0.40 2 Call 45.25 0.18 2 Call 45.50 0.04 2 The speculator wants to make profit from his view by adopting an option strategy using all the above four options, and simultaneously would like to reduce his maximum potential loss. You are required to suggest a strategy to the speculator and prepare pay-off profile and pay off diagram indicating maximum profit, maximum loss and break-even point(s) for price range of Rs. / $ 44.25 - 45.00. 2. Mr.Amit Singhal, an exporter of ready made garments to U.S.A is expecting US$ 1.25 million at the end of March '08. He anticipates rupee to further appreciate against dollar and hence wants to hedge his exposure with either forward or futures market On January 15, 2008 the following rates are being quoted: Rs./$ spot Rs.39.50 March forward Rs.39.65 March $ futures Rs.39.60 The futures closed at Rs.39.82 in March. You are required to calculate the net cash flow to Mr. Singhal, if he had booked i. ii. Forward contract. Futures contract. iii. Left the position unhedged. (State assumptions if any) 3. The current stock price of HCL Infosys is Rs.400 and the market expectation about this stock is that it's value may increase or decrease by 20% in each of the next two half- years. The return on Government Securities being traded in the market for the same maturity is 5% p.a. and investors can exercise the European call option on HCL Infosys stock at Rs.420. Assuming that each time step is six months, you are required to calculate the value of call option using Two — Step Binomial model. 4. The current market price of ABB's stock is Rs. 290. The following European call and put options are available in the market: Option —— Strike Price Premium LS,) Call (Its.) 21 280 280 Put The risk- free interest rate is 6% p.a. You are required to find out whether there is any arbitrage opportunity available in the put and call prices if no, justify why Pot. 'ryes, show how you can make arbitrage profit. 5. Two companies, Bharat Ltd, and Bharathi Ltd. required $100 million each for next five years. The following are the requirements and the costs of borrowings faced by them In different markets: Company Requirements Fixed rate Floating rate Bharat Floating rate 5.2% LIBOR + 0.30% Bharathi Fixed rate 5.9% LIBOR + 0.80% Bharat and Bharathi, not being satisfied witl the costs of borrowings at the markets of their choice, have approached a financial institution for swap arrangement to reduce their interest burden. You are required to: a. Show how financial institution arranges a swap between two parties in such a way that the financial institution takes 0.03% out of the benefit of swap and the romalning benefit is equally divided between the two parties. Also calculate the effective cost of borrowing to each party, after the swap. b. Explain the various risks involved in this swap deal. 6. a. A Forward-Rate Agreement (FRA) for US$ 20,000,000 has a contracted rate of 6.15 per cent and the actual rate for the three months' (91 days) deposit at expiry is 6.375 per cent. What will be the amount paid or received by the seller of the contract? b. Calculate the no-arbitrage forward price for a 90-day forward on a stock that is currently priced at $50.00 and is expected to pay a dividend of $0.50 in 30 days and a $0.60 in 75 days. The annual risk free rate is 5% and the yield curve is flat. CASE (20 MARKS) Read the case carefully and answer the following questions: 7. Evaluate the various alternatives available for hedging the export proceeds of $ 80 million for various exchange rate scenarios. 8. What strategy Mr. Jeff should adopt to reduce the cost of capping the loan? Calculate the effective cost of the capped loan if the 6-month LIBOR rates on reset dates are turned out as 5.70%, 5.95%, 6.05%, 5.60%, 5.75%, 5.25%, 4.90%, 4.80% and 4.75%. (Amortize the upfront-fee over the period of loan using a discount rate of 5.50%). iness Produc Innovative Bus ts (IBP) Ltd., a company based in Tonton in United Kingdom manufactures a wide variety of sophisticated electronic appliances for the various office processes. The company's products are well-known for their convenience, durability and reasonable prices. The company is also well respected for its after sales services which are gh its dealer netw offered throu ork present in major markets and also through its franchises in the emerging markets, Over a period of time, the company has developed a huge market in Europe and North America and supplies customized office equipments for a specified need of a company, In December 2006, the company acquired a fresh order worth $80 million from a US company for renovating its offices in entire North America. The order has to be delivered in the month of March and the payment for the same will be realized sometime in the month of April. Since the middle of the year 2006, IBP was facing severe capacity constraints in its production facility in Tonton. It had to overload its processes by 10% to meet the demand from around the world. In anticipation of the increased business activity in the year 2007, it has invested E 60 million to expand its production facilities in UK. Mr. Jeff Robertson, the Chief Operating Officer of [BP, is trying to estimate the amount of € the company will be able to realize from the order. But it is not an easy task. Every moment his estimates are changing due to the volatile market movements for exchange rate of dollar. The recent volatility in the foreign exchange market shows the strengthening of dollar against pound sterling. The analysts forecasted that dollar may appreciate against euro in coming months. However, if there is no strong economic turnaround in the US, then dollar may reverse its current trend. As E is closely related to Euro, it may also appreciate against dollar, as a result the inflow to the company from the export bill may get reduced. So he is considering various hedging alternatives to reduce the uncertainty of future cash inflows. The various alternatives Mr. Jeff is evaluating are hedging through call options, put options and futures market. To finance the investment requirement in expanding the facilities the company has borrowed €50 million for five years from a local bank. The interest rate quoted is 6-month € LIBOR plus 75 basis points. The 6-month € LIBOR at the time of entering into the contract was 5.30%. Interest is payable semi-annually and first payment is due on June 01, 2007. The principal has to be repaid by bullet payment at the end of 5th year. Jeff is apprehensive of rise in interest rate in near future. The increase of dollar interest rate in recent past by the Federal Reserve is forcing Euro zone authorities to review the euro interest rate. Since pound sterling is closely related to euro, any decision of rate hike in the Euro zone will also increase the pound sterling interest rate. So Jeff is trying to hedge the interest rate risk of the borrowing. He wanted to put a cap on his cost of borrowing. Buying a 5-year cap close to the prevailing interest rate is the most appropriate strategy to hedge the 5-year loan. However, he finds out that such a cap is quite costly and the benefit of cap may not be fully realized, if the interest rate does not change significantly. So he is trying to find out the ways to reduce the cost of the capped loan. The following 5-year interest rate options on 6-month E LIBOR are available at the market: Term Underlying interest rate Reset dates Face value Cap strike rate Cap premium Floor strike rate Floor premium 5 years 6-month LIBOR June 1, December 1 € 50 million 5.50% 1.20% of face value 5.00% 0.90% of face value The following rates are quoted in the market: Spot E/$ 0.5141/43 March € Futures $ 1.9432 June € Futures $ 1.9421 (Size of futures: E 62,500) Pound sterling options: Options Call Put Strike price ($/€) 1.95 1.94 1.95 1.94 Premium ($) 0.0010 0.0045 0.0055 0.0003 Expiration April April April April
