Amity Campus Uttar Pradesh India 201303

ASSIGNMENTS
PROGRAM: MFC SEMESTER-IV
Subject Name Study COUNTRY Roll Number (Reg.No.) Student Name : FINANCIAL ENGINEERING : MALAWI : MFC001172009-2011033 : ROY KACHALE

INSTRUCTIONS a) Students are required to submit all three assignment sets. ASSIGNMENT Assignment A Assignment B Assignment C b) c) d) e) DETAILS Five Subjective Questions Three Subjective Questions + Case Study Objective or one line Questions MARKS 10 10 10

Total weightage given to these assignments is 30%. OR 30 Marks All assignments are to be completed as typed in word/pdf. All questions are required to be attempted. All the three assignments are to be completed by due dates and need to be submitted for evaluation by Amity University. f) The students have to attached a scan signature in the form.

Signature : Date :

_________________________________ _________________________________

( ) Tick mark in front of the assignments submitted Assignment Assignment B Assignment C A

FINANCIAL ENGINEERING ASSINGMENT QUESTION 1 Swaps are used by companies or investors in general to hedge risks associated with financial transactions. Such swaps can be categorized as interest rate swaps, current swaps and equity swaps. An interest rate swap is when one party agrees to pay a second party a stream of cash payments whose size is reset regularly on the basis of a highly visible interest rate like the London Interbank Offer Rate (LIBOR). In return the second counterparty agrees to pay the first counter party a stream of fixed sized cash payment that is based on the level of interest rates in existence at the time that contract is signed. A currency swap is an agreement to exchange principal and fixed interest in one currency for principal and fixed interest in another. It is a long term financing tool that helps to manage both the interest rate and exchange rate risk. An Equity swap on the other hand involves the exchange of variable sized cash payment based on the equity market for fixed sized payments based on the prevailing interest rates. At the middle of the transactions is a swap bank (usually a commercial or investment bank) that oversees the contract. The counterparties to the swap do not meet directly. The swap bank organizes the contract. In fact the counterparties, often times, do not know who the other counterparty is. The risk to the swap bank arises when one of the counterparties defaults. The swap bank has to make cash payment to the non-defaulting counterparty. It means that the bank has assured the risk that should one of the counterparties defaults the swap bank has to in some ways pay for this default. It is therefore imperative that swap bank scrutinizes the credit worthiness of the counterparties before getting involved in swap agreement.

QUESTION 2 A call option is a financial derivative that gives the buyer the right, but not obligation, to buy a specific number of shares of specific company from the option writer at a specific price at any time until expiration. A call option is said to be in the money if the immediate exercise of the option would give the buyer positive cash flow. It is said to be at the money and out of the money if the immediate exercise of the call option will give zero and negative cash flows respectively. When considering the profitability of a call option, one needs to take care not to overlook the effects of the premium. Premium is the consideration that the buyer pays the writer to acquire an option. Let us assume, for example that the current price for National Bank of Malawi (NBM) shares is MK45. An investor B can sign a call option contract to buy 100 NBM shares at MK50 within the next 6 months, if he feels that the price the price for NBM shares will rise substantially during the next 6 month for his trouble the writer (W) may charge a premium of say MK3 per share. This contract will not be profitable for the option buyer if the price of NBM shares does not rise above MK53. If for example the price only rises to MK50, the buyer would have lost MK300 as illustrated

100 shares @MK50 Premium on 100 shares @MK3 Value of shares received Loss on contract

= MK5000 =MK 300 MK5300 =MK5000 (300)

This transaction is said to be out of the money because it would result in a negative cash flow In the same example if the price rises to MK53, it would

be said to be at the money because it would result in a zero cash flow as illustrated. 100 shares @ Premium on 100 shares MK3 Value of shares 100@MK53 Cash flow =MK5000 =MK 300 =MK5300 =MK5300 0

If however the price of the NBM shares rises above MK53, it will be said to be in the money. For example if the price of NBM shares rises to MK60 the buyer would make a profit by exercising the call option as follows Value of shares received 100 @60 Price paid for shares 100 @ 50 Premium paid for shares 100 @3 Cash inflow =MK 6000 =MK (5000) = ( 300) 700

A put option on the other hand is the right to sell shares at a particular price during a specified period of time. A put option can be said to be in the money, at the money or out of money depending on whether the immediate exercise of the same would result in a positive, zero or negative cash flow for the buyer. For example a buyer of a put option can enter into a contract which gives him the right to sell his 100 NBM shares at MK30 at any point during the next 6 months. The NBM share price is currently at MK35. The buyer anticipates that the price of NBM shares will fall below MK30. For his trouble the writer of the put option demands a premium of MK3. If the price of the put option does not fall below MK27 e.g. @31, he will be said to be out of money because it would result in a negative cash flow as follows

Value of shares sold 100@ MK31 Price received for shares 100@MK30 Premium paid for shares 100@ MK3 Cash flow =

=MK (3100) = MK 3000 300 (200)

On the other hand if the price of NBM shares falls below MK27 to MK25, the put option would be said to be in the money as follows Value of shares sold 100 @25 Price received for shares 100 @30 Premium 100 @ 3 Cash flow = MK(2500) = MK 3000 = (300) 200

In this situation the buyer (holder) of the put option would have made a profit.

QUESTION 3 a. A. Leveraged Buy Out (LBO) is the acquisition of an existing company, whether private or public, in which the money used to finance the takeover is predominantly sourced from debt. The debt can be combined with equity to acquire the company but a major portion is sourced from debt. The debit sourced to finance the takeover is secured by the assets of the company being taken over. The repayments on the debit incurred to acquire the company are expected to come from the cash flow of the acquired company.

It is imperative that the investors wishing to enter into a LBO are sure that the target company has steady and predictable cash flow and that its balance sheet has minimal debit. b. Corporate restructuring is any change in operations capital structure and ownership that is not part of the firms ordinary course of business. Corporate restructuring can take the form of expansion, contraction or the change of ownership and control of the company. Expansion includes mergers and acquisitions, consolidation and joint ventures construction includes sell offs, spin offs and disposal of assets. Leveraged buy outs and stock re purchase programs are changes in the control and ownership structures of a company. These activities are what constitute corporate restructuring.

QUESTION 4 Futures and forwards are agreements to buy or sell an asset, called an underlying asset, at a specified future date at a price agreed upon today. For example a trader might enter into a contract to buy 5000 bushels of wheat at MK600 per bushel 6 months from now even though the price may or may not currently be equal to MK600. In this case the current price of wheat is known as the spot price while the agreed future price is known as the forward price. The difference between future and forward are as follows 1. Forwards are private contracts and are therefore not rigid in their conditions while futures are exchange traded instruments.

2. Because forwards are private agreements the risks of defaults is higher while the futures are well scrutinized. 3. When dealing with futures, a settlement is expected on an agreed upon date while forwards are marked to market and can therefore change hands continuously until the end.

QUESTION 5 The price of futures is supposed to be equal to the spot price of the stock index (1+cost of capital) the cost of capital is determined by the risk free rate and reduced by any dividends paid. Therefore,

If any of the 2 sides of this equation is less than the other then an opportunity to make arbitrage profits exists. In this example we have the futures market on the left hand side of the equation and spot market for the stock index itself on the right hand side as follows

Clearly the right hand side of the equation is greater than the left hand side. The cardinal rule in finance is that you buy assets that are underpriced and you sell those that are overpriced. In this case we should sell the stock index on the spot market and buy the futures market. The friend should therefore go short on the spot stock index for the following cash inflow

This inflow can then be invested at the risk free rate as follows

Since the stock index is short, the investor will be required to pay dividends to the party from whom the stock was acquired as follows

So the actual inflow from short selling the stock and investing will earn the investor

At the time of unwinding the investment, the price of the futures is supposed to be paid In order to acquire the stock as follows

This can be repaid from the proceeds of the shorting of the stock index. After paying for the futures the investor will be left with

And that is the arbitrage profit.

ASSIGNMENT B QUESTION 2 a. A straddle is a strategy whereby an investor buys a call option and put option of the same underlying stock that have the same strike price and the same expiration date. The investor who employs the straddle aims to benefit from either a loss or gain on the price of the stock. Usually investors who employ the straddle are those that have a feeling that there is going to be a major shift in the price of the stock but are unsure in which direction. The profit in a straddle strategy grows, the further the price moves away from the strike price. b. A strangle strategy is one where the investor buys a put and a call on the same underlying stocks which have the sane expiration date but have a different strike prices. The investors who employ this strategy are those who are of the opinion that there will be a large movement in the price of stock, but are unsure of the direction The put and the call are usually purchased out of the money so that the move is only Profitable if there is a huge shift in the price of the underlying stock.

QUESTION 3 There are several assumptions made by the Black-Scholes model. The first assumption that the model makes is that taxes and transaction fess do not apply when assessing the value of option. Apart from this, the Black-Scholes model also assumes that

a. Arbitrage opportunity does not exist b. The security that underlies the option the option does not pay dividends. c. That there are limitless short selling opportunities d. That there is a constant drift and volatility in the geometric Brownian motion of the stock price e. That there are limitless opportunities to borrow and lend at risk free rates.

CASE STUDY (I). Strip strategy When employing the strip strategy one buys one call option and 2 put options. In our case the premium payable on the purchase of a strip would be as follows 1. Call option 2. Put options (2x 0.05) 0.40 The payoff would look like this Price of expirati on 48.50 47.00 48.50 48.00 48.50 49.00 0.30 0.10

Strike price

differe nce 1.50 0.50 0.50

premiu m 0.40 0.40 0.40

call 0.00 0.00 0.50

Put 3.00 1.00 0.00

Payoff 2.60 0.60 0.10

48.50

50.00

1.50

0.40

1.50

0.00

1.10

The strip strategy has two break even points, a lower break-even point and an upper Break-even point. These will be calculated as follows Lower break-even point = = =

Upper break-even point =

(ii.) The strap strategy involves the buying of one put option and two call options. In our case the premium payable would be as follows 2 call options (2x 0.30) = 1 put option =

And the payoff would look like this

Strike price 48.50 48.50 48.50 48.50

Price at expirati on 47.00 48.00 49.00 50.00

Differen ce 1.50 0.50 0.50 1.50

Premiu m 0.65 0.65 0.65 0.65

Calls

Puts

Payoff

0 0 0.50 1.50

3.00 1.00 0 0

2.35 0.35 -0.15 0.85

As with the strip strategy, the strap strategy has a lower and upper Breakeven point, these can be calculated as follows Lower BreakEven point = =

Upper Break Even Point = =

The strip strategy is more suited for the bearish investor or in general bearish situations. The strap strategy is the opposite of the strip strategy as it is more desirable for the bullish investor or in the general bullish situations. B. The Black- Scholes model calculates the price of an option as

Where

and

or

Therefore

Therefore

The price of the call option

Assignment C
1 2 3 4 5 6 7 8 9 10 B A E B E A D F C A 11 12 13 14 15 16 17 18 19 20 B B C A B A D C C D 21 22 23 24 25 26 27 28 29 30 B A D D A A C C C D 31 32 33 34 35 36 37 38 39 40 B B D B E B D E A A