Case+Studies Der

Chester Midway Case Scenario
Chester Midway, CFA, is a portfolio manager for Pacific Capital, a hedge fund which invests in debt,
equity and related derivatives securities. Midway is reviewing several investment recommendations
from his research staff with respect to Yorktown Carrier Corporation.
Midway believes that Yorktowns stock price will increase over the next six months, but he does not
want to purchase the stock today. In order to protect against the stock price rising over the next six
months, Midway is considering a forward purchase. Yorktowns common stock currently trades at $100
per share and is expected to pay quarterly dividends of $0.75 per share with the next dividend payment
expected 90 days from today. To evaluate this transaction, Midway uses the data provided in Exhibit 1.
Exhibit 1
Risk Free Interest Rates
Maturity Rate
3 months 0.50%
6 months 0.50%
1 year 1.00%
Michael Edwards, an equity analyst at Pacific, believes that call options are an alternative approach to
establishing a long position in Yorktown stock. The current market price of a six month put option with a
strike price of $100.00 is $5.35.
Midway asks Edwards if there are ways to measure the risk of option positions. Edwards responds by
stating that numerical risk measures such as delta and gamma are used by investors to monitor the price
relationship between a call option and the underlying stock. Edwards makes the following statements:
Statement 1: A smaller gamma limits the effectiveness of delta hedging.

Statement 2: A negative delta indicates that the call option price and the stock price will move in
opposite directions.
Statement 3: A larger gamma means that there is more uncertainty as to whether the call option will
expire out-of-the-money.
Midway has analyzed Yorktowns recent price history and estimates that historical volatility is 30%. He
uses the Black-Scholes option pricing model to observe that the volatility implied by the market prices of
Yorktown options is 20%. Midways forecast is that Yorktowns price volatility will remain at 30%.
Midway recommends buying put options and selling call options in order to profit from his view on the
volatility for Yorktowns stock relative to the market consensus.
Jim Frank is Pacifics fixed income analyst. He has analyzed Yorktowns balance sheet, and is meeting
with the companys treasurer. He asks the treasurer if Yorktowns stock price may be adversely affected
by rising interest rates given the high level of floating rate debt within its capital structure. Frank,
however, believes that interest rates will not rise. The treasurer tells him that Yorktown could consider
interest rate swaptions which hedge against a rise in rates but which simultaneously provides the
flexibility to not engage in the swap should rates not rise.
Frank has evaluated Yorktowns senior debt and its credit default swaps (CDS). Frank has a positive
outlook regarding Yorktowns credit condition over the next two years but is concerned about
Yorktowns longer term (5 years) credit outlook based on secular trends within Yorktowns industry.
7. The six month forward price on Yorktown stock that Midway should expect to pay is closest to:
A. $98.50.
B. $98.75.
C. $99.00.
8. Based on Exhibit 1 and put-call parity, the price of a 6-month call option with a strike price of
$100.00 on Yorktown stock is closest to:
A. $5.10.
B. $5.60.
C. $5.85.
9. Which of Edwards statements to Midway regarding options is mostly likely correct:
A. Statement 1.
B. Statement 2.
C. Statement 3.
10. Holding all of the other components of the Black-Scholes model constant, Midways put and call
strategy to exploit volatility is most likely incorrect because:
A. both puts and calls will increase in value.

B. both puts and calls will decrease in value.
C. puts will decrease in value while calls will increase in value.
11. Which interest rate hedge instrument is most suitable for Yorktown given Franks assessment of
Yorktowns interest rate exposure and his view on interest rates:
A. Payer Swaption
B. Receiver Swaption
C. Plain Vanilla Swap
12. Given Franks credit evaluation of Yorktown, which CDS strategy is most appropriate for Pacific?
A. Sell 2-year CDS.

B. Sell 2-year CDS and buy 5-year CDS.
C. Buy 2-year CDS and sell 5-year CDS.
Chester Midway Case Scenario
Chester Midway, CFA, is a portfolio manager for Pacific Capital, a hedge fund which invests in debt,
equity and related derivatives securities. Midway is reviewing several investment recommendations
from his research staff with respect to Yorktown Carrier Corporation.
Midway believes that Yorktowns stock price will increase over the next six months, but he does not
want to purchase the stock today. In order to protect against the stock price rising over the next six
months, Midway is considering a forward purchase. Yorktowns common stock currently trades at $100
per share and is expected to pay quarterly dividends of $0.75 per share with the next dividend payment
expected 90 days from today. To evaluate this transaction, Midway uses the data provided in Exhibit 1.
Exhibit 1
Risk Free Interest Rates
Maturity Rate
3 months 0.50%
6 months 0.50%
1 year 1.00%
Michael Edwards, an equity analyst at Pacific, believes that call options are an alternative approach to
establishing a long position in Yorktown stock. The current market price of a six month put option with a
strike price of $100.00 is $5.35.
Midway asks Edwards if there are ways to measure the risk of option positions. Edwards responds by
stating that numerical risk measures such as delta and gamma are used by investors to monitor the price
relationship between a call option and the underlying stock. Edwards makes the following statements:
Statement 1: A smaller gamma limits the effectiveness of delta hedging.

Statement 2: A negative delta indicates that the call option price and the stock price will move in
opposite directions.
Statement 3: A larger gamma means that there is more uncertainty as to whether the call option will
expire out-of-the-money.
Midway has analyzed Yorktowns recent price history and estimates that historical volatility is 30%. He
uses the Black-Scholes option pricing model to observe that the volatility implied by the market prices of
Yorktown options is 20%. Midways forecast is that Yorktowns price volatility will remain at 30%.
Midway recommends buying put options and selling call options in order to profit from his view on the
volatility for Yorktowns stock relative to the market consensus.
Jim Frank is Pacifics fixed income analyst. He has analyzed Yorktowns balance sheet, and is meeting
with the companys treasurer. He asks the treasurer if Yorktowns stock price may be adversely affected
by rising interest rates given the high level of floating rate debt within its capital structure. Frank,
however, believes that interest rates will not rise. The treasurer tells him that Yorktown could consider
interest rate swaptions which hedge against a rise in rates but which simultaneously provides the
flexibility to not engage in the swap should rates not rise.
Frank has evaluated Yorktowns senior debt and its credit default swaps (CDS). Frank has a positive
outlook regarding Yorktowns credit condition over the next two years but is concerned about
Yorktowns longer term (5 years) credit outlook based on secular trends within Yorktowns industry.
7. The six month forward price on Yorktown stock that Midway should expect to pay is closest to:
A. $98.50.
B. $98.75.
C. $99.00.
Answer = B
Derivative Markets and Instruments, Don M. Chance

2011 Modular Level II, Vol. 6, pp. 26-31
Study Session 16-60-b
Calculate and interpret the price and the value of an equity forward contract, assuming
dividends are paid either discretely or continuously.
B is correct because
Forward Price = (Stock Price Present value of dividends over life of contract) X (1+r)T
98.75 = (100 - .7491 - .7481) (1.005) (180/360)
Where:
PV D1 = (.75) / (1+.005)90/360 = .7491
PV D2 = (.75) / (1+.005)180/360 = .7481
8. Based on Exhibit 1 and put-call parity, the price of a 6-month call option with a strike price of
$100.00 on Yorktown stock is closest to:
A. $5.10.
B. $5.60.
C. $5.85.
Answer = B

2011 Modular Level II, Vol. 6, pp.171-176
Study Session 17-62-a
Calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic bond,
and synthetic underlying stock, and infer why an investor would want to create such
instruments.
B is correct:
Call value = Short Bond + Put + Stock
= -$100/(1.005) (180/360) + $5.35 + $100.00 = $5.60
9. Which of Edwards statements to Midway regarding options is mostly likely correct:
A. Statement 1.
B. Statement 2.
C. Statement 3.
Answer = C

2011 Modular Level II, Vol. 6 pp 203-206
Study Session 17-62-f
Explain the gamma effect of an options price and delta and how gamma can affect a delta
hedge.
C is correct because Gamma is larger when there is more uncertainty about whether the option
will expire in- or out-of-the-money.
10. Holding all of the other components of the Black-Scholes model constant, Midways put and call
strategy to exploit volatility is most likely incorrect because:
A. both puts and calls will increase in value.

B. both puts and calls will decrease in value.
C. puts will decrease in value while calls will increase in value.
Answer = A

2011 Modular Level II, Vol. 6 pp. 202, 208, 209, 212, 213, 214
Study Session 17-62-d
Explain how an option price, as represented by the Black-Scholes-Merton model, is affected by
each of the input values (the option Greeks).
A is correct because Pacific will want to purchase Call Options and Put Options, since both will
increase in value should Implied Volatility rise to match the level of historical volatility.
11. Which interest rate hedge instrument is most suitable for Yorktown given Franks assessment of
Yorktowns interest rate exposure and his view on interest rates:
A. Payer Swaption
B. Receiver Swaption
C. Plain Vanilla Swap
Answer = A
2011 Modular Level II, Vol. 6 p. 283
Explain and interpret the characteristics and uses of swaptions, including the difference
between payer and receiver swaptions.
A is correct because entering into a Payer Swaption provides a simultaneous benefit - Yorktown
owns the option to enter into a pay fixed swap should rates increase but it may choose not to
enter into the pay fixed swap should rates not increase.
12. Given Franks credit evaluation of Yorktown, which CDS strategy is most appropriate for Pacific?
A. Sell 2-year CDS.

B. Sell 2-year CDS and buy 5-year CDS.
C. Buy 2-year CDS and sell 5-year CDS.
Answer = B
Derivative Markets and Instruments, George Spentzos, CFA

2011 Modular Level II, Vol. 6, p.361
Study Session 17-65- d
Discuss credit derivatives trading strategies, and how they are used by hedge funds and other
managers.
B is correct because Pacific will collect CDS income over the first three years (when
creditworthiness is projected to be OK) but will benefit from owning credit protection via the
CDS between year 3 and 5. This strategy is known as a steepener.
Meredith Whitney Case Scenario
Meredith Whitney is a senior consultant in the Swaps Advisory Group of DCM Capital, an independent
advisory firm. Whitney will be meeting with three clients who need advice on structuring and
implementing swap programs to manage their interest rate exposures.
For her meetings, Whitney plans to use the data presented in Exhibit 1 below.
Exhibit 1
Current Term Structure of Rates (%)
Days LIBOR EURIBOR HIBOR
90 1.42 1.86 1.22
180 1.84 2.11 1.53
270 2.12 2.24 1.70
360 3.42 2.34 1.87
Note: LIBOR is the London Interbank Offer rate. EURIBOR is Euro Interbank Offer Rate. HIBOR is
the Hong Kong Interbank Offer rate. All rates shown are annualized.
Whitneys first meeting is with Novatel, a U.S. based company that currently has an outstanding loan of
$250,000,000 that carries a 5.15% fixed interest rate. Novatels managers feel that the current interest
rate on the loan is high and they also believe that interest rates are poised to decline. Whitney advises
Novatel to enter into a one-year pay floating LIBOR receive fixed interest rate swap with quarterly
payments. The notional principal on the swap will be $250,000,000.
Novatel has asked Whitney to provide recommendations on how it can terminate the swap. Whitney
outlines three options:
Option 1: A cash settlement with the counterparty.
Option 2: Enter into a payer swaption
Option 3: Enter into a receiver swaption.
Next, Whitney meets with Grand Manufacturing. This client is based in Hong Kong but requires a
25,000,000 one-year bridge loan to fund operations in Germany. Grand manufacturing is currently
able to borrow Euros at an interest rate of 3.75%, but wonders if there is a less expensive alternative.
Whitney advises Grand to borrow in HK$ and enter into a one-year foreign currency swap with quarterly
payments to pay Euros at a fixed rate of 2.32% and receive HK$ at a fixed rate of 1.84%. The current
exchange rate is HK$11.42 per 1.
The final meeting is with KPS Financial Services, a U.S. based asset manager. KPS wants to increase the
equity exposure to the U.S. market in one of its portfolios by $100,000,000. Whitney advises KPS to
enter into a one-year equity swap with quarterly payments to receive the return on a U.S stock index
and pay a floating LIBOR interest rate. The current value of the U.S. stock index is 925.
Each client follows Whitneys advice and immediately implements the recommended position.
Forty five days have passed since Whitneys initial meetings and in the interim a worldwide financial
crisis has caused interest rates to rise dramatically. Whitneys clients have asked to meet with her to
review their positions.
In order to prepare for the meeting Whitney has obtained updated interest rate data that is presented
in Exhibit 2. In addition, she notes that the exchange rate for the Hong Kong dollar is HK$9.96 per 1 and
the U.S. stock index is at 905.
Exhibit 2
Term Structure of Rates 45 Days Later (%)
90 2.21 2.94 1.95
180 2.62 3.03 2.45
270 3.73 3.08 2.70
360 4.92 4.15 3.85
7. Using data in Exhibit 1, the annualized fixed rate of the swap recommended by Whitney for
Novatel is closest to:
A. 2.22%
B. 3.36%
C. 5.15%
8. Using data in Exhibit 2, the market value of Novatels swap after 45 days is closest to:
A. -$2,875,000
B. -$2,250,000
C. -$718,750
9. With regard to the recommendations for the termination of Novatels swap position, Whitney is
least likely correct with respect to:
A. option 1.
B. option 2.
C. option 3.
10. Using data in Exhibit 2, the market value of Grand Manufacturings swap after 45 days is closest
to:
A. HK$1,313,300
B. HK$35,402,000
C. HK$36,500,000
11. Using data in Exhibit 2, the market value of KPS Financial Services swap after 45 days is closest
to:
A. -$4,372,000
B. -$2,232,000
C. -$2,162,000
12. At what point in the swaps life is the credit risk with respect to KPS Financial Services swap
position most likely the highest?
A. End
B. Middle
C. Beginning
Meredith Whitney Case Scenario
Meredith Whitney is a senior consultant in the Swaps Advisory Group of DCM Capital, an independent
advisory firm. Whitney will be meeting with three clients who need advice on structuring and
implementing swap programs to manage their interest rate exposures.
For her meetings, Whitney plans to use the data presented in Exhibit 1 below.
Exhibit 1
Current Term Structure of Rates (%)
90 1.42 1.86 1.22
180 1.84 2.11 1.53
270 2.12 2.24 1.70
360 3.42 2.34 1.87
Whitneys first meeting is with Novatel, a U.S. based company that currently has an outstanding loan of
$250,000,000 that carries a 5.15% fixed interest rate. Novatels managers feel that the current interest
rate on the loan is high and they also believe that interest rates are poised to decline. Whitney advises
Novatel to enter into a one-year pay floating LIBOR receive fixed interest rate swap with quarterly
payments. The notional principal on the swap will be $250,000,000.
Novatel has asked Whitney to provide recommendations on how it can terminate the swap. Whitney
outlines three options:
Option 1: A cash settlement with the counterparty.
Option 2: Enter into a payer swaption
Option 3: Enter into a receiver swaption.
Next, Whitney meets with Grand Manufacturing. This client is based in Hong Kong but requires a
25,000,000 one-year bridge loan to fund operations in Germany. Grand manufacturing is currently
able to borrow Euros at an interest rate of 3.75%, but wonders if there is a less expensive alternative.
Whitney advises Grand to borrow in HK$ and enter into a one-year foreign currency swap with quarterly
payments to pay Euros at a fixed rate of 2.32% and receive HK$ at a fixed rate of 1.84%. The current
exchange rate is HK$11.42 per 1.
The final meeting is with KPS Financial Services, a U.S. based asset manager. KPS wants to increase the
equity exposure to the U.S. market in one of its portfolios by $100,000,000. Whitney advises KPS to
enter into a one-year equity swap with quarterly payments to receive the return on a U.S stock index
and pay a floating LIBOR interest rate. The current value of the U.S. stock index is 925.
Each client follows Whitneys advice and immediately implements the recommended position.
Forty five days have passed since Whitneys initial meetings and in the interim a worldwide financial
crisis has caused interest rates to rise dramatically. Whitneys clients have asked to meet with her to
review their positions.
In order to prepare for the meeting Whitney has obtained updated interest rate data that is presented
in Exhibit 2. In addition, she notes that the exchange rate for the Hong Kong dollar is HK$9.96 per 1 and
the U.S. stock index is at 905.
Exhibit 2
Term Structure of Rates 45 Days Later (%)
90 2.21 2.94 1.95
180 2.62 3.03 2.45
270 3.73 3.08 2.70
360 4.92 4.15 3.85
7. Using data in Exhibit 1, the annualized fixed rate of the swap recommended by Whitney for
Novatel is closest to:
A. 2.22%
B. 3.36%
C. 5.15%
Answer = B
Swap Markets and Contracts, Don M. Chance

Study Session 17-63-c
Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market value
of the swap during its life.
B is correct. The appropriate present value factors are provided below:
Bo(90) 0.9965
Bo(180) 0.9909
Bo(270) 0.9844
Bo(360) 0.9669
For example, B0(90) is calculated as:
Other present value factors are calculated in a similar manner.

The fixed rate is calculated as follows:
The annualized rate = 0.0084 4 = 0.0336
8. Using data in Exhibit 2, the market value of Novatels swap after 45 days is closest to:
A. -$2,875,000
B. -$2,250,000
C. -$718,750
Answer = B

Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market value
of the swap during its life.
B is correct. Per $1 of notional principal the present value of the fixed payments
= (0.0084) (0.9972 + 0.9903 + 0.9772 + 0.9587) + (1 0.9587) = 0.9917. Note that the
payments now occur in 45, 135, 225 and 315 days.
Per $1 the present value of the floating payments = present value of first floating payment + the
present value of future floating payments
= ((.0142 90/360) + 1) (0.9972) = 1.0007
The market value of the pay floating receive fixed rate swap = $250,000,000 (0.9917 1.0007)
= -$2,250,000
9. With regard to the recommendations for the termination of Novatels swap position, Whitney is
least likely correct with respect to:
A. option 1.
B. option 2.
C. option 3.
Answer = C

2011 Modular Level II, Vol. 6, pp. 283,293
between payor and receiver swaptions.
C is correct. A receiver swaption cannot be used to terminate a pay floating receive fixed swap.
10. Using data in Exhibit 2, the market value of Grand Manufacturings swap after 45 days is closest
to:
A. HK$1,313,300
B. HK$35,402,000
C. HK$36,500,000
Answer = B

Calculate and interpret the fixed rate, if applicable, and the foreign notional principal for a given
domestic notional principal on a currency swap, and determine the market values of each of the
different types of currency swaps during their lives.
B is correct. Initially, Grand receives 25,000,000 and pays HK$285,500,000 based on the
current exchange rate of HK$11.42 per euro. We are told that Grand will pay an interest rate of
2.32% on the euro and receive 1.84% on the Hong Kong dollar.
Forty five days into the swap:
Per HK$1 of notional principal the present value of the fixed payments received on the Hong
dollar
= (0.0046) (0.9976 + 0.9909 + 0.9834 + 0.9674) + (1 0.9674) = 0.9855
Per 1 of notional principal the present value of the fixed payments paid on the euro
= (0.0058) (0.9963 + 0.9888 + 0.9811 + 0.9650) + (1 0.9650) = 0.9878
Note that based on the exchange rate of HK$11.42 the actual notional principal = 111.42 =
0.08757
The present value of euro fixed payments = 0.9878 0.08757 = 0.08649
The present value of euro fixed payments in HK$ = 0.08649 9.96 = 0.8615
The market value of the swap = 285,500,000 (0.9855 0.8615) = HK$35,402,000
11. Using data in Exhibit 2, the market value of KPS Financial Services swap after 45 days is closest
to:
A. -$4,372,000
B. -$2,232,000
C. -$2,162,000
Answer = B

Study Session 17-63-e
Calculate and interpret the fixed rate, if applicable, on an equity swap and the market values of
the different types of equity swaps during their lives.
B is correct. The market value of the swap per $ notional principal = value of $1 investment in
equity - present value of floating payment.
Value of $1 investment in equity = 905 925 = 0.97838
Per $1 the present value of the floating payments = present value of first floating payment + the
present value of future floating payments
= ((.0142 90/360) + 1) (0.9972) = 1.0007
Market value of swap = (0.97838 1.0007) $100,000,000 = -$2,232,000
12. At what point in the swaps life is the credit risk with respect to KPS Financial Services swap
position most likely the highest?
A. End
B. Middle
C. Beginning
Answer = B
2011 Modular Level II, Vol. 6, p. 288
Study Session 17-63-i
Evaluate swap credit risk for each party and during the life of the swap, distinguish between
current credit risk and potential credit risk, and illustrate how swap credit risk is reduced by
both netting and marking to market.
B is correct. Interest rate and equity swaps do not involve an exchange of principal. Therefore,
credit risk is greater during the middle of the life of these swaps. KPS Financial has entered into
an equity swap, so the credit risk is higher during the middle of its life.
Questions 49 through 54 relate to Derivative Investments.
Ravi Baloo Case Scenario
Ravi Baloo is a portfolio manager with Springtree Investments, a U.S.-based asset management
firm. Baloo is considering using derivatives to enhance returns and manage risk. He asks his
junior analyst, Thomas Monk, to help him.
In Exhibit 1, Monk summarizes the relationship between an increase in the value of each of the
listed inputs and the value of a European-style call option, holding all else constant.
Exhibit 1
Effect of Increasing Input Values on European Call Option Values
Effect on
Input
Call Option Value
Exercise price Decrease
Risk-free rate Decrease
Time to expiration Increase
Volatility of the underlying Increase
Monk wonders about the delta and gamma of a long call option position. Monk makes the
following statements:
Statement 1: The delta of an out-of-the-money call moves towards 0 as expiration

approaches even if the price of the underlying does not change.
Statement 2: Gamma is smaller when there is more uncertainty about whether the option
Statement 3: Delta is a more precise measure of the change in the options value when
the gamma of the option is larger.
Baloo asks Monk to assist him in analyzing the following transactions:
Transaction 1: Arbitrage Strategy on Acuriva Ltd. (ACT) Equity. Exhibit 2 provides current
market prices and data of selected instruments related to ACT equity.
Exhibit 2
Current Market Prices and Data
Security Price
European call option on ACT equity $2.25
European put option on ACT equity $3.40
ACT equity price $33.66
Time to expiration of options 3 months
Exercise price of options $35.00
Annualized risk-free rate 6.00%
Monk determines that the value of a synthetic call option expiring in 3 months with an exercise
price of $35.00 is $2.58.
Transaction 2: Purchase of a European put option on Tekvonix (TVX) equity. Monk uses a one-
period binomial model to calculate the value of a one-year put option on TVX equity. Details of
the put option are given in Exhibit 3.
Exhibit 3
European Put Option on TVX Equity
Time to expiration 1 year
TVX equity price $52
Exercise price $45
Model predicted up move 15%
Model predicted down move 20%
Transaction 3: Equity swap to gain exposure to the Russell 2000 index. Springtree enters into a
two-year equity swap in which it will receive the rate of return on the Russell 2000 Index and
will pay a fixed interest rate equal to 4.99 percent. The swap has annual payments. The Russell
2000 Index is at 757.09 at the beginning of the swap and the notional principal of the swap is
$100 million.
Transaction 4: Baloo expects to enter a pay-fixed position in a 4-year interest rate swap in six
months. He asks Monk to explain how a swaption can be used to protect Springtree from an
adverse change in interest rates. Monk makes the following statements:
Statement 4: Springtree should purchase a payer swaption.

Statement 5: The swaption fixes the rate that Springtree will pay on its swap.
Statement 6: A swaption can be settled in cash at expiration.
Monk considers a scenario in which the Russell 2000 Index falls to 723.86 in 100 days and the
term structure of interest rates is as presented in Exhibit 4.
Exhibit 4
Term Structure of LIBOR Interest Rates 100 Days Later
Days (T) (T) (T)
260 0.0442 0.9691
620 0.0499 0.9209
Note: Calculations are on a 360-day basis. T = Time to expiration;
(T) = LIBOR rate to time T; (T) = Discount factor of $1 from time
T to the present.
Monk states, The value of this equity swap is the amount of money that is exchanged on the
annual payment date.
49. Which of the relationships shown in Exhibit 1 is incorrect?
A. Volatility
B. Risk-free rate
C. Exercise price
50. Which of Baloos statements regarding the delta and gamma of a call option is correct?
A. Statement 1
B. Statement 2
C. Statement 3
51. Baloos arbitrage strategy in Transaction 1 should include:
A. selling the put option in the market and buying the equity.
B. selling the put option in the market and shorting the equity.
C. buying the put option in the market and shorting the equity.
52. The value of the one-year put option in Transaction 2 is closest to:
A. $0.83.
B. $1.70.
C. $2.38.
53. Given Monks scenario, the market value of Transaction 3 is closest to:
A. $5,910,000.
B. $3,070,000.
C. -$1,070,000.
54. Which of the statements Monk makes with respect to Transaction 4 is incorrect?
A. Statement 4
B. Statement 5
C. Statement 6
Ravi Baloo Case Scenario
Ravi Baloo is a portfolio manager with Springtree Investments, a U.S.-based asset management
firm. Baloo is considering using derivatives to enhance returns and manage risk. He asks his
junior analyst, Thomas Monk, to help him.
In Exhibit 1, Monk summarizes the relationship between an increase in the value of each of the
listed inputs and the value of a European-style call option, holding all else constant.
Exhibit 1
Effect of Increasing Input Values on European Call Option Values
Effect on
Input
Call Option Value
Exercise price Decrease
Risk-free rate Decrease
Time to expiration Increase
Volatility of the underlying Increase
Monk wonders about the delta and gamma of a long call option position. Monk makes the
following statements:
Statement 1: The delta of an out-of-the-money call moves towards 0 as expiration

approaches even if the price of the underlying does not change.
Statement 2: Gamma is smaller when there is more uncertainty about whether the option
Statement 3: Delta is a more precise measure of the change in the options value when
the gamma of the option is larger.
Baloo asks Monk to assist him in analyzing the following transactions:
Transaction 1: Arbitrage Strategy on Acuriva Ltd. (ACT) Equity. Exhibit 2 provides current
market prices and data of selected instruments related to ACT equity.
Exhibit 2
Current Market Prices and Data
Security Price
European call option on ACT equity $2.25
European put option on ACT equity $3.40
ACT equity price $33.66
Time to expiration of options 3 months
Exercise price of options $35.00
Monk determines that the value of a synthetic call option expiring in 3 months with an exercise
price of $35.00 is $2.58.
Transaction 2: Purchase of a European put option on Tekvonix (TVX) equity. Monk uses a one-
period binomial model to calculate the value of a one-year put option on TVX equity. Details of
the put option are given in Exhibit 3.
Exhibit 3
European Put Option on TVX Equity
Time to expiration 1 year
TVX equity price $52
Exercise price $45
Model predicted up move 15%
Model predicted down move 20%
Transaction 3: Equity swap to gain exposure to the Russell 2000 index. Springtree enters into a
two-year equity swap in which it will receive the rate of return on the Russell 2000 Index and
will pay a fixed interest rate equal to 4.99 percent. The swap has annual payments. The Russell
2000 Index is at 757.09 at the beginning of the swap and the notional principal of the swap is
$100 million.
Transaction 4: Baloo expects to enter a pay-fixed position in a 4-year interest rate swap in six
months. He asks Monk to explain how a swaption can be used to protect Springtree from an
adverse change in interest rates. Monk makes the following statements:
Statement 4: Springtree should purchase a payer swaption.

Statement 5: The swaption fixes the rate that Springtree will pay on its swap.
Statement 6: A swaption can be settled in cash at expiration.
Monk considers a scenario in which the Russell 2000 Index falls to 723.86 in 100 days and the
term structure of interest rates is as presented in Exhibit 4.
Exhibit 4
Term Structure of LIBOR Interest Rates 100 Days Later
Days (T) L0(T) B0(T)
260 0.0442 0.9691
620 0.0499 0.9209
Note: Calculations are on a 360-day basis. T = Time to expiration;
L0(T) = LIBOR rate to time T; B0(T) = Discount factor of $1 from
time T to the present.
Monk states, The value of this equity swap is the amount of money that is exchanged on the
annual payment date.
49. Which of the relationships shown in Exhibit 1 is incorrect?
A. Volatility
B. Risk-free rate
C. Exercise price
Answer: B
Option Markets and Contracts, Don M. Chance

2009 Modular Level II, Volume 6, pp. 193-194
Explain how an option price, as represented by the Black-Scholes-Merton model, is affected
by each of the input values (the option Greeks).
As the risk-free rate increases, the value of a call option increases.
50. Which of Baloos statements regarding the delta and gamma of a call option is correct?
A. Statement 1
B. Statement 2
C. Statement 3
Answer: A

Explain the gamma effect on an options price and delta and how gamma can affect a delta
hedge.
Even if the price of the underlying does not change, the delta of an option changes as the
option moves towards expiration. The delta of an out-of-the-money call will move towards 0
as expiration approaches.
51. Baloos arbitrage strategy in Transaction 1 should include:
A. selling the put option in the market and buying the equity.
B. selling the put option in the market and shorting the equity.
C. buying the put option in the market and shorting the equity.
Answer: B

Calculate and interpret the prices of a synthetic call option, synthetic put option, synthetic
bond, and synthetic underlying stock and infer why an investor would want to create such
instruments.
The synthetic call (long put, long underlying and short bond) is more expensive than the
market price thus the call is under priced in the market. Using put-call parity, Baloo should
buy the call in the market and sell the synthetic call. Thus the correct arbitrage transaction
(see put-call parity formula below) is to buy the call and sell the put, short the equity, and
buy the bond.
Put-call parity: co + X/(1 + r)T = po + So
co current price of call option with exercise price X, expiring in T years
X exercise price
r risk-free rate
po current price of put option with exercise price X, expiring in T years
So current equity price
52. The value of the one-year put option in Transaction 2 is closest to:
A. $0.83.
B. $1.70.
C. $2.38.
Answer: A

2009 Modular Level II, Volume 6, pp. 166-170, 176
Calculate and interpret prices of interest rate options and options on assets using one- and
two-period binomial models
The value of the one-year put is calculated as follows:

Su= 52*1.15 = 59.8
Sd=52*0.8 = 41.6
P+ = 0
P- = 45-41.6 = 3.40
0.8)/(1.15 0.8) = 0.7429
+ -
+ (1- ) /(1+r) ) = (0.7427$0 + 0.2573$3.40)/1.06 = $0.83
53. Given Monks scenario, the market value of Transaction 3 is closest to:
A. $5,910,000.
B. $3,070,000.
C. -$1,070,000.
Answer: A
Swap Markets and Contracts. Don M. Chance

Calculate and interpret the fixed rate, if applicable, on an equity swap and the market values
of the different types of equity swaps during their lives
Fixed rate on swap = 4.99 % (Given in vignette)

Market value of a swap:
n
St
t(hn) FS(0,n,m) Bt (h j )
S0 j 1
=((723.86/757.09)-0.9209-0.0499*(0.9691+0.9209))*100,000,000= -$5,910,000
54. Which of the statements Monk makes with respect to Transaction 4 is incorrect?
A. Statement 4
B. Statement 5
C. Statement 6
Answer: B

Calculate and interpret the fixed rate, if applicable, on an equity swap and the market values
of the different types of equity swaps during their lives
The exercise rate on a payer swaption is the fixed rate at which the holder can enter a pay-
fixed position in a swap, if it chooses.
Robyn Lawrence Case Scenario
Robyn Lawrence is a senior quantitative analyst in the Global Derivatives Group of Ridgeview Capital, an
investment management firm based in New York City. Lawrence is conducting a training session for two
recently hired analysts, Wilma Kaplan and Anita Mehra. At the meeting, Kaplan and Mehra are asked
questions about the Berkeley Corporation and are provided with the information in Exhibit 1.
Exhibit 1
Stock and Options Data for Berkeley Corporation
and Risk-Free Interest Rate
Current Call Price $2.30
Current Put Price $4.70
Exercise Price $130.00
Days to Expiration* 60
Current Stock Price $128.55
Up Move on Stock 15%
Down Move on Stock 10%
Risk-Free Interest Rate 3%
*Note: Assume a 365-day year.
Lawrence begins the meeting by stating:
Statement 1:
You have both been asked to use the information provided in Exhibit 1 to perform certain calculations.
One of your tasks was to calculate the synthetic values of call and put options for Berkeley Corporation.
Can one of you tell me why it is useful to construct and value synthetic calls and puts?
Kaplan responds, Deriving synthetic values enables us to determine whether it is possible to earn
arbitrage profits. For example, if we find that the current call price is greater than the synthetic call price
then we could earn an arbitrage profit by carrying out the following transactions: selling the call,
purchasing the put, and taking short positions in the stock and the bond.
The discussion then moves on to the BlackScholesMerton option pricing model. Lawrence states: The
BlackScholesMerton option pricing model is based on a number of assumptions, including: underlying
prices follow a lognormal probability distribution, the risk-free rate is known and constant, there are no
cash flows on the underlying, and the options being priced are European options. What are the other
assumptions of this model? Kaplan responds:
The other assumptions of the model are:
Assumption 1: There are no taxes or transactions costs.

Assumption 2: The volatility of the underlying assets change through time.
Assumption 3: The prices of the underlying asset follow a lognormal distribution.
Lawrence continues the discussion: In the BlackScholesMerton model, option prices for European
calls and puts are impacted by a number of variables, including time to expiration, volatility, and the
risk-free rate. Can one of you explain the effect of changes in these variables on the prices of European
call and put options?
Mehra responds: Call and put prices are higher when volatility is higher, and call and put prices are
lower for higher risk-free rates. However, while call options are higher for longer time to expiration, put
option prices can be higher or lower the longer the time to expiration.
Lawrence ends the meeting with the following statement:
Statement 2:
An important option Greek that you should be familiar with is the option delta, because traders can use
this to construct hedges to offset the risks of their option positions. You should note that for in-the-
money call and put options, delta approaches 1 as the option moves toward expiration.
7. Based on the information provided for the Berkeley Corporation in Exhibit 1, the price of a
synthetic 60-day call option with a $130.00 strike price is closest to:
A. $3.25
B. $3.88
C. $5.52
8. Kaplans response to Lawrences Statement 1 is most likely:
A. correct.
B. incorrect with regard to purchasing the put.
C. incorrect with regard to taking a short position in the stock.
9. Based on the information in Exhibit 1 and using a one-period binomial model, the value of a 60-
day Berkeley Corporation call option with a strike of $130.00, is closest to:
A. $6.67.
B. $8.31.
10. Kaplans response to Lawrence regarding the assumptions of the BlackScholesMerton model
is least likely correct with respect to:
A. Assumption 1.
B. Assumption 2.
C. Assumption 3.
11. Mehras response to Lawrence is least likely correct with respect to the impact on call and put
prices of:
A. volatility.
B. the risk-free rate.
C. time to expiration.
12. Is Statement 2 by Lawrence most likely correct?
A. Yes.
B. No, she is incorrect with respect to calls.
C. No, she is incorrect with respect to puts.
Robyn Lawrence Case Scenario
Robyn Lawrence is a senior quantitative analyst in the Global Derivatives Group of Ridgeview Capital, an
investment management firm based in New York City. Lawrence is conducting a training session for two
recently hired analysts, Wilma Kaplan and Anita Mehra. At the meeting, Kaplan and Mehra are asked
questions about the Berkeley Corporation and are provided with the information in Exhibit 1.
Exhibit 1
Stock and Options Data for Berkeley Corporation
and Risk-Free Interest Rate
Current Call Price $2.30
Current Put Price $4.70
Exercise Price $130.00
Days to Expiration* 60
Current Stock Price $128.55
Up Move on Stock 15%
Down Move on Stock 10%
Risk-Free Interest Rate 3%
*Note: Assume a 365-day year.
Lawrence begins the meeting by stating:
Statement 1:
One of your tasks was to calculate the synthetic values of call and put options for Berkeley Corporation.
Can one of you tell me why it is
arbitrage profits. For example, if we find that the current call price is greater than the synthetic call price
then we could earn an arbitrage profit by carrying out the following transactions: selling the call,
The discussion then moves on to the Black Scholes Merton option pr

Black Scholes Merton option pricing model is based on a number of assumptions, including: underlying
prices follow a lognormal probability distribution, the risk-free rate is known and constant, there are no
cash flows on the underlying, and the options being priced are European options. What are the other
assumptions of this model? Kaplan responds:
Assumption 1: There are no taxes or transactions costs.
Assumption 2: The volatility of the underlying assets change through time.
Lawrence continues the discussion: Scholes Merton model, option prices for European
calls and puts are impacted by a number of variables, including time to expiration, volatility, and the
risk-free rate. Can one of you explain the effect of changes in these variables on the prices of European
Mehra responds: gher when volatility is higher, and call and put prices are
lower for higher risk-free rates. However, while call options are higher for longer time to expiration, put
Lawrence ends the meeting with the following statement:
Statement 2:
this to construct hedges to offset the risks of their option positions. You should note that for in-the-
7. Based on the information provided for the Berkeley Corporation in Exhibit 1, the price of a
synthetic 60-day call option with a $130.00 strike price is closest to:
A. $3.25
B. $3.88
C. $5.52
Answer = B
2012 Modular Level II, Vol. 6, pp. 171 176

instruments.
B is correct. The synthetic call option is constructed by going long the put and the stock and
short the bond.
Synthetic call =
= = $3.88.
8. most likely:
A. correct.
B. incorrect with regard to purchasing the put.
C. incorrect with regard to taking a short position in the stock.
Answer = C

instruments.
C is correct. Kaplan is correct about the reason for calculating synthetic option values; it allows
one to determine if it is possible to earn arbitrage profits. However, Kaplan is incorrect about
the set of transactions that can be used to earn an arbitrage profit if the current price of the call
option is greater than the synthetic value. The correct strategy is to sell the call option and then
take long positions in the put and the stock and a short position in the bond (purchase the
synthetic call). He incorrectly states that a short position should be taken in the stock.
9. Based on the information in Exhibit 1 and using a one-period binomial model, the value of a 60-
day Berkeley Corporation call option with a strike of $130.00, is closest to:
A. $6.67.
B. $8.31.
C. $9.00.
Answer = C

Calculate and interpret prices of interest rate options and options on assets using one- and two-
period binomial models.
C is correct. The value of the call option using the one-period binomial model is calculated as
follows:
= =$9.00 given by:

+
S = 128.55 1.15 = 147.8325
S- = 128.55 0.90 = 115.695
c+ = Max[0, S+ X] = Max[0, 147.8325 130] = 17.8325
c- = Max[0, S- X] = Max[0, 115.695 130] = 0
10. Scholes Merton model

is least likely correct with respect to:
A. Assumption 1.
B. Assumption 2.
C. Assumption 3.
Answer = B

Explain and evaluate the assumptions underlying the Black Scholes Merton model.
B is correct. Kaplan is incorrect. The Black Scholes Merton model assumes that the volatility of
the underlying asset is known and is constant.
11. least likely correct with respect to the impact on call and put
prices of:
A. volatility.
B. the risk-free rate.
C. time to expiration.
Answer = B
Explain how an option price, as represented by the Black Scholes Merton model, is affected by
a change in the value each of the inputs.
B is correct. Mehra incorrectly states the relationship between the risk-free rate and the prices
of call and put options. The price of a call option rises as the risk-free rate goes up. The price of a
put option, however, declines as the risk-free rate rises.
12. Is Statement 2 by Lawrence most likely correct?
A. Yes.
B. No, she is incorrect with respect to calls.
C. No, she is incorrect with respect to puts.
Answer = C

Study Session 17-56-d, e
Explain how an option price, as represented by the Black Scholes Merton model, is affected by
a change in the value each of the inputs.
Explain the delta of an option and demonstrate how it is used in dynamic hedging.
C is correct. For in-the-money put options, delta approaches 1, not 1, as the option moves
toward expiration.
Tarja Stahlberg Case Scenario
Tarja Stahlberg, the company treasurer for the Finnish-based Borealis Group Oyj, is planning to
repatriate million from its British subsidiary. She intends to convert the British pounds to
euros (the home currency for Borealis) in 90 days.
Nicholas Howell is advising Stahlberg on these transactions. Stahlberg has told Howell that she
wants to protect Borealis against the possibility that the British pound depreciates against the
euro before the funds are repatriated.
Howell suggests that Stahlberg consider the use of foreign currency options. In particular, a
European call option on euros will allow Borealis to hedge its foreign currency risk. Howell
makes the following statements:
Statement 1: The call option price will decrease as the time to expiration decreases or the
exercise price decreases; and is very sensitive to the risk-free rate.
Statement 2: You can use 90-day call options on the euro with a strike price of
current 90-day forward exchange rate is uropean call option on the euro
can be created by combining a long put position on the euro, a short position in a forward
contract on the euro, and a short position in a zero-coupon bond.
Stahlberg mentions that Borealis will have ongoing U.S. dollar borrowing needs, and that she
wants to use the Eurodollar market to meet these. She prefers to use floating rate debt, and is
considering issuing a U.S. dollar denominated floating rate note (FRN). Stahlberg is concerned
that an increase in U.S. yields before the FRN issuance date will increase her future borrowing
costs (measured in U.S. dollars).
Howell explains how swaps and swaptions can be used to address Stahlbergs concerns, stating:
Statement 3: Similar to a forward contract, a plain vanilla interest rate swap can fix borrowing
costs. For example, if you issued a US$100 million FRN today that has a 180-day term and
coupon payments that reset every 90 days at the 90-day LIBOR, a plain vanilla interest rate swap
could convert it to a fixed rate obligation.
Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk, but has
potential credit risk that will increase steadily over the life of the swap.
Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is
equivalent to a put option.
Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has
a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. You would
want a European swaption with a notional principal amount of US$100 million and a 90-day
expiry at the time of FRN issuance. The data for this example is presented in Exhibit 1.
Exhibit 1
U.S. dollar LIBOR and Fixed Rates
LIBOR, Swap, and Swaption
Today In 90 days
Rates are Annualized
90-day U.S. LIBOR 3.50% 4.00%
180-day U.S. LIBOR 3.85% 4.35%
Fixed rate on swaption 3.90% n/a
Fixed rate on swap n/a 4.32%
90-day discount factor 0.9913 0.9901
49. The information in Statement 1 is correct with respect to:
A. exercise price.
B. time to expiration.
C. risk-free interest rate.
50. Statement 2 is incorrect with respect to which position?
A. put option
B. forward contract
C. zero-coupon bond
51. Given the information in Statement 3 and Exhibit 1, the annualized fixed rate on the plain
vanilla interest rate swap would be closest to:
A. 1.76%.
B. 3.84%.
C. 4.32%.
52. Statement 4 can be best characterized as:
A. correct with respect to current credit risk only.

B. correct with respect to potential credit risk only.
C. correct with respect to both current credit risk and potential credit risk.
A. incorrect with respect to the pay floating position.

B. incorrect with respect to the put option equivalency.
C. correct with respect to both put option equivalency and pay floating position.
54. Based on Statement 6 and Exhibit 1, the market value of the swaption at expiration would
be closest to:
A. $206,725.
B. $207,764.
C. $208,961.
Tarja Stahlberg Case Scenario
Tarja Stahlberg, the company treasurer for the Finnish-based Borealis Group Oyj, is planning to
repatriate million from its British subsidiary. She intends to convert the British pounds to
euros (the home currency for Borealis) in 90 days.
Nicholas Howell is advising Stahlberg on these transactions. Stahlberg has told Howell that she
wants to protect Borealis against the possibility that the British pound depreciates against the
euro before the funds are repatriated.
Howell suggests that Stahlberg consider the use of foreign currency options. In particular, a
European call option on euros will allow Borealis to hedge its foreign currency risk. Howell
makes the following statements:
Statement 1: The call option price will decrease as the time to expiration decreases or the
exercise price decreases; and is very sensitive to the risk-free rate.
Statement 2: You can use 90-day call options on the euro with a strike price of
current 90-day forward exchange rate is uropean call option on the euro
can be created by combining a long put position on the euro, a short position in a forward
contract on the euro, and a short position in a zero-coupon bond.
Stahlberg mentions that Borealis will have ongoing U.S. dollar borrowing needs, and that she
wants to use the Eurodollar market to meet these. She prefers to use floating rate debt, and is
considering issuing a U.S. dollar denominated floating rate note (FRN). Stahlberg is concerned
that an increase in U.S. yields before the FRN issuance date will increase her future borrowing
costs (measured in U.S. dollars).
Howell explains how swaps and swaptions can be used to address Stahlbergs concerns, stating:
Statement 3: Similar to a forward contract, a plain vanilla interest rate swap can fix borrowing
costs. For example, if you issued a US$100 million FRN today that has a 180-day term and
coupon payments that reset every 90 days at the 90-day LIBOR, a plain vanilla interest rate swap
could convert it to a fixed rate obligation.
Statement 4: A newly entered plain vanilla interest rate swap has no current credit risk, but has
potential credit risk that will increase steadily over the life of the swap.
Statement 5: A receiver swaption permits the holder to enter into a pay floating position and is
equivalent to a put option.
Statement 6: Suppose that you planned to issue a US$100 million FRN in 90 days time that has
a 180-day term and coupon payments that reset every 90 days at the 90-day LIBOR. You would
want a European swaption with a notional principal amount of US$100 million and a 90-day
expiry at the time of FRN issuance. The data for this example is presented in Exhibit 1.
Exhibit 1
U.S. dollar LIBOR and Fixed Rates
LIBOR, Swap, and Swaption
Today In 90 days
Rates are Annualized
90-day U.S. LIBOR 3.50% 4.00%
180-day U.S. LIBOR 3.85% 4.35%
Fixed rate on swaption 3.90% n/a
Fixed rate on swap n/a 4.32%
49. The information in Statement 1 is correct with respect to:
A. exercise price.
B. time to expiration.
C. risk-free interest rate.
Answer: B

2009 Modular Level II, Volume 6, pp.195-197
Explain how an option price, as presented by the Black-Scholes-Merton model, is
affected by each of the input values (the option Greeks).
As expiration approaches, the price of the option moves toward the payoff value of the
option at expiration, a process known as time value decay.
50. Statement 2 is incorrect with respect to which position?
A. put option
B. forward contract
C. zero-coupon bond
Answer: B
Study Session17-62-i
Illustrate how put-call parity for options on forwards (or futures) is established.
A synthetic call option is constructed by being long a forward, long the put option, and
long or short a zero-coupon bond. Since Howell stated that F(0,T) > X, then this would
be a short position in the zero-coupon bond.
Put-call-forward parity states that:
Rearranging terms a synthetic call option is:
That is you take a long position in the put, a short bond position and a long forward
position.
51. Given the information in Statement 3 and Exhibit 1, the annualized fixed rate on the plain
vanilla interest rate swap would be closest to:
A. 1.76%.
B. 3.84%.
C. 4.32%.
Answer: B

Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the market
value of the swap during its life.
The fixed rate on a swap is calculated as:

FS(0,n,m) = [ 1.0 ( ) ] / j ( )
where:
FS(0,n,m) is the fixed payment on a swap starting at time 0 making n payments
based on the m-day rate
( ) is the present value factor for the final notional payment
( ) is the sum of the present value factors for each payment
Based on Howells third statement and the data in Exhibit 1:
FS(0,4,90) = [ 1.0 ( ) ] / [ ( ) + ( ) ]
( ) = 1 / [ 1 + 0.0385(180/360) ] = 0.9811
Thus, FS(0,4,90) = ( 1.0 0.9811) / (0.9913 + 0.9811) = 0.0096. This is the quarterly
rate and annualizing it (multiplying by four) leads to 3.84%.
A. correct with respect to current credit risk only.

B. correct with respect to potential credit risk only.
C. correct with respect to both current credit risk and potential credit risk.
Answer: A

Study Session17-63-i
Evaluate swap credit risk for each party and over the life of the swap, distinguish between
current credit risk and potential credit risk, and illustrate how swap credit risk is reduced
by both netting and marking to market.
While there is no credit risk at contract initiation, the potential credit risk of an interest
rate swap is greatest at the middle of its life; it does not increase throughout the life of the
swap.
53. Statement 5 is can be best characterized as:
A. incorrect with respect to the pay floating position.

B. incorrect with respect to the put option equivalency.
C. correct with respect to both put option equivalency and pay floating position.
Answer: B

2009 Modular Level II, Volume 6, pp.256-257
between payer and receiver swaptions.
A receiver swaption is equivalent to a call option.

54. Based on Statement 6 and Exhibit 1, the market value of the swaption at expiration would
be closest to:
A. $206,725.
B. $207,764.
C. $208,961.
Answer: A

Study Session 17-63-h
Calculate and interpret the value of an interest rate swaption on the expiration day
The payoff of a payer swap in which the exercise price is x and the market rate on the
underlying swap is FS(0,n,m) is:
Max[0, FS(0,n,m) x] * j (hj)
Using the information in Exhibit 1 and Howells sixth statement:
[4.32% - 3.90%) * (90/360)]= $105,000
( ) = 1 / ( 1 + 0.0400*90/360) = 0.9901
( ) = 1 / ( 1 + 0.0435*180/360) = 0.9787
($105,000 * 0.9901) + ($105,000 * 0.9787) = $206,725
Tyra Merinar Case Scenario
Tyra Merinar is a portfolio manager at Ridge Row Capital Advisors (RRCA), a hedge fund based in
Charlottesville, Virginia. Merinar is meeting with two assistant portfolio managers, Vinay Jani
and Zhong Geng, to review the performance of investments made by RRCA and to evaluate
potential new investments. At this meeting they will discuss two recent investments, an equity
swap and a swaption, as well as two potential new investments.
RRCA entered into a one-year equity swap 30 days ago. Under the terms of the swap, the fund
would receive the return on the S&P/ASX 300 Metals & Mining Index and pay a fixed annual
interest rate of 4.8% on notional principal of $75,000,000. The swap calls for quarterly
payments. At the time the swap was initiated, 30 days ago, the S&P/ASX 300 index was 3,250.
The value of the S&P/ASX 300 index today is 3,738. Merinar wishes to determine the market
value of the equity swap today using the current term structure of interest rates presented in
Exhibit 1.
Exhibit 1
Term Structure of Interest Rates (%)
Days LIBOR
60 1.42
150 1.84
240 2.12
330 3.42
Three months ago, RRCA purchased a European receiver swaption that is exercisable into a two-
year swap with semiannual payments. The swaption has a semiannual exercise rate of 2.75%
and a notional principal of $25,000,000. The swaption has just expired, and Merinar asks Jani to
determine its cash settlement using the term structure presented below in Exhibit 2.
Exhibit 2
Days LIBOR
180 1.95
360 3.68
540 4.11
720 4.65
strategy that invo

have been evaluating bonds of Onex Corporation, which are currently rated BBB. Onex has just
announced an acquisition that we believe will likely weaken its credit metrics over the next two
years. However, longer term, say 4 to 5 years, Onex should generate enough cash flow to
improve credit quality to pre-acquisition levels. We could use forward contracts on a credit
default swap (CDS) index, such as the CDX, to take advantage of this. The best way to do this is
to buy CDX investment grade expiring in 5 years and sell CDX high yield expiring
Merinar asks Jani to assess potential mispricing in equity futures markets with a view to
implementing an investment strategy to take advantage of any mispricing. Specifically, she asks
him to evaluate a futures contract on the S&P 400 Mid Cap stock index expiring in 145 days. The
annual risk-free rate is 3.5%, and the index is at 840 today. The accumulated value of dividends
reinvested over the life of the futures contract is expected to be $3.15 per contract.
Merinar explains the investment strategy to be implemented if the stock index futures contract
e calculation, the appropriate
Merinar closes the meeting by asking if Geng and Jani can explain the relation between futures
s prices are an accurate estimate of
Expected spot prices are e
43. Using the information provided in Exhibit 1, the market value of the equity swap is
closest to:
A. $7,717,500.
B. $7,665,000.
C. $9,997,500.
44. Using the information in Exhibit 2, the market value of the receiver swaption is closest
to:
A. $106,250.
B. $495,508.
C. $687,500.
45. most likely appropriate?
A. Yes.
B. No, the appropriate strategy would be to sell 2-year CDS and buy 5-year CDS for
Onex Corporation.
C. No, the appropriate strategy would be to buy 2-year CDS and sell 5-year CDS for
Onex Corporation.
46. Assuming a 365-day year, the S&P 400 Mid Cap stock index futures price is closest to:
A. 836.85.
B. 848.11.
C. 854.71.
47. most likely correct?
A. Yes.
B. No, the correct strategy would be to only purchase stock index futures.
C. No, the correct strategy would be to purchase the stock index and sell stock index
futures.
48. Who correctly states the relationship between futures prices and expected spot prices?
A. Jani
B. Geng
C. Merinar
Tyra Merinar Case Scenario
Tyra Merinar is a portfolio manager at Ridge Row Capital Advisors (RRCA), a hedge fund based in
Charlottesville, Virginia. Merinar is meeting with two assistant portfolio managers, Vinay Jani
and Zhong Geng, to review the performance of investments made by RRCA and to evaluate
potential new investments. At this meeting they will discuss two recent investments, an equity
swap and a swaption, as well as two potential new investments.
RRCA entered into a one-year equity swap 30 days ago. Under the terms of the swap, the fund
would receive the return on the S&P/ASX 300 Metals & Mining Index and pay a fixed annual
interest rate of 4.8% on notional principal of $75,000,000. The swap calls for quarterly
payments. At the time the swap was initiated, 30 days ago, the S&P/ASX 300 index was 3,250.
The value of the S&P/ASX 300 index today is 3,738. Merinar wishes to determine the market
value of the equity swap today using the current term structure of interest rates presented in
Exhibit 1.
Exhibit 1
Days LIBOR
60 1.42
150 1.84
240 2.12
330 3.42
Three months ago, RRCA purchased a European receiver swaption that is exercisable into a two-
year swap with semiannual payments. The swaption has a semiannual exercise rate of 2.75%
and a notional principal of $25,000,000. The swaption has just expired, and Merinar asks Jani to
determine its cash settlement using the term structure presented below in Exhibit 2.
Exhibit 2
Days LIBOR
180 1.95
360 3.68
540 4.11
720 4.65
strategy that involve

have been evaluating bonds of Onex Corporation, which are currently rated BBB. Onex has just
announced an acquisition that we believe will likely weaken its credit metrics over the next two
years. However, longer term, say 4 to 5 years, Onex should generate enough cash flow to
improve credit quality to pre-acquisition levels. We could use forward contracts on a credit
default swap (CDS) index, such as the CDX, to take advantage of this. The best way to do this is
to buy CDX investment grade expiring in 5 years and sell CDX high yield expiring
Merinar asks Jani to assess potential mispricing in equity futures markets with a view to
implementing an investment strategy to take advantage of any mispricing. Specifically, she asks
him to evaluate a futures contract on the S&P 400 Mid Cap stock index expiring in 145 days. The
annual risk-free rate is 3.5%, and the index is at 840 today. The accumulated value of dividends
reinvested over the life of the futures contract is expected to be $3.15 per contract.
Merinar explains the investment strategy to be implemented if the stock index futures contract
alculation, the appropriate
Merinar closes the meeting by asking if Geng and Jani can explain the relation between futures
rices are an accurate estimate of
Expected spot prices are equa
43. Using the information provided in Exhibit 1, the market value of the equity swap is
closest to:
A. $7,717,500.
B. $7,665,000.
C. $9,997,500.
Answer = C

Calculate and interpret the fixed rate, if applicable, on an equity swap and the market
values of the different types of equity swaps during their lives.
C is correct. Per $1 of notional principal, the market value of the equity swap is
calculated as follows:
The market value of the swap = 0.1333 $75,000,000 = $9,997,500
The appropriate present value factors are provided below:

B30(90) 0.9976
B30(180) 0.9924
B30(270) 0.9861
B30(360) 0.9696

44. Using the information in Exhibit 2, the market value of the receiver swaption is closest
to:
A. $106,250.
B. $495,508.
C. $687,500.
Answer = B
Don M. Chance
2012 Modular Level II, Vol. 6, pp. 268 269, 286 287
Calculate and interpret the value of an interest rate swaption at expiration.
B is correct. The market value of the receiver swaption is calculated as:

Max [0, (0.0275 0.0223)] (0.9903 + 0.9645 + 0.9419 + 0.0149) $25,000,000
= $495,508.
The appropriate present value factors are provided below:

Bo(180) 0.9903
Bo(360) 0.9645
Bo(540) 0.9419
Bo(720) 0.9149
Other present value factors are calculated in a similar manner.

The fixed rate is calculated as follows:
The annualized rate = 0.0223 2 = 0.0446

45. most likely appropriate?
A. Yes.
B. No, the appropriate strategy would be to sell 2-year CDS and buy 5-year CDS for
Onex Corporation.
C. No, the appropriate strategy would be to buy 2-year CDS and sell 5-year CDS for
Onex Corporation.
Answer = C
rge Spentzos
Describe credit derivatives trading strategies, and explain how they are used by hedge
funds and other managers.
C is correct. Since Geng expects credit ratings for Onex Corporation bonds to weaken
over the near term up to two years, and then strengthen over the longer term (five
years), the appropriate strategy is to buy 2-year CDS and sell 5-year CDS. The 2-year CDS
would provide a hedge against short-term volatility, and the sale of the 5-year CDS
would partially fund the purchase of 2-year CDS. This is a flattener curve trade.
46. Assuming a 365-day year, the S&P 400 Mid Cap stock index futures price is closest to:
A. 836.85.
B. 848.11.
C. 854.71.
Answer = B

Calculate and interpret the prices of Treasury bond futures, stock index futures, and
currency futures.
B is correct. The S&P 400 Mid Cap futures price is:

840 (1.035)(145/365) 3.15 = 848.41
47. most likely correct?
A. Yes.
B. No, the correct strategy would be to only purchase stock index futures.
C. No, the correct strategy would be to purchase the stock index and sell stock index
futures.
Answer = A
2012 Modular Level II, Vol. 6, p. 116

Calculate and interpret the prices of Treasury bond futures, stock index futures, and
currency futures.
A is correct. Merinar is correct. If stock index futures are underpriced, the correct
arbitrage strategy would be to short the stock index and purchase stock index futures.
This strategy will effectively ensure that Merinar has borrowed money at the risk-free
rate and repaid at a rate less than the risk-free rate.
48. Who correctly states the relationship between futures prices and expected spot prices?
A. Jani
B. Geng
C. Merinar
Answer = A
ts
Explain the relation between futures prices and expected spot prices.
A is correct. Jani is correct. The futures price is equal to the expected spot price minus a
risk premium. Alternatively, the expected spot price equals the futures price plus a risk
premium.

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Chester Midway Case Scenario

Statement 1: A smaller gamma limits the effectiveness of delta hedging.

9. Which of Edwards statements to Midway regarding options is mostly likely correct:

A. both puts and calls will increase in value.

A. Sell 2-year CDS.

Statement 1: A smaller gamma limits the effectiveness of delta hedging.

Derivative Markets and Instruments, Don M. Chance

Derivative Markets and Instruments, Don M. Chance

Derivative Markets and Instruments, Don M. Chance

A. both puts and calls will increase in value.

Derivative Markets and Instruments, Don M. Chance

A. Sell 2-year CDS.

Derivative Markets and Instruments, George Spentzos, CFA

Swap Markets and Contracts, Don M. Chance

For example, B0(90) is calculated as:

Other present value factors are calculated in a similar manner.

The annualized rate = 0.0084 4 = 0.0336

Swap Markets and Contracts, Don M. Chance

Swap Markets and Contracts, Don M. Chance

Swap Markets and Contracts, Don M. Chance

Swap Markets and Contracts, Don M. Chance

Ravi Baloo Case Scenario

Statement 1: The delta of an out-of-the-money call moves towards 0 as expiration

Baloo asks Monk to assist him in analyzing the following transactions:

Statement 4: Springtree should purchase a payer swaption.

49. Which of the relationships shown in Exhibit 1 is incorrect?

51. Baloos arbitrage strategy in Transaction 1 should include:

Ravi Baloo Case Scenario

Statement 1: The delta of an out-of-the-money call moves towards 0 as expiration

Baloo asks Monk to assist him in analyzing the following transactions:

Statement 4: Springtree should purchase a payer swaption.

49. Which of the relationships shown in Exhibit 1 is incorrect?

Option Markets and Contracts, Don M. Chance

As the risk-free rate increases, the value of a call option increases.

Option Markets and Contracts, Don M. Chance

51. Baloos arbitrage strategy in Transaction 1 should include:

Option Markets and Contracts, Don M. Chance

Option Markets and Contracts, Don M. Chance

The value of the one-year put is calculated as follows:

Swap Markets and Contracts. Don M. Chance

Fixed rate on swap = 4.99 % (Given in vignette)

Swap Markets and Contracts, Don M. Chance

Lawrence begins the meeting by stating:

Assumption 1: There are no taxes or transactions costs.

Lawrence ends the meeting with the following statement:

8. Kaplans response to Lawrences Statement 1 is most likely:

12. Is Statement 2 by Lawrence most likely correct?

Lawrence begins the meeting by stating:

The discussion then moves on to the Black Scholes Merton option pr

Lawrence ends the meeting with the following statement:

2012 Modular Level II, Vol. 6, pp. 171 176

2012 Modular Level II, Vol. 6, pp. 175 177

2012 Modular Level II, Vol. 6, pp. 180 183

= =$9.00 given by:

10. Scholes Merton model

2012 Modular Level II, Vol. 6, pp. 198 199

12. Is Statement 2 by Lawrence most likely correct?

2012 Modular Level II, Vol. 6, pp. 202 204