Derivatives: Years May Nov
Derivatives: Years May Nov
Derivatives: Years May Nov
Derivatives
Years May Nov
RTP Paper RTP Paper
2008 No No Yes Yes
2009 Yes Yes Yes Yes
2010 Yes Yes Yes Yes
2011 Yes Yes Yes Yes
2012 Yes Yes Yes Yes
2013 Yes Yes Yes Yes
2014 Yes No Yes No
2015 Yes No Yes Yes
2016 Yes Yes Yes Yes
2017 Yes Yes Yes Yes
2018 (Old) Yes No Yes Yes
2018 (New) Yes Yes Yes Yes
2008
Question 1 : Nov 2008 - RTP
The market received rumour about XYZ Company’s tie-up with a
multinational company. This has induced the market price to move up. If the
rumour is false, the XYZ Company stock price will probably fall dramatically.
To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of Rs.52 for Rs.2
premium, and paid Re.1 per share premium for a 3 months put with a striking
price of Rs.50.
(i) Determine the Investor’s position if the tie up offer bids the price of stock
up to Rs.53 in 3 months.
(ii) Determine the Investor’s ending position, if the tie up programme fails
and the price of the stocks falls to Rs.46 in 3 months.
Solution
Cost of call and put options
= (Rs.2 per share) x (100 share call) + (Re.1 per share) x (100 share put)
= Rs.2 x 100 + 1 x 100
= Rs.300
(i) Price increases to Rs.53. Since the market price is higher than the strike
price of the call, the investor will exercise it.
330 SFM - COMPILER
Ending position = (-Rs.300 cost of option) + (Re.1 per share gain on call)
x 100
= -Rs.300 + 100
Net Loss = Rs.200
(ii) The price of the stock falls to Rs.46. Since the market price is lower than
the strike price, the investor may not exercise the call option but shall
exercise put option.
= -Rs.300 + 400
Gain = Rs.100
Note: Student may please note that in the above question the lot size has
been assumed to be 100. However, this question can be solved by
assuming any quantity instead of 100 share call say 1,10,1000 etc.
(ii) Find the first floating rate payment for (i) above if the six month period
from the effective date of swap to the settlement date comprises 181 days
and that the corresponding libor was 6% on the effective date of swap.
In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate
payer would pay to the floating rate payer?
Generic swap is based on 30/360 days basis.
Solution
(i) Semi-annual fixed payment
= (N) (AIC) (Period)
Where N = Notional Principal amount = Rs.5,00,000
AIC = All-in-cost = 8% = 0.08
180
= 5,00,000 x 0.08 x 360
= Rs.20,000/-
181
= 5,00,000 × 0.06 x 360
= Rs.15090
d2 = d1 – σ t
Where,
C = Theoretical call premium
S = Current stock price = 80
t = time until option expiration = 0.5
K = option striking price = 75
r = risk-free interest rate = 12%
N = Cumulative standard normal distribution
e = exponential term
σ = Standard deviation of continuously compounded annual return.
In = natural logarithim
In(1.0667) + (12%+(0.08))0.5
d1 =
0.40 0.5
0.0645+(0.02)0.5
= 0.40 x 0.701
0.1645
=0.2828 = 0.5817
72 Payoff = 22
Strike Price = 50
B = 60
A = 50 48 Payoff = Nil
C = 40
32 Payoff = Nil
Using the single period model, the probability of price increase is
R - d 1.06 - 0.8
P = U - d = 1.2 - 0.8 = 0.65
72 Payoff = 22
Strike Price = 50
B = 60
13.49
A = 50 48 Payoff = Nil
C = 40
32 Payoff = Nil
336 SFM - COMPILER
Using the single period binomial model the value of call option at node c will
be Nil – because the payoff in both the, up move and down move is Zero
13.49 x 0.65 + Nil x 0.35
The value of option at node ‘A’ is = 1.06 = 8.272
Since the futures price exceeds its appropriate value it pays to do the
following:-
Action Initial Cash flow at T (3
Cash flow months)
time
Borrow Rs.300 now and repay + Rs.300 – Rs.300
with interest after3 months (1.008)3
= –Rs.307.26
Buy a share –Rs.300 ST
Equity share of PQR Ltd. is presently quoted at Rs.320. The Market Price
of the share after 6 months has the following probability distribution:
Market Price Rs.180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of Rs.300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
Solution
Probable price at expiry = 180 x 0.1 + 260 x 0.2 + 280 x 0.5 + 320 x 0.1 +
400 x 0.1 = 282
Strike Price = 300
Expected Value of option on Maturity = 300 – 282 = Rs.18
Using the Binomial model, calculate the current fair value of a regular
call option on CAB Stock with the following characteristics : X = Rs.28, Risk
Free Rate = 5 percent (per sub period ). You should also indicate the
composition of the implied riskless hedge portfolio at the valuation date.
Solution
u = 33.00/30.00 = 36.30/33.00 = 1.10
d = 27.00/30.00 = 24.30/27.00 = 0.90
r = (1 + 0.05)1/2 = 1.0247
R - d 1.0247 - 0.90
P = U - d = 1.1 - 0.90 = =0.1247/0.20 =0.6235
8.3
Strike Price = 50
5.68
3.84 1.7
1.03
0.0
(0.6235)(8.30)+(0.3765)(1.70) 5.175+0.64
Node B = 1.025 = 1.025 = 5.815/1.025
= Rs.5.675
(0.6235)(1.70)+(0.3765)(0.00) 1.05995
Node C = 1.025 = 1.025 = Rs.1.0340
(0.6235)(5.675)+(0.3765)(1.0340) 3.538+0.3895
Node A == 1.025 = 1.025
= Rs.3.83
h = (33.00– 27.00)/(5.68–1.03) = 6.00/4.65 = 1.29
Question 16 : May 2010 - RTP
In March, a derivatives dealer offers you the following quotes for June
British pound option contracts (expressed in U.S. dollars per GBP):
MARKET PRICE OF CONTRACT
Contract Strike Price
Bid Offer
Call USD 1.40 0.0642 0.0647
Put 0.0255 0.0260
Call 1.44 0.0417 0.0422
Put 0.0422 0.0427
Call 1.48 0.0255 0.0260
Put 0.0642 0.0647
(a) Assuming each of these contracts specifies the delivery of GBP 31,250
and expires in exactly three months, complete a table similar to the
following (expressed in dollars) for a portfolio consisting of the following
positions:
(1) Long a 1.44 call
(2) Short a 1.48 call
(3) Long a 1.40 put
(4) Short a 1.44 put
(b) Graph the total net profit (i.e., cumulative profit less net initial cost,
ignoring time value considerations) relationship using the June
USD/GBP rate on the horizontal axis (be sure to label the breakeven
point(s)). Also, comment briefly on the nature of the currency
speculation represented by this portfolio.
(c) If in exactly one month (i.e., in April) the spot USD/GBP rate falls to
1.385 and the effective annual risk-free rates in the United States and
England are 5 percent and 7 percent, respectively, calculate the
equilibrium price differential that should exist between a long 1.44 call
and a short 1.44 put position.
Solution
(a) Initial Cost
Cost/Contract x 31,250
long 1.44 Call 0.0422 ($1,318.75)
short 1.48 Call 0.0255 $ 796.88
long 1.40 Put 0.0260 ($ 812.50)
short 1.44 Put 0.0422 $1,318.75
($ 15.62)
Long Short Long Short
Net
June Call Call Put Put Total Net
Initial
USD/GBP 1.44 1.48 1.40 1.44 Profit
Cost
Profit Profit Profit Profit
1.36 ($15.62) 0 0 1250 -2500 ($1,265.62)
1.40 ($15.62) 0 0 0 -1250 ($1,265.62)
1.44 ($15.62) 0 0 0 0 ($15.62)
1.48 ($15.62) 1250 0 0 0 $1,234.38
1.52 ($15.62) 2500 -1250 0 0 $1,234.38
Example: Long Call 1.44 profit = (1.48 – 1.44) x 31,250 = $1250
(b)
$1,000.00
$ 500
342 SFM - COMPILER
$0.00
1.36 1.40 1.44 1.48 1.52
($500.00)
($1,000.00)
Since the market price at the end of 3 months falls to Rs.350 which is below
the exercise price under the call option, the call option will not be exercised.
Only put option becomes viable.
call option on X Ltd.’s share has an exercise price of Rs.165. Assuming risk
free rate of interest to be 20%, calculate.
(a) Value of call option on X Ltd’s share.
(b) Option Delta for the second six month, in case stock price rises to Rs.440
or falls to Rs.110.
(c) Now suppose in 6 months the share price is Rs.110. How at this point we
can replicate portfolio of call options and risk-free lending.
SFM - COMPILER 345
Solution
The possible prices of X Ltd.’s share and the associated call option values
shown below:
880 (715)
Strike Price = 50
440 (290)
A = 220 220 (55)
110 (20)
55 (0)
a. Let p is the probability of a rise in the stock price. Then, if investors are
risk-neutral:
p (1.00) + (1 – p)(–0.50) = 0.10
p = 0.4
If the stock price in month 6 is Rs.110, then the option will not be
exercised. So expected value of call option is:
[(0.4 × Rs.55) + (0.6 × Rs.0)]
And its worth to be
[(0.4 × Rs.55) + (0.6 × Rs.0)]/1.10 = Rs.20
`715 - `55
Delta = = 1.0
`880 - `220
`55 - `0
Delta = = 0.33
`220 - `55
346 SFM - COMPILER
The Payment will be made at the interval of 90 days for one year and it
will be based on the adjustment factor 90/360. The term structure of LIBOR
on the date of agreement is as follows:
Days Rate (%)
90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate fixed rate on the swap and first net payment
on the swap.
Solution
(i) The discount bond prices are as follows:
Term Rate% Discount Bond Price
90 days 7.00 B0(90) = 1/(1 + 0.07(90/360)) = 0.9828
180 days 7.25 B0(180) = 1/(1 + 0.0725(180/360)) = 0.9650
270 days 7.45 B0(270) = 1/(1 + 0.0745(270/360)) = 0.9471
360 days 7.55 B0(360) = 1/(1 + 0.0755(360/360)) = 0.9298
1 - 0.9298 360
The fixed rate is 0.9828+0.9650+0.9471+9298 x 90 = 0.0734
(ii) The first net payment is based on a fixed rate of 7.34 percent and a
floating rate of 7 percent:
Fixed payment: €35,00,000(0.0734)(90/360) = €64,225
SFM - COMPILER 347
If Derivative Bank received Rs.317 net on settlement, calculate Fixed rate and
interest under both legs.
Notes:
I. Sunday is Holiday.
II. Work in rounded rupees and avoid decimal working.
Solution
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of 0.07999914%
Interest
Approx. 8%
(*) i.e. interest for two days.
Note: Alternatively, answer can also be calculated on the basis of 360days in a
year.
2011
Question 23 : May 2011 - RTP
The following table provides the prices of options on equity shares of X
Ltd. and Y Ltd. The risk free interest is 9%. You as a financial planner are
required to spot any mispricing in the quotations of option premium and
348 SFM - COMPILER
stock prices? Suppose, if you find any such mispricing then how you can take
advantage of this pricing position.
Share Time to Exercise Share Call Put
Exercise Price (`) Price (`) Price (`) Price (`)
X Ltd 6 months 100 160 56 4
Y Ltd 3 months 80 100 26 2
Solution
In order to find out any mispricing we shall use Put Call Parity theorem.
Accordingly,
Value of Call + PV (exercise price) = Value of Put + Share Price
Thus,
For share of X Ltd.
56+ 100 e-0.045 = 4 + 160
56 + 95.60 = 164
Thus there is price mismatch. The strategy to be adopted to take advantage of
situation will be to buy call and sell put and share. The strategy will lead to
cash flow position as follows:
Inflow (`) Outflow (`)
Buying the Call - 56
Selling the Put 4 -
Short Selling the share 160 -
Total 164 56
Net inflow - 108
164 164
Invest Rs.108 for 6 months and get Rs.108 x e 0.045 (Rs.108 x1.046) Rs.112.97
After 6 months: Inflow from investment Rs.112.97
Out flow due to exercise of option Rs.100.00
Net Gain Rs. 12.97
Similarly for Share of Y Ltd.
26 + 80 e-0.045 = 2 + 100
26 + 76.48 = 102
102.48 =102
Thus, there is a mismatch The strategy to be adopted sell call and buy
put and share. The position of cash flows on the strategy adopted will be as
follows:
Inflow (`) Outflow (`)
Buy the share - 100
Buy the Put - 2
SFM - COMPILER 349
(ii) DEF Ltd. shall borrow at 5% and lend it to ABC Ltd. at 4.25% and
shall borrow from ABC Ltd at floating rate of PLR +2%.
Thus net result will be as follows:
Cost to ABC Ltd. = PLR + 2% - (PLR + 2%) + 4.25% = 4.25%
Cost to DEF Ltd = 5% - 4.25% + PLR + 2% = PLR +2.75%
(b) Suppose if theory of expectations hold good, the cost of fund to DEF Ltd.
will be as follows:
Year Expected Annual PLR Rate Loading Effective Effective Rate
Rate under Cap
1 2.75% 2.75% 5.50% 5.50%
2 (1.032 ÷ 1.0275) – 1 = 3.25% 2.75% 6.00% 5.625%
3 (1.0323 ÷ 1.032 ) – 1 = 3.60% 2.75% 6.35% 5.625%
4 (1.0334 ÷ 1.0323 ) – 1 = 3.60% 2.75% 6.35% 5.625%
Solution
The company can hedge position by selling future contracts as it will
receive amount from outside.
$4,00,000
No of Contracts = $1000 = 40 Contracts
Gain by trading in futures = (Rs.45 - Rs.44.50) 4,00,000 = Rs.2,00,000
= Rs.1,80,00,000
`1,80,00,000
Effective Price Realization = = Rs.45 / $
$4,00,000
2,344,470
Number of Contracts = 62,500 = 37 Contracts (Approximately)
credit rating, it has a comparative over lower rated companies in fixed rate
market. It can borrow at fixed rate of 6.25% or floating rate MIBOR+0.75%.
Presently, MIBOR is 5.25% but is expected to change in 6 months
due to political situation in the country. X Ltd. an intermediary bank agreed
to arrange a swap. The bank will offset the swap risk with a counter party (B.
Ltd.) a comparative lower credit rated company, which could borrow at a fixed
rate of 7.25% and floating rate of MIBOR + 1.25%. X Ltd. would charge
Rs.12,00,000 per year as its fee from each party. Mr. Fin the CFO, of A Ltd.
desires that A Ltd. should receive 60% of any arbitrage saving (before
payment of fees) from the swap as A Ltd. enjoying high credit rating.
Any fees paid to the bank are tax allowable. The applicable tax rate is
30%. You are required to:
(a) Evaluate whether the proposal is beneficial for both parties or not.
(b) Assuming that MIBOR was to increase to 5.75% immediately after
political crisis over and shall remain constant for the period of swap.
Evaluate the present value of savings from the swap for A Ltd., assuming
that interest payment are made semi- annually in arrears.
Solution
(a) Swap Position
Fixed Rate Floating Rate
A Ltd 6.25% Mibor + 0.75%
B Ltd. 7.25% Mibor + 1.25%
Difference 1.00% 0.50%
Thus, there is potential saving of 0.50% from the swap proposal.
€ 4 million
= 1.1770 = £3398471
(b) Use of Forward Contract
Forward Rate = €1.1770+0.0055 = 1.1825
Using Forward Market hedge Sterling receipt would be
€ 4 million
= 1.1825 = £ 3382664
(c) Use of Future Contract
The equivalent sterling of the order placed based on future price
(€1.1760)
€ 4 million
= 1.1760 £ 3401360
£ 3401360
Number of Contracts = 62,500 = 54 Contracts (to the nearest whole
number)
Thus, € amount hedged by future contract will be = 54·£62,500 =
£3375000
Buy Future at €1.1760
Sell Future at €1.1785
€0.0025
Total profit on Future Contracts = 54 x £ 62,500 x €0.0025 = €8438
After 6 months
Amount Received € 4000000
Add: Profit on Future Contracts € 8438
€ 4008438
Sterling Receipts
4008438
On sale of € at spot = 1.1785 = €3401305
(ii) Proposal of option (c) is preferable because the option (a) & (b) produces
least receipts.
2012
Question 39 : May 2012 - RTP
On 31-7-2011, the value of stock index is Rs.2,600. The risk free rate of
return is 9% p.a.
The dividend yield on this stock index is as follows:
Month Dividend Paid
January 2%
February 5%
March 2%
April 2%
360 SFM - COMPILER
May 5%
June 2%
July 2%
August 5%
September 2%
October 2%
November 5%
December 2%
Assuming that interest is continuously compounded daily, then what will
be future price of contract deliverable on 31-12-2011.
Given = e0.02417 = 1.02446.
Solution
The duration of future contract is 5 months. The average yield during
this period will be :
5% + 2% + 2% + 5% + 2%
5 = 3.2%
0
123.5 124.5 126.5 128.5 132.5
(1)
(1.5)
u = 592/421 = 1.406
1.037 - 0.976
= 1.406 - 0.976 = 0.1418
amount in Indian Rupee (`) the company is worried about exposure due
exchange rate volatility.
You are required to:
(a) Construct a swap that will help the Drilldip to reduce the exchange rate
risk.
(b) Assuming that Indian Government offers a swap at spot rate which is
1US$ = Rs.50 in one year, then should the company should opt for this
option or should it just do nothing. The spot rate after one year is
expected to be 1US$ = Rs.54. Further you may also assume that the
Drilldip can also take a US$ loan at 8% p.a.
Solution
(a) The following swap arrangements can be entered by Drilldip.
(i) Swap a US$ loan today at an agreed rate with any party to obtain
Indian Rupees (`) to make initial investment.
(ii) After one year swap back the Indian Rupees with US$ at the agreed
rate. In such case the company is exposed only on the profit earned
from the project.
(b) With the swap
Year 0 Year 1
(Million US$) (Million
US$)
(100.00) 136.44
Net result is a net receipt of US$ 36.44 million.
Without the swap
Year 0 Year 1
(Million US$) (Million
US$)
Solution
(a) TM will make a profit of 25 basis points since a 6X9 FRA is a contract on
3-month interest rate in 6 months, which turns out to be 5.50% (higher
than FRA price).
(b) The settlement amount shall be calculated by using the following
formula:
Error!
Where
N = Notional Principal Amount
RR = Reference Rate
FR = Agreed upon Forward Rate
dtm = FRA period specified in days.
Accordingly:
Error! = Rs.6,30,032
Rs.9.00 in 90 days.
= Rs.7.50e-0.12X30/360 + Rs.8.50e-0.12X60/360+Rs.9.00e-
0.12X90/360
= Rs.24.49
Calculate the expiration date cash flow, investment value, and net profit from:
(i) Buy 1.0 call
(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put
for expiration date stock prices of Rs.50, Rs.55, Rs.60, Rs.65, Rs.70.
Solution
Expiration date cash flows
Stock Prices Rs.50 Rs.55 Rs.60 Rs.65 Rs.70
Buy 1.0 call 0 0 0 -60 -60
Write 1.0 call 0 0 0 60 60
Buy 1.0 Put 60 60 0 0 0
Write 1.0 Put -60 -60 0 0 0
Expiration date Investment Value - Premium
Stock Prices Rs.50 Rs.55 Rs.60 Rs.65 Rs.70
Buy 1.0 call 0 0 0 -5 -10
Write 1.0 call 0 0 0 5 10
SFM - COMPILER 369
exercise price Rs.150. You expect the price to range between Rs.120 to Rs.190.
The expected share price of X Ltd. and related probability is given below:
Expected Price 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:
(1) Expected Share price at the end of 4 months.
(2) Value of Call Option at the end of 4 months, if the exercise price prevails.
(3) In case the option is held to its maturity, what will be the expected value
of the call option?
Solution
(1) Expected share price at the end of 4 months
120 x 0.05 + 140 x 0.20 + 160 x 0.50 + 180 x 0.10 + 190 x 0.15
= Rs.160.50
(2) Value of Call option if the exercise price prevails
You are required to show how far interest rate risk is hedged through Cap
Option. For calculation, work out figures at each stage up to four decimal
points and amount nearest to £. It should be part of working notes.
Solution
First of all we shall calculate premium payable to bank as follows:
rp
P= 1 1 xA
[ i - t]
i x (1+i)
Where
P = Premium
A = Principal Amount
rp = Rate of Premium
i = Fixed Rate of Interest
t = Time
0.01
P = 1 1 x 15,00,000
[0.035 - 4]
i0.035 x (1+0.035)
0.01
= 1 x 15,00,000
28.5714 - 0.04016
= 40,861 £
Now we see the net payment received from bank
Reset Additional Amount Premium Net
Period interest due received paid to Amount
to rise in from Bank Bank received
interest rate from Bank
1 £ 75,000 £ 75,000 £ 40,861 £34,139
2 £ 1,12,500 £ 1,12,500 £ 40,861 £71,639
3 £ 1,50,000 £ 1,50,000 £ 40,861 £109,139
Total £ 337,500 £ 337,500 £122,583 £ 214,917
Thus, from above it can be seen that interest rate risk amount of £
337,500 reduced by £ 214,917 by using of Cap option.
= 5000 + 50 = Rs.5050
Price of the future contract = Rs.50 х 5,050 = Rs.2,52,500
10,10,000
(ii) Hedge Ratio = 2,52,500 x 1.5 = 6 contracts
= 4,511.25
Therefore, Gain from the short futures position is = 6 х (5050 – 4511.25) х
50
= Rs.1,61,625
(iii) To use CAPM we require risk-free rate of return, beta of portfolio and
Market Return. Since risk-free rate of return and beta of portfolio is given
first we shall calculate market return as follows:
Change in Index Value = 4500-5000 = -500
- 500
Return from Index = 5000 x 100 = -10% for 3 months
Assuming that Risk Free Rate of Interest is 12%, show how Mr. X (an
arbitrageur) can earn an abnormal rate of return irrespective of outcome after
6 months. You can assume that after 6 months index closes at Rs.10,200 and
Rs.15,600 and 50% of stock included in index shall pay divided in next 6
months.
Also calculate implied risk free rate.
Solution
The fair price of the index future contract can calculated as follows:
FC = 13,800 + [(13,800 x 0.12 x 6/12 – 13,800 x 0.048 x 0.500)]
= 13,800 + (828 – 331.20)
= Rs.14,296.80
Rs.
871.20
Rs.
SFM - COMPILER 375
871.20
871.20
6 months return = 13,800 x 100 = 6.31%
Where
σS = Standard deviation of ΔS
σF =Standard deviation of ΔF
ρ = coefficient of correlation between ΔS and ΔF
H = Hedge Ratio
ΔS = change in Spot price.
ΔF = change in Future price.
Accordingly
0.04
H = 0.75 x 0.06 = 0.5
= Rs.78,550 – Rs.90,000
= – Rs.11,450 (Loss)
378 SFM - COMPILER
2014
Question 65 : May 2014 – RTP
XYZ Inc. issues a £ 10 million floating rate loan on July 1, 2013 with
resetting of coupon rate every 6 months equal to LIBOR + 50 bp. XYZ is
interested in a collar strategy by selling a Floor and buying a Cap. XYZ buys
the 3 years Cap and sell 3 years Floor as per the following details on July 1,
2013:
Notional Principal Amount $ 10 million
Reference Rate 6 months LIBOR
Strike Rate 4% for Floor and 7% for Cap
Premium 0*
*Since Premium paid for Cap = Premium received for Floor
Using the following data you are required to determine:
(i) Effective interest paid out at each reset date,
(ii) The average overall effective rate of interest p.a.
Reset Date LIBOR (%)
31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
Solution
(A) The pay-off of each leg shall be computed as follows:
Cap Receipt
Max {0, [Notional principal x (LIBOR on Reset date – Cap Strike Rate)
Number of days in the settlement period
x 365
Floor Pay-off
Max {0, [Notional principal x (Floor Strike Rate – LIBOR on Reset date)
Number of days in the settlement period
x 365
Statement showing effective interest on each re-set date
Reset Date LIBOR Days Interest Cap Floor Effective
(%) Payment ($) Receipts Payoff Interest
LIBOR + 0.5% ($) ($)
SFM - COMPILER 379
(b) Since firm is a borrower it will like to off-set interest cost by profit on
Future Contract. Accordingly, if interest rate rises it will gain hence it
should sell interest rate futures.
Amount of Borrowing Duration of Loan
No of Contracts = Contract Size x 3 months = 2000 contracts
Step 3 :
Initial margin payable is 10 x Rs.15,000 = Rs.1,50,000
Step 4 :
Final Settlement
A. Settlement of Future contract
[(0.02134 – 0.02118) x 10 x 472000/-]/0.02133 35,406
B. Settlement of Exposure
= US$1,00,000/0.02133 46,88,233
C. Interest on Initial Margin
= 1,50,000 x 0.08 x 3/12 (3,000)
Net Inflow 47,20,639
Alternative 3 : No cover
382 SFM - COMPILER
Settlement of Exposure
= US$1,00,000/0.02133 46,88,233
Decision : The most advantageous option would have been to hedge with
futures.
2015
Question 73 : May 2015 – RTP
Mr. Careless was employed with ABC Portfolio Consultants. The work
profile of Mr. Careless involves advising the clients about taking position in
Future Market to obtain hedge in the position they are holding. Mr. ZZZ, their
regular client purchased 100,000 shares of X Inc. at a price of $22 and sold
50,000 shares of A plc for $40 each having beta 2. Mr. Careless advised Mr.
ZZZ to take short position in Index Future trading at $1,000 each contract.
Though Mr. Careless noted the name of A plc along with its beta value
during discussion with Mr. ZZZ but forgot to record the beta value of X Inc.
On next day Mr. ZZZ closed out his position when:
• Share price of X Inc. dropped by 2%
• Share price of A plc appreciated by 3%
• Index Future dropped by 1.5%
Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due
to the position taken. Since record of Mr. Careless was incomplete he
approached you to help him to find the number of contract of Future contract
he advised Mr. ZZZ to be short to obtain a complete hedge and beta value of X
Inc.
You are required to find these values.
Solution
Let the number of contract in Index future be y and Beta of X Inc. be x. Then,
10,000 x 22 xX + 50,000 x 40 x 2
Y= 1,000
2,200,000 x – 4,000,000 = -1,000y
Cash Outlay (Outflow)
Purchase of 100,000 shares of X Inc. at a price of $22 2,200,000
(100,000 × 22)
Sale of 50,000 shares of A plc for $40 (50,000 × 40) – 2,000,000
Short Position in Index Futures (1,000 × y) -1,000y
Net 200,000 – 1,000y
Cash Inflow
384 SFM - COMPILER
= 2303.65
(b) Gain/loss on Long Position after 28 days
= 2450 – 2290 e28/365(0.0416 – 0.0175)
= 2450 – 2290 e0.001849
= 2450 – 2290(1.001851)
= 2450 – 2294.24
= 155.76
(c) Gain/loss on Long Position at maturity
= Sn – S0en(r – y)
= 2470.00 – 2303.65
= 166.35
σ = Standard Deviation
Accordingly
= Rs.16,000
= Rs.12,000
The exchange rates for dollar in the interbank market on 10th June and
20th June were :
10th June 20th June
Spot USD 1 = Rs.63.8000/8200 Rs.63.6800/7200
Spot / June Rs.63.9200/9500 Rs.63.8000/8500
July Rs.64.0500/0900 Rs.63.9300/9900
August Rs.64.3000/3500 Rs.64.1800/2500
September Rs.64.6000/6600 Rs.64.4800/5600
Net Rs.1,56,740
(iii) Swap Loss
Agreed Rate 63.9500
Settlement Rate 63.8000
Loss 0.1500
(iv) New Contract Rate 64.2800
(v) Total Cost = 2,00,000 x 64.2800 = 1,28,56,000 + 1,56,740 = 1,30,12,740
388 SFM - COMPILER
from Sleepless at PLR+80bp per annuam and will lend Rs.50 crore to
Sleepless at fixed rate of 10% p.a. The settlement shall be made at the net
amount due from each other. For this services NoBank will charge
commission @0.2% p.a. if the loan amount. The present PLR is 8.2%.
You as a financial consultant of NoBank have been asked to carry out
scenario analysis of this arrangement.
Three possible scenarios of interest rates expected to remain in coming 4
years are as follows:
Year 1 Year 2 Year 3 Year 4
Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70
Assuming that cost of capital is 10%, whether this arrangement should be
accepted or not.
Solution
Interest and Commission due from Sleepless = Rs.50 crore (0.10+0.002)
= Rs.5.10 crore
Net Sum Due to Sleepless in each of Scenarios
Scenario 1
Year PLR Sum due to Sleepless Net Sum Due PVF (Rs.Crores)
(Rs.Crore)
1 10.25 50 (10.25 + 0.8)%= 5.525 5.10 –5.525 = - 0.425 0.909 -0.38633
2 10.50 50 (10.50 + 0.8)%= 5.650 5.10 –5.650 = - 0.550 0.826 -0.4543
3 10.75 50 (10.75 + 0.8)%= 5.775 5.10–5.775 = - 0.675 0.751 -0.50693
SFM - COMPILER 389
Scenario 3
Year PLR Sum due to Sleepless Net Sum Due PVF (Rs.Crores)
(Rs.Crore)
1 7.20 50 (7.20 + 0.8)%= 4.00 5.10 – 4.00 = 1.10 0.909 0.9999
2 7.40 50 (7.40 + 0.8)%= 4.10 5.10 – 4.10 = 1.00 0.826 0.826
3 7.60 50 (7.60 + 0.8)%= 4.20 5.10– 4.20 = 0.90 0.751 0.6759
4 7.70 50 (7.70 + 0.8)%= 4.25 5.10 – 4.25 = 0.85 0.683 0.58055
3.08235
Solution
Consider one-year Treasury bill.
1,00,000
91,500 =
(1+ r1 )
1,00,000
1 + r1 = = 1.092896
91,500
1,10,000
89350.87 =
1.093(1+ r2 )
1 + r2 = 1.126351
r2 = 0.12635
r2 = 0.1263 say 12.63%
Consider three-year Government Securities
10,500 10,500 1,10,500
99,000 = + +
1.093 1.093 x 1.1263 1.093 x 1.1263(1+ r3 )
89.761.07
99,000 = 9,606.587 + 8,529.33 +
1+ r3
89.761.07
80,864.083 =
1+ r3
1 + r3 = 1.1100240
r3 = 0.1100240 say 11.002%
XYZ, an indian firm, will need to pay Japanese Yen 5,00,000 on 30th June .
To hedge the transaction he has 2 alternative
Alternative 1 : Forward Cover
Alternative 2 : Option Cover
Alternative 1 : Forward Cover
3 month Forward Rate : JPY/INR 1.9726/1.9923
5,00,000
Amount Payable = 1.9726 = Rs.2,53,500
Total = `. 2,47,109
Since outflow of cash is least in case of Option same should be opted for.
Further if price of INR goes above JY 2.125/INR the outflow shall further be
reduced.
Question 85 Nov 2015 – Paper – 8 Marks
On April 1, 2015, an investor has a portfolio consisting of eight securities
as shown below :
Security Market Price No of Shares β Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05
H 170.50 900 0.76
The cost of Capital is 20% P.A continuously compounded. The investor
fears a fall in prices of the shares in the near future. Accordingly, he
approaches you for the advice to protect the interest of his portfolio.
You can make use of the following information:
(i) The current Nifty Value is 8500
(ii) NIFTY Futures can be traded in units of 25 only.
(iii) Futures for May are currently quoted at 8700 and Futures for June
are being quoted at 8550
You are required to calculate
(i) The Beta of his portfolio
(ii) The theoretical Value of the Futures contract for contracts expiring
in May and June
Given (e0.03 = 1.03045, e0.04 = 1.04081, e0.05 = 1.05127)
(iii) The number of NIFTY Contracts that he would have to sell if he
desires to hedge until June in each of the following cases :
(a) His total Portfolio (b) 50% of his Portfolio
394 SFM - COMPILER
(ii) Portfolio beta after 3 months if the trader on current date goes for long
position on Rs.100 lakhs Nifty futures.
Solution
(i) Current portfolio
Current Beta for share = 1.6
Beta for cash =0
Current portfolio beta = 0.85 x 1.6 + 0 x 0.15
= 1.36
0.032
1.6 =
Change in value of market portfolio (Index)
(5) 2% rises in Nifty is accompanied by 2% x 1.30 i.e. 2.6% rise for portfolio of
shares
Rs. lakh
Current Value of Portfolio of Shares 5000
Value of Portfolio after rise 5130
Mark-to-Market Margin paid (8125 x 0.020 x Rs.200 x 120) 39
Value of the portfolio after rise of Nifty 5091
% change in value of portfolio (5091-55000)/5000 7.82%
% rise in the value of Nifty 2%
Beta 0.91
Solution
Decision tree showing pay off
Year 0 Year 1 Pay off
195 0
150
90 100-90 = 10
SFM - COMPILER 399
First of all we shall calculate probability of high demand (P) using risk neutral
method as follows:
8% = p x 30% + (1-p) x (-40%)
0.08 = 0.30 p - 0.40 + 0.40p
0.48
p= = 0.6857 say 0.686
0.70
Since expected pay off at year 1 is 3.14 crore, present value of expected pay off
will be:
3.14
= 2.907 crore.
1.08
26000
24700 0
The Delta (⧍) Ratio
400 SFM - COMPILER
𝟏𝟑𝟎𝟎−𝟎
⧍= = 0.50
𝟐𝟕𝟑𝟎𝟎−𝟐𝟒𝟕𝟎𝟎
Replicating portfolio Buy 5 gram of gold and sell one call option.
The pay off if price goes up = 0.50 x Rs.27300 - Rs.1,300
= Rs. 12,350
First of all we shall calculate probability of high demand (P) using risk neutral
method as follows:
3% = p x 5% + (1-p) x (-5%)
0.03 = 0.05 p - 0.05 + 0.05p
𝟎.𝟎𝟖
p= = 0.80
𝟎.𝟏𝟎
To purchase the caps this borrower is required to pay the premium upfront at
the time of buying caps. The payment of such premium will entitle him with
right to receive the compensation from the seller of the caps as soon as the
rate of interest on this loan rises above 8.5%. The compensation will be at the
rate of the difference between the rate of none of the cases the cost of this loan
will rise above 8.5% calculated on Rs.40,00,000/-. This implies that in none
of the cases the cost of this loan will rise above 8.5%. This hedging benefit is
received at the respective interest due dates at the cost of premium to be paid
only once.
The premium to be paid on 1st October 2012 is 30,000/- (Rs.40,00,000 x
0.75/100). The payment of this premium will entitle the buyer of the caps to
receive the compensation from the seller of the caps whereas the buyer will
not have obligation. The compensation received by the buyer of caps will be as
follows:
On 31st March 2013
The buyer of the caps will receive the compensation at the rate of 1.70%
(10.20 - 8.50) to be calculated on Rs.40,00,000, the amount of compensation
will be Rs.68000/- (40,00,000 x 1.70/100)
On 31st March 2014
The buyer of the caps will receive the compensation at the rate of 3.00%
(11.50 – 8.50) to be calculated on Rs.40,00,000/-, the amount of
compensation will be Rs.120000/- (40,00,000 x 3.00/100).
On 31st March 2015
The buyer of the caps will receive the compensation at the rate of 0.75% (9.25
– 8.50) to be calculated on Rs.40,00,000/-, the amount of compensation will
be Rs.30,000 (40,00,000 x 0.75/100).
On 31st March 2016
The buyer of the caps will not receive the compensation as the actual rate of
interest is 8.25% whereas strike rate of caps is 8.5%. Hence, his interest
liability shall not exceed 8.50%.
Thus, by paying the premium upfront buyer of the caps gets the compensation
on the respective interest due dates without any obligations.
Question 105 May 2018 – RTP
TMC Holding Ltd. has a portfolio of shares of diversified companies valued at
Rs.400 crore enters into a swap arrangement with None Bank on the terms
that it will get 1.15% quarterly on notional principal of Rs.80 crore in
exchange of return on portfolio which is exactly tracking the Sensex which is
presently 21600.
You are required to determine the net payment to be received/ paid at the end
of each quarter if Sensex turns out to be 21,860, 21,780, 22,080 and 21,960.
Solution
Qtrs. Sensex Sensex Amount Fixed Return Net
(1) (2) Return Payable (Receivables) (Rs.Crore)
(%) (3) (Rs.crore) (4) (Rs.Crore) (5) (5) – (4)
0 21,600 - - - -
SFM - COMPILER 403
Step I
He will buy PQR Stock at Rs.220 by borrowing at 15% for 3 months.
Therefore, his outflows are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years (220×0.15×0.25) 8.25
Total Outflows (A) 228.25
Step II
He will sell March 2000 futures at Rs.230. Meanwhile he would receive
dividend for his stock.
Hence his inflows are 230.00
Sale proceeds of March 2000 futures 2.50
Total inflows (B) 232.50
30
2. Cost of GDR = + 0.12 = 18.38%
470.4
406 SFM - COMPILER
Solution
Net payoff for the holder of the call option
Rs.
Share price on exercise day 300 310 320 330 340
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 320 320
Out flow (premium) 8 8 8 8 8
Total Outflow 8 8 8 328 328
SFM - COMPILER 409
(iii)Net Amount
= (i) – (ii)
= Rs.15,000 – Rs.12,575
= Rs.2,425
or
= Rs.15,000 – Rs.12,659
= Rs.2,341