Segment 1

1. Suppose that the standard deviation of quarterly changes in the prices of a commodity is Rs 8,
the standard deviation of quarterly changes in the futures price on the same commodity is Rs 10
and the coefficient of correlation between the two changes is 0.8.What is the optimal hedge ratio
for a 3-month contract? What does it mean?

2. A Company has a Rs 2 million portfolio with a beta 1.2.It would like to use futures contracts
on the Nifty 50 to hedge its risk. The index is currently standing at 4200 and each contract is for
delivery of Rs 200 times the index. What is the hedge that minimizes risk? What should the
company do if it wants to reduce the beta of the portfolio to 0.6?

3. The standard deviation of monthly changes in the spot price of live cattle is(in cents per
pound) 1.2.The standard deviation of monthly changes in the futures price of live cattle for the
closest contract is 1.4.The correlation between the futures price changes and the spot price
changes is 0.7.It is now October 15.A beef producer is committed to purchasing 200,000 pounds
of live cattle on November 15.The producer wants to use the December live cattle futures
contracts to hedge its risk. Each contract is for the delivery of 40,000 pounds of cattle. What
strategy should the beef producer follow?

4.On July 1,an investor holds 50,000 shares of a certain stock. The market price is Rs 30 per
share. The investor is interested in hedging against movements in the market over the next month
and decides to use the September NSE futures contract. The index is currently 4,200 and one
contract is for delivery of Rs 200 times the index. The beta of the stock is 1.3.What strategy
should the investor follow?

5.Suppose that the 1-year gold lease rate is 1.5% and the 1-year risk-free rate is 6.0?%.Both rates
are compounded annually. Use the discussion in business snapshot 3.1 to calculate the
maximum1-year gold forward price MCX should quote when the spot price is Rs 25000.

6.A fund manager has a portfolio worth Rs 50 million with a beta of 0.87.The manager is
concerned about the performance of the market over the next 2 months and plans to use 3-month
future contract on NSE to hedge the risk. The current level of the index is 4200,one contract is on
200 times the index, the risk free rate is 6% per annum,and the dividend yield on the index is
4% per annum.The current 3-month future price is 4270.

a) What position should the fund manager take to eliminate all exposure to the market over the
next two years?

b) Calculate the effect of your strategy on the fund managers returns if the level of market in 2
months is 4000, 4100and 4300.Assume that the 1-month future is 0.25% higher than the index
level at this time.
Segment B

Questions from Hedging of an equity Portfolio

1. A Portfolio worth Rs 50,50,000 mirrors the S&P 500.The index future price is 1010
and each future contract is Rs 250 times the index. Find the number of future
contracts that should be shorted?

Ans 1:

In this case Portfolio value (P) =$5050000,

Size of a Futures contract(F) =$1010 x 250=$252500

No. of Future contract to be shorted (N*) = P/F= $5050000/$252500= 20 contracts

2. A Portfolio worth Rs 50,50,000 does not exactly mirrors the S&P 500. However the
portfolio beta with respect to S&P 500 is 0.5 and the index future price is 1010 and
each future contract is Rs 250 times the index. Find the number of future contracts
that should be shorted?

Ans 2:

In this case Portfolio value (P) =$5050000,

Size of a Futures contract(F) =$1010 x 250=$252500

No. of Future contract to be shorted (N*) =beta* P/F= 0.5*$5050000/$252500= 10 contracts

3. A Futures contract with 4 months to maturity is used to hedge the value of a portfolio
over the next three months in the following situations:

Value of S&P 500 index=1000

S&P 500 futures price=1010

Value of portfolio=Rs 50,50,000

Risk-free interest rate=4% p.a

Dividend yield on index=1% p.a

Beta of portfolio=1.5

One future contract is for delivery of Rs 250 times the index.

 i. Find the number of futures contracts that should be shorted to hedge the portfolio?
ii. In the above problem, if the index turns out to be 900 in 3 months and the futures
price is 902.Find the gain from short futures position?

Answer

i) No. of Future contract to be shorted (N*) =beta* P/F =1.5*$5050000/$252500 =30

contracts
ii) Gain from short future position will be = 30x($1010-$902)*250 =$810000
iii)

Segment C

1.On Monday morning, you short one IMM yen futures contract containing 12,50,0000 at a
price of $0.009433.Suppose the broker requires a performance bond of $4590 and a maintenance
performance bond of $3400.The settlement prices for Monday through Thursday are
$0.009542,$0.009581,$0.009375 and $0.009369 respectively. On Friday, you close out the
contract at a price of 0.009394.Calculate the daily cash flows on your account. Describe any
performance bond calls on your account. What is your cash balance with your broker as of the
close of business on Friday? Assume that you begin with an initial balance of $4590 and that
your round trip commission was $27.

Solution

Time Action Cash Flow on Contract

Monday morning Sell one IMM yen futures
contract.Price is $0.009433
Monday close Future price rises to
$0.009542.Contract is marked
to market
Tuesday close Future price rises to
$0.009581.Contract is marked
to market
Wednesday close Future price falls to
$0.009375.Contract is marked
None
You pay out
12500000*(0.009433-
0.009542)=-$1362.50
You pay out an additional
12500000*(0.009542-
0.009581)=-$487.50
You receive
12500000*(0.009581-
 to market 0.009375)=$2575.00
Thursday close Future price falls to You receive an additional
$0.009369.Contract is marked 12500000*(0.009375-
to market 0.009369)=$75
Friday You close out your contract at You pay out
a futures price of $0.009394 12500000*(0.009369-
0.009394)=-$312.50
You pay out a round trip
commission=-$27.00
Net gain on the futures $460.50
contract

Your performance bond calls and cash balances as of the close of each day were as follows:

With a loss of $1362.50,your account balance falls to $3227.50($4590-$1362.50).

Monday: You must add $172.50($3400-$3227.50) to your account to meet the maintenance performance
bond of $3400.

Tuesday: With an additional loss of $487.50, your balance falls to $4102.50($3400-$487.50)

You must add $487.50 to your account to meet the maintenance performance bond of $3400.

Wednesday: With a gain of $2575, your balance rises to $5975.

Thursday: With a gain of $75, your balance rises further to $6050.

Friday: With a loss of $312.50, your account balance falls to $5737.50.After subtracting the

round trip commission of $27,your account balance ends at $5710.50.

2. Suppose the interbank forward bid for June 18 on pounds sterling is $1.2927 at the same time
that the price of IMM sterling futures for delivery on June 18 is $1.2915.How could the dealer
use arbitrage to profit from this situation?

Solution

The dealer would simultaneously buy the June sterling futures contract for
$80,718.75(62,500*$1.2915) and sell an equivalent amount of sterling forward, worth
$80,793.75(62,500*$1.2927) for June delivery. Upon settlement, the dealer would earn a profit
of $75.Alternatively,if the markets come back together before June 18,the dealer can unwind his
position(by simultaneously buying 62,500 forward and selling a futures contract, both for
delivery on June 18) and earn the same $75 profit. Although the amount of profit on this
transaction is tiny, it becomes $7,500 if 100 futures contracts are traded.

Using currency options

Consider a U.S. importer with a 62500 payment to make to a German exporter in 60 days. The
importer could purchase a European call option to have the euros delivered to him at a specified
exchange rate(the strike price) on the due date. suppose the option premium is $0.02 per euro and
the exercise price is $0.94.The importer has paid $1250 for a 94 call option, which gives him
the right to buy 62500 at a price of $0.94 per euro at the end of 60 days. If at the time the
importers payment falls due, consider two scenarios where the value of the (i) euro has risen to,
say, $1.00 and euro has declined $0.90. Examine both the scenarios and state whether importer
would be fortunate or unfortunate under these scenarios. Also show the amount of net gain and
net loss in each of the scenario.

Answer

Case I: the option would be in the money. In this case, the importer exercises his call option and
purchases euros for $0.94.The importer would earn a profit of $3750(62500*0.06),which would
more than cover the $1250 cost of the option.

Case II: If the rate has declined below the contracted rate to,say,$0.90, the 94 option would be
out of the money. consequently the importer would let the option expire and purchase the euros
in the spot market. Despite losing the $1250 option premium, the importer would still be $1250
better off than if he had locked in a rate of $0.94 with a forward or futures contract.

Explanation: At a spot rate on expiration of $0.94 or lower, the option will not be exercised,
resulting in a loss of the $1250 option premium. Between $0.94 and $0.96,the option will be
exercised, but the gain is insufficient to cover the premium. The breakeven price-at which the
gain on the option just equals the option premium-is $0.96.Above $0.96 per euro, the option is
sufficiently deep in the money to cover the option premium and yield a potentially unlimited net
profit. Because this is a Zero-sum game, the profit from selling a call is the mirror image of the
profit from buying the call. For example, if the spot rate at expiration is above $0.96/,the call
option writer is exposed to potentially unlimited losses. Why would an option writer accept such
risks? For one thing, the option writer may already be long euros, effectively hedging much of
the risk. Alternatively, the writer might be willing to take a risk in the hope of profiting from the
option premium because of a belief that the euro will depreciate over the life of the contract. If
the spot rate at expiration is $0.94 or less, the option ends out of the money and the call option
writer gets to keep the full $1250 premium. For spot rates between $0.94 and $0.96,the option
writer still earns a profit, albeit a diminishing one.
(Draw a call option diagram and show each and every component of that option payoff).