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Questions based on week 7 topics due in week 8

Textbook questions: BKMCh 20: Q 7, 8, 13, 14, 22, CFA1 Additional questions T7Q1

You are managing a share portfolio for a long term investor, APT Superannuation. Given its longterm investment profile, APT is willing to invest in shares that have strong growth prospects and isnot concerned about income.

QUC Group shares (ASX Code QUC) have been range trading at around $5 for the last few months.QUC is a mining company with excellent prospects over the long term but short term

growthprospects are limited so you believe that the share will continue to range trade for the next 6 to 12months. It is not paying a dividend at the moment and is unlikely to pay a dividend for theforeseeable future.

a) The three month risk free rate is 3% per annum convertible quarterly and at-the-money putoptions are quoted at $0.50.

b) At what price would you expect a three month at-the-money call option to be quoted? c) Recommend a strategy using put and call options that would take advantage of your viewthat QUC will continue to range trade at around $5.

d) What is the maximum profit you could make from this strategy? e) At what stock price(s) at expiry does this transaction break even?

f) Are there any other issues you may want to consider before implementing this strategy? T7Q2

It is February 2016. You have formed a consortium of Monash University finance alumni and your group, currently called Finance Fanatics, is planning a significant investment in six months. You will be required to contribute $40,000. Fortunately you now have an excellent job working in financial markets and spent your undergraduate and postgraduate time trading shares rather than partying and so you have $40,000 invested in BHP shares (1,000 shares at $40 per share).

You would rather not sell your portfolio immediately because you are now on a high tax rate but plan to travel overseas in nine months by taking unpaid leave of absence and will earn less so you would prefer to sell the shares in the new financial year and pay less tax.

However, you are conscious that you are exposing yourself to the risk that the price of your BHP shares may fall. You are also saving money to go overseas and have calculated that if the value of your portfolio of BHP shares falls by more than 10% (to less than $36,000) you will have to postpone your travels. You also realise that if the value of the portfolio increases, you can afford to spend more time in London and New York.

To manage this risk, you are considering three alternative strategies:

1. Write six month call options on BHP shares with a strike price of $44. 2. Buy six month put options on BHP with a strike price of $36.

3. Write six month calls and buy six month puts to create a zero cost collar.

Six month $36 puts and $44 calls are both currently trading at $3. Ignore any interest accruing or paid on option premiums over this period.)

For each strategy, evaluate how well it meets your investment target and determine the advantages and disadvantages.

Based on your analysis, which strategy would you recommend and why?

Questions based on week 8 topics due in week 9

Textbook questions: (Ch15 &16) BK Ch 15: Q10, 12, 14, CFA3 BK Ch 16: Q 13, 14, 16, CFA 1, 2, 7. Additional question T81

ABC bonds are currently priced at $959.45. The par value is $1,000, the coupon rate is 7% paid semi-annually and the bonds mature in five years. The Macauley duration is 4.29 years.

a) Calculate the yield to maturity

b) Calculate the modified duration based on the information above and your answer to (a) c) Explain why modified duration is a better measure of a bond’s sensitivity to changes in

interest rates than maturity. d) Determine the direction of the change in modified duration if:

1. The bond matured in 10 years rather than 5 years 2. The coupon was 3% rather than 7%.

(Note that you should not need to do any calculations for this part of the question. If you understand the concept of duration, you should be able to identify whether duration will increase or decrease without doing calculation.)

e) Define convexity. Explain how modified duration and convexity can be used to determine

the approximate amount by which price will change for a given movement in interest rates.

Questions based on week 9 topics due in week 10

Textbook questions: BKM Ch 22: BKM Ch 23:

8, 10, 11, 18, CFA3

13, 14, 16, CFA 1, 2

Additional T9Q1

a) Suppose the value of the ASX200 is currently 1,500. The six month risk free rate is 3% and

the expected dividend yield is 5%.

(i) (ii)

What is the expected price of the six month futures contract? You have invested in a well diversified portfolio of Australian shares and are concerned that global economic conditions will deteriorate over the next several months. How would you use this futures contract to protect your investment? Suppose the futures price for delivery in one year is 1,500. Construct an arbitrate strategy and show that the profits on the arbitrage strategy are equal to the futures market mispricing.

(iii)

b) It is March 2014 and the September 2014 gold futures contract price is $1,200 while the

December gold futures contract price is $1,300. You also observe that the risk free rate is 3%. Is there an arbitrage opportunity and, if so, how would you exploit it? T9Q2

Wheat Trading Corp (WTC) is planning to issue $50m of 10 year bonds in three months at par value. In the current markets these bonds will have a modified duration of 7.5 years. There is a ten year government bond contract expiring in three months with a face value of $100,000 that is trading at par value and has a modified duration of 6 years. Recommend a futures strategy that WTC can use to hedge their interest rate risk.

a) Wheat is a relatively risky product, with a beta of 0.75. The spot price is $250 per tonne,

the three month futures price is $261 and the monthly storage cost is $1.32 per tonne. If the risk free rate is 3% per annum (compounding monthly; 0.5% per month) and your expected return is 6% per annum (also compounding monthly) should you sell wheat in the spot market or store it for three months?

Questions based on week 10 topics due in week 11

T10Q1ABC is trading currently at $100. Assume a one period Binomial Model, that the stock price will either go up or down by 10% over the next period and the risk-free rate over the period is 5% (Take the period to be a year).

(a) Build a replicating portfolio to value a call option written today with a

strike price of 100. What is the value hedge ratio Δ?

(b) Calculate the risk-neutral probabilities and value the call using the risk-neutral probabilities. (Check that you get the same answer as in a. above) (c) Using the risk-neutral probabilities above also calculate the value of the

find the value of a put option written today, lasting one period, and with an exercise price of 100.

(d) Verify that the same price for the put results from put-call parity.

T10Q2Microsoft stock is currently trading at $41. Consider call and put options with a strike of $42.00 expiring in 30 days (=0.082 years). Suppose that the volatility of Microsoft stock is 40% and that the interest rate is 3%. What are the Black-Scholes prices of the call and the put? What are the option deltas?

T10Q3What is meant by the delta of a stock option?

T10Q4 A stock price is currently $50. It is known that at the end of six months it will be either $45 or $55. The risk-free interest rate is 10% per annum with continuous compounding. What is the value of a six-month European put option with a strike price of $50?

T10Q5A company uses delta hedging to hedge a portfolio of long positions in put and calloptions on a currency. Which of the following would give the most favorable result?

a) A virtually constant spot rate b) Wild movements in the spot rate Explain your answer.