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COURSEWORK ASSIGNMENT: This is an individual assignment

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COURSEWORK ASSIGNMENT:

This is an individual assignment. You are required to answer all questions in the assignment and show enough calculations and explanations to show you understand how to apply the formulas and/or models.

The Intended Learning Outcomes of the Assignment are: -Apply quantitative derivative models to analyse and manage risk. - Evaluate relevant empirical research literature.

Required: Question 1 ( Futures/Forward Markets and Hedging – 2 5 marks) Required;

(a ) A company based in Japan expects that it has to pay 1 0 million dollars in seven months for imports from United States. How can the treasury manager hedge the exchange rate risk using

1. a forward contract and
2. an option? What is the difference between the two strategies?

(b ) You recently got a job a s a treasury manager a t Touchstone Exploration Plc, a young oil producing company. You are proposing to the executive management of the company the use of futures contracts to hedge oil price risk. The response o f the chief executive is that “ using futures is similar to betting in a casino a s you can never predict whether oil prices a t maturity are going to b e greater o r lower than futures price. I don’t see the need therefore for using futures contracts”. Discuss the executive’s viewpoint.

(c) Discuss the reasons why the treasurer of a company might not hedge the company’s exposure to a particular risk.

Question 2 ( Interest Rates and Interest Rate Futures

Portfolio A consists o f: - a 1 -year zero-coupon bond with a face value o f £2 ,5 0 0 and - a 1 0-year zero-coupon bond with a face value of £5 ,0 0 0 .

Portfolio B consists o f: - a 5 .44-year zero coupon bond with a face value of £4 ,0 0 0 . The current yield on all bonds is 8 % per annum.

Required;

(a ) Calculate the percentage changes in the values o f the two portfolios for a per annum increase in yields of 0 .1 % and 4 .0 %. Which portfolio has the higher convexity? (b ) Show that both portfolios have the same duration. What assumptions does a duration based hedging scheme make about the way in which the term structure moves?
(c) Describe the three main theories of the term structure and explain why one of them is more consistent with the observation that the term structure tends to be upward sloping more often than it is downward sloping.

The cheapest-to-deliver bond in a July 2022 Treasury bond futures contract is a 6% coupon bond, and delivery is expected to be made on July 31, 2022. It is now 15 May 2022, and coupon payments on the bond are made on December 28 and June 28 each year. The term structure is flat, and the rate of interest with semiannual compounding is 5% per annum. The conversion factor for the bond is 1.5, and the current quoted bond price is 108.

Required;

(d) Estimate the quoted futures price for the contract.

Question 3 (Futures and Forward Prices

The two-month risk-free rates in UK and Singapore are 3% and 6% per annum respectively with continuous compounding. The spot price of the UK pound is $1.7000 Singapore Dollars.

Required;

(a) What is the two-month futures price?

(b) Assume that the futures price for a contract deliverable in six months is $1.7100. What arbitrage opportunities does this create?

(c) The futures price of gold can be calculated from its spot price and other observable variables whereas the futures price of copper cannot. Discuss why this is the case.

An investor has just taken a short position in a six-month forward contract on a dividend-paying stock. The stock price is £123.00, and the risk-free rate of interest is 5% per annum with continuous compounding for all maturities. The stock is expected to pay a dividend of £2.5 per share in two months and in five months.

Required

(d) What are the forward price and the initial value of the forward contract?

(e) Three months later, the price of the stock is £120 and the risk-free rate of interest is still 5% per annum. What are the forward price and the value of the short position in the forward contract?

Question 4 (SWAPS)

Glaxco Plc and Tesle Plc face the following interest rates (adjusted for the differential impact of

taxes):
Glaxco plc Tesle Plc

US Dollars (fixed rate) 6.0% 4.6%

UK Sterling (fixed rate) 4.5% 3.7%

Assume that Glaxco Plc, a British manufacturer, wishes to borrow U.S. dollars at a fixed rate of interest and Tesle Plc, a US multinational, wishes to borrow sterling at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 30-basis-point spread.

Required;

a) If the swap is equally attractive to Glasco and Tesle, what rates of interest will Glaxco and

Tesle end up paying?

b) Are there any kinds of risk the bank is exposed to when it enters into two offsetting swap

contracts?

c) Critically discuss the comparative advantage argument in relation to swaps.

Word Count :

The coursework word count is a MAXIMUM OF 2,000 WORDS (THERE IS NO ±10% MARGIN) excluding reference list, bibliography, appendices, the cover page, abstract, glossary and list of tables, figures, charts and abbreviation. Tables are expected to be primarily for the presentation of numerical data.

Your Report Should;

? Be written in a plain style, using subheadings and lists where appropriate.

? Be properly referenced acknowledging all the sources you have used, and only the sources you have used.

? Include evidence of locating and reading sources beyond the suggested initial reading.