THROUGH 30 RELATE TO RISK MANAGEMENT APPLICATION OF DERIV...
Questions 25 through 30 relate to Risk Management Application of Derivatives.
Kira Smith Case Scenario
Kira Smith works at Derivative Strategists (DST), a firm that specializes in implementing
portfolio management strategies involving futures, forwards, options and swaps. DST
has worked with a number of investment management firms as a free-lance derivatives
consultant, and has taken the opposite side of numerous transactions involving forwards,
options, and swaps. Recently, Smith was hired as a consultant by Tiger Asset
Management (TAM) to manage the risk of their $350 million portfolio. The portfolio
currently has a duration of 6.70, but due to an anticipation of rising interest rates in the
future, TAM wants to reduce the interest rate sensitivity of their portfolio. Smith
presented the investment committee at TAM with an option to invest in either of the
following swaps to achieve their objective:
•
A two year swap with semiannual payments.
•
A one year swap with quarterly settlements.
After a thorough meeting with the investment committee and performing all the
necessary calculations assuming the duration of a fixed rate bond equals 75% of its
maturity, Smith decided to use the swap with the higher absolute duration to achieve the
objective. The notional principal was set at $270 million, just enough to meet the
requirement.
Peter Ramos, the CEO at TAM, invited Smith over for lunch to discuss an institutional
fund his firm had been managing. The fund is worth $150 million and is owned by X-
Tech Corporation, a firm producing high-tech equipment for computer manufacturing
firms and the telecommunications industry. Last year, the firm expanded its operations to
include the German market. However, given the wide fluctuations in the euro/dollar
exchange rate, Ramos wants to hedge the currency risk of their euro inflows using a swap
contract. During his lunch with Smith, Ramos expressed the objective of receiving a fixed
amount of quarterly cash flows equal to $3,758,483, from their German subsidiary, for
the coming year. The fixed rates on plain vanilla interest rate swaps in Germany and
United States are 6.7% and 7.5% respectively. The current spot exchange rate is
€0.7685/$.
X-Tech issued a ten-year callable bond with a face value of €55 million to support its
expansion strategy. X-Tech has agreed to pay a coupon rate of 15% annually, of which
4.5% is the estimated credit premium. The finance department at the firm regularly
monitors the interest rate environment to determine the risk of their debt portfolio. During
a recent examination, X-Tech determined that interest rates were expected to fall in the
euro zone. Knowing that such a scenario can prove to be unfavorable for their bond
position, the firm decided to remove the call feature from their bond issue. Ramos asked
Smith how X-Tech can synthetically achieve this objective.
Ramos has invested $10 million in a passive investment vehicle that tracks a
comprehensive U.S. stock market index representing the large-cap segment of the market.
Ramos wants to alter the beta of his portfolio and is deciding which method of doing so
would be more appropriate. When he talked to Smith about it, Smith made the following
comment:
Statement 1: “To change the beta of your portfolio, you can either transact in the
individual securities that constitute your portfolio, or transact in the
portfolio itself and the risk free asset. A third method is to use derivatives.
Derivatives have the advantage of being low cost and more liquid.
However, due to rounding issues, if you want to achieve the exact beta that
you desire, the former two methods are more appropriate.”
Smith recently constructed a synthetic index fund consisting of a position of $30 million
by buying futures and investing money in risk free bonds. The fund will track a price
index representing U.S. stocks and will be equivalent to investing in 35,204 units of the
index. While talking to Ramos about it, Smith made the following comment:
Statement 2: “Although the synthetic replication strategy will result in exposure to the
market, the transaction will not capture the dividends that would be earned
if one held the underlying stocks directly.”
Apart from creating a synthetic index fund, Smith has also worked at synthetically
converting an indexed position into cash. Smith did this for a pension fund that held an
$85 million indexed position tracking the S&P 500 index. Given that the index was
expected to underperform, Smith was advised to convert the position to cash for a six
month period. Smith used a futures contract on the S&P 500 priced at 1784.49 to create
synthetic cash. The contract had a multiplier of $150, and expired in six months. The
dividend yield on the S&P 500 index and the risk free rate were 0.56% and 5.45%
respectively.
Ramos read an article on money spreads to better understand how such strategies can be
utilized by equity portfolio managers. When mentioning examples of money spread
strategies, the article made the following comment:
“For most money spreads, the maximum loss at expiration is the net premium paid.”
25. The duration of TAM’s bond portfolio after taking the appropriate swap position
will be closest to:
A.
4.53.
B.
4.88.
C.
5.73.
26. To achieve his objective of hedging currency risk, the amount of euros that
Ramos will have to deliver each quarter is closest to:
A.
€2,580,299.
B.
€3,759,039.
C.
€4,369,002.
27. Which of the following would best achieve X-Tech’s objective of removing the
call feature from their callable issue?
A.
Purchasing a receiver swaption with an exercise rate of 15%.
B.
Selling a receiver swaption with an exercise rate of 10.5%.
C.
Buying a payer swaption with an exercise rate of 19.5%.
28. Smith is most accurate with respect to:
A.
Statement 1 only.
B.
Statement 2 only.
C.
neither Statement 1 nor Statement 2.
29. When Smith created synthetic cash for the pension fund, the number of units of
stock delivered at contract expiration would have been closest to:
A.
47,920.
B.
48,764.
C.
48,900.
30. The article’s comment is most accurate with respect to:
A.
bull spreads but not bear spreads.
B.
butterfly spreads with calls but not butterfly spreads with puts.
C.
bull and bear spreads but not a sandwich spread.