54 RELATE TO RISK MANAGEMENT APPLICATIONS OF DERIVATIVES....

Questions 49-54 relate to Risk Management Applications of Derivatives.

Elkridge Inc., based in St. Paul, Minnesota, is one of the largest manufacturers and

distributors of baby care products in the U.S. The company recently filled two new senior

level investment strategist positions by hiring Andrea Willow and Craig Townsend directly

out of graduate school. While both Willow and Townsend have similar strengths, they have

very different outlooks on the markets, including the short-term outlook. Willow firmly

believes that the stock market is poised to increase, but is pessimistic about the bond market.

In contrast, Townsend is optimistic about the bond market, but feels that stocks are

overbought and about to correct.

As part of their first major assignment, Willow and Townsend have been asked to analyze

and evaluate two of Elkridge's major investment portfolios. Exhibit 1 provides statistics on

Portfolio 1, an actively managed portfolio, along with data on six-month S&P futures and

bond futures contracts which the company is considering as a means to manage portfolio risk.

Exhibit 1. Portfolio 1 and Futures Contracts

Portfolio 1

Size $168 million

Allocation 70% stocks, 30%

bonds

Beta (stock portion) 0.85

Target Modified Duration (bond portion) 4.3

Effective Duration (Cash equivalents and any

hedged positions) 0.25

6-month S&P Futures

Current Price 1526.00

Beta 0.92

Multiplier 250

6-month Bond Futures

Current Price 96,500

Implied Modified Duration 5.2

Yield Beta 0.94

Exhibit 2 provides statistics on Portfolio 2 and the terms of a potential swap (Swap A) that

Elkridge is interested in using to lower the portfolio's modified duration.

Exhibit 2. Portfolio 2 and Swap Contract

Portfolio 2

Size $96 million

Allocation 100 percent bonds

Modified Duration 6.3

Target Modified Duration 4.5

Swap A

Tenor 1 year

Payment Frequency Quarterly

Long Float Duration 0.125

Short Fixed Duration 0.875

In reviewing Portfolio 1, Willow recommends using 187 S&P futures contracts to adjust

portfolio beta to 1.41 to take advantage of projected stock market increases. Also reviewing

Portfolio 1, Townsend would like to see the company reallocate its holdings to 55% stocks

and 45% bonds by using bond futures contracts to capitalize on his projections for bond

market increases.

Six months later, the bond futures contract price has fallen 6%. Over that same time, the

stock market has risen 2.2%, the stocks in Portfolio 1 have generated a total return of

$2,199,120, and the S&P futures contracts are priced at 1547.00. However Willow is

surprised to find the effective beta (realized hedged beta) did not meet her target of 1.41. She

and Townsend discuss possible reasons this could have happened:

Reason 1. The beta of her stocks showed mean reversion.

Reason 2. The futures contract was initially mispriced.

Willow and Townsend then formulate two hypothetical situations with identical facts except:

Situation 1. Purchase 6-month contracts to increase equity exposure by $10,000,000 (not

a synthetic position).

Situation 2. The $10,000,000 will be received in 6 months and the contracts are being

purchased to create a $10,000,000 synthetic position.

Among its liabilities, Elkridge has a $50 million floating-rate bond issuance outstanding with

coupons paying LIBOR + 1% (resetting semiannually). The firm would like to pay a fixed

rate instead and is looking at engaging in a $50 million notional, 4-year, semi-annual swap

(Swap B) where it would receive LIBOR.

...

Assume the company had followed Willow's recommendation for Portfolio 1. Calculate

effective beta and determine which of the two reasons for effective beta diverging from the

target is most likely?

Effective Beta Reason

A) 0.87 1

B) 1.23 1

C) 1.23 2

Question #50 of 60

Assume that Elkridge has followed Townsend's advice. Using the data and assumptions in

Exhibit 1, after six months, the loss on the bond futures position is closest to:

A) $1,105,890.

B) $1,175,370.

C) $1,250,640.

Question #51 of 60

Suppose Elkridge considers futures contract transactions to implement the strategies espoused

by Willow and Townsend. A potential goal (means) of these transactions and the individual

strategist's viewpoint supported by that goal would be to:

A) decrease target beta by selling stock futures, as supported by Willow.

B) increase stock exposure by buying stock futures, as supported by Townsend.

C) increase modified duration by buying bond futures, as supported by Townsend.

Question #52 of 60

The number of contracts purchased for Situation 2 compared to Situation 1 would most

likely be:

A) greater.

B) equal.

C) less.

Question #53 of 60

In regard to its floating-rate bond issuance, in what direction must Elkridge feel interest rates

are moving and what fixed rate will it pay on Swap B to have a net cost of funds of 7.25%?

Rate Direction Fixed Rate

A) Fall 8.25%

B) Rise 6.25%

C) Rise 8.25%

Question #54 of 60

Extending the tenor of Swap A to three years, assuming a short fixed duration of 2.625,

would result in a notional principal of:

A) $69,120,000.

B) $76,800,000.

C) $230,400,000.

Question #55 of 60