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

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.  

B.  

C.  

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.