Question Paper

Financial Risk Management - I (231) : April 2006

Section A : Basic Concepts (30 Marks)
• • This section consists of questions with serial number 1 - 30.
• • Answer all questions.
• • Each question carries one mark.
• • Maximum time for answering Section A is 30 Minutes.

< Answer
1. A reverse time spread option involves >
(a) Purchase and sell a call with the same time to maturity but different strike prices
(b) Sell a long period of time call and write another call with shorter time period to maturity, both
having same strike prices
(c) Purchase a long period of time call and write another call with shorter time period maturity, both
having same strike prices
(d) Purchase a call expiring in a short period of time and write another call with longer time period to
maturity, both having same strike prices
(e) Sell a short period of time call and write another call with longer time period to maturity, both
having same strike prices.
< Answer
2. An Indian exporter is exporting goods to his Japanese clients. The payment in Yen will be made on July >
01, 2006. The current spot rate is Rs.38.39/100¥. The exporter hedges the receivables by selling July
Yen futures. If Rupee appreciates in the spot market and basis remains unchanged till the payment is
received, which of the following condition must be true?
(a) Gain in the spot market is more than the gain in the futures market
(b) Gain in the futures market is more than the gain in the spot market
(c) Loss in the spot market is more than the gain in the futures market
(d) Loss in the futures market is equal to the gain in the spot market
(e) Loss in the spot market is equal to the gain in the futures market.
< Answer
3. If speculators believe interest rates will _______, they would consider ______ a T-bill futures contract >
today.
(a) Increase; selling (b) Increase; buying
(c) Decrease, selling (d) Decrease; selling a call option on
(e) Increase; purchasing a call option on.
< Answer
4. Costs involved in increased precautions and limits on the risky activities in order to reduce the chances >
of recurrence of risk is known as
(a) Loss financing costs (b) Risk handling costs
(c) Loss control costs (d) Social costs
(e) Residual uncertainty costs.
< Answer
5. XYZ Corporation sells for Rs.35 per share; the SEP option series has exactly six months until >
expiration. At the moment, the SEP 35 call sells for Rs.3, and the SEP 35 put sells for Rs.1.40. What
annual interest rate is implied in the option prices?
(a) 5.62% (b) 6.49% (c) 7.89% (d) 9.81% (e) 10.58%.
< Answer
6. Which of the following statements is not true regarding Swap markets? >
(a) The swap deal cannot be terminated without the agreement of parties involved in the transaction
 (b) The swap market is an exchange controlled market
(c) Swaps are not easily tradable
(d) Comparative advantage theorem used in swap market is illusionary
(e) It is difficult to identify a Counterparty to take opposite side of the transaction once a party has
approached the swap dealer with his requirements.
< Answer
7. Which of the following kinds of swap is useful to those users of fund that need funds immediately but >
do not consider the current rates of interest very attractive and feel that the rates may fall in future?
(a) Extendible Swap (b) Roller-Coaster Swap
(c) Putable Swap (d) Forward Swap
(e) Deferred Rate Swap.
< Answer
8. The cash flow hedge between an interest-bearing financial instrument and an interest rate swap is said >
to be effective if,
I. The financial instrument is not pre-payable.
II. The fair value of swap is positive at origin.
III. The principal amount and the notional amount of the swap matches.
IV. All variable rates of interest payments or receipts on the instrument beyond the swap term are
designated as hedged.

(a) Both (I) and (II) above (b) Both (I) and (III) above
(c) Both (III) and (IV) above (d) (I), (II) and (III) above
(e) (II), (III) and (IV) above.
< Answer
9. Which of the following is not a derivative financial instrument according to FASB–133? >
(a) Interest only obligations (b) Letters of credit
(c) Note issuance facility (d) Forward rate agreements
(e) Interest rate indexes.
< Answer
10. Mr. Shyam has written APR 06 call option with strike price of Rs.45, priced at Rs.5 and purchased JUN >
06 call option with strike price of Rs.45, priced at Rs.6. Under which of the following situation the
investor will make profit on both the calls?
(a) Stock price remains below Rs.50 until April, 06 and then starts increasing
(b) Stock price remains above Rs.45 until April, 06 and then starts decreasing
(c) Stock price remains below Rs.45 until April, 06 and then starts increasing
(d) Stock prices remains above Rs.44 until June, 06 and then starts decreasing
(e) Stock prices remains below Rs.51 until June, 06 and then starts increasing.
< Answer
11. Which of the following statements is not true? >
(a) Delta of call will be most sensitive to change in the stock prices, when the underlying stock prices
approaches the exercise price
(b) For a put option that is near-the-money gamma decreases as expiration approaches
(c) Rho will be lower for deep-out-of-the-money call option
(d) Vega will be highest for a near-the-money put option
(e) Normally, theta is always less then zero.
< Answer
12. If a risk less portfolio can be constructed by combining 500 long call options on TTK Ltd. with a short >
position of 100 shares of TTK Ltd. Which of the following statements is true?
(a) The option’s hedge ratio is 0.20
(b) The option’s lambda is 0.5213
(c) The option’s delta is 5.00
(d) The option’s theta is 5.00
(e) The option’s gamma is 0.25.
< Answer
13. If a day’s temperature is 720 F, then Heating Degree Days (HDD) index is >
 (a) – 7 (b) –5 (c) 0 (d) 5 (e) 7.
< Answer
14. The contract size for futures contracts on weather derivatives in CME is >
(a) $1 million
(b) $100 times the CME Degree Day Index
(c) $ 200 times the CME Degree Day Index
(d) 100 future contracts
(e) 20 future contracts.
< Answer
15. In a single period binomial option-pricing model, the underlying stock is currently selling for Rs.80 and >
will rise or fall by 15% over the next period. A call option with an exercise price of Rs.95 would have a
premium of
(a) Zero (b) Rs.3 (c) Rs.5 (d) Rs.8 (e) Rs.15.
< Answer
16. Which of the following statements is not true with respect to Value At Risk (VAR)? >
(a) Prices may not respond in a linear fashion to change in the market variables, resulting in erroneous
measurement by VAR
(b) Intra-day positions are considered in VAR
(c) It is based on the past data
(d) It focuses on single arbitrary point
(e) Firms with market risk measurement systems which apply portfolio diversification theory can
lower their risk with the use of VAR.
< Answer
17. Which of the following is an implied warranty in Marine Insurance? >
(a) The ship will sail on a particular day
(b) The ship is neutral and will remain so during the voyage
(c) The ship is seaworthy on a particular day
(d) The ship is not overloaded or badly loaded
(e) The ship will proceed to the destination without any deviation.
< Answer
18. The road transit insurance policy ceases _____ days after arrival of lorry at the destination named in the >
policy.
(a) 3 (b) 7 (c) 10 (d) 14 (e) 30.
< Answer
19. Options in inter-bank market are quoted in terms of >
(a) Explicit volatility (b) Historical volatility
(c) Future volatility (d) Implied volatility
(e) Market volatility.
< Answer
20. Which of the following statements does not explain the fact that mispricing or arbitrage opportunities in >
stock index persist for a short period of time?
(a) Large orders are not guaranteed and any price or prices can change quickly
(b) There can be a potential tracking error
(c) There is a dividend risk
(d) There is transaction costs involved in the trading
(e) It is easy to duplicate the underlying stocks comprising the index.
< Answer
21. The discount yield on a 90-day T-bill futures of remaining maturity 60 days and size $1,000,000, traded >
on IMM at $992,417 is
(a) 4.45% (b) 4.50% (c) 4.55% (d) 4.60% (e) 4.65%.
< Answer
22. An investor has taken long position in Microsys stock for Rs.6,00,000. The beta of the stock is 1.5. To >
hedge its position against the market movement, what would be the appropriate action?
(a) Short on index futures for Rs.4,00,000
(b) Short on index futures for Rs.6,00,000
 (c) Long on index futures for Rs.6,00,000
(d) Short on index futures for Rs.9,00,000
(e) Long on index futures for Rs.4,00,000.
< Answer
23. If the previous fixed day payment date and forthcoming fixed day payment date are 01-08-2005 and 01- >
03-2006, then fixed day count fraction as per 30/360 convention will be
(a) 208/360 (b) 209/360 (c) 210/360 (d) 212/360 (e) 214/360.
< Answer
24. Which of the following statements is/are not true regarding portfolio insurance? >
I. It is a dynamic hedging strategy which uses stock index future.
II. It implies buying and selling securities periodically in order to maintain limit of the portfolio
value.
III. The working of portfolio insurance is similar to buying an index call option.
IV. Portfolio insurance can be done by using listed index options.
(a) Only (II) above (b) Only (III) above
(c) Both (I) and (IV) above (d) Both (II) and (III) above
(e) (I), (II) and (IV) above.
< Answer
25. An order to execute a transaction at the best available price, when the market reaches a price specified >
by the customer is called
(a) Market Order (b) Market-if-touched Order
(c) Market on close Order (d) Stop-loss Order (e) Not held Order.
< Answer
26. Which of the following is/are not true with respect to US T-bill futures and Eurodollar futures quoted in >
US exchanges?
I. Unlike Eurodollar futures, T-bill futures are cash settled.
II. Eurodollar future contract is a future contract on an interest rate whereas T-bill future contract is a
future contract on price of a T-bill.
III. Minimum tick size for both the contracts is 10 basis points each.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (II) and (III) above
(e) Both (I) and (III) above.
< Answer
27. An investor buys a strap using July call of 140 with a premium of Rs.5 and July put of 140 with a >
premium of Rs.6. What will be the break-even points for the strategy?
(a) Rs.124 and Rs.148 (b) Rs.136 and Rs.145
(c) Rs.134 and Rs.150 (d) Rs.131.5 and Rs.157
(e) Rs.123 and Rs.147.5.
< Answer
28. A US exporter is exporting goods to his Australian client. On September 14, 2005, the exporter got >
confirmation from the Australian importer that the payment of AUS$6,00,000 will be made on
November 1, 2005. The exporter uses futures market to cover the exchange risk. On September 14,
2005, the spot exchange rate is 0.7462$/AUS$ and December futures contract rate is 0.7497$/AUS$. If,
on November 1, 2005 the spot exchange rate is 0.7446$/AUS$ and December futures rate is
0.7481$/AUS$, what will be US$ cash flow to the exporter?
(a) $4,45,800 (b) $4,46,760 (c) $4,47,720 (d) $4,47,960 (e) $4,48,860.
< Answer
29. A savings and loan association has long-term fixed-rate mortgages financed by short-term funds. It >
hedges by selling Treasury bond futures. If interest rates decline, and many mortgages are prepaid,
(a) The gain on the futures contracts offsets the loss on the mortgages
(b) The gain on the mortgages offsets the loss on the futures contracts
(c) The gain on the futures contracts more than offsets any unfavorable effects on mortgages
(d) A loss on the futures contracts more than offsets the favorable effect on the mortgage portfolio
(e) The loss on the mortgages offset by the gain on the futures contracts.
 < Answer
30. Assume that a futures contract on Treasury bonds with a face value of $100,000 is purchased at 93-00. >
If the same contract is later sold at 94-18, what is the gain, ignoring transactions costs?
(a) $1,180,000 (b) $118 (c) $11,800 (d) $15,625 (e) $1,562.50.

END OF SECTION A
 Section B : Problems (50 Marks)
• • This section consists of questions with serial number 1 – 5.
• • Answer all questions.
• • Marks are indicated against each question.
• • Detailed workings should form part of your answer.
• • Do not spend more than 110 - 120 minutes on Section B.

1. On September 16, a London bank needs to issue $10 million for 180-day Eurodollar time deposits. The current
rate on such deposits is 8.75%. The bank is considering the alternative of selling a Eurodollar futures contract and
issuing a 90-day time deposit and rollover it.
The following data is available for 90-day time deposit and Eurodollar future contract:

Interest rate on Price of December

Date 90-day time Eurodollar future
deposit (%) contract on IMM ($)
September 16 8.25 91.37
December 16 7.96 92.04
Based on the above information you are
required to suggest the alternative that should be adopted by the bank.
(10 marks) < Answer >
2. Following information is available with respect to the share price and call options on the shares of Anant Ltd.:
Call Option Strike Price
Variable X = Rs.90 Stock
X = Rs.100 X = Rs.110
Price Rs.16.33 Rs.10.30 Rs.6.06 Rs.100

Delta 0.5862 0.8025 0.4365 1

Gamma 0.0138 0.0181 0.0187 0
Vega 0.2046 0.2684 0.2766 0
Mr. Manish, a
trader, has sold 200 call options with the strike price of Rs.100 and each option is on 100 shares of stock. Using
the above-mentioned information you are required to show what position Mr. Manish will take on calls with
exercise prices Rs.90 and Rs.110 and on the stock to create a portfolio that is delta-gamma-vega neutral?
(10 marks) < Answer >
3. Ziemenns GmbH, a German firm, is in need of $200 million for its foreign investment
requirements for 5 years. A US firm, Sandvik Inc., needs an amount of €160 million for its
European operations for 5 years. Following information is available for borrowings in different
markets for both the parties:
Firm US market ($) Euro market (€)
Ziemenns GmbH 8% 6%
Sandvik Inc. 7% 8%
Both the firms swap their
borrowings to meet their requirements. After a year interest rates have dropped uniformly by 75
 bp in US market and by 50 bp in Euro market. At the end of the first year, you are required to
find out
i. Dollar value of the swap to Sandvik
ii. Euro value of the swap to Ziemenns
Spot rate at the time of entering in to swap was $ 1.25/€ and spot rate after a year is $ 1.22/€.
(10 marks) < Answer >

4. A European company has decided to take a 5-year floating rate loan of $250 million to finance its acquisition. The
loan is indexed to 6 months LIBOR with a spread of 50 basis points.
The company has identified the following caps and floors quoted by a European bank:
Term Cap Floor
5-years 5-years 5-years 5-years
Underlying interest rate 6-m LIBOR 6-m LIBOR 6-m LIBOR 6-m LIBOR
Strike rate 3.0% 3.5% 3.0% 3.5%
Premium 2.0% 1.5% 1.2% 2.0%
Face value $250million $250 million $250million $250 million You are
required to state how the company can hedge its interest rate exposure by using an interest rate Collar strategy.
Also calculate the effective cost of the loan showing all the relevant cash flows if the 6 months LIBOR at the 10
reset dates turn out to be: 3.60%, 4.00%, 3.55%, 3.40%, 2.90%, 2.80%, 2.65%, 2.75%, 3.00% and 3.25%.
(Use a discount rate of 4% to amortize the premium)
(10 marks) < Answer >
5. Excel Export Inc. (EEI) of US has a one-month forward currency contract to sell AUS$ 310 million at the forward
rate of AUS$1.58/US$. The spot rate is AUS$1.55/US$. The 1-month interest rate for US$ is 5% p.a. and the 1-
month interest rates in AUS$ is 7.30% p.a. The annual volatility of the AUS$/US $ exchange rate is 6.04%. The
yield volatility of 1-month remaining maturity zero coupon AUS$ bond is 1.32% p.a. and the yield volatility of 1-
month remaining maturity zero coupon dollar bond is 1.88% p.a. The correlation of returns between two bonds is
0.55.
You are required to compute 1-day VAR for the forward contract at 99% confidence level using
variance/covariance approach. (Assume 250 days in a year).
(10 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

• • This section consists of questions with serial number 6 - 7.
• • Answer all questions.
• • Marks are indicated against each question.
• • Do not spend more than 25 -30 minutes on section C.

6. (a) How interest rate swaps can be terminated? Explain.

 (b) Are swaps similar to forward contracts? Discuss.
(5 + 5 = 10 marks) < Answer >
7. The liquidity of stock index futures has made them the market of choice especially for institutional investors.
Explain various features of index futures contracts and mechanism of pricing of index futures contracts.
(10 marks) < Answer >
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Financial Risk Management - I (231) : April 2006
Section A : Basic Concepts
1. Answer : (d) <
TOP
Reason: The reverse time spread options >

involves the purchase of a call expiring

in a short period of time and writing
another call with longer expiry period
until maturity both having same strike
prices, as the investor believes that the
price of the underlying stock will
decline before expiration of the written
call. The purchase of the short-term call
is to protect the investor in case the
stock moves in the opposite direction in
the short-term.
2. Answer : (e) <
TOP
Reason: As Rupee is appreciating there will be a >
loss in the spot market. But given the
basis is unchanged the loss in the spot
market arising from the appreciation of
dollar, is offset by the profit in the
futures market. Hence (e) is the answer.
3. Answer : (a) <
TOP
Reason: If the speculators believe the interest >
rates will increase, they should sell a T-
bill futures contract today. This is
because rise in interest rates will reduce
the prices of T-bills futures which
enables the speculators to make profit
by selling T-bill futures today at higher
 price and buying it back in future when
prices decrease because of rise in
interest rates.
Hence, option (a) is the correct answer.
4. Answer : (c) <
TOP
Reason: Loss control costs are the increased >
precautions and limits on the risky
activities in order to reduce the chances
of recurrence of risks.
Hence, option (c) is the correct answer.
5. Answer : (d) <
TOP
Reason: C – P = S – K/(1+R)T >

3 – 1.40 = 35 – 35/(1 + R)0.5

1.60 – 35 = -35/(1 + R)0.5
33.40 = 35/(1 + R)0.5
1.0479 = (1 + R)0.5
R = 9.81%
6. Answer : (b) <
TOP
Reason: Swap market is not exchange controlled >
and it is an over-the –counter market.
Hence, statement (b) is false. All other
statements are correct.
Hence, option (b) is the correct answer.
7. Answer : (e) <
TOP
Reason: A deferred rate swap allows the fixed >
rate payer to enter in to the swap at any
time up to a specified future date. It is
particulary attractive to those users of
funds that needs funds immediately but
do not consider the current rates of
interest very attractive and feel that the
rates may fall in future.
8. Answer : (b) <
TOP
Reason: The assumption of no inefectiveness in >
a cash flow hedge between an interest
bearing financial instruments and an
interst rate swap canbe assumed if the
fair value of swap is zero at origin and
all variable rate of interst payments or
receipts on the instrument during the
swap term are designated as hedged and
 none beyond that term. Hence,
statement (II) and (IV) are false.
Hence, option (b) is the correct answer.
9. Answer : (a) <
TOP
Reason: According to FASB-133, DFI exclude >
mortgage-backed securities, interest
only obligations, principal only
obligations, indexed debt and contracts
that require exchange for a non-
financial commodity.
10 Answer : (c) <
TOP
. Reason: A long time spread using calls will >
allow investor to purchase a call with
several months until expiration and
write a call only several weeks until
expiration. Both the calls having same
exercise price. Investors using this
strategy will make profits on both the
calls if the stock remains below the
exercise price until the written call
expires, allowing investor to capture
100% of the premium written. After the
expiration of of the written call, investor
would hope for the underlying stock to
make a bullish move making the
purchased call even more valuable.
Hence, option (c) is the correct answer.
11. Answer : (b) <
TOP
Reason: Delta of call will be most sensitive >
to change in the stock prices, when the
underlying stock prices approaches the
exercise price. Hence, statement (a) is
true. For a put option that is near-the-
money gamma increases as expiration
approaches. Hence, statement (b) is
false. Rho will be lower for deep-out-of-
the-money call option. Hence, statement
(c) is true. Vega will be highest for a
near-the-money put option. For deep-in-
the-money and deep-out-of-the-money,
the Vega will always be low and tends
to be zero. Hence, statement (d) is true.
Theta of a call and a put can be greater
or less than zero but in normal
 circumstances, it is always less than
zero. Hence, statement (e) is true.
Hence, option (b) is the correct answer.
12 Answer : (a) <
TOP
. Reason: The given portfolio is a riskless >
portfolio.
The value of the long calls = Value of
the underlying assets.
No. of long calls x Unit pirce = No. of
underlying assets x Unit price.
500 x Unit price = 100 x Unit price
Unit price of long call 100
Unitprice of undelying 500
=
Hedge ratio or Delta = 0.20.
13 Answer : (c) <
TOP
. Reason: HDD = ( 0 or 65 – Actual temperature) >

HDD cannot be negative. Here, actual

temperature is more than 65. Hence,
HDD will be zero.
14 Answer : (b) <
TOP
. Reason: The contract size for future contracton >
weather derivatives in CME is $100
times the CME Degree Day Index.
Hence, option (b) is the correct answer.
15 Answer : (a) <
TOP
. Reason: The price after one year can be either >
Rs. 92 or Rs. 68. The call option with
exercise price of Rs. 95 will be out-of-
the money, so the value of call will be
zero according to binomial option
pricing model.
16 Answer : (b) <
TOP
. Reason: Intra-day positions are not considered in >

VAR, which usualy takes only the

closing position into consideration.
Hence, statement (b) is false. Prices
may not respond in a linear fashion to
changes in the market variables,
resulting in erroneous measurement by
VAR. Hence, statement (a) is true.
Calculationof VAR is based on past
 data. Hence, statement (c) is true. It
focuses on single arbitrary point. Hence,
statement (d) is true. Firms with market
risk measurement systems which apply
portfolio diversification theory can
lower their risk with the use of VAR.
Hence, statement (e) is true.
Hence, option (b) is correct answer.
17 Answer : (d) <
TOP
. Reason: In marine insurance, an express >
warranty might be generally included
as:
• • that the ship is seaworthy on a
paricular day;
• • the ship will sail on a particular
day;
• • the ship will proceed to the
destination without any deviations;
• • the ship isneutral and will
remain so during the voyage.
Hence, option (d) is the correct answer.
18 Answer : (b) <
TOP
. Reason: The road transit insurance policy >

commences with the loading of each

package into the vehicle and ceases 7
days after arrival of the lorry at the
destination named in the policy.
Hence, option (b) is the correct answer.
19 Answer : (d) <
TOP
. Reason: Options in inter-bank market is quoted >
in terms of implied volatiliy.
Hence, option (d) is the correct answer.
20 Answer : (e) <
TOP
. Reason: The stock index arbitrage or program >

trading is not simple, since mispricing

does not persist for a long period of
time, the arbitrageur who wants to be
ahead of the pack in exploiting the
opportunity must have extensive
resources including elaborate
telecommunications networks to quickly
spot and act upon such opportunities.
 Moreover it may not be easy to
duplicate the underlying stocks
comprising the index, which is being
imitated. This happens mainly because
the said stocks may not be easily
available or may not have takers while
selling the same. Hence (e) is the
answer.
21 Answer : (c) <
TOP
.  r 60  >
1 − × 
Reason: 992,417 = 1,000,000  100 360 
Or, r = 4.55%.
<
22 Answer : (d) TOP
. Reason: In order to hedge his position, the >

investor simply sells the index futures

contract. By doing so, he is said to have
hedged away his index exposure. In
order to determine the number of
futures he has to sell, the beta of the
stock should be known. Here beta =1.5
the size of the position that the investor
needs to hedge his index exposure is 1.5
x 6,00,000 = Rs 9,00,000.
Once he does this his position will be as
follows:
Long stock : 6,00,000
Short index futures : 9,00,000
<
23 Answer : (a) TOP
. Reason: In 30/360 convention each month will >

be taken as 30days, including previous

fixed date and excluding forthcoming
fixed date. However, there are certain
exception to this rule. If the forthcoming
fixed date is 1st of any month and the
previous month does not have 30 days
then actual days in that month will be
taken for calculating fixed day count
fraction. Therefore, in this case, the
fixed day count fraction will be (30 x 6
+ 28) i.e. 208/360.
24 Answer : (b) <
TOP
. Reason: Portfolio insurance is an investment >
 strategy where various financial
instrumnets like equities and debts and
derivatives are combined in such a way
that degradation of portfolio value is
protected. The working of portfolio
insurance is akin to buying an index put
option. Hence, statement (III) is false.
Hence, option (b) is the correct answer.
25 Answer : (b) <
TOP
. Reason: A Market Order is the one which has to >
be executed immediately at the best
possible rate after order reaches the
trading floor.
A Market–If–Touched order is an order
to execute a transaction at the best
available price when the market reaches
a price specified by the customer.
Market On Close is the one, under
which an instruction is given to the
broker to execute the order during the
official period for the contract.
A Stop-Loss-Order is an order to buy or
sell when the price reaches a specified
level.
A Not Held Order is a type of
discretionary order, where the broker is
given a discretion to wait to buy if he
feels that the prices will go further down
or wait to sell if he feels that the prices
may go further up.
26 Answer : (e) <
TOP
. Reason: Unlike T-bill futures, Eurodollar futures >
are cash settled. Hence, statement (I) is
false. Eurodollar future contract is a
future contract on an interest rate
whereas T-bill future contract is a future
contract on price of a T-bill or a
discount rate. Hence, statement (II) is
true. Minimum tick size for both the
contracts is 1 basis points each. Hence,
statement (III) is false.
Hence, option (e) is the correct answer.
27 Answer : (a) <
TOP
. Reason: A long strap involves buying two call >

options and one put option with the

same exercise price and expiration date.
Therefore, initial outflow = (10 + 6) =
Rs.16. The break-even point will be
Rs.124 and Rs.148. When the stock
price is Rs.124, net cash flow will be
Initial inflow + Gain from put + Gain
from calls
= (-16) + 16 + 0 = 0
When stock price is Rs.148, net cash
flow wil be,
Initial inflow +Gain from put +Gain
from calls
= (-16) + 0+ 2(8) = (-16) + 0 + 16 = 0.
Hence, option (a) is the correct answer.
28 Answer : (c) <
TOP
. Reason: If AUS$ depreciates there will be a loss >
to the exporter. To cover this risk the
exporter can sell six AUS$ future
contract, as the size of each contract is
AUS$ 1,00,000, at the prevailing rate in
the market.
He will make profit on future market =
(0.7497 – 0.7481) x 6 x 1,00,000 =
$960.
He will sell AUS$ 6,00,000 in spot
market at the exchange rate of
AUS$0.7466/$.
Therefore on November 1, 2005 the
exporter will have cash flow of
(6,00,000 x 0.7446) = $4,46,760+ $960
= $4,47,720.
29 Answer : (d) <
TOP
. Reason: Due to decline in the interest rates >
prices of T-bond futures will increase.
As the association is short on T-bond
futures contracts, it will make losses in
futures market due to decline in interest
rates. Benefit of decline in interest rates
on mortgages will be less than loss in T-
bond futures market as many mortgages
will be pre-paid.
 Hence, option (d) is the correct answer.
30 Answer : (e) <
TOP
. Reason: The T-bond futures contract is >
purchased at 93-00 and sold at 94-18. In
US T-bond futures contract 1% change
is equal to 32 bp. Therefore total change
is (32 + 18) = 50 b.p. For US T-bond
future contract tick size is $31.25.
Hence, gain on the futures contract =
(50 x 31.25) = $1562.50
Hence, option (e) is the correct answer.
 Section B : Problems
1. Alternative-I: Issue of 180-day time deposit:
If the bank issues 180-day time deposit it will have to pay back
  180  
10, 000, 000   1  0.0875  
  360  
= $10,437,500 on maturity i.e. on March 16.
Thus, the effective annual borrowing rate for the company will be
 365

 10437500  180 
 1  100
  10000000 
 
 
= 9.07% p.a.
Alternative-II: Issue of 90-day time deposit & rollover it and selling Eurodollar future
contract.
On September 16: - The bank will issue 90-day time deposits of $10,000,000 at the rate of
8.25% p.a. and sell Eurodollar futures contract. On Sep. 16 December Eurodollar futures
contract is selling at 91.37.
As the standard size of Eurodollar futures contract is $1,000,000, the bank needs to sell 10
futures contracts.

On December 16: - The 90-day time deposit issued on Sep. 16 will mature and thus, bank will
have to pay
 90 
10, 000, 000  1   0.0825  
 360  = $10,206,250

Eurodollar futures contract is quoting at 92.04.

Loss on futures market = (92.04 – 91.37) x 100 x $25 x 10
= $16,750
Therefore, total funds required on December 16 = $10,206,250 + $16,750
= $10,223,000
In order to raise these funds bank will issue new 90-day time deposit for $10,223,000 at the
interest rate of 7.96%.
Therefore, on March 16, bank will pay off the new time deposit owning
 90 
10, 223, 000  1   0.0796  
 360  = $10426437.7 ≈ $10,426,438.

Thus, the effective annual borrowing rate for the company will be
 365

 10426438  180 
 1  100
  10000000 
 
 
= 8.84% p.a.
Thus, bank should raise the funds by selling Eurodollar future contract and issuing 90-day time
deposit and rollover it as the effective cost of fund for this alternative less by 23 basis point
than alternative-I.
 < TOP >

2. As the trader wants to create a portfolio that is delta-gamma-vega neutral, he must

simultaneously solve the number of shares to purchase, the position in the Rs.110 calls and the
position in the Rs.90 calls.
Suppose the number of shares required to be purchased to create delta-gamma-vega neutral
portfolio is S, the position required in Rs.110 calls is K110, and position required in Rs.90 calls is
K90. That is, he must choose the position in these securities so that the portfolio’s delta, gamma
and vega all equal to zero. To solve this problem we begin by noting that the gamma and the
vega of the stock are zero and that the position in the option with the strike price of Rs.100 is
given i.e. K100 = -200. Thus, to be gamma neutral implies
(-200 x 100 x 0.0181) + (S x 0) + (K110 x 100 x 0.0187) + (K90 x 100 x 0.0138) = 0
-362 + 0 + 1.87K110 + 1.38K90 = 0
-362 + 1.87K110 + 1.38K90 = 0 ----------------------------(I)
And, to be vega neutral implies
(-200 x 100 x 0.2684) + (S x 0) + (K110 x 100 x 0.2766) + (K90 x 100 x 0.2046) = 0
-5368 + 0 + 27.66K110 + 20.46K90 = 0
-5368 + 27.66K110 + 20.46K90 = 0 ----------------------(II)
Solving these two equations simultaneously, we get
K110 = -13.37 ≈ -13 and K90 = 280.44 ≈ 280 for any values of S. Then, solving for the number of
shares is accomplished by noting that the delta of share is 1 and that the trader also wants to
hold a delta-neutral portfolio. Accordingly,
(-200 x 100 x 0.8025) + (S x 1) + (-13 x 100 x 0.4365) + (280 x 100 x 0.5862) = 0
-16050 + S – 567.45 + 16413.6 = 0
-203.85 + S = 0
S = 203.85 ≈ 204
Therefore, in order to make the portfolio delta-gamma-vega neutral the trader should buy 204
shares of Anant Ltd. and simultaneously sell 13 call options with strike price of Rs.110 and buy
280 call option with strike price of Rs.90.
< TOP >
3.
Firm US market ($) Euro market
(€)
Ziemenns 8% 6%
Sandvik 7% 8% Requirement:
Euro 160 million
US$ 200 million
The German firm Ziemenns can borrow in € at 6% and the US firm Sandvik Inc. borrow in $ at
7%. Then they
swap their borrowings to meet their requirements.
Euro borrowings was worth € 160 million when the swap was contracted, with a Euro interest
rate of 6%. The
value of the borrowings after a year when the interest rate falls to 5.5%.
 V€ = (160 x 0.06) x PVIFA (5.5%,4) + 160 x PVIF (5.5%, 4)
= €162.804
Similarly the dollar borrowings was worth $ 200 million when swap was contracted, with a
dollar interest rate of
7%. The value of the borrowings after a year when interest rate falls to 6.25%.
V$ = (200 x 0.07) x PVIFA (6.25%,4) + 200 x PVIF (6.25%, 4)
= $205.168
Dollar value of the swap to Sandvick = $ 205.168 - [€ 162.804 x $1.22 /€] = $6.547
1
Euro value of swap to Ziemenns = €162.804 - $205.168 x 1.22 = - €5.366
< TOP >

4. The company should go for interest rate collar i.e. it should buy the cap at a higher strike rate
and sell the floor at the lower strike rate. Therefore, the company should buy cap at the strike
rate of 3.5% and sell floor at the strike rate of 3.0%.
Net premium outflow = (1.5% – 1.2%) of $ 250 million
= $ 750,000
$750, 000 750, 000
=
PVIFA(2.00%,10) 8.9826
Amortization of premium =
= $ 83,495
Cash
Time LIBOR Cash flow Amortization Cash flow flow Net
semester (%) on loan of premium from Cap from cash flow
floor
0 250,000,000 250,000,000
1 3.60 – – 83,495 +125,000 – 5,083,495
5,125,000
2 4.00 – 5,625,000 – 83,495 +625,000 _ 5,083,495
3 3.55 – 5,062,500 –83,495 +62,500 _ 5,083,495
4 3.40 – 4,875,000 –83,495 – _ 4,958,495
5 2.90 – 4,250,000 –83,495 – -125,000 4,458,495
6 2.80 – 4,125,000 –83,495 _ –250,000 4,458,495
7 2.65 – 3,937,500 –83,495 _ –437,500 4,458,495
8 2.75 – 4,062,500 –83,495 _ –312,500 4,458,495
9 3.00 – 4,375,000 –83,495 _ – 4,458,495
10 3.25 – 4,687,500 –83,495 _ – 254,770,995
–
250,000,000
Effective cost ‘r’ is given by the following equation:
250,000,000 = 5,083,495 PVIF (r, 1) + 5,083,495 PVIF (r, 2)
+ 5,083,495 PVIF (r, 3) + 4,958,495 PVIF (r, 4)
+ 4,458,495 PVIF (r, 5) + 4,458,495 PVIF (r, 6)
+ 4,458,495 PVIF (r, 7) + 4,458,495 PVIF (r, 8)
 + 4,458,495 PVIF (r, 9) + 254,770,995 PVIF (r, 10)
Therefore, r = 1.90%
∴ Annualized rate = 3.80%
< TOP >

5. EFI will sell AUS$310 million at a 1-month forward rate of AUS$1.58/$ to buy US$.
At forward rate, AUS$310 million = $310/1.58 million = $196.20 million
The forward position can be broken down into the following two positions:
 
 310 
= 
 1 + 0.073 
i. Going short on 1-month zero-coupon AUS$ bond at AUS$308.13 million  12  ,
where maturity value is AUS$310 million.
 
 196.20 
= 
 1 + 0.05 
ii. Going long on 1-month zero-coupon US$ bond at $ 195.39 million  12  , where
maturity value is US$ 196.20 million. The value of this bond in AUS$ is AUS$302.85
million at spot market.
For AUS$, yield volatility = 1.32%
Duration = 0.083 year
Yield = 7.30%
0.083
Modified duration = 1.073 =
0.0774
Delta yield = Yield × Yield volatility
= 7.30 × 1.32
= 9.636%

Price volatility = Modified duration × Delta yield

= 0.0774 × 9.636
= 0.7458%
0.7458
Price volatility for 1-day = 250 = 0.0472%
1-day volatility of AUS$ bond = 308.13 × 0.000472 = AUS$0.1453 million
For $, yield volatility = 1.88%
Duration = 0.0833 year
Yield = 5.0%
0.0833
Modified duration = 1.05 = 0.0794
Delta yield = 5.0 × 1.88
 = 9.40%
Price volatility = 0.0794 × 9.40
= 0.7464%
0.7464
Price volatility for 1-day = 250 = 0.0472%
1-day volatility of $ bond = 195.39 × 0.000472 = $ 0.0922 million

1-day volatility of AUS$ bond in dollar term

1  0.0604 
1 + 
= AUS$0.1453 × 1.55 ×  250 

= $0.0941
The standard deviation of portfolio value for 1-day
1
0.09412 + 0.09222 − 2 × 0.55 × 0.0941× 0.0922 2
= 
= $0.0884 million
1-day VAR at 99% confidence level
= 0.0884 × 2.33
= $ 0.2060 million.
< TOP
>

Section C: Applied Theory

6. a. There are several ways to terminate a swap. A party can go back to the counterparty and
ask for an offsetting swap. The parties effectively create the opposite swap. They then hold
opposite positions to each other. They can keep the two swaps in place with each making
their series of payments, but there will be credit risk. Alternatively, the parties can cancel
the two swaps, with the party owing the greater amount making a cash payment of the net
amount owed on the two swaps to the other party. If this method is used, the parties simply
agree to accept whatever terms exist in the market at the time the opposite swap is put in
place. Another means of canceling the swap is for one party to have already entered into
either a forward contract or an option on a swap of the opposite position. This arrangement
permits establishment of the terms of the offsetting swap before that swap is needed.
b. Swaps are similar to forward contracts in that they involve the commitment to make a
fixed payment and receive a floating payment at a future date. While a forward contract is
a single payment, a swap is a series of payments. Thus, a swap is like a series of forward
contracts. Both swaps and forward contracts require no up front payments, and both are
subject to default risk. There are some differences, however, in that in a swap both sides of
the first payment are known. Also, for a swap, all of the fixed payments are the same,
whereas in a series of forward contracts, each contract would be priced separately and
would have different fixed rates.
< TOP >
7. The first index futures contract was introduced in 1982 at the Kansas City Board of Trade and
today, index futures are one of the most popular types of futures as far as trading is concerned.
An index futures contract is basically an obligation to deliver at settlement, an amount equal to
'x' times the difference between the stock index value on the expiration date of the contract and
the price at whi9h the contract was originally struck. The value of 'x', which is referred to 'as
the multiple, is predetermined for each stock market index. For example, futures contracts on
S&P 500 Stock Index use a multiple of 250 while the futures contracts on BSE Sensex use a
multiple of 50. Stock index futures are based on complex cash instruments.
The multiple enables us to calculate the monetary value of an index futures contract. Forz
example, if the settlement price of the S&P 500 futures contract is 350, the value of the
contract in monetary terms is 350 x 25 = $87,500.
The salient features of the index futures contracts are as follows:
1. The index futures contracts are cash settled; there is usually no d,elivery of the underlying
stocks or stock certificates, as matching the physical stocks as per the index may be quite
difficult and costlier than settling the contract by cash.
2. An investor can either buy or sell an index futures contract. When an investor goes long in
the index futures contract, he will receive a cash settlement on the expiration date, if the
closing price exceeds the contract price. On the other hand, if the closing price is less than
the contract price, the investor will be required to pay the difference.
3. Since index futures contracts are listed and traded on futures exchanges, the investor can
offset his position on any day prior to the expiration day.
4. The performance of all index futures contracts are guaranteed by the exchange clearing
house. As in case of options exchanges, the clearing house becomes the counterparty to
both the buyer and the seller.
5. The index future carries the margin requirements that are applicable to both the buyer and
the seller. The purpose of maintaining margin money is to minimize the risk of default by
either party. The payment of margin ensures that the risk is limited to the previous day's
price movement on each outstanding position. Margin money is a kind of security deposit
or insurance against a possible future loss of value. The margin can be maintained either in
the form of risk-free short dated government securities or in the form of cash.
Additional margin is imposed only when the exchange fears that the market has become too
volatile and may result in some critical situation, like payment crisis. This is a protective
measure available to the exchange to prevent any breakdown.
Pricing-of Index Futures Contracts
Unlike options, the valuation of index futures is easy to understand. To start with, let us
consider an investor who wants to hold a portfolio, which is identical to the composition of a
stock market index for a period of one year. During the course of the year, he will receive
dividends and at the end of the year, the principal value would have changed in line with the
change in the index. If we denote the current index value as, Io the expiration day index value
as It and the dividends received as Dt the rupee return earned by the investor is given by the
equation
(It - Io) + Dt
If the investor contemplated investment in an index futures contract as an alternative to
investing in the underlying portfolio, he will buy the index futures contract and invest all his
money in risk-free treasury bills or short-dated government securities. If we denote the current
price of the index futures contract as Fo, the expiration day price as Ft and the interest earned as
Rf, the rupee return, earned by the investor is given by the equation
(Ft - Fo) + Rf
If the investor has to be indifferent between the two alternatives then the above equation
will be
(It - Io) + Dt = (Ft - Fo) + Rf
Since Ft = It, i.e. the final settlement price of the index futures contract is set equal to the spot
index value, the above equation can be simplified as
Fo = 10 + (Rf - Dt)
The above equation states that the current index futures price must be equal to the index value
plus the difference between the risk-free interest" and dividends obtainable over the life of the
contract. The difference between Rf and Dt is referred to as the 'cost-of-carry' and we can say
that the futures contract must be priced to reflect the 'cost-of-carry'.
The 'cost-of-carry' or the 'basis' is typically positive because the annualized risk-free rate of interest (about 10% in
the Indian context) exceeds the annualized dividend yield (which is around 1% for the BSE National Index). But
then this need not always be true. Depending upon the timing of the settlement date and the initiation of the
position, the impact of cost-of-carry, i.e. difference between Rf and Dt can vary substantially. We can have a
situation where the dividend yield exceeds the risk-free return and in that case, the theoretical price of the index
futures can be below that of the index.

< TOP >

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