FINANCIAL ENGINEERING
QUESTIONS AND SOLUTIONS:
Distinguish between the terms open interest and trading volume.
Answer: The open interest of a futures contract at a particular time is the total
number of long positions outstanding. (Equivalently, it is the total number of short
positions outstanding). The trading volume during a certain period of time is the
number of contracts traded during this period.
Explain careful1y the difference between hedging, speculation, and arbitrage.
Answer:
A trader is hedging when she has an exposure to the price of an asset and takes a
position in a derivative to offset the exposure. In a speculation the trader has no
exposure to offset. She is betting on the future movements in the price of the asset.
Arbitrage involves taking a position in two or more different markets to lock in a
profit.
What is the difference between a local and a futures commission merchant?
Answer: A futures commission merchant trades on behalf of a client and charges a
commission. A local trades on his or her own behalf.
What is the difference between the over-the-counter market and the exchange-
traded market? What are the bid and offer quotes of a market in the over-the-
counter market?
Answer: The OTC market is a telephone – and computer- linked network of
financial institutions, fund managers, and corporate treasurers where two
participants can enter into any mutually acceptable contract. An exchange-traded
market is a market organised by an exchange where traders either meet physically
or communicate electronically and the contracts that can be traded have been
defined by the exchange. When a market quotes a bid and an offer, the bid is the
price at which the market maker is prepared to buy and the offer is the price at
which the market maker is prepared to sell.
Show that, if the futures price of a commodity is greater than the spot price during
the delivery period, then there is an arbitrage opportunity. Does an arbitrage
opportunity exist if the futures price is less than the spot price? Explain your answer.
Solution:
If the futures price is greater than the spot price during the delivery period, an
arbitrageur buys the asset, shorts a futures contract, and makes delivery for an
immediate profit. If the futures price is less than the spot price during the delivery
period, there is no similar perfect arbitrage strategy. An arbitrageur can take a long
futures position but cannot force immediate delivery of the asset. The decision on
when delivery will be made is made by the party with the short position.
Nevertheless companies interested in acquiring the asset will find it attractive to
enter into a long futures contract and wait for delivery to be made.
What is the difference between entering into a long forward contract when the
forward price is $50 and taking a long position in a call option with a strike price of
$50?
Solution:
In the first case the trader is obligated to buy the asset for $50. (The trader does not
have a choice.) In the second case the trader has an option to buy the asset for $50.
(The trader does not have to exercise the option.)
Suppose that you enter into a short futures contract to sell July silver for $17.20 per
ounce. The size of the contract is 5,000 ounces. The initial margin is $4,000 and the
maintenance margin is $3,000. What change in the futures price will lead to a
margin call? What happens if you do not meet the margin call?
Answer: There will be a margin call when $1,000 has been lost from the margin
account. This will occur when the price of silver increases by 1,000/5,000 = $0.20.
The price of silver must therefore rise to $17.40 per ounce for there to be a margin
call. If the margin call is not met, your broker closes out your position.
An investor enters into a short forward contract to sell £100,000 for US $ at an
exchange rate of $1.4000 per GBP. How much does the investor gain or lose if the
exchange rate at the end of the contract is (i) $1.3900 and (ii) $1.4200?
Answer:
a) The investor is obligated to sell £ when they are worth 1.3900. The gain is
(1.400 – 1.3900) * 100000 = $1000
b) The investor is obligated to sell £ for 1.400 when they are worth 1.4200. The
loss is (1.4200- 1.400) * 100000 = $ 2000
What is the difference between entering into a long forward contract when the
forward price is $50 and taking a long position in a call option with a strike price of
$50? Explain.
Answer: In the first case the trader is obligated to buy the asset for $50. (The trader
does not have a choice) In the second case the trader has an option to buy the asset
for $50. (The trader does not have to exercise the option)
A trader enters into a short cotton futures contract when the futures price is 50 cents
per pound. The contract is for the delivery of 50,000 pounds. How much does the
trader gain or lose if the cotton price at the end of the contract is;
i) 48.20 cents per pound?
ii) 51.30 cents per pound?
Answer:
i) The trader sells for 50 cents per pound something that is worth 48.20 cents
per pound. Gain = ($0.5000 - $ 0.4820)* 50,000 = $900
The trader sells for 50 cents per pound something that is worth 51.30 cents per
pound. Loss = ($0.51.30 - $0.5000)* 50,000 = $650
Suppose that in September 2015 a Company takes a long position in a contract on
May 2016 crude oil futures. It closes out its position in March 2016. The futures
price (per barrel) is $68.30 when it enters into the contract, $70.50 when it closes out
its position and $69.10 at the end of December 2015. One contract is for the delivery
of 1,000 barrels. What is the company’s total profit? When is it realised? How is it
taxed if it is (a) a hedger and (b) a speculator?
Assume that the company has a December 31 year end.
Answer: The total profit is ($70.50 - $68.30)*1000 = $2200. Of this ($69.10 - $68.30) *
1000 or $ 800 is realised on a day-by-day basis between September 2012 and
December 31, 2012. A further ($70.50 - $69.10) * 1000 = $1400 is realised on a day-
by-day basis between January 1, 2013 and March 2013. The hedger would be taxed
on the whole profit of $2200 in 2013. A speculator would be taxed on $800 in 2012
and $1400 in 2013.
What does a stop order to sell at $2 mean? When might it be used? What does a limit
order to sell at $2 mean? When might it be used?
Answer: A stop order to sell at $2 is an order to sell at the best available price once a
price of $2 or less is reached. It could be used to limit the losses from an existing
long position. A limit order to sell at $2 is an order to sell at a price of $2 or more. It
could be used to instruct a broker that a short position should be taken, providing it
can be done at a price more favourable than $2.
Companies A and B have been offered the following rates per annum on a $20
million five year loan:
Fixed Rate Floating Rate
Company A 5.0% Libor + 0.1%
Company B 6.4% Libor + 0.6%
Company A requires a floating-rate loan; company B requires a fixed-rate loan.
Design a swap that will net a bank; acting as intermediary, 0.1% per annum and that
will appear equally attractive to both companies.
Answer: A has an apparent comparative advantage in fixed-rate markets but wants
to borrow floating. B has an apparent comparative advantage in floating-rate
markets but wants to borrow fixed. This provides the basis for the swap. There is a
1.4% per annum differential between the fixed rates offered to the two companies
and a 0.5% per annum differential between the floating rates offered to the two
companies. The total gain to all parties from the swap is therefore 1.4 – 0.5 = 0.9%
per annum. Because the bank gets 0.1% per annum of this gain, the swap should
make each of A and B 0.4% per annum better off. This means that it should lead to
A borrowing at LIBOR -0.3% and to B borrowing at 6%. The appropriate
arrangement will be as shown below.
The arrangement can be as follows:
i) ‘A’ borrows @ 5% and will hand over to the Bank @5.4%. Bank will hand
over to ‘B’ @ 6% and retains a margin of 0.6%.
ii) ‘B’ borrows @L+0.6% and will hand over to Bank @ L+0.6%. Bank will
hand over to ‘A’ @ L+0.1%
Company X wishes to borrow U.S. dollars at a fixed rate of interest. Company Y
wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by
the two companies are roughly the same at the current exchange rate. The
companies have been quoted the following interest rates, which have been adjusted
for the impact of taxes:
Yen Dollars
Company X 5.0% 9.6%
Company Y 6.5% 10.0%
Design a swap that will net a bank, acting as intermediary, 50 basis points per
annum. Make the swap equally attractive to the two companies and ensure that all
foreign exchange risk is assumed by the bank.
Answer: X has a comparative advantage in Yen markets but wants to borrow
Dollars. Y has a comparative advantage in Dollar markets but wants to borrow
Yen. This provides the basis for the swap. There is a 1.5% per annum differential
between the Yen and a 0.4% per annum differential between the Dollar rates. The
total gain to all parties from the Swap is therefore 1.5 – 0.4= 1.1% per annum. The
bank requires 0.5% per annum, leaving 0.3% per annum for each of X and Y. The
Swap should lead to X borrowing Dollars at 9.6 – 0.3 = 9.3% per annum and to Y
borrowing Yen at 6.5 – 0.3 = 6.2% per annum. All foreign exchange risk is borne by
the bank. The appropriate arrangement is therefore as shown below.
Firm X borrows fixed @ 5% and will hand over to the intermediary @5.3%. The
intermediary will hand over to Firm Y @ 6.2%.
Firm Y borrows fixed @ 10% and will hand over to intermediary @ 10%. The
intermediary will hand over to firm X @ 9.6%.
Companies X and Y have been offered the following rates per annum on a $5 million 10-
year investment:
Fixed Rate Floating Rate
Company X 8.0% LIBOR
Company Y 8.8% LIBOR
Company X requires a fixed-rate investment; company Y requires a floating-rate
investment. Design a swap that will net a bank, acting as intermediary, 0.2% per annum and
will appear equally attractive to X and Y.
Answer: The spread between the interest rates offered to X and Y is 0.8% per annum on
fixed rate investments and 0.0% per annum on floating rate investments. This means that
the total apparent benefit to all parties from the swap is 0.8% per annum. Of this 0.2% per
annum will go to the bank. This leaves 0.3% per annum for each of X and Y. In other
words, company X should be able to get a fixed-rate return of 8.3% per annum while
company Y should be able to get a floating-rate return LIBOR + 0.3% per annum. The
bank earns 0.2%, company X earns 8.3%, and company Y earns LIBOR + 0.3%.
Companies A and B face the following interest rates (adjusted for the differential impact of
taxes):
A B
US Dollars (floating rate) LIBOR+0.5% LIBOR+1.0%
Canadian dollars (fixed rate) 5.0% 6.5%
Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants to
borrow Canadian dollars at a fixed rate of interest. A financial institution is planning to
arrange a swap and requires a 50-basis-point spread. If the swap is equally attractive to A
and B, what rates of interest will A and B end up paying?
Solution:
Company A has a comparative advantage in the Canadian dollar fixed-rate market.
Company B has a comparative advantage in the U.S. dollar floating-rate market. (This may
be because of their tax positions.) However, company A wants to borrow in the U.S. dollar
floating-rate market and company B wants to borrow in the Canadian dollar fixed-rate
market. This gives rise to the swap opportunity.
The differential between the U.S. dollar floating rates is 0.5% per annum, and the
differential between the Canadian dollar fixed rates is 1.5% per annum. The difference
between the differentials is 1% per annum. The total potential gain to all parties from the
swap is therefore 1% per annum, or 100 basis points. If the financial intermediary requires
50 basis points, each of A and B can be made 25 basis points better off. Thus a swap can be
designed so that it provides A with U.S. dollars at LIBOR 0.25% per annum, and B with
Canadian dollars at 6.25% per annum.
The arrangement can as follows:
Firm A borrows Canadian Dollar at 5% fixed, and will hand over to intermediary at the
same rate. Intermediary will hand over the amount to firm B at 6.25%. Here firm B gets a
gain of 0.25% and intermediary has taken a gain of 1.25%.
Secondly, firm B borrows at LIBOR +1% and will hand over the amount to intermediary at
the same rate. Intermediary bank will hand over this to firm A at LIBOR+.25%. In this case
firm gets a gain of 0.25% and intermediary lost 0.75%.
So, the net results of the Swap deal are, A gained 0.25%, B gained 0.25% and intermediary
bank gained 0.50% (1.25% - 0.75%).
A speculator is considering the purchase of five three-month Japanese yen call options with
a striking price of 96 cents per 100 yen. The premium is 1.35 cents per 100 yen. The spot
price is 95.28 cents per 100 yen and the 90-day forward rate is 95.71 cents. The speculator
believes the yen will appreciate to $1.00 per 100 yen over the next three months. As the
speculator’s assistant, you have been asked to prepare the following:
1. Graph the call option cash flow schedule.
2. Determine the speculator’s profit if the yen appreciates to $1.00/100 yen.
3. Determine the speculator’s profit if the yen only appreciates to the forward rate.
4. Determine the future spot price at which the speculator will only break even.
Solution:
1. +
-
2. (5) x [(100 - 96) - 1.35] = $.1325.
3. Since the option expires out-of-the-money, the speculator will let the option expire
worthless. He will only lose the option premium.
4. ST = E + C = 96 + 1.35 = 97.35 cents per 100 yen.
You would like to speculate on the rise of a certain stock. The current price is $29 and a 3-
month call with a strike price of $30 costs $2.90. You have $5,800 to invest. Identify two
alternative investment strategies, one in the stock and the other in an option on the stock.
What are the potential gains and losses from each?
Solution:
One strategy would be to buy 200 shares. Another would be to buy 2000 options. If the
share price does well the second strategy will give rise to greater gains.
For example, if the price goes up to $40, you gain [2,000* (40-30)] – 5,800 = $ 14,200 from
the second strategy and only 200*($40-$29) = $2,200from the first strategy. However, if the
share price does badly, the second strategy gives greater losses.
For example, if the share price goes down to $25, the first strategy leads to a loss of $200*
($29-$25) = $800, whereas the second strategy leads to a loss of the whole $5,800 investment.
This example shows that, options contain built in leverage.
