Derivatives – Question Sheet

Case No. 1
Wang Chen is a swap trader for a large hedge fund. Petra
Freund manages a global macro fund for the same firm.
Freund wants to speculate on relative interest rate
movements in Japan and Australia and asks Chen to price a
3-year, at-market, fixed-for-fixed, annual-payment, pay-JPY,
receive-AUD currency swap. Selected data for JPY and AUD
interest rates, as well as discount factors for pricing the
swap, are contained in Exhibit 1:

Freund wants the swap structured so that the notional

amounts are exchanged at both initiation and expiration.
Exhibit 2 contains selected data on the swap and JPY/AUD
exchange rates at the swap's initiation:

One year ago, Freund entered into a pay-fixed, receive-

floating USD interest rate swap to speculate on
expectations of rising USD interest rates. US interest rates
have increased, so she is considering taking profits on the
trade. Freund asks Chen to estimate the value of the swap
based on the information contained in Exhibit 3:
Derivatives – Question Sheet

Exhibit 4 shows USD interest rates for valuing the swap:

Freund's fund also holds a quarterly-payment, receive-

equity, pay-fixed equity swap based on the S&P 500 Index
total return. The swap had a maturity of 1 year when it was
initiated 3 months ago, and the first quarterly payment has
just occurred. Freund is uncertain about the method for
valuing equity swaps and proposes three valuation methods
for this swap:

Method 1: Calculate the difference between the total

return over the last 3 months on the S&P index and the
interest accrued on the fixed-rate leg over the same period.
Method 2: Calculate the difference between the PVs of
the fixed-rate leg on the existing swap and the fixed-rate leg
of an otherwise equivalent, current at-market, S&P 500-
return-for-fixed-rate equity swap.
Method 3: Calculate the difference between the PV of
the equity leg, based on the expected total return on the
S&P 500 Index, and the PV of the swap's fixed-rate leg,
based on the coupon set at initiation.
Assume all financial instruments use the 30/360 day-count
convention.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 2
Herman Schmidt is a fund manager working at Rosige
Zukunft LLC (RZ), a derivatives trading firm. RZ uses the
carry arbitrage model to assess the value of bond forward
contracts. Exhibit 1 contains information on several
German government bonds that pay coupons once per
annum and have five years remaining until maturity.
Schmidt directs Hedwig Meyer, an RZ analyst, to price
forward contracts on Bond A, Bond B, and Bond C. The 6-
month risk-free rate is 1.50% and the 1-year risk-free rate is
2.00%.

Schmidt and Meyer discuss different methods for valuing

interest rate and currency swaps. Exhibit 2 contains
information on at-market EUR and CHF interest rate swaps,
and the CHF/EUR exchange rate.

Schmidt has RZ initiate a fixed-for-fixed EUR/CHF currency

swap, agreeing to pay 1.20% in CHF and receive 1.80% in
EUR. RZ exchanges the swap notional with the
counterparty at contract initiation, paying EUR 10 million
and receiving CHF 10.5 million. Six months later, at-market
2.5-year fixed-for-fixed EUR/CHF currency swaps are quoted
at 1.60% EUR for 1.40% CHF and the spot CHF/EUR
exchange rate is 1.1000.
Schmidt anticipates that the equity of Dash Haber Ltd., a UK
clothing retailer, will outperform versus expectations. He
decides to use a 1-year, quarterly settled, equity-return-for-
fixed-interest rate swap to gain long exposure to Dash
Haber equity. Exhibit 3 contains information related to the
swap:
Derivatives – Question Sheet

All interest rates are annual compound rates and are based
on a 360-day year.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 3
Johan Marten and Gisele Thierry are equity derivatives
traders for an international bank. They discuss the factors
underlying no-arbitrage pricing of forward commitment
derivatives, focusing on how these factors apply to pricing a
2-year forward contract on the Euro Stoxx 50 Index. The
details of this forward contract are:

The current market value of the Euro Stoxx 50 Index is

3900.
The continuously compounded dividend yield on the index
is 2.5%.
The continuously compounded risk-free interest rate is 3%.
Thierry's previous experience has mostly involved trading
equity options, futures, and forwards. She asks Marten to
describe the structure and pricing of equity swaps. In
response, he makes the following statements:

Statement 1: Equity swaps are always structured to have:

one equity leg, with a value based on the return of the
underlying equity, and
one interest rate leg, with a value based on either a fixed or
floating rate.
Statement 2: The return of the equity leg can be valued on
either a total return basis or a price-change-only basis.
Statement 3: The fixed-rate leg in an equity return-for-
fixed interest rate swap is a weighted average of the
interest rates used in valuing the equity forward contracts
that would replicate the swap's cash flows.
Thierry is unsure that she fully understands the relationship
between the value of an equity swap and the price of the
underlying equity. She asks Marten to explain that
relationship, using the receive-equity, pay-fixed interest
rate swap on Marticart common stock shown in Exhibit 1.
The EUR term structure is flat at 1.5%.
Derivatives – Question Sheet

The discount factors relevant for valuing the swap, based on

the current term structure, are shown in Exhibit 2:

The bank currently holds a position in a Gamboling

Corporation common stock pay-equity, receive-fixed
interest rate swap. Exhibit 3 contains select information
regarding the swap. The swap was initiated 6 months
earlier, and the settlement payment for the quarter ending
yesterday is due by the close of business today. Thierry
asks Marten how the settlement payment is calculated.

Assume all swap periodic settlement payments use a

30/360 day-count convention.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 4
Sondra Schute manages an interest rate and fixed-income
trading desk for an international bank. Rick Patere is a
recently hired junior analyst supporting the desk. Schute
wants to evaluate Patere's understanding of forward
commitment contracts and asks him to describe the
valuation of bond forward and futures contracts. Patere
says that forward and futures prices are similar
conceptually, but there is a fundamental difference in the
valuation of the two types of derivatives:

Statement 1: The value of a forward contract after

initiation is the future value of the difference between the
agreed price in the existing contract and the no-arbitrage
forward price of a contract initiated today, assuming both
contracts are written on the same underlying bond and
have the same expiration date.
Statement 2: The value of a futures contract resets to zero
after every trading session since there is a mark-to-market
cash settlement equal to the change in the future's price
from the previous day's settlement.
Schute asks Patere to assess the value of a bond futures
contract relative to the underlying bond, using a risk-free
rate of 1.00% and given the current data shown in Exhibit 1:

A commercial loan officer has requested a quote for an at-

market, pay-fixed, receive-floating 3 × 9 forward rate
agreement (FRA) to hedge the interest rate on a future loan
to a client. Schute directs Patere to calculate the fixed rate
on an at-market FRA and then to describe how the value of
Derivatives – Question Sheet

the trading desk's FRA position will be affected by shifts in

the yield curve, as the receive-fixed, pay-floating party.
Current reference index interest rate data is shown in
Exhibit 2:

Schute asks Patere to describe how he would value a pay-

fixed, receive-floating, interest rate swap initiated 1 year
ago. The swap has 2 years remaining until expiration and a
fixed-leg coupon of 3%. Patere identifies two methods to
value the swap. The value of the swap is equal to:

Method 1: The present value of the difference between

3% and the coupon of the fixed-rate leg of a new at-market,
annual payment, 2-year swap, assuming the same notional
amount and floating-leg reference interest rate as the swap
being valued.
Method 2: The difference between the value of two 2-
year annual-pay bonds with par values equal to the swap
notional amount, assuming one bond has a 3% fixed-
coupon rate and the other has a floating-rate coupon based
on the same reference interest rate as the floating leg of
the swap.
Schute directs Patere to price a 4-year, at-market interest
rate swap based on the information in Exhibit 3:
Derivatives – Question Sheet

Unless stated otherwise, assume all instruments have

annual payment frequencies and use the 30/360 day-count
convention, and that all interest rates are stated on an
annual compound basis.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 5
Alexa Rohm, an option trader at a large hedge fund, is
assisted by Brian Bosnik, a derivatives analyst that works at
the firm. Rohm directs Bosnik to construct a binomial
interest rate tree to value a $1 million notional 2.75% 2-
year interest rate call. The binomial tree, based on a 50%
probability of an up move, is shown in Exhibit 1:

Rohm is considering the use of various option-pricing

models to evaluate equity options. She asks Bosnik to
provide a general description of how binomial models
analyze European option values. In response Bosnik
comments on the value of the option from a binomial tree:

Comment 1: The value of an option is the PV of the

expected payoffs.
Comment 2: The payoffs reflect the cash flows at
expiration from the exercise of the option if it is in the
money, discounted at the investor's required rate of return.
Comment 3: The PVs of the expected payoffs are
weighted by risk-neutral probabilities.
Rohm is long 5,000 shares of Positron Corporation's
common stock. Near the end of the day's trading, she
hedges the Positron stock holding by selling Positron equity
calls to create a delta-neutral position. Exhibit 2 contains
information on Positron stock and options:
Derivatives – Question Sheet

The day after Rohm establishes the delta-neutral position in

Positron, its stock opens at $65 per share at the beginning
of the trading session.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 6
Parker Brookes, CFA, works for a portfolio management firm
that invests in options to hedge its equity positions.
Brookes is analyzing equity options for Alphatron, Inc. and
Omegasys Corp. The relevant information for each
company is provided in Exhibits 1 and 2:

Exhibit 3 shows the information for Alphatron options. All

the options are European options that expire in one year,
and each option allows the holder to purchase or sell one
share of Alphatron common stock:

Neither Alphatron nor Omegasys currently pays a dividend.

While talking with a colleague, Brookes makes the following
statements about the expectations approach for valuing
options:
Statement 1: The expectations approach relies on the
investor's subjective belief as to how the underlying asset
will move.
Statement 2: The discount rate used for the expectations
approach is not adjusted for the investor's risk preferences.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 7
Yannes Bolger is a newly hired junior analyst at a derivatives
trading firm, working on an interest rate option trading desk
managed by Hidemi Okura. To assess Bolger's
understanding of derivatives, Okura first asks him which
combination of interest rate puts and calls is most similar to
a pay-fixed, receive-floating forward rate agreement (FRA).
She then asks Bolger to identify which of the strategies
below is equivalent to being short an interest rate cap and
long an interest rate floor, assuming both options are 1-year
contracts based on the 3-month market reference rate
(MRR), with quarterly settlement payments, 3% exercise
rates, and $1 million notional amounts.
Strategy 1: Positions in two $1 million par value 1-year
bonds that pay interest quarterly: long a floating-rate bond
with a coupon rate based on the 3-month MRR, and short a
3% fixed-coupon bond.
Strategy 2: A 1-year, $1 million notional, quarterly
settled, receive-fixed, pay-floating interest rate swap with a
3% fixed-rate leg and a floating-rate leg based on the 3-
month MRR.
Strategy 3: Long a payer swaption on a 1-year, quarterly
settled, $1 million notional swap with a 3% fixed-rate leg
and a floating-rate leg based on the 3-month MRR.
A corporate client contacts Okura for advice on structuring
a debt offering. The client wants to borrow at a fixed cost
for a specified maturity but expects interest rates to rise
over the next few years. The client believes the bond
market is underpricing interest rate options relative to the
derivatives market. Therefore, the client asks how interest
rate options might be used to achieve the preferred fixed-
rate funding for the specified maturity while also reducing
financing costs by taking advantage of the mispricing of
embedded calls in the bond market.
Another client has requested a quote on a €10 million
notional amount, 2-year, 4% European interest rate put.
Okura asks Bolger to value the put option using the
binomial interest rate tree shown in Exhibit 1.
Derivatives – Question Sheet

Assume all instruments use a 30/360 day-count convention.

Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 8
Axeron Financial Corporation

Axeron is a proprietary trading firm that invests in securities

and derivatives markets around the world. The firm uses
the carry arbitrage model to identify when forward
commitment derivatives appear to be mispriced relative to
the underlying asset.
Nichi Tano, CFA, who manages a derivatives-trading desk for
Axeron, is overseeing the training of Ralle Mittan, a new
research associate. To assess Mittan's familiarity with
equity derivatives, Tano asks her to evaluate the accuracy of
the following statements regarding otherwise equivalent
(ie, same underlying asset, same expiration date) equity
futures and forward contracts:

Statement 1: Long futures and forward positions exhibit

the same pattern of cash flows over the time to expiration.
Statement 2: The no-arbitrage value of futures and
forward contracts is the same given the same time to
expiration.
Statement 3: Futures and forward prices decrease by
similar amounts if the expected dividends from holding the
underlying increase.
After discussing these statements, Tano asks Mittan to
describe the elements of the arbitrage carry model and
address what effect, if any, an increase in the risk-free rate
has on equity forward prices.
Axeron is the pay-fixed/receive-floating party in a 3 × 6
forward rate agreement (FRA) initiated 30 days earlier.
Information on this existing FRA and current index rates are
presented in Exhibits 1 and 2.
Derivatives – Question Sheet

Gahbi Faddal, an Axeron swap trader, gathers the exchange

rate and risk-free rate data to evaluate a fixed-for-fixed EUR
/ GBP currency swap. The terms of the swap and related
information are given in Exhibit 3.

Axeron is the fixed-rate payer/floating-rate receiver in an

annual reset USD interest rate swap. The USD 25,000,000
notional amount contract was created at-market with a
2.50% fixed rate and 4 years to maturity when initiated 1
year ago. Exhibit 4 contains current data for valuing USD
fixed-for-floating interest rate swaps.

Axeron is the equity-return receiver/fixed-rate payer in the

swap described in Exhibit 5.
Derivatives – Question Sheet

Unless otherwise noted, assume a 30/360 day-count

convention applies to all pricing and valuation questions.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 9
Antoine Nim manages a bond portfolio for a small hedge
fund. He contacts Julia Trussock, a derivatives trader at a
bank. Nim intends to use bond forward and futures
contracts to adjust portfolio risks and asks Trussock about
the carry arbitrage model for pricing derivatives.

Trussock makes two observations regarding no-arbitrage

bond forward prices:

Observation 1:Zero-coupon bond forward prices are always

greater than their spot prices.
Observation 2:Forward prices for coupon bonds may be
either greater or less than their spot prices, depending on
the bond's current yield relative to the risk-free rate.
Nim expects the European Central Bank (ECB) to raise its
policy rate. He goes long a forward contract on a German
government bond to profit from the market reaction he
anticipates. Information on the contract is contained in
Exhibit 1. At the time of the purchase, the government par
bond yield curve is flat at 3%.

Later that day, the ECB increases its policy rate as Nim
expected. The ECB rate move has resulted in the German
government bond yield curve inverting. Exhibit 2 contains
information on the current government bond yield curve.
Derivatives – Question Sheet

Nim's portfolio contains an off-the-run German government

bond that is deliverable against the standardized futures
contract. Since the bond's coupon rate differs from the
futures contract coupon, Nim is uncertain if the futures
contract is fairly valued relative to his bond. Nim asks
Trussock to explain how to assess the relative fair value of
the two instruments. Exhibit 3 contains information on the
bond and the standardized futures contract. The 0.75-year
risk-free rate is 3.50%.

Another client of Trussock's wants to lock in the rate on a 3-

month loan to be taken 6 months in the future. Exhibit 4
contains selected data on the market reference rates
(MRRs) used for pricing forward rate agreements (FRAs).

All interest rates are expressed as annual rates, and all

instruments use the 30/360 day-count conventions.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 10
Samir Madeq, an experienced equity derivatives trader at a
large bank, has been mentoring Alana Hernan, who was
recently hired as a trainee after earning a degree in
quantitative finance. Madeq wants to assess Hernan's
familiarity with the Black-Scholes-Merton (BSM) model and
option pricing theory. Madeq asks Hernan to describe how
a call option on Voltrin Corporation common stock can be
replicated with positions in the underlying shares and risk-
free bonds, using the inputs and selected outputs from a
BSM valuation of the Voltrin options, shown in Exhibit 1:

Madeq then turns the conversation to option Greeks. He

asks Hernan to interpret (rho) relative to put options. She
responds that put option values are inversely related to
interest rate changes and provides two reasons:

Reason 1: In the context of BSM, interest rates affect

option values through their impact on the PV of the
exercise price.
Reason 2: BSM implies that a put option is equivalent
to having a delta-weighted short position in the underlying
shares. A higher interest rate implies a greater opportunity
cost of not earning interest on short-sale proceeds.
Madeq then asks Hernan to describe the meaning of
implied volatility and how it is used in assessing option
values. In response, Hernan makes three statements
regarding implied volatility:
Derivatives – Question Sheet

Statement 1: Implied volatility can be used as an estimate

of future asset price volatility and therefore may be more
insightful than historical volatility regarding market
expectations.
Statement 2: When investors perceive increased
uncertainty about the future, the demand for options
increases, resulting in higher option prices and increases in
observed implied volatility.
Statement 3: No-arbitrage pricing ensures that all options
on the same underlying will have the same implied volatility
regardless of strike price or time to expiration.
Madeq is long 2,500 call options with a 50 exercise price on
Demino Corporation common stock. Madeq intends to
create a delta-neutral call spread by selling calls with a 40
exercise price. Information concerning Demino common
stock and call options is shown in Exhibit 2:

Assume each stock option contract is for one share of the

underlying stock.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 11
Parasail Trading Corp. (Parasail) is a broker-dealer firm with
several operating subsidiaries. One Parasail division is a
market maker in over-the-counter stocks. Another division
conducts proprietary trading in equities and equity options.
Parasail's market-making unit operates under tight risk-
management policies and requires traders to minimize
market exposure by using options to hedge their overnight
positions. Kerry Young is the trader responsible for making
markets in High-Grade Gold Ltd. (High-Grade) and Pure
Platinum Plus Inc. (Pure Platinum).

Young uses the Black-Scholes-Merton (BSM) model to

evaluate options on High-Grade and Pure Platinum stock.
Neither company pays dividends. All options on both
stocks are trading at fair value according to the BSM model.
Options on High-Grade
Exhibit 1 contains the BSM model inputs for the stock price
(S), strike price (X), risk-free rate (r), volatility (σ), time to
expiration in years (T) and dividend yield (ẟ). The exhibit
also contains selected BSM-model outputs.

Options on Pure Platinum

Young has a significant long position in Pure Platinum
shares, which she intends to delta hedge with call options.
Exhibit 2 contains information on Pure Platinum shares and
options. These options have two months until expiration.
Derivatives – Question Sheet

Options on Code Shift

Lee Philips is a managing director in Parasail's proprietary
trading business. Parasail currently holds 200,000 shares of
Code Shift Programming (Code Shift) common stock.
Although Code Shift is now a publicly traded company, the
shares were acquired through Parasail's participation in a
round of venture funding before Code Shift's initial public
offering. The Code Shift shares are subject to a lockup
agreement that expires in six months. Exhibit 3 contains
information on Code Shift stock and options.

Philips intends to sell the Code Shift shares as soon as the

lockup period expires. In the interim, Philips decides to sell
call options against the shares to generate income. Two
different call-writing strategies are being considered:

Strategy A: Sell 200,000 at-the-money (ATM) Code Shift

calls having six months until expiration.
Derivatives – Question Sheet

Strategy B: Sell 200,000 ATM Code Shift calls that have two
months until expiration. When those options expire, sell
another 200,000 ATM options that have two months until
expiration. When the second group of options expires, sell
another 200,000 ATM calls that have two months until
expiration.

Philips also has a 50,000-share short position in Nano Node

Semiconductor Inc. (Nano Node). Philips decides to use
Nano Node options to construct a delta-neutral hedge that
has a positive gamma.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 12
Shanna Zephron is a risk management specialist at an
international bank. She advises the bank's corporate clients
on the use of derivatives to manage interest rate and
currency risk. Raymundo Mattis is responsible for
overseeing the funding operations for Tazenda Group, a
Germany-based multinational. Tazenda entered a EUR pay-
fixed, receive-floating forward rate agreement (FRA) 1
month ago. Mattis wants Zephron to calculate the FRA's
current value. Information on the FRA is contained in
Exhibit 1:

Exhibit 2 contains information on current EUR market

reference rates (MRRs):

Mattis is also interested in entering a EUR interest rate

swap to manage the interest rate risk of a floating-rate
bond issued several years earlier. Exhibit 3 contains
selected data on the bond:

Exhibit 4 shows the EUR spot interest rates used in valuing

the swap:
Derivatives – Question Sheet

Mattis wants to move some of Tazenda's interest rate

exposure between CHF and EUR. He asks Zephron for a
quote on an at-market receive-fixed-EUR, pay-floating-CHF
currency swap. The terms of the swap are shown in Exhibit
5:

Mattis wants to make sure he understands the pricing and

valuation of the currency swap described in Exhibit 5.
Mattis states his understanding of those issues and asks
Zephron whether his statements are correct.

Statement 1: Currency swaps are effectively interest rate

swaps with legs denominated in different currencies.
Therefore, a fixed-rate leg in an at-market currency swap is
the same as the fixed-rate leg of an otherwise equivalent
fixed-for-floating interest swap in the same currency.
Statement 2: The swap's value is based on the difference
between the value of two 3-year, semiannual-pay bonds
that replicate the swap's cash flows:
short a EUR 55 million par-value bond with 1.80% fixed
coupon, and
long a CHF 50 million par-value bond with a floating-rate
coupon that resets at the 6-month CHF MRR.
Derivatives – Question Sheet

Tazenda needs to raise debt funding for a UK-based

subsidiary. Mattis views GBP fixed-rate borrowing costs as
relatively attractive. However, the subsidiary primarily
holds floating-rate assets. Mattis asks Zephron if a swap
can be used to take advantage of attractive fixed-rate
funding in GBP while better matching the effective
financing rate to the subsidiary's asset returns.

All the financial instruments in this scenario use the 30/360

day-count convention.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 13
Mitoshi & Santer Options Advisory for Clients
Mitoshi and Santer LLC (M&S) is a firm that offers advisory
services for high-net-worth clients and corporations. Javi
Jalli is a senior derivatives consultant at M&S.
Several M&S clients have positions in Elephantine Airlines
common stock, which does not pay a dividend. There are
no exchange-traded options on Elephantine. Several clients
have asked M&S to evaluate over-the-counter (OTC)
options on Elephantine shares. M&S uses the Black-
Scholes-Merton (BSM) model to evaluate equity options.

Options on Elephantine
Exhibit 1 contains the BSM model inputs and selected BSM
model outputs.

Tim Smith, an employee of an M&S client, contacts Jalli for

advice on taking a leveraged position in Elephantine using
OTC options. To confirm that his interpretations of BSM are
correct, Smith makes several statements regarding volatility
and asks Jalli if they are accurate.

Statement 1: The BSM model implies the volatility surface

is flat and fixed over time, whereas implied volatility varies
across strike prices and expirations and changes over time.

Statement 2: Implied volatility provides a means for

comparing the relative value of different options on the
same underlying.
Derivatives – Question Sheet

Another M&S client, Comper Halle, has a well-diversified

equity portfolio in which Elephantine is the largest position.
Halle meets with Jalli to discuss M&S's use of pricing
models to value options and design trading strategies. To
verify his understanding of the BSM approach to estimating
option values, Halle states several of the assumptions upon
which the BSM model is based.
Assumption 1: Options are continuously exercisable from
purchase until expiration.
Assumption 2: Traders have full use of the proceeds from
short sale of the underlying asset.
Assumption 3: Asset prices exhibit geometric Brownian
motion and normally distributed returns.

Halle had requested that M&S get a quote for an

Elephantine 50 put to protect the value of his position in
the stock. However, Halle is concerned that the put is too
expensive and asks Jalli to recommend a less costly strategy
to achieve his objective.
Halle asks Jalli about which types of derivatives could be
used to manage the market risk of his equity portfolio.
They discuss the relative benefits of options in equity
indexes, index futures options, and equity swaptions. Jalli
describes the models M&S uses to assess the values of the
various options.

Swaptions
M&S has been retained by Peak Performance
Manufacturing (Peak), an AA-rated company, for advice on
debt financing alternatives. Peak is considering the
issuance of a five-year fixed-rate bond. M&S suggests that
Peak can reduce its effective funding rate by using synthetic
noncallable debt that is created by issuing a callable bond
and selling a receiver swaption. M&S advisors use the Black
model to establish the terms of the swaption.

Exhibit 2 contains relevant interest rate information.

Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 14
Aki Ming is a derivatives trader at a global hedge fund.
Ming is seeking profitable trading opportunities with the
assistance of Tara Sinn, an equity derivatives analyst with
the firm. Ming wants to evaluate the potential for index-
arbitrage trades using a S&P 500 futures contract that has 6
months until expiration. Exhibit 1 contains the information
needed to price the futures contract:

Ming and Sinn discuss using the carry arbitrage model for
pricing equity derivatives and how changes in the carry
affect no-arbitrage forward prices. Ming has a position in a
forward contract in Vector Transport common stock that
had one year to expiration when it was initiated. Ming asks
Sinn to value the contract based on current market
conditions. The information gathered by Sinn is shown in
Exhibit 2:

Ming and Sinn discuss equity swap pricing and valuation.

Afterward, Ming has Sinn evaluate a position the hedge
fund currently holds in an annual-pay, receive-equity, pay-
fixed swap on Hitashi Corporation common stock.
Information on the swap is shown in Exhibit 3:
Derivatives – Question Sheet

The PV factors for valuing annually settled swaps is shown

in Exhibit 4:

The hedge fund borrows opportunistically in a variety of

currencies to reduce its cost of debt. Ming wants to use a
currency swap to move interest exposure from USD to EUR.
Exhibit 4 contains selected data related to the pricing and
valuation of quarterly settled USD/EUR currency swaps.
The spot exchange rate between the currencies is currently
$1.20 per €.

Unless stated otherwise, assume all instruments use the

30/360 day-count convention and that all interest rates are
stated on an annual compound basis.
Derivatives – Question Sheet

Case No. 1
Derivatives – Question Sheet

Case No. 1