Financial Derivatives — DU B.A. (Hons.) Economics Previous Year Question Papers

1. (a) Give three possible reasons why a company's treasurer may choose not to hedge against a specific risk exposure. (6) (b) Explain why a short hedger's position improves when the basis strengthens unexpectedly and worsens when the basis weakens unexpectedly. (c) On July 1, an investor holds 50,000 shares of a certain stock. The market price is $30 per share. The investor is interested in hedging against market movements over the next month and decides to use the September Mini S&P 500 futures contract. The index is currently 1,500 and one contract is for delivery of $50 times the index. The stock's (6+6) beta is 1.3. What strategy should the investor follow? (4) Agreements' with a suitable example. (5) 2. (a) Consider a 10-month forward contract on a stock when the stock price is 780. Assume that the risk-free rate of interest (continuously (4) compounded) is 8% per annum for all maturities and dividends of 72 per share are expected after (5) 3 months, 6 months, and 9 months. Calculate the forward price. (b) A company has a $20 million portfolio with a beta of 1.2. It would like to use futures contracts on a stock index to hedge its risk. The index futures price is currently standing at 1000, and each contract is for delivery of $250 times the index. How many contracts should be hedged to minimise risk? What should the company do to reduce the portfolio's beta to 0.5? (5) (c) How are the pricing and valuation of a swap determined? (8) 3. (a) State and derive the put-call parity relationship for European options on a dividend-paying stock. Carefully mention the assumptions. (3+6) (b) A European call on a stock has six months to (5) expiry, a strike price of 7150 and a premium of 78. The stock price is 7146, and dividends of 72 are expected in two months and five months. The risk-free interest rate for all maturities is 9% per annum with continuous compounding. Compute the is 30% per annum, the time to maturity is three no-arbitrage price of the corresponding European months, N(d,) = 0.7042 and N(d,) = 0.6504. put with the same strike and maturity. What Calculate d,, d, and determine the price of the arbitrage opportunities arise if the put actually call option. (3+3+3) Write short notes on any three of the following: 4. (a) Explain with a payoff diagram how a bull spread (i) Covered Call and Protective Put can be created using put options. Use put-call parity to show that the cost of a butterfly spread (ii) Theta constructed from calls is the same as the cost of one constructed from puts. (6+6) (iii) Implied Volatilities (iv) Delta Hedging (6+6+6) (b) Discuss six major factors that affect the value of a stock option, briefly explaining the direction of their impact on call and put prices. (6) 5. (a) Compute the value of a six-month European call option with a strike price of $51, given that the current stock price is $50 and that, over each of the next two 3-month intervals, the stock price is expected to increase by 6% or decrease by 5%. (3)