QUESTION BANK FT305F: FINANCIAL ENGINEERING. Unit 1: Introduction to Derivatives

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1 QUESTION BANK FT305F: FINANCIAL ENGINEERING Unit 1: Introduction to Derivatives 1) Explain the term Derivative. Describe and explain in detail the various types of derivatives. 2) Diagrammatically represent the various types of derivative contracts allowed for trading in Indian markets. 3) Explain the different categories of traders in the derivatives market. 4) Explain the important types of orders allowed for trading in derivatives. 5) Discuss in detail the various participants in the derivatives markets. 6) Explain the following terms: a. Contract Size b. Multiplier c. Lot Size d. Tick Size 7) Bring out the differences between speculation and hedging. 8) Explain the features of an over-the-counter market. What are the advantages of OTC contracts vis-à-vis exchange traded contracts? 9) Explain the difference between open interest and volumes that are reported in the business press. 10) What does marked-to-market mean? 11) Explain the difference between MTM margin and initial margin. 12) In the futures market, the clearing house bears all default risk because it guarantees all futures contract to both the buyer and the seller. Evaluate the statement. 13) What is the difference between a long forward position and a short forward position? 14) Explain carefully the difference between selling a call option and buying a put option.

2 15) What is the benefit of futures trading in exchanges? 16) What are the limitations of forward markets? 17) What is meant by open interest? What does the movement of open interest indicate? 18) Explain the following terms with regards to Futures contracts: a. Spot price b. Futures price c. Contract cycle d. Expiry date e. Contract size f. Basis g. Cost-of-carry 19) Explain the settlement mechanism of futures contracts.

3 Unit 2: Futures Contract 1) Explain how a futures market can be used for speculation or hedging. 2) Why do future and forward prices differ? 3) What are Index Futures and Index Option Contracts? Explain with examples. 4) Distinguish between Forward contracts and Future contracts. 5) What is the margining system in the equity derivatives market? 6) What is the role of a clearing house? 7) What are currency futures? 8) Explain the following terms in relation to Hedging: a. Long hedge b.short hedge c. Cross hedge d.hedge contract month e. Hedge Ratio 9) Explain the uses of stock index futures. 10) What are interest rate futures? Discuss the probable benefits of interest rate futures to market participants. 11) What are foreign exchange risks? Explain the different categories of exposures in relation with forex risks. 12) What are the bid and offer quotes of a market maker in the over-the-counter market? 13) A company knows that it is due to receive a certain amount of a foreign currency in 4 months. What type of option contract is appropriate for hedging? 14) Forward, Option and Futures are zero-sum games. What do you think is meant by this statement? 15) Suppose that USD/sterling spot and forward exchange rates are as follows: (MENTION REASONING ALSO) Spot day forward day forward

4 What opportunities are open to an arbitrageur in the following situations? a) A 180-day European call option to buy 1 for $1.97 costs 2 cents. b) A 90-day European put option to sell 1 for $2.04 costs 2 cents. 16) The price of gold is currently $600 per ounce. The forward price for delivery in 1 year is $800. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. 17) Explain how margins protect investors against the possibility of default. 18) A trader buys two July futures contracts on orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the initial margin is $6,000 per contract, and the maintenance margin is $4,500 per contract. What price is change would lead to a margin call? Under what circumstances $ 2,000 could be withdrawn from the margin account? 20) Suppose that, on October 24, 2009, a company sells one April 2010 live cattle futures contract. It closes out its position on January 21, The future price (per pound) is cents when it enters into the contract, cents at the end of December One contract is for the delivery of 40,000 pounds of cattle. What is the total profit? How is it taxed if the company is (a) a hedger and (b) a speculator? Assume that the company has a December 31 year end. 21) A cattle farmer expects to have 120,000 pounds of live cattle to sell in 3 months. The live cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer s viewpoint, what are the pros and cons of hedging. 22) A company enters into a short futures contract to sell 5,000 bushels of wheat for 450 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account? 23) Calculate the price of month RIL futures. If RIL (FV Rs.) quotes Rs on NSE, and the 3 month futures price quotes at Rs. 542, and the one month borrowing rate is given as 15% and the expected annual dividend yield is nil p.a. payable before expiry.

5 24) Calculate the price of 3-month ACC futures, if ACC (FV Rs. 10) quotes Rs. 220 on NSE, and the 3 month futures price quotes at Rs. 230, and the one month borrowing rate is given as 15% and the expected annual dividend yield is 25% p.a. payable before expiry. Also examine arbitrage opportunities. 25) The following data relates to ABC Ltd. s share price: Current price per share: Rs. 180 Price per share in the 6m futures market: Rs. 195 It is possible to borrow money in the market for securities transactions at the rate of 12% pr annum. Required: a) Calculate the theoretical minimum price of a 6-month forward contract. b) Explain if any arbitrage opportunities exists 26) On Nov. 15, then the spot price for Telco is Rs. 473/share, Mr. X buys 15 contracts of July Telco futures at 491. Assume that the initial margin for Telco futures is Rs. 800 pr contract, and the maintenance margin is Rs. 600 per contract. Given that each contract is 50 shares. Daily settlement prices for the next few days are as follows: Nov Nov Nov Nov Nov Assume that Mr. X withdraws profits from his margin account only once, on Nov 16 th,when he withdraws half the maximum amount allowed. Compute the balance in the account at the end of each of these 5 days. 27) The settlement price of December Nifty futures contract on a particular day was Rs The minimum trading lot on Nifty futures is 100. The initial margin is 8% and the maintenance margin is 6%. The index closed at the following levels on the next five days. Day Closing Price i) Calculate the mark to market cash flows and daily closing balance in the a/c of a) an investor who has gone long at 1310 and b) an investor who has gone short at 1310 ii) Calculate the net profit or loss on each of the contracts 28) On May 2, you buy 30 contracts of September Reliance futures at 420. Assume that each contract covers 50 shares, the initial margin is Rs. 900 per contract, and the maintenance margin is Rs. 675 per contract. Daily settlement prices are as follows: May 2 409

6 May May May You meet all margin calls. Whenever you are allowed to withdraw money from the margin account, you withdraw half the maximum amount you are allowed. For each day, describe what changes take place in the margin account, and what the balance in the account is at the end of the day. 29) A future contract is available on a company that pays an annual dividend of Rs. 5 and whose stock is currently price at Rs Each futures contract calls on delivery of 1,000 shares of stock in one year, daily marketing to market, an initial margin of 10% and a maintenance margin of 5%. The current Treasury bill rate is 8%. a) Given the above information, what should the price of one futures contract be? b) If the company stock decreases by 7, what will be, if any, the change in the futures price? c) As a result of the company stock decreases, will an investor that has a long position in one futures contract of this company realize a gain or a loss? Why? What will be the amount of this gain or loss? d) What must be the initial balance in the margin account be? Following the stock decreases, what will be, if any, the change in the margin account? Will the investor need to top up the margin account? If yes, by how much and why? e) Give the company stock decreases, what is the percentage return on the investor s position? Is it higher, equal or lower than the 7% company stock decreases? Why? 30) Suppose that you bought 1,000 shares of student.com for Rs. 70 per share. The initial margin is 50%. The Maintenance margin is 40%. a) Suppose that the stock price drops to Rs. 60 per share. Do you need to put additional funds to your account? b) What is the break even price student.com can fall before you will receive a margin call? c) Suppose that the price rises to Rs.80. What is your rate of return on this investment?

7 Unit 3: Option Contracts 1) What is an option? What do you understand by call and put in relations with options? 2) What do you understand by the term option premium? 3) What is the strike price or the exercise price of the option? 4) Explain the following terms relating to options: a. In-the-money b. At-the-money c. Out-of-the-money d. Index options e. Stock options f. Buyer of an option g. Writer of an option h. Intrinsic value of an option 5) How an American option is different from a European option? 6) Suppose that a March call option to buy a share for $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a long position in the option depends on the stock price at maturity of the option. 7) Suppose that a June put option to sell a share for $60 costs $4 and is held until June. Under what circumstances will the seller of the option (i.e. the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option. 8) Describe the profit from the following portfolio: a long forward contract on an asset and a long European put option on the asset with the same maturity as the forward contract and a strike price that is equal to the forward price of the asset at the time the portfolio is set up. 9) The current price of a stock is $94, and 3-month European call options with a strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is trying to decide between buying 100 shares and buying 2,000 call

8 options (=20 contracts). Both strategies involve an investment of $9,400. What advice would you give? How high does the stock price have to rise for the option strategy to be more profitable? 10) A trader buys a European call option and sells a European put option. The options have the same underlying asset, strike price, and maturity. Describe the trader s position. Under what circumstances does the price of the call equal the price of the put? 11) An investor buys a European put on a share for $3. The stock price is $42 and the strike price is $40. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investor s profit with the stock price at the maturity of the option. 12) An investor sells a European call on a share for $4. The stock price is $47 and the strike price is $50. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investor s profit with the stock price at the maturity of the option. 13) An investor sells a European call option with strike price of K and maturity T and buys a put with the same strike price and maturity. Describe the investor s position. 14) Suppose that a European call option to buy a share for $ costs $5.00 and is held until maturity. Under what circumstances will the holder of the option make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a long position in the option depends on the stock price at maturity of the option. 15) A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the variation of the trader s profit with the asset price. 16) If most of the call options on a stock are in the money, it is likely that the stock price has risen rapidly in the last few months. Discuss this statement. 17) The price of a stock is $40. The price of a 1-year European put option on the stock with a strike price of 430 is quoted as $7 and the price of a 1-year European call option on the stock with a strike price of $50 is quoted as $5. Suppose that an investor buys 100 shares, shorts 100 call options, and buys 100 put options. Draw a diagram illustrating how the investor s profit or loss varies with the stock price over the next

9 year. How does your answer change if the investor buys 100 shares, shorts 200 call options, and buys 200 put options? 18) Draw payoff diagram for the following clearly and legibly using pencil and scale : a. Buyer of Call Option b. Seller of Call Option c. Buyer of Put Option d. Seller of Put Option 19) Using the data given below pertaining to the options on Tisco stock, find the following: a. Which options are in-the-money and which are not when Tisco is trading at Rs.358. b. The intrinsic value of a put with an exercise price of Rs.310 c. The intrinsic value of a call with an exercise price of Rs.340 d. The time value of a put with an exercise price of Rs.350 expiring in May e. The time value of a call with an exercise price of Rs.350 expiring in May Option Price (Rs.) Option Price (Rs.) CA-May PA-May CA-May PA-May CA-May PA-May CA-May PA-May CA-Jun PA-May ) A person owns a call option contract of Cipla at an exercise price of Rs.260. a. How much will he gain by exercising it immediately? Explain how this gain arises. b. If the exercise price on the call option had been Rs.325, would he exercise it gainfully? Why or why not? Assume that currently the stock is trading at Rs ) Find whether holder of the following options would exercise the respective calls/puts. Strike Price Price on Expiry Holding CALL PUT CALL

10 PUT CALL PUT CALL 22) Identify whether the position is In-The-Money (ITM), At-The Money (ATM) or Out-of-The-Money (OTM) for the buyer of option. Sr. Strike Price Nature of Option Market Price No Call Put Put Call Call Put Put Call ) Find the Intrinsic & Time Value for the following options bought when market price is Rs Sr. No. Strike Price Nature of Option Premium Call Call Call Call Put Put Put Put 3 24) You buy a January call option on Andhra Bank s stock, with an exercise price of Rs. 50. a) What is the intrinsic value of the option today if Andhra Bank is trading at Rs. 40? b) What would be the intrinsic value today be if Andhra Bank were trading at Rs. 60? c) What action will you take on the expiration date if Andhra Bank then trades at Rs. 60? d) What action will you take on the expiration date if Andhra Bank then trades at Rs. 55? e) Assume that when you bought the option, Andhra Bank was selling for Rs. 54. Would the premium you paid to buy the option be more than Rs. 4 or less? f) Assume you bought the call option as described above at a premium of Rs Make a table showing the total profit you make (in Rs. And in % terms) if, on the

11 expiration date, Andhra Bank is trading at the following prices: Rs. 30, Rs. 40, Rs. 50, Rs. 60, Rs. 70, Rs. 80, Rs. 90. g) Draw the corresponding profit diagram. 25) Explain two days in which a bear spread can be created. 26) When is it appropriate for an investor to purchase to butterfly spread? 27) Call options on a stock are available with strike prices of $15, $17 ½ and $20, and expiration dates in 3 months. Their prices are $4, $2, and $½, respectively. Explain how the options can be used to create a butterfly spread. Construct a table showing how profit varies with stock price for the butterfly spread. 28) What trading strategy creates a reverse calendar spread? 29) What is the difference between a strangle and a straddle? 30) A call with a strike price of $60 costs $6. A put with the same strike price and expiration date costs $4. Construct a table that shows the profit from a straddle. For what range of stock prices would the straddle lead to a loss? 31) Construct a table showing the payoff from a bull spread when puts with strike prices K 1 and K 2 with K 2 > K 1, are used. 32) An investor believes that there will be a big jump in a stock price, but is uncertain as to the direction. Identify six different strategies the investor can follow and explain the difference among them. 33) How can a forward contract on a stock with a particular delivery price and delivery date be created from options? 34) What is the result if the strike price of the put is higher than the strike price of the call in a strangle? 35) Three put options on a stock have the same expiration date and strike prices of $55, $60 and $65. The market prices are $3, $5, and $8, respectively. Explain how a butterfly spread can be created. Construct a table showing the profit from the strategy. For what range of stock prices would the butterfly spread lead to a loss? 36) A diagonal spread is created by buying a call with strike price K 2 and exercise date T 2 and selling a call with strike price K 1 and exercise date T 1, where T 2 > T 1. Draw a diagram showing the profit when (a) K 2 > K 1 and (b) K 2 < K 1. 37) Draw a diagram showing the variation of an investor s profit and loss with the terminal stock price for a portfolio consisting of:

12 a) One share and a short position in one call option b) Two shares and a short position in one call option c) One share and a short position in two call options d) One share and a short position in four call options. In each case, assume that the call option has an exercise price equal to the current stock price. 38) What trading position is created from a long strangle and a short straddle when both have the same time to maturity? Assume that the strike price in the straddle is half way between the two strike prices of the strangle. 39) Review the assumptions and limitations of the Black-Schole option pricing model. 40) List the six factors that affect the stock option prices. 41) Explain the following concepts: a. Delta b. Theta c. Gamma d. Vega

13 Unit 4: Swaps 1. What does Swap mean? Explain the different types of swaps. 2. Explain the following components of Swap price: a. Benchmark price b. Liquidity c. Transaction cost d. Credit risk 3. Explain the mechanics of Swap transactions. 4. Explain the economic motives of Swaps. 5. What is interest rate Swaps? Explain three uses of interest rate swaps for corporates/banks. 6. Discuss the various ways of exiting from a swap contract. 7. What are Currency rate swaps? Explain their benefits and limitations. 8. Explain LIBOR with suitable example. 9. Explain the difference between the credit risk and the market risk in a financial contract. 10. What are the advantages of swaps over forward rate agreements or futures? 11. suppose on 1 st April,2011 a three year swap contract is entered into between company A & B. terms of the contract are as follows:- (1) Notional principal is RS.100 lakhs (2) A will pay 5% p.a. on notional principal to B. (3) B will pay six month PLR on the same notional principal to A. (4) Interest is payable six monthly Find out cash flow over a period of three years in the abovementioned problem.

14 12. Suppose that two companies A & B both wishes to borrow Rs /-for five years and have been offered the rate shown below:- Particular Fixed Floating Company A 10% 6 month PLR +2% Company B 11% 6 month PLR +1% Company A, want to borrow at floating rate while Company B, wants to borrow at fixed rate. How SWAP can help both the parties in reducing their borrowing cost. Here A & B share advantage in the ratio of 2: Company X and Y have been offered the following rates per annum on a 5$ million investment. Particular Fixed Floating Company X 8% LIBOR +1% 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 bank acting as intermediary, 0.2% per annum and which will appear to be equally attractive to X and y. 14.Suppose two company, A & B both wishes to borrow RS /- for five year sand have been offered the rates shown below:- Particular Fixed Floating Company A 10% 6 month PLR +1% Company B 14% 6 month PLR +2% Company A want to borrow at floating rate while company B wants to borrow at fixed rate, How SWAP can help both the parties in reducing their borrowing cost.

15 15. Company A and B have been offered the following rates per annum on a 20$ million five year loan. Particular Fixed Floating Company A 12% LIBOR +0.1% Company B 13.4% LIBOR+0.6% Company A requires a floating rate loan; Company B requires a fixed rate loan. Design a SWAP that will net bank acting as intermediary, 0.1% per annum and which will appear to be equally attractive to A and B. 16.Infosys Ltd. An Indian company wants to raise $10million and Claredon textile Inc. an American company wants to borrow INR470 million for its Indian unit. The following interest rate are quoted for these companies: Particular Dollars Rupee Infosys Ltd. 15% p.a. 12%p.a. Claredon textile Inc. 13.%p.a. 14%p.a. Exchange rate is $1=INR47. if the intermediary banks total spread is 1% p.a. and the swap results equal gain to both the parties.how SWAP Agreement help to each other.

16 17.Company A & B face the following interest rate: Particular A B U.S.dollors 8% 6.5% Company B 5% 7.5% Assume that A wants to borrow dollars and B wants to borrow marks. A financial Institution is planning to arrange a SWAP and require a 50-basis point spread. If the swap is to appear to be equally attractive to A & B, what rate of interest will A & B end up paying? 18. Company X An Indian company wants to borrow US dollars at fixed rate of interest. Company Y wants 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 to reflect the tax situations of the two companies: Particular YEN Dollars Company X 5% p.a. 9.6%p.a. Company Y 6.5.%p.a. 10%p.a. Design a swap that will net a bank, acting as intermediary, 50basis point per annum. Make the swap equally attractive to the companies and ensure that all foreign exchange risk is assumed by the bank.

17 19. Company X and Y have been offered the following rates per annum on a 5$ million investment. Particular Fixed Floating Company X 16% LIBOR +2% Company Y 17.6% LIBOR Company X requires a fixed rate investment; Company Y requires a floating rate investment. Design a SWAP that will net bank acting as intermediary, 0.4% per annum and which will appear to be equally attractive to X and y.