Nawaf Alhumaid FIN5308 Problem Set 1:

Contents
Question 1.33.........................................................................................................................3
Given.................................................................................................................................3
Formula.............................................................................................................................3
Solution.............................................................................................................................3
Answer..............................................................................................................................3
Question 1.35.........................................................................................................................4
Given.................................................................................................................................4
Formula.............................................................................................................................4
Solution.............................................................................................................................4
Answer..............................................................................................................................5
Question 2.26.........................................................................................................................6
Definition...........................................................................................................................6
Explanation.........................................................................................................................6
Given.................................................................................................................................6
Solution.............................................................................................................................6
Answer..............................................................................................................................6
Question 3.29.........................................................................................................................7
Given.................................................................................................................................7
Step 1 Determine the number of contracts per hedge...................................................................7
Step 2 Hedge strategy by date.................................................................................................7
Step 3 Effective price for each purchase date..............................................................................8
Step 4 Initial margin and margin call assessment.........................................................................9
Answer..............................................................................................................................9
Question 3.30.......................................................................................................................10
Given...............................................................................................................................10
Step 1 Number of contracts to short.......................................................................................10
Step 2 Portfolio and futures profit formulas..............................................................................10
Step 3 Results for alternative index levels................................................................................10
Answer............................................................................................................................11

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Question 4.30.......................................................................................................................12
Given...............................................................................................................................12
Step 1 Zero coupon spot rates...............................................................................................12
Step 2 Bootstrap r1.5 using the 1.5 year coupon bond.................................................................12
Step 3 Bootstrap r2 using the 2 year coupon bond.....................................................................12
Step 4 Forward rates...........................................................................................................13
Step 5 Par yields.................................................................................................................13
Step 6 Price and yield of a 2 year bond with 7 percent coupon......................................................13
Answer............................................................................................................................14
Question 5.30.......................................................................................................................15
Given...............................................................................................................................15
Step 1 Convert the gold loan interest rate to continuous form......................................................15
Step 2 Use the quoted forward price to infer the implied gold borrowing rate..................................15
Step 3 Compare the bank’s quoted borrowing rates...................................................................15
Answer............................................................................................................................16
Question 5.32.......................................................................................................................17
Given...............................................................................................................................17
Solution...........................................................................................................................17
Answer............................................................................................................................17

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Question 1.33
The price of gold is currently $1,200 per ounce. Forward contracts are available to buy or sell
gold at $1,400 per ounce for delivery in one year. An arbitrageur can borrow money at 5% per
annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that
gold provides no income.

S0 = 1200, F0 = 1400, r = 0.05, T = 1, u = 0

Given

Assume the interest rate is continuously compounded.

F0* = S0 erT
Formula

Solution
Step 1 calculates the no arbitrage forward price.
F0* = 1200 e0.05×1 = 1200×1.051271 = 1261.53
Step 2 compares the quoted forward price with the no arbitrage forward price and identifies the
arbitrage direction.
1400 > 1261.53
Step 3 executes a cash and carry arbitrage.
At time 0 borrow 1200, buy 1 ounce of gold in the spot market, and short 1 forward contract
with delivery price 1400.
At time 1 deliver the gold into the forward contract and receive 1400, then repay the loan.
Loan repayment = 1200 e0.05 = 1261.53
Arbitrage profit = 1400 − 1261.53 = 138.47

Answer
The arbitrageur should borrow 1200, buy 1 ounce of gold at the spot price, and short the 1 year
forward at 1400. The arbitrage profit is 138.47 per ounce.

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Question 1.35
The current price of a stock is $94, and three-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 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?

S0 = 94, K = 95, c = 4.70, shares = 100, options = 2000

Given

Profitstock = 100(ST − 94)

Formula

Profitoption = 2000 max (ST − 95, 0) − 9400

Solution
Step 1 writes each strategy payoff and profit at maturity.
Stock strategy payoff is 100S_T and the initial cost is 9400.
Option strategy payoff is 2000 max (S_T − 95, 0) and the initial cost is 9400.
Step 2 finds the stock price level where the option strategy becomes more profitable.
Case 1 uses S_T ≤ 95.
Profitoption = −9400
Profitstock = 100ST − 9400
For 0 ≤ S_T ≤ 95 the stock strategy has profit ≥ −9400, so it is at least as good as the option
strategy.
Case 2 uses S_T > 95.
Profitoption = 2000(ST − 95) − 9400
Profitstock = 100(ST − 94)
Set Profit_option > Profit_stock and solve for S_T.
2000(ST − 95) − 9400 > 100(ST − 94)
2000ST − 199400 > 100ST − 9400
1900ST > 190000

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ST > 100
Nawaf Alhumaid FIN5308 Problem Set 1:

Answer
The stock price must be greater than 100 at maturity for the option strategy to be more
profitable. The stock strategy dominates for 0 ≤ S_T ≤ 100 because it does not lose the entire
premium when S_T ≤ 95 and it performs better for moderate price increases. The option
strategy provides higher upside when S_T is sufficiently above 100, but it has higher downside
risk because the maximum loss is 9400 when S_T ≤ 95.

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 Nawaf Alhumaid FIN5308 Problem Set 1:

Question 2.26
Explain what is meant by open interest. Why does the open interest usually decline during the
month preceding the delivery month? On a particular day, there were 2,000 trades in a
particular futures contract. This means that there were 2,000 buyers (going long) and 2,000
sellers (going short). Of the 2,000 buyers, 1,400 were closing out positions and 600 were
entering into new positions. Of the 2,000 sellers, 1,200 were closing out positions and 800 were
entering into new positions. What is the impact of the day’s trading on open interest?

Definition
Open interest is the number of outstanding futures contracts that remain open at the end of the
trading day. A contract is open when it has not been closed out by an offsetting trade and has
not yet reached delivery and final settlement.

Explanation
Open interest usually declines during the month preceding the delivery month because market
participants close positions to avoid delivery or because they roll positions into later maturities.
Closing long positions matched with closing short positions reduces the number of outstanding
contracts.

Total trade = 2000, buyers closing = 1400, buyers opening = 600, sellers
Given

closing = 1200, sellers opening = 800

Solution
Open interest changes only when both sides of a trade are opening or both sides are closing.
Step 1 calculates the number of new contracts created when both sides open positions.
New contracts = min (600, 800) = 600
Step 2 calculates the number of contracts eliminated when both sides close positions.
Closed contracts = min (1400, 1200) = 1200

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Step 3 calculates the net change in open interest.
Δ open interest = 600 − 1200 = −600

Answer
The day’s trading decreases open interest by 600 contracts.

Question 3.29
It is now October 2016. A company anticipates that it will purchase 1 million pounds of copper
in each of February 2017, August 2017, February 2018, and August 2018. The company has
decided to use the futures contracts traded by the CME Group to hedge its risk. One contract is
for the delivery of 25,000 pounds of copper. The initial margin is $2,000 per contract and the
maintenance margin is $1,500 per contract. The company’s policy is to hedge 80% of its
exposure. Contracts with maturities up to 13 months into the future are considered to have
sufficient liquidity to meet the company’s needs. Devise a hedging strategy for the company.
(Do not make the adjustment for daily settlement described in Section 3.4.) Assume the market
prices (in cents per pound) today and at future dates are as in the following table. What is the
impact of the strategy you propose on the price the company pays for copper? What is the initial
margin requirement in October 2016? Is the company subject to any margin calls?

Quantity per purchase date, Q = 1000000 lb, hedge ratio, h = 0.80,

Given

contract size = 25000 lb, initial margin per contract = 2000, maintenance
margin per contract = 1500
Spot and futures prices in cents per pound are summarized in Table 1.
Date Spot Mar 2017 Sep 2017 Mar 2018 Sep 2018
Oct 2016 369.80 372.30 372.80
Feb 2017 369.00 369.10 370.20 370.70
Aug 2017 365.00 364.80 364.30 364.20
Feb 2018 377.00 376.70 376.50
Aug 2018 388.00 388.20

Hedged quantity per purchase = hQ = 0.80×1000000 = 800000 lb

Step 1 Determine the number of contracts per hedge

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Contracts per purchase = 800000 ÷ 25000 = 32
Nawaf Alhumaid FIN5308 Problem Set 1:

Each purchase date therefore uses 32 long futures contracts for the chosen maturity. Because
futures exist only for the listed delivery months, a stack and roll strategy is used to hedge
February and August requirements that do not coincide with delivery months.

Step 2 Hedge strategy by date

At Oct 2016 open long futures positions as follows.
Feb 2017 purchase: 32 long Mar 2017 at 372.30
Aug 2017 purchase: 32 long Sep 2017 at 372.80
Feb 2018 purchase: 32 long Sep 2017 at 372.80
Aug 2018 purchase: 32 long Sep 2017 at 372.80
This is a stack strategy because the 64 contracts for Feb 2018 and Aug 2018 are stacked into the
same Sep 2017 maturity until the first roll date.
At Feb 2017 close out the Mar 2017 hedge for the Feb 2017 purchase and roll the remaining
long exposure for Feb 2018 and Aug 2018 from Sep 2017 into Mar 2018.
Close 32 Mar 2017 at 369.10
For Feb 2018 and Aug 2018: close 64 Sep 2017 at 370.20 and open 64 Mar
2018 at 370.70
At Aug 2017 close out the Sep 2017 hedge for the Aug 2017 purchase, keep the Mar 2018
hedge for Feb 2018, and roll the remaining Aug 2018 exposure from Mar 2018 into Sep 2018.
Close 32 Sep 2017 at 364.80
For Aug 2018: close 32 Mar 2018 at 364.30 and open 32 Sep 2018 at
364.20
At Feb 2018 close 32 Mar 2018 at 376.70 for the Feb 2018 purchase.
At Aug 2018 close 32 Sep 2018 at 388.20 for the Aug 2018 purchase.

Step 3 Effective price for each purchase date

For a long futures hedge used to buy the commodity, the effective futures adjusted purchase
price in cents per pound is:
Effective hedged price = St + (Fopen − Fclose)

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 Nawaf Alhumaid FIN5308 Problem Set 1:
With multiple rolls, add the terms (F_open − F_close) across all rolls for that purchase date. The
overall effective price that reflects a hedge ratio h is:
Overall effective price = h×(effective hedged price) + (1 − h)×St
Purchase Spot S_t Effective hedged price Overall effective
date price with h = 0.80
Feb 2017 369.00 369.00 + (372.30 − 369.10) = 372.20 371.56
Aug 2017 365.00 365.00 + (372.80 − 364.80) = 373.00 371.40
Feb 2018 377.00 377.00 + (372.80 − 370.20) + (370.70 − 376.70) = 373.60 374.28

Aug 2018 388.00 388.00 + (372.80 − 370.20) + (370.70 − 364.30) + (364.20 − 376.00
388.20) = 373.00

The hedge reduces the variability of the effective purchase price relative to the spot prices. The
overall effective purchase prices are 371.56, 371.40, 374.28, and 376.00 cents per pound for
Feb 2017, Aug 2017, Feb 2018, and Aug 2018 respectively.

Step 4 Initial margin and margin call assessment

At Oct 2016 the total number of open contracts is 32 + 32 + 64 = 128.
Initial margin deposited = 128×2000 = 256000
Maintenance margin level = 128×1500 = 192000
From Oct 2016 to Feb 2017 the long futures positions lose value because futures prices decline.
The daily marking to market reduces the margin balance by the cumulative futures loss.
Loss on Mar 2017 contracts for the Feb 2017 close out is:
Loss per contract = (369.10 − 372.30)×25000 = −0.032×25000 = −800
Total loss = 32×800 = 25600
Loss on Sep 2017 contracts held until Feb 2017 is:
Loss per contract = (370.20 − 372.80)×25000 = −0.026×25000 = −650
Total loss = 96×650 = 62400
Cumulative loss = 25600 + 62400 = 88000
Margin balance at Feb 2017 = 256000 − 88000 = 168000
168000 < 192000

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Because the margin balance falls below the maintenance margin, a margin call occurs. The
deposit required to restore the balance to the initial margin level is:
Margin call deposit = 256000 − 168000 = 88000

Answer
The hedge uses 32 long futures contracts per purchase date, implemented with a stack and roll
strategy across Mar 2017, Sep 2017, Mar 2018, and Sep 2018 maturities. The overall effective
purchase prices are 371.56, 371.40, 374.28, and 376.00 cents per pound. The initial margin in
Oct 2016 is 256000 and the maintenance margin level is 192000. The cumulative marked to
market loss by Feb 2017 reduces the margin balance to 168000, which triggers a margin call
and requires an additional deposit of 88000.

Question 3.30
A fund manager has a portfolio worth $50 million with a beta of 0.87. The manager is
concerned
about the performance of the market over the next two months and plans to use three-month
futures contracts on a well-diversified index to hedge its risk. The current index level is 1,250,
one contract is on 250 times the index, the risk-free rate is 6% per annum, and the dividend
yield on the index is 3% per annum. The current three-month futures price is 1,259.
What position should the fund manager take to hedge exposure to the market over the next two
months?
Calculate the effect of your strategy on the fund manager’s returns if the index in two months is
1,000, 1,100, 1,200, 1,300, and 1,400. Assume that the one-month futures price is 0.25% higher
than the index level at this time.

Portfolio value, VP = 50000000, β = 0.87, S0 = 1250, F0 = 1259, multiplier

Given

= 250
The futures price at the end of the 2 month holding period is assumed to be 0.25 percent above
the index level, so:
F2 = 1.0025×S2

Step 1 Number of contracts to short

A beta hedge uses:

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N = βVP ÷ (F0×250)
Nawaf Alhumaid FIN5308 Problem Set 1:

N = 0.87×50000000 ÷ (1259×250) = 138.2049 ≈ 138

The hedge therefore shorts 138 S&P 500 futures contracts.

Step 2 Portfolio and futures profit formulas

Portfolio change over the 2 month period is approximated by the beta scaled index return:
ΔVP = βVP×(S2 − S0)÷S0
Futures profit for a short position is:
P/Lfut = N×(F0 − F2)×250

Step 3 Results for alternative index levels

Table 2 reports the portfolio profit or loss, futures profit or loss, total profit or loss, and total
return for each possible index level in 2 months. The hedge uses N = 138 contracts.

Index level S2 Futures price Portfolio P/L Futures P/L Total P/L Total return
F2
1000 1002.50 -8,700,000 8,849,250 149,250 0.299%
1100 1102.75 -5,220,000 5,390,625 170,625 0.341%
1200 1203.00 -1,740,000 1,932,000 192,000 0.384%
1300 1303.25 1,740,000 -1,526,625 213,375 0.427%
1400 1403.50 5,220,000 -4,985,250 234,750 0.470%

Answer
Short 138 S&P 500 futures contracts. The table shows that the hedge largely offsets index
driven changes in the portfolio value, leaving a relatively stable positive total return driven by
the futures mispricing assumption and rounding the number of contracts to an integer.

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 Nawaf Alhumaid FIN5308 Problem Set 1:

Question 4.30
The following table gives the prices of Treasury bonds:

Given
All rates are continuously compounded and all bond prices are per 100 of face value.
Maturity (years) Type Coupon (annual %) Price Notes
0.5 Zero 0 98
1.0 Zero 0 95
1.5 Coupon 6.2 101 Coupons semiannual
2.0 Coupon 8.0 104 Coupons semiannual

Step 1 Zero coupon spot rates

Discount factors for zero coupon bonds are:
DF0.5 = 98/100 = 0.98
DF1 = 95/100 = 0.95
Continuously compounded spot rates are r_T = −ln(DF_T)/T.
r0.5 = −ln(0.98)/0.5 = 0.040405 = 4.0405%
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r1 = −ln(0.95)/1 = 0.051293 = 5.1293%
Nawaf Alhumaid FIN5308 Problem Set 1:

Step 2 Bootstrap r1.5 using the 1.5 year coupon bond

The bond pays 3.1 at 0.5 years, 3.1 at 1.0 years, and 103.1 at 1.5 years. Price equals discounted
cash flows.
101 = 3.1 DF0.5 + 3.1 DF1 + 103.1 DF1.5
DF1.5 = (101 − 3.1×0.98 − 3.1×0.95) ÷ 103.1 = 0.921600
r1.5 = −ln(0.921600) ÷ 1.5 = 0.054429 = 5.4429%

Step 3 Bootstrap r2 using the 2 year coupon bond

The bond pays 4 at 0.5 years, 4 at 1.0 years, 4 at 1.5 years, and 104 at 2.0 years.
104 = 4 DF0.5 + 4 DF1 + 4 DF1.5 + 104 DF2
DF2 = (104 − 4×0.98 − 4×0.95 − 4×0.9216) ÷ 104 = 0.890323
r2 = −ln(0.890323) ÷ 2 = 0.058085 = 5.8085%

Step 4 Forward rates

For continuous compounding, the forward rate between T1 and T2 is f_T1,T2 = (r_T2×T2 −
r_T1×T1) ÷ (T2 − T1).
f0.5,1 = (0.051293×1 − 0.040405×0.5) ÷ 0.5 = 0.062181 = 6.2181%
f1,1.5 = (0.054429×1.5 − 0.051293×1) ÷ 0.5 = 0.060701 = 6.0701%
f1.5,2 = (0.058085×2 − 0.054429×1.5) ÷ 0.5 = 0.069055 = 6.9055%

Step 5 Par yields

Let c_T be the annual coupon rate of a par bond maturing at T with semiannual coupons. The
par bond has price 100.
For T = 0.5:
100 = (100 + 50c0.5) DF0.5
c0.5 = 2(1/0.98 − 1) = 0.040816 = 4.0816%
For T = 1.0:
100 = 50c1 DF0.5 + (100 + 50c1) DF1
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c1 = (100 − 100×0.95) ÷ (50(0.98 + 0.95)) = 0.051813 = 5.1813%
Nawaf Alhumaid FIN5308 Problem Set 1:

For T = 1.5:
100 = 50c1.5(DF0.5 + DF1 + DF1.5) + 100 DF1.5
c1.5 = (100 − 100×0.921600) ÷ (50(0.98 + 0.95 + 0.921600)) = 0.054986 =
5.4986%
For T = 2.0:
100 = 50c2(DF0.5 + DF1 + DF1.5 + DF2) + 100 DF2
c2 = (100 − 100×0.890323) ÷ (50(0.98 + 0.95 + 0.921600 + 0.890323)) =
0.058621 = 5.8621%

Step 6 Price and yield of a 2 year bond with 7 percent coupon

Coupon per half year is 3.5 and the final payment is 103.5. Price from the spot curve is:
P = 3.5 DF0.5 + 3.5 DF1 + 3.5 DF1.5 + 103.5 DF2
P = 3.5×0.98 + 3.5×0.95 + 3.5×0.921600 + 103.5×0.890323 = 102.129
The yield y solves the standard bond pricing equation with semiannual compounding:

102.129 = 3.5/(1 + y/2)^1 + 3.5/(1 + y/2)^2 + 3.5/(1 + y/2)^3 + 103.5/(1

+ y/2)^4
y = 0.058564 = 5.8564%

Answer
Spot rates are r_0.5 = 4.0405%, r_1 = 5.1293%, r_1.5 = 5.4429%, and r_2 = 5.8085%. Forward
rates are f_0.5,1 = 6.2181%, f_1,1.5 = 6.0701%, and f_1.5,2 = 6.9055%. Par yields are 4.0816%
for 0.5 years, 5.1813% for 1 year, 5.4986% for 1.5 years, and 5.8621% for 2 years. The 2 year
7% coupon bond price is 102.129 and its yield is 5.8564%.

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 Nawaf Alhumaid FIN5308 Problem Set 1:

Question 5.30
A bank offers a corporate client a choice between borrowing cash at 11% per annum and
borrowing gold at 2% per annum. (If gold is borrowed, interest must be repaid in gold. Thus,
100 ounces borrowed today would require 102 ounces to be repaid in one year.) The risk-free
interest rate is 9.25% per annum, and storage costs are 0.5% per annum. Discuss whether the
rate of interest on the gold loan is too high or too low in relation to the rate of interest on the
cash loan. The interest rates on the two loans are expressed with annual compounding. The risk-
free interest rate and storage costs are expressed with continuous compounding.

S0 = 400, F0 = 410, r = 0.0925 (cont), u = 0.005 (cont), T = 1, gold loan

Given

interest = 2% (annual, once per year)

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Step 1 Convert the gold loan interest rate to continuous form
A 2 percent annual interest rate paid once per year means 100 ounces become 102 ounces after
1 year.
y = ln(1.02) = 0.019803
Here y is the implied continuous gold lease rate over 1 year.

Step 2 Use the quoted forward price to infer the implied gold borrowing rate
Under no arbitrage with continuous compounding, the forward price satisfies:
F0 = S0 e(r + u − y)T
Solve for y using the quoted forward price F0 = 410 and spot price S0 = 400.
y = r + u − ln(F0/S0) ÷ T
y = 0.0925 + 0.005 − ln(410/400) = 0.0925 + 0.005 − 0.024693 =
0.072807
Implied gold borrowing rate (effective annual) = e^0.072807 − 1 = 0.0755
= 7.55%
The quoted forward therefore implies that borrowing gold is expensive relative to borrowing
cash, because a higher y reduces the forward price.

Step 3 Compare the bank’s quoted borrowing rates

The bank quotes a gold loan interest rate of 2% per year, which in continuous form is y_bank =
ln(1.02) = 0.019803. The forward implied gold borrowing rate is y_imp = 0.072807, which is
much higher than 0.019803.
Equivalently, the spread between the cash rate and the forward implied gold rate is:

r − y_imp = 0.0925 − 0.072807 = 0.019693 = 1.9693% (continuous)

Using the bank’s gold loan rate, borrowing gold and converting it to cash implies an effective
cash borrowing rate based on the forward purchase required to repay the gold loan:
Effective cash rate from gold loan = (1.02F0/S0) − 1
= (1.02×410/400) − 1 = 0.0455 = 4.55% (annual)
Because 4.55% is well below the bank’s cash loan rate of 11%, the bank’s gold loan rate of 2%
is too low relative to the cash loan rate, given the quoted forward price.

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 Nawaf Alhumaid FIN5308 Problem Set 1:
If the borrower can invest cash at the risk free rate, the arbitrage profit from borrowing 100
ounces, selling spot, investing at r, and buying 102 ounces forward is:
Profit = 100S0 e^0.0925 − 102F0 = 40000 e^0.0925 − 41820 = 2,056.53

Answer
The forward price implies an implied gold borrowing rate y_imp = 0.072807 (continuous),
which is 7.55% effective per year. The implied difference between borrowing cash at r = 9.25%
(continuous) and borrowing gold is r − y_imp = 1.9693% (continuous). Because the bank
quotes only 2% for borrowing gold while quoting 11% for borrowing cash, the gold loan rate is
too low relative to the cash loan rate and would permit an arbitrage based on borrowing gold,
selling spot, and repurchasing via the forward.

Question 5.32
A trader owns a commodity as part of a long-term investment portfolio. The trader can buy the
commodity for $950 per ounce and sell it for $949 per ounce. The trader can borrow funds at
6% per year and invest funds at 5.5% per year. (Both interest rates are expressed with annual
compounding.) For what range of one-year forward prices does the trader have no arbitrage
opportunities? Assume there is no bid–offer spread for forward prices.

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 Nawaf Alhumaid FIN5308 Problem Set 1:
Given
S0 (ask) = 950, S0 (bid) = 949, cash borrowing rate = 6% (annual, once per year), cash
investing rate = 5.5% (annual, once per year), storage cost = 0, T = 1

Solution
No arbitrage implies a forward price bound because an arbitrageur can replicate a forward
contract using either a cash loan to buy the asset or a physical borrowing of the asset to short it.
Upper bound uses borrowing cash at 6 percent to buy the asset and carry it for 1 year.
Upper bound = S0(1 + 0.06) = 950×1.06 = 1007.00
Lower bound uses short selling at the spot bid price and investing the proceeds at 5.5 percent
for 1 year.
Lower bound = 949×(1 + 0.055) = 949×1.055 = 1001.20

Answer
The no arbitrage range for the 1 year forward price is 1001.20 ≤ F0 ≤ 1007.00 per ounce. If the
forward price is within this range, there are no arbitrage opportunities.

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