SCHOOL OF ECONOMIC AND BUSINESS SCIENCES

BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

SECTION A: Derivatives Security Analysis (James Britten)

This section contains 4 questions.

INSTRUCTIONS: Answer all questions in the book provided.

It is in your best interest to show calculations.
Round off all answers to 2 decimal places, unless indicated.

Question 1 (27 marks)

An options trader is investigating the implied volatility of two South African Banks,
Firstrand Ltd. (FSR) and Standard Bank Group Ltd. (SBK). Firstrand has been more
volatile than its peer Standard Bank and she decides to take a closer look. She
estimates the daily volatility of Firstrand’s share price to be 2.07% which is notably
higher than the implied volatility of an at-the-money call on Firstrand. Firstrand’s last
traded price was R64.00 and has an annualised dividend yield of 6.90%. The current
risk-free rate is 5.75% per annum.

a) If the trader’s estimate of volatility is correct, what should the value of an at-the-
money call option be on Firstrand with six-months until expiration? (10 marks)

b) Based on the trader’s observation on Firstrand’s implied volatility, what position

should she take in the call option? (2 marks)

c) Although she is confident in her assessment of the true volatility of Firstrand,

she is concerned that Firstrand’s share price may move against her position.
What would you recommend to the trader to hedge her position and at what
ratio? (5 marks)

d) Your risk officer reminds you to keep an eye on share price fluctuations and he
warns that the recent instability in the market may continue. If you have
managed to eliminate your exposure to changes in Firstrand’s share price, why
would he be worried about further swings in the market? How would additional
instability affect your hedge? (5 marks)

The trader has also been asked to evaluate a collar on RMB Holdings Ltd. (RMH),
which was put in place by a client a month ago. The collar was established with a put
option at an exercise price of R70 and a call option with an exercise price of R80. Both
options expire in 6-months. Based on RMB’s volatility, you calculate that for an
exercise price of R70 and an expiration of 6-months, N(d1) = 0.60, whereas for the
exercise price of R80, N(d1) = 0.35. RMB’s current share price is R75.

e) What will be the change in value of the portfolio if RMB’s share price increases
by R1? Show all your workings. (5 marks)
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Question 2 (30 marks)

Samson Capital is looking into a potential arbitrage opportunity with the Financial (Fini)
15 Futures. On the 1st of November 2019, the Fini 15 was trading at 15 455.20. At the
same time, the Fini 15 futures contract maturing on the 1st of December 2019 was
priced at 15 654.00. Samson also manages a R500 million portfolio of which 55% is
invested mainly in financial shares with the rest in bonds and cash. Samson wishes to
increase the portfolio’s beta from 0.80 to 1.50 and a trader has been asked to make
this happen. Furthermore, Samson wishes to shift 5% of their portfolio into Capitec
Bank Holdings Ltd. (CPI), without increasing their exposure to the Fini 15 index. The
trader looks up the following relevant details: The annualised risk-free rate is 5.75%
and the annualised dividend yield of the Fini 15 is 4.11%. Capitec has a beta of 1.6.
Note that the Fini 15 futures has a contract multiplier of 10.

a) What is the theoretical value of the futures contract? Show all your
workings. (5 marks)

b) Given the market price of the Fini 15 contract, is arbitrage possible? If yes,
describe the steps undertaken to initiate the trade and the anticipated
profit. If there is no arbitrage opportunity, demonstrate this by showing
there are zero profits to be made. Show all calculations. (8 marks)

c) If transactions costs are 2.7% (round trip) per futures, calculate the upper
and lower bound of the futures price. Also, is arbitrage still possible once
transaction costs are taken into account? (6 marks)

d) Using the actual quoted Industrial futures contract price, how many futures
(long or short) must Armitage trade to increase the equity portfolio’s beta
from 0.80 to 1.50? (6 marks)

e) How can Samson take a long position in Capitec without increasing its
exposure to the Fini 15? Show all your workings. (5 marks)
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Question 3 (16 marks)

As a bond analyst, you cover the convertible bond sector and you have decided to
take a closer look at a bond that has caught your eye:

CONVERTIBLE BOND AND UNDERLYING STOCK CHARACTERISTICS

Convertible Bond Characteristics
Par value $1000
Annual coupon rate 7.5%
Conversion ratio 32
Market price 150% of par value
Straight value 99% of par share
Maturity 31/3/2025
Underlying Stock Characteristics
Current market price $40 per share
Annual cash dividend $0.80 per share

Compute and interpret the following:

a) Conversion value (5 marks)

b) Market conversion price (5 marks)

c) Premium payback period (6 marks)

Question 4 (27 marks)

At the beginning of October this year, Prometheus, a US hedge fund, is of the view
that the US is likely to enter into a recession in the coming months. While they reckon
that the US Federal Reserve can intervene with cuts to the Fed Fund’s rate, they
believe that equity markets will, ultimately, react negatively. Prometheus decided that
the best way to take advantage of their view is to enter into an equity-linked swap.
They are prepared to commit $200 million to the trade. In addition, Prometheus is also
of the view that corporate credit conditions will deteriorate if a recession hits. They
contacted a swap dealer, Swift Trade, who suggested a swap structured around the
S&P 500. Furthermore, Swift Trade quotes several CDS contracts and quote a CDS
of 183.00 that references a general corporate bond index. The following levels of the
S&P 500 and LIBOR were observed over the life of the swap:
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

S&P 500 Index 1-Month Libor (%)

Date Actual days Close

2019/10/01 2711.73 2.0409

2019/11/01 31 2760.16 2.057

2019/12/01 30 2506.85 2.0443

2020/01/01 31 2704.10 2.0459

2020/02/01 31 2784.48 2.0365

a) What swap should Prometheus undertake to express their view? (4 marks)

b) If the two counterparties decide to stick to the specify in advance, pay in arrears
convention, calculate the cash flows that Prometheus will receive or pay. At the
end of the 4-month term, is the swap ultimately profitable? Show all your
workings. (14 marks)

c) What can Swift Trade do to hedge its position? Contrast the different
alternatives (i.e. futures, swaps, etc) open to Swift Trade and substantiate your
answer. (5 marks)

d) What trade can you recommend to Prometheus to take advantage of their

outlook for deteriorating credit conditions? How much will this cost if they
commit $50 million to the trade? (4 marks)

[100]
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

SECTION B: Portfolio Management (Yudhvir Seetharam)

This section contains five questions. Three questions are compulsory; and you must
choose one of the remaining two questions to answer. In total, you will answer four out of
the five questions.

INSTRUCTIONS: Answer all questions in the book provided.

It is in your best interest to show calculations.
Round off all answers to 2 decimal places, unless indicated.
Answer each question on a new page.

Question 1 (22 marks) (COMPULSORY)

You recently bought a car, valued at R1 million. You are considering whether to purchase
insurance or not. The cost of the monthly insurance premium is R2500. As a new driver, there
is a 20% chance that you will be in an accident. Assuming that your utility function is
𝑈(𝑊) = 10 + 𝑊𝑒 ! + 𝑊 "

a) What is your risk appetite? (6 marks)

b) Will you decide to take out insurance (on a yearly basis)? (6 marks)

c) What are the absolute and relative percentages of your wealth (ARA and RRA)?
(10 marks)

Question 2 (32 marks) (OPTIONAL – answer Question 2 OR Question

3, NOT BOTH)

a) Define a heuristic. (3 marks)

b) Explain the home bias, as well as potential reasons for the anomaly existing in
the literature. (7 marks)

c) Define herding behaviour; give an example of when it is rational; and a further

example of when it is not rational. Lastly, give an example of a share (or any
traded security) where you believe there is herding behaviour. (8 marks)

d) What is a robo-advisor? (3 marks)

e) In your opinion, if a robo-advisor invests only in Exchange Traded Funds

(ETFs), is it still a passive investment? (6 marks)

f) Do you think that good companies make good investments? (5 marks)

SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

The following information applies (in differing amounts) to Questions 3, 4 and 5.

The Everlasting ESG Fund is an equally weighted index of 17 ESG securities. The
fund is designed to provide discerning investors with appropriate themes to invest and
gain exposure to both listed and alternate assets. The fund is classified as “open” and
has a deferred fee structure which only charges 1.5% at the end of 2 years.

Beginning Value as at 1 USD 17 trillion

August 2018

End Value as at 31 October USD 12.4 trillion

2019

Risk free rate as at 31 0.75%

October 2019

Downside Standard 34.50%

Deviation

Number of shares as at 1 1 billion

August 2018

Number of shares as at 31 1.3 billion

October 2019

α (alpha) 120%

β (beta) 0.01

Τ (tau) 14.3%

Market return 1.6%

Investment Weights (100%) Returns as at 31 October 2019

Asset Actual Benchmark Excess Actual Benchmark Excess

Class

ESG ? 20% ? 1.64% 3.64% ?

bonds

Property 25% 0% ? 2.4% 0.54% ?

ESG 85% ? ? 13.5% ? 8.01%

Shares
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Figure 1: Market Allocations

Question 3 (32 marks) (OPTIONAL – answer Question 2 OR Question

3, NOT BOTH)

a) Define the acronym of “ESG”; and explain the concept of ESG investing.
(7 marks)

b) Explain why ESG investing may not produce a mean-variance optimal portfolio.
(4 marks)

c) Give an example of a sustainable thematic investing strategy. (3 marks)

d) Calculate the NAV of the above fund, as at 31 October 2019, assuming that you
bought into the fund as at 1 August 2018. (5 marks)

e) Comment on which of the above portfolio allocations will best work in today’s
economic environment. Which alternate assets will you include in your portfolio?
(5 marks)

f) List any four characteristics of alternative assets. (8 marks)

SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Question 4 (20 marks) (COMPULSORY)

List and define one principle from each standard (two from the CFA code of
ethics; and another three from the SAIFM code of ethics), and provide an example
of when a member violates that particular principle. (20 marks)

Question 5 (26 marks) (COMPULSORY)

a) Calculate the Sharpe ratio (using the holding period return) and Treynor ratio
(using the holding period return). Explain the difference in your answers of the two
ratios. (8 marks)

b) Calculate the Total Value Added for the fund. (15 marks)

c) Is the fund manager better at selecting assets or specific securities? Explain your
answer (3 marks)

[100]
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Derivatives Formula Sheet

Put call spot parity:

X
S0 + P0,T - C0,T =
(1+ RFR)T

Put call spot parity adjusted for dividends:

X DT
P0,T + S0 = C0,T + T
+
(1+ RFR) (1+ RFR)T

Put call forward parity:

X - F0,T
P0,T - C0,T =
(1+ RFR)T

Binomial option pricing:

Cu - C d
H=
S 0u - S 0 d

C = [ pC u + (1 - p)Cd ]e - RFR (T )

Where

e rT - d
p=
u-d
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Generalised binomial formula:

N
C0 = {å (N -N!j)! j!p (1- p)
j N- j
}÷ r
[(u j d N - j )S - X] N

N= m

Black-Scholes formula for call options:

C0 = SN(d1 ) - X(e-(RFR )T )N(d2 )

Where

ln(S / X) + (RFR + 0.5s 2 )T

d1 =
s [T]1/ 2
d2 = d1 - s [T]1/ 2

Black-Scholes formula adjusted for dividends:

C0 = (e-(D )T )SN(d1) - X(e-(RFR )T )N(d2 )

ln((e-(D )T )S / X) + (RFR + 0.5s 2 )T
d1 =
s [T]1/ 2
d2 = d1 - s [T]1/ 2
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Black-Scholes formula for put options:

P = X(e-(RFR )T )N(-d2 ) - SN(-d1)

Interpolation formula:

N(d) » 0.5e-(d
2
)/ 2-281/(83-351/ d )
if d < 0
N(d) » 1- 0.5e-(d
2
)/ 2-281/(83+351/ d )
if d ³ 0

Basis:

Bt,T = St - Ft,T
Bt,T - B0,T = (St - Ft,T ) - (S0 - F0,T )

Hedge ratios:

æs ö
N * = ç DS ÷r
è s DF ø
D S
N * = mod S ´ b i ´
Dmod F F

Forwards and futures:

F0,T = S0 + (PC0,T + i0,T - D0,T )

F0,T = S0 + S0 (RFRt - dT )
Vt,T = (Q)[Ft,T - F0,T ] ÷ (1+ i)(T -t )
Vt,T* = (Q)[Ft,T
*
- Fo,T
*
]
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)

Forward-based interest rate contracts:

[LIBOR – Fixed rate] x [Notional Principal] x [Number of days/360]

Cap settlement:

(Notional Principal) x (Number of days/360) x max[LIBORt-1 – XC, 0]

Floor settlement:

(Notional Principal) x (Number of days/360) x max[Xf - LIBORt-1, 0]

Equity index linked swap:

Payment = [LIBOR – Spread] x [Notional Principal] x [Number of days/360]

Receipt = [(Indexnew – Indexold)/Indexold] x [Notional Principal]

Warrants:

WT = [1/(1 + NW/N)]CT

Where CT = the expiration date value of a regular call option with otherwise identical terms
as the warrant.
SCHOOL OF ECONOMIC AND BUSINESS SCIENCES
BUSE 3014/BUSE 3015 PAPER 3 – Derivative Securities Analysis (Section A) and Portfolio
Management (Section B)