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Capital market practice questions. Question 1: Explain how STIR futures can be used to hedge the interest rate reset risk in the FRNs.

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Introduction

Question 1: Explain how STIR futures can be used to hedge the interest rate reset risk in the FRNs. As scenario, one of the concerns that the company has to face is the steady rise in short-term interest rates over the next three years. To hedge against rates rising, the company can sell future contracts as a STIR futures tool. The future to use can be the three-month interest rate future. For example, the company can use LIFFE three - month sterling interest rate futures contract (ST3) as STIR futures tool. The STIR futures Contract Specification: Name of the contract LIFFE three-month sterling interest rate futures contract (ST3) Unit of trading � 500,000 Delivery months March, June, September, December, and two serial months, such that 26 delivery months are available for trading, with the nearest three delivery months being consecutive calendar months. Last trading day 11:00, third Wednesday of the delivery month Quotation 100.00 minus rate of interest (%) Tick size 0.01 % on annual basis Tick value � 12.5 (Tick value = 500000�0.0001�3/12 = � 12.5) Specifically, the company should sell n futures. Number of futures to trade to establish hedge: � Where: - FVCP = Face Value of Cash Position - NVFT = ...read more.

Middle

the number of days in the forward period C = the number of days in a year according to the appropriate convention. For example, the Forward Rate LIBOR 1 year and 1.5 year are: Step 3: Calculate the Floating Cash Flow. Where: P = notional principle D = number of days and C is the assumed number of days in a year according to the appropriate day count convention. 250* * = 5.485 250* * = 6.192 Step 4: Calculate the present value of the floating leg using the spot rates. The present value of the floating leg of the swap is calculated as: Step 5: Calculate the fixed payment The semi-annual fixed payment is 6.69 million �, so the swap price of a three-year swap that will hedge reset risk for the company is 13.38 million �. Question 4: Explain the difference between Hedging and Insurance, and how using a Futures contract or an Option will enable you to manage the equity market risk in the pension fund portfolio. 4.1. Explain the difference between Hedging and Insurance. Hedging and Insurance are the effective strategies for the companies facing cash-flow risks. ...read more.

Conclusion

Portfolio yield enhancement 1. Sale of out-of-the-money (OTM) index/bond calls, anticipating limited market upside. 2. Sale of OTM index puts/bond puts, anticipating limited market downside. 3. Sale of OTM index/bond calls and puts, anticipating range bound market conditions. Question 5: Calculate the arbitrage free price of a six-month future on the FTSE 100 index. The annual dividend yield is 4%pa. and the future value (expressed in index points) of dividends due over the next six months is 30 index points, so the futures price in this case will be: In particular: Dividend DIV 30 Dtdiv1 R(tdiv1,t) 0.04 T-t 0.5 Asset price St 5500 Spot rate R 0.044 FD index FD Future Price F The FD index is: The future price is: In conclusion, the arbitrage free price of a six-month future on the FTSE 100 index is 5590.4. Question 6: Calculate the price of a six month, at-the-money, put on the FTSE 100 index. The annual dividend yield is 4%pa, therefore q = 0.04. Moreover, the volatility is 20% so the sigma = 20%, S = X = 5500, r = 0.044. The price of put on FTSE 100 index would be: With: N(-d1) = Normsdist(-0.084853) = 0.466189 N(-d2) = Normsdist (0.05657) = 0.522556 In conclusion, the price of a six month, at-the-money, put on the FTSE 100 index is �298.2511 million. ...read more.

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