N =
? 0 million 1.5
7,500.
4,000 ? 0
c. According to the CAPM, the expected return on the British portfolio (before hedging) is:
E(R) = 4% +1.5 (10% 4%) = 13%.
If you hedge the portfolio by selling FTSE contracts as in Question (b), the expected return
becomes the riskfree interest rate of 4%.
d. Hedging with British stock index futures does not protect you against a depreciation of the
British pound.
e. Your current exposure is 20 million and this is the amount to be sold forward.
5. You hold a portfolio made of French stocks and worth 10 million. The beta () of this portfolio
relative to the CAC index is 1.5. The interest rate for the euro is 4% for all maturities and the annual
dividend yield is 2%. The spot value of the CAC index on January 1, 2000, is 5,000. A CAC contract
has a size of 10 for each index point.
a. What should be the future price of the CAC contract with a threemonth maturity?
b. You fear a fall in the French stock market. What should be your hedge ratio? How many
contracts do you buy/sell?
Solution
a. F = 5,000 + ((4% 2%)/4) 5000 = 5,025.
b. h
*
=  = 1.5.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 119
and
N =
portfolio value
beta
stock index contract size
$
1 1 12%/ 4
1.1 1.1218 $/
1 1 4%/ 4
r
F S
r
+ +
= = =
+ +
where:
$
r is the dollar interest rate,
r
is the euro interest rate.
This is a pure arbitrage relation. It must hold exactly for a forward contract and hold closely for a
futures contract. Arbitrage costs are very small on the currency market.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 121
c. Eurodollars futures
The futures price is equal to 100% minus the annualized forward interest rate. The forward
interest rate r
F
is the threemonth interest rate that will be valid in three months (the delivery date
of the futures contract). By arbitrage, it should be equivalent today to buy the futures contract or
to invest for six months (r
m
interest rate to maturity) and simultaneously borrow for three months
(r
d
interest rate to delivery).
1
1 .
1
m
F
d
r
r
r
+
+ =
+
Here, the interest rate to maturity is r
m
= 10% 6/12 = 5%.
The interest rate to delivery is r
d
= 12% 3/12 = 3%.
The futures interest rate is then r
F
= 1.05/1.03 1 = 1.9417%.
On an annual basis, this is equal to 1.9417% 12/3 = 7.7670%.
Therefore, the futures price on the eurodollar contract should be equal to:
F = 100 7.7670 = 92.233%.
d. Stock index
F = S (1 + r
s
r
d
)
where: r
s
is the shortterm interest rate,
r
d is the dividend yield.
F = 1200 (1 + 12%/4 2%/4) = 1230.
The market price may diverge from this theoretical value because:
 The dividend yield is an annual approximation,
 and arbitrage costs are quite high for the large number of stocks represented in the index.
Note: In all these applications, one must be very careful to calculate interest pro rata temporis.
Interest rates are always quoted on an annual basis. For example, the 12% rate on a threemonth bill
yields a 12% 3/12 = 3% per quarter.
9. You wish to establish the theoretical futures price on a Euribor contract quoted on the London
International Financial Futures Exchange (LIFFE) in London. The futures contract is for a 90day
Euribor rate at expiration of the futures contract. You look at the current term structure of Euribor
interest rates. Following the standard conventions for shortterm rates, all interest rates are quoted as
annualized linear rates. In other words, the interest paid for a maturity of T days is equal to the
annualized rate quoted, divided by 360 and multiplied by T. The observed rates are as follows:
60Day 90Day 150Day 180Day
Euribor Rate 4.125% 4.250% 4.500% 4.550%
a. What should be the Euribor futures price quoted today with an expiration date in exactly
90 days?
b. What should be the Euribor futures price quoted today with an expiration date in exactly
60 days?
122 Solnik/McLeavey Global Investments, Sixth Edition
Solution
a. This futures contract is for a 90day bill issued in 90 days and maturing in 180 days. The
annualized forward interest rate r
F
is given by:
180
360
90
360
1 4.55%
1 1.011998
4 1 4.25%
F
r +
+ = =
+
r
F
= 4.80%
F = 100% 4.80% = 95.20%.
b. This futures contract is for a 90day bill issued in 60 days and maturing in 150 days. The
annualized forward interest rate r
F
is given by:
150
360
60
360
1 4.5%
1 1.011794
4 1 4.125%
F
r +
+ =
+
r
F
= 4.72%
F = 100% 4.72% = 95.28%.
10. You specialize in arbitrage between the futures and the cash market on the Paris Bourse. The CAC
stock index is made up of 40 leading stocks. The futures price of the CAC contract with delivery in a
month is 2,120. The size of the contract is 10 times the index. The spot value of the index is given as
2,000. Actually, there are transaction costs in the cash market; the bidask spread is around 40 points.
You can buy a basket of stocks representing the index for 2,020 and sell the same basket for 1,980.
Transaction costs on the futures contracts are assumed to be negligible. During the next month, the
stocks in the index will pay dividends amounting to 5 per index. These dividends have already been
announced, so there is no uncertainty about this cash flow. The current onemonth interest rate in
euros is 6
1
/
2
5
/
8
%.
a. Do you detect any arbitrage opportunity?
b. What profit could you make per contract?
c. What is the theoretical value of the futures bid and ask prices?
Solution
a. The basis is equal to 120 per index or 6% of the spot value. This seems very large. An arbitrage
would be to sell futures, buy spot, and carry the position till expiration of the futures contract. At
expiration, both positions would be liquidated (futures contracts on the index are settled by cash,
not by physical delivery of the shares).
b. Lets look at the exact arbitrage per index:
 Sell the futures at 2,120.
 Buy a basket of stocks at 2,020.
 Carry the position for a month with a financing cost at a rate of 6 5/8% and with the receipt of
5 in dividends.
 Buy back the futures at expiration at the prevailing spot index value S (by definition of the
contract, the futures price is equal to the spot value in expiration).
 Sell the basket of stocks at S minus 20.
Note that the futures contract is settled in cash, so the basket of stocks cannot be used for
physical delivery; it increases the transaction costs.
Lets look at the profit at the end of the month:
Profit = 2120 2020 2020
5
8
6
5 ( 20)
12 100
S S
 
+ +

\ .
= 73.85.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 123
c. By arbitrage, the bid (F
bid
) and ask (F
ask
) are given by the following equations:
0 = F
bid
+ 1,980 + 1,980
1
2
6
5 ( 20)
12 100
S S
 
+ +

\ .
F
bid
= 1,980 + 10.72 5 20 = 1,965.72.
0 = F
ask
2,020 2,020
5
8
6
5 ( 20)
12 100
S S
 
+ +

\ .
F
ask
= 2,020 + 11.15 5 + 20 = 2,046.15.
The futures price should be between 1,965.72 and 2,046.15.
In practice, the transaction cost on a basket of shares will generally be much less than the 2%
assumed here on a return transaction.
11. A few years ago when the French franc (FF) still existed, the MATIF futures exchange in Paris had a
very active market for the French government bond contract. The underlying asset is a notional long
term government bond with a yield of 10%. The size of the contract is FF 500,000 of nominal value.
Futures prices are quoted in percentage of the nominal value. On April 1, the French term structure of
interest rate is flat. The bond futures price for delivery in June is equal to 106.21%. The three French
government bonds that can be used for delivery have the following characteristics:
Market Price Duration Conversion Factor
Bond A 107.46% 7.00 101.1771%
Bond B 105.57% 7.90 98.1441%
Bond C 106.32% 8.80 99.3104%
a. Is the futures price consistent with the spot bond prices? (Find the bond cheapest to deliver.)
b. Estimate the interest rate sensitivity (duration) of the futures price.
c. You are an insurance company with a portfolio of French government bonds. The portfolio has a
nominal value of FF 100 million and a market value of FF 110 million. Its average duration is 3.5.
You are worried that social unrest in France could lead to an increase in French interest rates.
Rather than selling the bonds, you wish to temporarily hedge the French interest rate risk. How
many futures contracts would you sell and why?
Note to the instructor: The section on optimal hedge ratios for bond portfolios has been
removed from the 5th edition. We include a brief summary of the theoretical derivations
given at the end of the solution.
Solution
a. To answer this question we need to determine which is the cheapesttodeliver bond.
We search for the cheapesttodeliver bond. If we deliver bond i with price P
i
and conversion
factor CF
i
, the net receipt will be (assuming a flat yieldcurve):
F CF
i
P
i
.
124 Solnik/McLeavey Global Investments, Sixth Edition
Since F = 106.21%
Bond A: 0
Bond B: 1.33%
Bond C: 0.84%
Bond A is the cheapesttodeliver bond and its price should drive the futures price:
F = P
A
/CF
A
.
Since P
A
/CF
A
= 106.21%, spot bond prices are consistent with the futures price.
b. The duration of the futures should be equal to that of Bond A, or:
D
F
= 7.00
since .
A
A
A
dP dF
D dr
F P
= =
c. A naive hedge would be to sell an equal nominal quantity of futures contract, that is, a nominal
value of FF 100 million or 200 contracts. However, the futures price is twice as sensitive to
interest rate movements as the portfolio (durations of 7 and 3.5, respectively). So, you should sell
only 100 contracts.
More precisely the optimal hedge ratio is (see Appendix):
h
*
=
110 3.5
0.518.
106.21 7
You should sell N contracts:
N = 0.518
100 millions
103.6.
0.5 million
=
Appendix: Theoretical Derivations
Theoretical value of the futures price:
The theoretical value of the futures price is derived by arbitrage between the futures and the cheapest
todeliver bond. Assume that the futures price is too high. Then an arbitrageur could buy a
deliverable bond B at a price P
B
on the cash market and simultaneously sell the futures at F. Bond B
has a conversion factor CF
B
. The carrying cost of this position is the difference between the short
term interest rate paid to finance the purchase of the bond and the longterm interest rate (yield)
received while holding the bond. Lets assume that the yield curve is flat, so that there is no carrying
cost in this arbitrage (basis equals zero).
At delivery the arbitrageur will make a profit equal to:
F CF
B
P
B
.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 125
Of course, the arbitrageur will choose the bond (Bond B) that maximizes this profit (i.e., the
cheapesttodeliver bond). By arbitrage this riskless profit must be zero (it will be negative for
deliverable bonds that are not the cheapesttodeliver). So, the futures price should be equal to:
.
B
B
P
F
CF
=
The price of the cheapesttodeliver bond (Bond B) drives the futures prices (the conversion factor is
a constant).
Optimal hedge ratio:
Lets assume that we wish to hedge the interest rate risk of a portfolio with a value V (here
FF 110 million), consisting of a nominal value Q (here FF 100 million) times an average spot bond
price S % (here 110%). The duration equation for the portfolio for a small variation dr in the market
yield is:
S
dV Q dS dS
D dr
V Q S S
= = =
or
.
S
dV D Q S dr =
The duration equation for the futures price is driven by the equation duration for the cheapestto
deliver bond (remember that the conversion factor is a constant):
B
B
B
dP dF
D dr
F P
= =
hence
.
B
dF D F dr =
We hedge by selling N futures contracts with a fixed size (here FF 0.5 million). For a small variation
dr in the market yield, the futures position will generate a gain of:
Gain = .
B
N size dF N size D F dr =
The net result on the hedged portfolio is:
( ) .
S B B S
D Q S dr N size D F dr N size D F D Q S dr + =
The optimal number of contracts that will immunize the hedged portfolio to small variations in
market yield is such that:
0
B S
N size D F D Q S =
or
.
S
B
D S Q
N
Size D F
The optimal hedge ratio is
*
.
S
B
D S
h
D F
126 Solnik/McLeavey Global Investments, Sixth Edition
12. An American investor wants to invest in a diversified portfolio of Japanese stocks but can invest only
a rather small sum. The investor also worries about fiscal and transaction cost considerations. Why
would futures contracts on the Nikkei index be an attractive alternative?
Solution
 With little capital, an investor can only buy a few Japanese shares and will only hold a poorly
diversified portfolio. Through a stock index futures contract this same investor holds a
participation in a fully diversified Japanese stock portfolio.
 Transaction costs on individual shares are higher than on a stock index futures contract.
 The futures prices should be set by Japanese investors who arbitrage between the futures contracts
and the stock market. On the other hand, foreign buyers of Japanese stocks tend to lose the
withholding tax on dividends paid; this is certainly the case for U.S. pension funds. Therefore, the
futures contract allows a purchase at fair prices without losing the withholding tax on dividends.
One has to be careful about the currency exposure, which is different in a direct stock purchase and a
long position in the futures contract.
13. A money manager holds $50 million worth of topquality international bonds denominated in dollars.
Their face value is $40 million, and most issues are highly illiquid. She fears a rise in U.S. interest
rates and decides to hedge, using U.S. Treasury bond futures. Why would it be difficult to achieve a
perfect hedge (list the various reasons)?
Solution
This is a typical example of a crosshedge where the asset to be hedged is different from the futures
contracts. Among the factors that could make the hedge imperfect:
 The maturity (and duration) of the portfolio of bonds is different from that of the notional bond.
 Movements in the Treasury bond rates are not perfectly correlated with those on international
bonds, which are mainly corporate bonds.
 Basis risk.
14. A manager holds a diversified portfolio of British stocks worth 5 million. He has shortterm fears
about the market but feels that it is a sound longterm investment. He is a firm believer in betas, and
his portfolios  is equal to 0.8. What are the alternatives open to temporarily reduce the risk on his
British portfolio?
Solution
One alternative is to sell all the British shares and buy them back when his fears disappear. At least
he could buy and sell shares to reduce the beta of his portfolio. This is a costly solution in terms of
transaction costs.
Another alternative is to sell Financial Times stock index futures contracts to hedge the British
market risks and remove the hedge when the fears disappear. Given the beta of his portfolio, the
investor should sell for 0.8 5 = 4 million.
Another alternative would be to buy put options on individual shares in the portfolio or on the stock
index.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 127
15. You are the treasurer of a major Japanese construction company. Today is January 15. You expect to
receive 10 million at the end of March, as payment from a client on some construction work in
France. You know that you will need this sum somewhere else in Europe at the end of June. Meanwhile,
you wish to invest these 10 million for three months. The current threemonth interest rate in euros
is 4%, but you are worried that it will quickly drop. Listed below are Euribor futures quotations on
EUREX:
Maturity (monthend) Price
February 96.02%
March 96.08%
June 96.20%
September 96.25%
a. Knowing that Euribor contracts have a size of 1 million, what should you do to freeze a lending
rate when you will receive the money?
b. At the end of March, when you receive the money, the threemonth Euribor is equal to 3%.
How much money (number of euros) have you gained by engaging in the above transaction
(as opposed to doing nothing on January 15)?
Solution
a. In order to freeze a lending rate when I will receive the money, I will buy 10 futures contracts
that expire in March and have a price of 96.08%. I am now freezing a threemonth lending rate of
3.92% for the end of March.
b. At the end of March, the futures price will converge to 97%, given the 3% interest rate at that
time. Hence, I will make a profit on the futures contracts equal to:
Profit = 10 million [97% 96.08%]/4 = 23,000.
This profit will offset the drop in interest rate from January to March. I can then invest from
March to June the 10 million received at a rate of 3%.
16. A dollarSwiss franc swap with a maturity of five years was contracted by Papaf Inc. three years ago.
Papaf swapped $100 million for CHF 250 million. The swap payments were annual, based on market
interest rates of 8% in dollars and 4% in CHF. In other words, Papaf Inc. contracted to pay dollars
and receive CHF. The current spot exchange rate is 2 CHF/$, and the current interest rates are 6% in
CHF and 10% in $ (the term structures are flat).
a. What is the swap payment at the end of year three? Does Papaf pay or receive?
b. On the final date of the swap, the spot exchange rate is 1.5 CHF/$.
What is the final swap payment at the end of year five?
Solution
a. At the end of year three, Papaf receives the balance of:
 Receipt of CHF 10 million.
 Payment of $8 million.
The net cash flow is:
10 8 2 = CHF 6 million.
Papaf has to pay CHF 6 million (or $3 million).
128 Solnik/McLeavey Global Investments, Sixth Edition
b. At the end of year five, Papaf receives the balance of:
 Receipt of 250 + 10 = CHF 260 million.
 Payment of 100 + 8 = $108 million.
The net cash flow is:
260 108 1.5 = CHF 98 million.
Papaf receives CHF 98 million (or $65.33 million).
17. An Italian corporation enters into a twoyear interest rate swap in euros on April 1, 2000. The swap is
based on a principal of 100 million, and the corporation will receive 7% fixed and pay sixmonth
Euribor. Swap payments are semiannual. The 7% fixed rate is quoted as an annual rate using the
European method, so the implied semiannual coupon is 3.44% [since (1.0344)
2
= 1.07]. Two years
later, the swap is finally settled, and the following Euribor rates have been observed:
Apr. 1, 2000 Oct. 1, 2000 Apr. 1, 2001 Oct. 1, 2001 Apr. 1, 2002
6.5% 7.5% 8% 7.5% 6%
a. What have the swap payments or receipts for the corporation been on each swap payment date?
b. The same Italian corporation also entered another twoyear interest rate swap in euros on April 1,
2000. The swap is based on a principal of 100 million, and the corporation contracted to receive
7% fixed and pay sixmonth Euribor. On this swap, the payments are annual. Hence, the two
successive sixmonth Euribor are compounded. Assuming that the Euribor rates given in the
previous problem have been observed, what have the two annual swap payments been?
Solution
a. Semiannual swap:
Swap receipts by the corporation
(based on the Euribor observed at the start of the sixmonth period)
Date
Net Receipt in Million
(payment if negative)
October 1, 2000 100 (3.44 3.25)% = 0.19
April 1, 2001 100 (3.44 3.75)% = 0.31
October 1, 2001 100 (3.44 4.00)% = 0.56
April 1, 2002 100 (3.44 3.75)% = 0.31
b. On each annual payment date, the floating leg is determined by compounding the two sixmonth
LIBOR observed in the previous year. For example, the floating leg on April 1, 2001, is equal to:
7,121,875
since 7.121875% = (1.0325)(1.0375) 1.
The floating leg on April 1, 2002, is equal to:
7,900,000
since 7.9% = (1.04)(1.0375) 1.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 129
The swap receipts by the corporation are
Date
Swap Receipts in Million
(payment if negative)
April 1, 2001 100 (7 7.1219)% = 0.1219
April 1, 2002 100 (7 7.9)% = 0.9
18. A swap dealer provides the following quotations for a yen/$ currency swap. The quotes are for a yen
fixed rate against the U.S. Treasury yield flat, with annual payments.
Years Fixed (ann.)
2 6.00 6.08
3 6.12
6.21
4 6.14 6.23
5 6.15 6.24
7 6.18 6.28
A client wishes to enter a fiveyear swap, paying yen and receiving $. The current yield on fiveyear
U.S. Treasury bonds is 7.20%, using the semiannual method, which amounts to 7.33%, using the
annual European method.
What will the exact terms of the swap be if the client accepts these quotations?
Solution
As stated in the table, the swap quotes use the European, or annual yield, method. A client entering a
fiveyear swap to pay yen and receive $ will pay an annual yield of 6.24% in yen and receive an
annual yield of 7.33% in $, with both yields using the annual European method.
19. Pouf is a rapidly growing and pleasant country in the Austral hemisphere. Its inhabitants are called
Poufans, and its currency is the pof. The bond market is fairly active with many issues by Poufan
companies, but there are no foreign investors or issuers. The current yield on pof bonds is 10%.
Poufan investors have to pay a 15% tax on interest income received. The newly elected Poufan
government wishes to internationalize its bond market and attract foreign issuers. To do so, it decides
to remove any taxation of income on bonds issued by foreign corporations in Pouf. Several changes
take place after the enactment of this tax provision:
 Several wellknown foreign corporations issue pofdenominated bonds in the Poufan bond market.
 Several wellknown Poufan corporations issue international bonds denominated in U.S. dollars.
 Several dollar/pof swaps are arranged.
Try to provide a sensible explanation for this phenomenon.
Solution
Foreign corporations issue bonds in pof and swap pofs for dollars (they receive pofs and pay $).
Poufan corporations issue bonds in dollars and swap dollars for pofs (they receive $ and pay pofs).
Foreign corporations can issue bonds in pofs at a lower yield than Poufan corporations because of
the tax advantage. Income is taxfree for Poufan investors. This tax advantage (15% of the yield) is
shared between Poufan and foreign corporations through the pof/dollar swap.
130 Solnik/McLeavey Global Investments, Sixth Edition
20. A Dutch institutional investor has decided to bet on a drop in U.S. dollar bond yields. It engages in a
leveraged strategy, borrowing $100 million at LIBOR plus 0.25% and investing the proceeds in
attractive, newly issued, longterm dollar international bonds. Suddenly, the investor becomes worried
that bond yields have hit bottom and will rise because of inflationary pressures. The investor wishes
to keep the specific international bonds that have been selected, partly because of their attractiveness
and partly because of their lack of market liquidity. What kind of swap could be arranged to hedge
this U.S. dollar bond yield risk?
Solution
The Dutch institutional investor should swap fixed for floating in dollars. It should contract to pay
fixed and receive floating (LIBOR).
21. A small German bank has the following portfolio of loans in U.S. dollars, valued at market value:
Assets Liabilities
$50 million of a fiveyear FRN at
LIBOR plus 0.5%
$10 million of a fiveyear loan at a fixed
rate of 9%
The German bank fears a longterm depreciation of the U.S. dollar relative to the euro and believes in
stable U.S. interest rates.
a. What is its currency exposure?
b. What type of swap arrangements should it contract?
c. What should the principal of the swaps be?
Solution
a. The net exposure to the $ exchange rate is a net asset position of $40 million.
b. The bank should enter in a swap to pay $ and receive euro.
c. The swap amount that minimizes the currency exposure is $40 million. If the German bank
wanted to speculate on a dollar depreciation, it would swap more than $40 million.
The answer would be different if the German bank feared a movement in U.S. interest rates.
22. A fiveyear currency swap involves two AAA borrowers and has been set at current market interest
rates. The swap is for US$100 million against AUD 200 million at the current spot exchange rate of
AUD/$ 2.00. The interest rates are 10% in U.S. dollars and 7% in Australian dollars, or annual swaps
of US$10 million for AUD 14 million. A year later, the interest rates have dropped to 8% in U.S.
dollars and 6% in Australian dollars, and the exchange rate is now AUD/$ 1.9.
a. What should the market value of the swap be in the secondary market?
Assume now that the swap is instead a currencyinterest rate swap whereby the dollar interest is set
at LIBOR.
b. What would the market value of the currencyinterest rate swap be if these conditions prevailed a
year later?
Solution
a. The new value of the swap is derived by considering the market value of two streams of cash
flows:
 P
$
: a bond in dollars with four years remaining, with annual cash flows of $10 million, and a
principal repayment of $100 million;
 P
AUD
: a bond in Australian dollars with four years remaining, with annual cash flows of AUD
14 million, and a principal repayment of AUD 200 million.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 131
The swap to receive AUD and pay dollars is worth in AUD:
Swap = P
AUD
(6%) spot AUD/$ P
$
(8%).
Swap =
2 3 4 2 3 4
14 14 14 214 10 10 10 110
1.9 .
1.06 1.06 1.06 1.06 1.08 1.08 1.08 1.08
   
+ + + + + +
 
\ . \ .
Swap = 206.93 1.9 (106.63) = AUD 4.34 million.
The U.S. dollar value of the swap is 4.34/1.9 = $ 2.28 million.
Of course, the seller of this swap who receives dollars for Australian dollars will realize a
corresponding loss.
b. Without further information, we can assume that the value of a bond with a floating rate stays
constant. Therefore, the swap value will change only because of a change in the AUD interest
rate and a change in the exchange rate. This second swap is now worth:
Swap = 206.93 1.9 (100) = AUD 16.93 million.
Swap = $ 8.91 million.
23. A fiveyear currency swap involves two AAA borrowers and has been set at current market interest
rates. The swap is for US$100 million against AUD 200 million at the current spot exchange rate of
AUD/$ 2.00. The interest rates are 4% in U.S. dollars and 7% in Australian dollars, or annual swaps
of $4 million for AUD 14 million. A year later, the interest rates have dropped to 3% in U.S. dollars
and 6% in Australian dollars, and the exchange rate is now AUD/$ 1.9.
a. What should the market value of the swap be in the secondary market?
Assume now that the swap is instead a currencyinterest rate swap whereby the dollar interest is set
at LIBOR.
b. What would the market value of the currencyinterest rate swap be if these conditions prevailed a
year later?
Solution
a. The new value of the swap is derived by considering the market value of two streams of cash
flows:
 P
$
: a bond in dollars with four years remaining, with annual cash flows of $4 million, and a
principal repayment of $100 million;
 P
AUD
: a bond in Australian dollars with four years remaining, with annual cash flows of AUD
14 million, and a principal repayment of AUD 200 million.
The swap to receive AUD and pay U.S. dollars is worth in AUD:
Swap = P
AUD
(6%) spot AUD/$ P
$
(3%).
Swap =
2 3 4 2 3 4
14 14 14 214 4 4 4 104
1.9 .
1.06 1.06 1.06 1.06 1.03 1.03 1.03 1.03
   
+ + + + + +
 
\ . \ .
Swap = 206.93 1.9 (103.72) = AUD 9.86 million.
The U.S. dollar value of the swap is 9.86/1.9 = $5.19 million.
Of course, the seller of this swap who receives dollars for Australian dollars will realize a
corresponding loss.
132 Solnik/McLeavey Global Investments, Sixth Edition
b. Without further information, we can assume that the value of a bond with a floating rate stays
constant. Therefore, the swap value will change only because of a change in the AUD interest
rate and a change in the exchange rate. This second swap is now worth:
Swap = 206.93 1.9 (100) = AUD 16.93 million.
Swap = $8.91 million.
24. Four years ago, a Swiss firm contracted a currency swap of US$100 million for 250 million Swiss
francs (SFr), with a maturity of seven years. The swap fixed rates are 8% in dollars and 4% in francs,
and swap payments are annual. The Swiss firm contracted to pay dollars and receive francs. The
market conditions are now (exactly four years later) as follows:
Spot exchange rate: 2.00 Swiss francs/U.S. dollar.
Term structure of zero swap rates:
Maturity Years U.S. Dollar % (ann.) Swiss Franc % (ann.)
1 9 5
2 9.5 5.75
3 10 6
4 10.25 6.25
5 10.75 6.5
6 11 7
7 11.5 7.5
a. What should the swap payment (receipt) be at the end of the fourth year, that is, today?
b. Right after this payment, what is the swap market value for the Swiss firm?
Solution
a. Each year, the company receives SFr and pays $. Given the interest rates as of the signature of
the swap contract (8% in $ and 4% in SF), the balance for year four is the following:
 Receipt of SFr 10 (250 4%) million.
 Payment of $8 (100 8%) million, or SFr 16 (8 2) million.
The net cash flow is 10 16 = SFr 6 million. The company has to pay SFr 6 million on year
four.
b. Right after the fourth payment, the market value of swap, V, is:
V = P
SF
spot SFr/$ P
$
where
P
SF
is a SFr 250 million threeyear bond with a SFr 10 million annual coupon.
P
$
is a $100 million threeyear bond with a $8 million annual coupon.
Hence, we have:
2 3 2 3
10 10 260 8 8 108
2 .
1.05 (1.0575) (1.06) 1.09 (1.095) (1.1)
V
(
= + + + +
(
V = SFr 46.46 million
V = $23.23 million
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 133
25. A small French bank has the following balance sheet, based on historical (nominal) values.
Assets Liabilities
Loan of 100 million: Debt of 50 million:
3 years, @ 3month Euribor + 5year maturity, @ 10%
Net worth: 50 million
All assets and liabilities are denominated in euros. The net worth is calculated as the difference
between the value of assets and liabilities. The current interest rate term structure in euro is flat at 8%.
The risk premium over Euribor required on the loan to a client remains at 50 basis points.
a. Value the balance sheet based on market value.
b. The bank anticipates a sharp drop in French interest rates. Would this drop be good for the bank?
The current market conditions for interest rate swaps with a maturity of three or five years are 8%
against Euribor.
c. Assume that the bank simply wishes to immunize its market value against any movements in
interest rates (drop or rise). What swap would you make to hedge this interest rate risk?
d. Assume that the bank is quite confident in its interest rate prediction (a drop). What would you
suggest?
The next day, all interest rates drop to 7%.
e. Value the balance sheet again, assuming that the floating rate debt remains at 100% and that the
bank has undertaken the swap that you recommended. How much did the bank save by
undertaking this swap?
Solution
a. The market value of the asset (A) is that of a threeyear floating rate loan at Euribor + 1/2. Since
the current risk premium required for this type of client is still 50 basis points, the loan should
still be valued at 100%, or 100 million.
The market value of the liability L can be determined by using the current market rate of 8%.
L =
5 5
1 1 50
5 53.99
1.08 1.08 1.08
 
+ + + =

\ .
million.
The net worth V of the bank is now:
V = A L = 100 53.99 = 46.01 million.
b. This drop in interest rates is bad for the bank as the market value of its liability will rise, while
the market value of its assets would remain unchanged.
c. The item exposed to interest rate risk is the 50 million debt with a maturity of five years. Its
market value would rise if interest rates drop. The objective is to maintain the market value of
the equity (net worth of 46.01 million). Hence, the bank would enter into a fiveyear swap to
receive fixed and pay floating.
The remaining question is the amount of the swap. A swap of 50 million would transform the
cash flow on the debt from a fixed 10% to a floating Euribor + 2% (since the swap is 8% fixed
for Euribor). If the bank focuses on market values, it would be a better idea to contract for a swap
amount of 53.99 million, the current market value of the debt.
134 Solnik/McLeavey Global Investments, Sixth Edition
d. If the bank is quite confident in a drop in interest rates, it will swap more than the above amount
to speculate. This can be risky if the forecast is proved wrong.
e. Lets market value the balance sheet items and the swap (offbalance sheet):
A = 100 million
L =
5 5
1 1 50
5 56.15
1.07 1.07 1.07
 
+ + + =

\ .
million.
The net worth without the swap is V
0
:
V
0
= 100 56.15 = 43.85 million.
 If we had swapped 50 million, the value of the swap would now be:
Swap
1
=
5 5
1 1 50
4 50 2.05
1.07 1.07 1.07
 
+ + + =

\ .
million.
The net worth V
1
of the bank is therefore:
V
1
= 100 + 2.05 56.15 = 45.90 million.
The previous net worth of 46.01 million is almost preserved, but not fully.
 If we had swapped 53.99 million, the value of the swap would now be:
Swap
2
=
5 5
1 1 53.99
4.32 53.99 2.21
1.07 1.07 1.07
 
+ + + =

\ .
million.
The net worth V
2
of the bank is therefore:
V
2
= 100 + 2.21 56.15 = 46.06 million.
The hedge is better, as the result is very close to the initial market value of 46.01. The difference
between 46.01 and 46.06 comes from the fact that quoted swaps had a 8%fixed rate, while the
debt was written with a 10%fixed coupon. The interest sensitivities (duration) of the swap and of
the debt are not identical because they have different coupons, albeit the same maturity.
26. A small Dutch bank has the following balance sheet (in euros), based on historical or nominal values.
Assets Liabilities
Loan of 200 million: FRN borrowing of 150 million:
3 years, @ 7% @ 3month Euribor, 5year maturity
Net worth: 50 million
All assets and liabilities are denominated in euros. The bank borrows shortterm on the Eurocurrency
market. The bank and its client are AAA quality. The net worth is calculated as the difference
between the value of assets and liabilities. The current euro term structure for AAA borrowers is flat
at 6.5%.
a. Value the balance sheet based on market value.
b. Compute the interestrate sensitivity (duration) of the asset. Infer the interest rate sensitivity of
the net worth of the bank. For example, how much would stockholders lose if euro interest rates
moved up by 0.10%? (Assume that the interest rate sensitivity of an floatingrate note (FRN) is
zero, as the coupon is reset to the market interest rate.)
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 135
c. The bank fears a rise in all euro interest rates. The current market conditions for interest rate
swaps in euros are as follows:
 With a maturity of three years are: 6.5% against Euribor.
 With a maturity of five years are: 6.75% against Euribor.
What would you do to hedge this interest rate risk?
d. The next day, all interest rates move up to 8%. Value again the balance sheet, assuming that the
floatingrate debt remains at 100% and that the bank has undertaken the swap that you
recommended. Is the hedge perfect? Why?
Solution
a. Lets value the bank equity based on market values:
Assets = A = 14 (1/1.065 + 1/1.065 + 1/1.065
3
) + 200/1.065
3
A = 202.65.
The market value of the FRN remains constant:
Liabilities = L = 150
Net Worth = V = AL = 52.65 million.
b. The interest rate sensitivity (or duration
*
)
V
D
of the bank net worth comes from that of the asset.
We have:
, or
, or
dr 0, or .
V V
A A
L L
dV
D dr dV D V dr
V
dA
D dr dA D A dr
A
dL
D dL D L dr
L
= =
= =
= = =
Note that V = A L, and dV = dA dL.
So we get:
dV = dA dL =
A
D A dr +
L
D L dr =
V
D V dr
A
D A +
L
D L =
V
D V
hence
A A L L
V
D V D V
D
A V
.
In this case, the duration of the liability L is nil. The duration of the asset can be calculated as:
D
A
=
2 3
1 14 14 214 1
1 2 3
1.065 1.065 1.065 1.065 202.65
 
+ +

\ .
D
A
= 2.64.
D
V
=
202.65
2.64 10.15.
52.65
=
136 Solnik/McLeavey Global Investments, Sixth Edition
If Dutch interest rates move up by 10 basis points, the market value of the bank should drop by
101.5 basis points. The stockholders should lose:
dV = D
V
. V. dr = 10.15 52.65 0.10% = 0.53 million.
c. A rise in all euro interest rates would lead to a decrease in the market value of the banks assets,
liabilities being unchanged.
To hedge this risk, we should swap to pay fixed at 6.5% and receive floating with a maturity
of three years.
The amount of the swap should be the market value of the assets: 202.65 million.
(An adjustment could be made for the differences in sensitivities.)
d. Lets revalue the balance sheet:
A = 14 (1/1.08 + 1/1.08 + 1/1.08
3
) + 200/1.08
3
= 194.85
L = 150.
Offbalance sheet, the swap has taken a positive value:
Swap Value = 202.65 (13.17/1.08 + 13.17/1.08 + 215.82/1.08
3
)
Swap Value = 7.83.
Total market value:
V = A L + Swap Value = 194.85 150 + 7.83 = 52.68.
It is, hence, a good hedge as the market value remains very stable (52.68 instead of 52.65),
but not perfect because of usual assumptions of sensitivity.
27. A differential swap, or switch LIBOR swap, involves the LIBOR rates in two different currencies but
with both legs denominated in the same currency. A Japanese insurance company engages in a
differential swap whereby it receives the sixmonth Japanese yen LIBOR and pays the sixmonth U.S.
dollar LIBOR plus 50 bp but with both legs denominated in yen. No principal is exchanged at the end.
The current LIBOR for the yen and the dollar are 6% and 4%, respectively, and the principal is 100
million yen. Hence, the first swap payment will be based on a differential of 1.5% in yen [6% = (4% 0.5%)].
The current yield pickup is 150 bp. There is no currency risk on this swap.
Provide some intuitive explanation for the pricing of such a swap, knowing that at the time, the dollar
yield curve was very steep (longterm rates are much higher than shortterm rates) and the yen yield
curve was almost flat.
Solution
This is not an easy task. Some preliminary remarks can be useful.
a. In a standard floatingforfloating currency swap, the terms would be yen LIBOR against dollar
LIBOR flat. The 50basispoint addition on the dollar LIBOR of the differential swap comes
from the fact that all cash flows on the dollar leg (interest and principal) are denominated in yen,
not in dollars.
b. The forward exchange rates reflect the differences in the two interest rates term structures. This
impacts on the pricing of the differential swap.
The difficulty in valuing a differential swap is the valuation of the dollar LIBOR (in yen) leg. The
fair spread to add (here 50 basis points) is the spread that makes the market value of this leg equal
to the market value of the yen LIBOR leg. The basic pricing idea is to replicate the dollar LIBOR
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 137
(in yen) leg by using forward dollar LIBOR rates and forward /$ exchange rates. This is detailed in
R. Litzenberger, Swaps: Plain and Fanciful, Journal of Finance, July 1992 (pages 842844).
28. You are an investment banker working in Switzerland where yields are very low (1% for all maturities).
You are planning to offer a fiveyear Swiss franc/British pound bond with the following characteristics:
 Issuer: Brit Ltd., a topquality British company.
 Issue amount: SFr 100 million.
 Coupon in SFr: 5% (or SFr 5 million).
 Reimbursed value: 40 million.
This bond qualifies as a Swiss franc bond for the portfolio of a Swiss insurance company.
The current spot exchange rate is 2.5 Swiss francs per British pound. The yield curve in British
pounds is flat at 7%. The pound/franc swap rates are 7% in pounds against 1% in francs for all
maturities.
a. Assume that Swiss insurance companies can account for their Swiss franc bond holdings
at historical costs. Give a reason why it would be attractive to invest in this bond.
b. Is the coupon rate set at fair pricing (i.e., consistent with current market conditions)?
c. The British company desires to borrow in pounds and does not wish to carry any currency risk on
its debt. The investment banker needs to design a coupon swap that would hedge the currency
risk on that dualcurrency bond for Brit Ltd. The designed swap should have a zero value at time
of contracting. Give one possible design for the swap and calculate its associated swap rate.
d. What is the pound yield paid by the British company, once it has hedged its currency risk on the
dualcurrency bond using the swap described above? What is the annual costsaving in British
pounds compared to a straight pound bond?
Solution
a. The bond seems attractive to Swiss institutional investors because it offers a higher SFr coupon
than a straight bond in Swiss francs. The annual income statement will show a higher income
than if the insurance company had subscribed to a straight Swiss franc bond (yield 1%).
b. The coupon C consistent with fair pricing is such that:
5
1
40
100 2.5
(1.01) (1.07)
t t
t
C
=
= +
hence a coupon rate of 5.91%.
If we value the bond at fair market value we find that it should be priced below par at 95.57%.
c. Brit Ltd. needs to swap the stream of Swiss franc coupons of SFr 5 million cash flow into a
stream of pounds coupon cash flows. A plainvanilla currency swap (1% in francs against 7% in
pounds) would not do it, because there are no reimbursement values to be swapped. We need
to do a couponswap where the SFr leg is a stream of SFr 5 million annual cash flow, and the
leg is a stream of X million annual cash flow. As the swap has a zero value at time of
contracting, we get:
5 5
1 1
5
0 2.5
(1.01) (1.07)
t t
t t
X
= =
=
hence X = 2.37 million or a rate of x = X/40 = 2.37/40 = 5.92%.
138 Solnik/McLeavey Global Investments, Sixth Edition
So this is a couponswap with a 1% swap rate on the SFr leg and a 5.92% swap rate on the leg.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 139
d. Brit Ltd. needs to get into a fiveyear swap to receive the SFr coupons and pay the coupons.
This is a swap to receive annually SFr 5 million and pay annually 2.37 million. The sum of
issuing the dualcurrency bond and entering into the swap will yield annual cash flows of
2.37 million and a final reimbursement of 40 million. The allincost on the 40 million bond
is an interest rate in pounds of 5.92%; hence, a reduction of 1.08% = 7% 5.92% in borrowing
cost, or an annual cost savings of 0.432 million.
29. Assume that an AAA customer pays 8% on a fiveyear loan and can contract a fiveyear interest
rate swap (paying fixed) at 8% against LIBOR. Assume that a BBB customer pays (8 + m)% on a
fiveyear loan and can contract a fiveyear interest rate swap (paying fixed) at (8 + )% against
LIBOR. Should a customer pay the same creditquality spread (m and ) on a loan and on a swap?
Solution
No. The bank writing both contracts stands to lose a much greater amount on the loan than on
the swap.
On the loan, the bank stands to lose all interest payments (8 + m)% plus the principal of 100%. On the
swap, the bank stands to lose only an interest rate differential (fixed minus floating) and no principal.
Furthermore, if the floating rate rose above the fixed rate, the bank would have to pay the difference
anyway, so the default of the other party does not worsen the situation.
The creditquality markup on the swap should be much smaller than on the loan m.
30. The current market conditions for an AAA client are 8% on a oneyear dollar loan, and 8% fixed U.S.
dollars for 9% fixed British pounds on a oneyear dollar/pound currency swap. Lets consider a BBB
client borrowing at (8 + m)% on a oneyear dollar loan. The same client can enter a dollar/pound
currency swap, paying (8 + )% fixed dollars and receiving 9% fixed pounds. Assume that the
customer has a probability of p% to default within a year. In case of default, the bank knows that it
will recover nothing on either transaction. The probability of default p (e.g., 5%) is known and
independent of movements in interest and exchange rates. The spot exchange rate is S
0
= 1 $/.
Assuming that you can observe the prices of $/ currency options, suggest some approach to
determine the fair values of m and . (Assume that the bank has a large number of clients whose
probabilities of default are independent; therefore, the bank can diversify away the uncertainty of
default on this specific client.)
Solution
The bank writing both contracts (loan and swap) stands to lose much more on the loan than on the
swap in case of default.
Lets write the dollar cash flows for the bank, in a year, for a principal of $100 assuming an initial
exchange rate S
0
= 1 $/. Lets denote the spot exchange rate in a year as S
1
, in $/. All rates are
expressed for 100.
 Cash flows
a. Loan
if no default CF
1
= 100 + 8 + m
if default CF
2
= 0.
b. Swap
if no default CF
3
= 100 + 8 + 109 S
1
if default CF
4
= Min {0 ; 108+ 109 S
1
}.
140 Solnik/McLeavey Global Investments, Sixth Edition
Lets now discuss the valuation of the two contracts at time of contracting; that is, lets try to
determine the fair values of m and under the stated assumptions.
a. It is useful to start by outlining the valuation principles for a client without default risk
(m = = 0):
 Defaultfree loan
Lets call V(CF), the present value of a future cash flow CF. The current oneyear riskfree rates
are 8% in dollars and 9% in pounds. The dollar loan is issued at 100 such that:
100 = V(108) = 108/1.08.
 Defaultfree swap
The swap is written with a zero initial market value. Hence:
0 = V($108 109).
As seen in the text, the two legs of the swap can be valued separately and the leg is converted at
the initial spot exchange rate S
0
= 1 $/.
0 = V($108 109) = V($108) S
0
V(109)
0 =
108 109
1
1.08 1.09
.
b. Lets now turn to the valuation of the loan and swap in the presence of default risk:
 Risky loan
The loan is still issued at 100 with a rate of (8 + m)% and a risk p of full default. Given that the
uncertainty of default can be diversified across many clients, the valuation gives:
100 = (1 p) V(108 + m) + p 0
100 = (1 p)
108
1.08
m +
hence
m = 108 .
1
p
p
(10.1)
If p = 5%, m = 5.68.
The underlying idea is that the rate markup of m = 5.68% should compensate for the total loss on
the 5% clients who default. The extra charge on 95% of the clients offsets the principal and
interest rate loss on 5% of the clients.
Note that we discount cash flows at 8% because the uncertainty can be diversified away by the
bank across many clients.
 Risky swap
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 141
We make the additional assumption that default is unrelated to the final exchange rate S
1
. The swap is
still issued with a zero initial value. The valuation yields:
0 = (1 p) V(CF
3
) + p V(CF
4
) (10.2)
with
V(CF
3
) = V($108 + $ 109) = V($108 109) + V($)
V(CF
3
) = 0 +
1.08
V(CF
4
) = V(min{0; 108 + 109 S
1
})
V(CF
4
) = V(max{0; 109 S
1
(108+ )})
V(CF
4
) = 109 V(max{0; S
1
108
109
+
}).
Note that the last term is the value of a oneyear pound call option with a strike of
108
109
.
+
Remember
that the forward exchange rate quoted at the time of contracting is F = 108/109, so the strike is equal
to F (1 + /108). The term /108 is the present value, in %, of the markup .
Hence, Equation (10.2) can be rewritten as:
0 = (1 ) 109 CALL(?
1.08
p p
(10.3)
where the call has a strike of
108
109
+
.
From Equation (10.3), we derive:
= 1.08 109 CALL(?
1
p
p
. (10.4)
= m 1.09 CALL(). (10.5)
Equation (10.5) is somewhat misleading, as the markup enters the strike price of the call. So an
iterative procedure must be used to solve it for . To get some ballpark estimate, assume that a pound
call with a strike equal to the current forward exchange rate quotes at $0.04 (a reasonable figure).
Then a pound call written with a higher strike price, F(1+ /1.08), should quote slightly less than
$0.04. If it quoted $0.04 anyway, the fair value of would be:
= 5.68 1.09 0.04 = 0.25
or 0.25% of the principal.
Actually, the fair value of should be found to be slightly less than 0.25, because the call will be
worth slightly less than $0.04. Note that the creditquality markup on the swap is 20 times less than
on the loan (m = 5.68).
142 Solnik/McLeavey Global Investments, Sixth Edition
On an interest rate swap in a single currency, the fair value of the swap markup would be even less
because there cannot be any difference in principal at the end of the swap. On a currency swap, the
principals on the two legs are affected by currency movements. A formula similar to Equation (10.3)
could be found for an interest rate swap, with the option value being that of a floor on the variable
interest rate. See Solnik, Swap Pricing and Default Risk: A Note, Journal of International
Financial Management and Accounting, Spring 1990.
31. A traditional interest rate swap has a notional capital of 100 and exchange LIBOR (the floating leg)
against 6% (fixed leg). At maturity of the swap there is no capital exchange as the same notional
capital of 100 is exchanged on both legs. Assume that the swap has a fiveyear maturity.
A company needs to create an immediate cash flow to offset an immediate loss and decides to use an
amortizing swap. Its offbalance sheet items are accounted at their book or historical values. The
floating leg is LIBOR, paid quarterly, with a notional capital of 100. The fixed leg also has a notional
capital of 100, however, there is only an initial cash flow of X on the fixed leg of the amortizing swap
and no other cash flow (zero coupons). Hence, there is no capital exchanged at maturity of the swap
(capital identical on both legs). The swap is priced (the value of X is set) so that the initial swap value
is zero.
The company enters the amortizing swap to pay floating and receive fixed. In other words, its cash
flows on the swap are as follows:
 Receive X at time 0.
 Pays LIBOR every quarter for five years.
 No cash flow at maturity.
a. Why is the amortizing swap interesting for this company, which wants to windowdress an
immediate loss? How will it impact its future earnings?
b. The term structure is flat at 6%. What should be the fair value of X?
c. The company expects a loss of 10 million, what should be the notional capital of the amortizing
swap that should be contracted?
d. Assume now that the company must value all offbalance sheet items at their market value. What
would happen to the value of the swap immediately after the payment of X is received by the
company? Are amortizing swaps useful in deferring losses with this accounting convention?
Solution
a. The company will have an immediate income of X appearing in its income statement, while the
swap only appears in the offbalance sheet. This income will offset the expected loss. However, it
generates a stream of future expenses that will reduce future earnings.
b. Lets treat the amortizing swap as the difference between a floating and the fixed bond (initial
cash flow of X, zerocoupons, and identical reimbursement value 100%). The floating leg should
have a current value of 100%. The fixed leg will be priced so that it also has an initial value
of 100. Hence, 100% = X% + 100%/(1 + 6%)
5
X = 25.274% of the notional capital.
c. X should be set to 10 million. Hence, the notional capital = 10 million/25.274% =
39.566 million.
d. Right after the payment of X = 10 million , the value of the swap for the company would drop
from zero to 10 million. There is no advantage in window dressing.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 143
32. LTCM observed the following tenyear swap spreads on July 1, 1998. You remember that U.S. dollar
interest swaps (fixed rate against LIBOR threemonth) are quoted as a spread over the Treasury yield
(so the fixed rate on the swap is equal to the interest rate on Treasury bonds for the same maturity
plus the quote spread). LTCM believes that the normal spread is 40 bp (basis points). The current
spread of 80 bp is expected to converge back to normal in three months.
If you borrow securities, you have to deposit as collateral an equivalent amount of cash that is
markedtomarket. For example, if you borrow a security that is worth 100, you have to deposit 100;
if the value of the security increases to 110, you have to deposit 10 more. Swaps are also markedto
market and free of default risk.
a. What arbitrage using Treasury bonds and swaps could you put in place if you believe that the
spread will revert back to its normal level? Be very precise and assume you do the above
arbitrage for $100 million. How much of LTCM capital is invested in the arbitrage?
b. Suppose that the spread is still at 80 bp on October 1, but that Treasury yields have moved
up by 40 bp on October 1 (reset date for the floating leg). What is your gain/loss in dollars?
[You only need to provide a rough estimate assuming that the sensitivity (duration) on the
Treasury bond and fixed leg of the swap is equal to 10.]
c. Other scenario: How much would you gain (from July 1) if Treasury yields do not move, but
the spread reverts back to 40 bp three months later on October 1 (reset date for the floating leg)?
[You only need to provide a rough estimate assuming that the sensitivity (duration) on the
Treasury bond and fixed leg of the swap is equal to 10.]
Solution
a. I would borrow 100 million of Treasury bonds and sell them. The proceeds of the sale would be
used as a deposit. So, I am short in Treasury bonds. I would then swap for 100 million paying
LIBOR and receiving fixed (at a spread of 80 bp above the Treasury yield). There is no invested
capital by LTCM. But because of the risk, I would earmark some capital.
b. The value of the Treasury bonds decreases, so LTCM gains on its short position. I can proxy this
gain on the short Treasury bond position by a simple duration calculation. The return on Treasury
bonds is proxied by:
dP/P = D dr = 4 %.
Being short on bonds, this translates into a gain of 4% on the short position or a gain of
$4 million.
144 Solnik/McLeavey Global Investments, Sixth Edition
The value of the swap becomes negative because LTCM receives on the swap a fixed rate (old
Treasury yield plus 80 bp), which is smaller than the new swap rate (new Treasury yield plus
80 bp): the difference in yield is 40 bp. I could value the swap as the difference between a fixed
rate bond and an FRN. The value of the FRN is still 100 on reset date. The value of the fixed leg
goes down. I can proxy the loss by a simple duration calculation:
dP/P = D 0.40% = 4 %. The loss is $4 million.
The net result is that there is no gain or loss on the arbitrage.
c. The value of the short treasury bonds remains unchanged. The value of the swap becomes
positive because I receive Treasury yield plus 80 bp, while current market conditions are
Treasury plus 40 bp. I could value the swap as the difference between a fixedrate bond and an
FRN. The value of the FRN is still 100 on reset date. The value of the fixed leg goes up. I can
proxy this gain by a simple duration calculation:
dP/P = D 0.40% = 4 %. The gain is $4 million.
Hence, the net gain is $4 million.
33. If the average premium on gold call options declines, does this mean that they are becoming
undervalued and, therefore, should be bought? Using valuation models, give at least two possible
reasons for this decline.
Solution
Probably not.
The premium on a gold call could decline because:
 The price of gold declines,
 the shortterm interest rate drops,
 the perceived volatility of the price of gold declines,
 the time to expiration declines.
In all four cases, the fair market value of the option will go down.
34. The average premium on currency calls has decreased, whereas the premium on currency puts has
increased. What explanations can you provide?
Solution
This phenomenon could have several causes:
 The value of the underlying currency, that is, the spot exchange rate, has gone down. This would
be the major reason for the described phenomenon.
 A change in the interest rate differential, domestic minus foreign.
 A change in the volatility of the underlying spot exchange rate would affect both puts and calls in
the same direction and therefore cannot explain this phenomenon.
35. You will receive $10 million at the end of June and will invest it for three months on the Eurodollar
market. The current threemonth Eurodollar rate is 6%, and you are worried that the rate will drop by
the end of June. Here are some market quotes:
 Eurodollar LIBOR futures, June delivery: Price 94%.
 Call eurodollar, June expiration, strike price 94%: Premium 0.4%.
 Put Eurodollar, June expiration, strike price 94%: Premium 0.4%.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 145
The contract sizes are $1 million.
a. Should you buy or sell futures to hedge your interest rate risk?
b. Should you buy (or sell) calls (or puts) to insure a minimum rate at the time you will invest your
money? What is this rate?
c. In June, the Eurodollar rate has moved to 4%. What is the result of your strategies using futures
and using options?
d. What if the rate is equal to 8% in June?
Solution
a. You should buy Eurodollar futures and thereby freeze a 6% investment rate.
b. You should buy Eurodollar calls and thereby insure a minimum investment rate of: 6.0%
0.4% = 5.6%. But you might invest at a higher rate if the interest rate is higher than 6% at the
end of June.
c. If the Eurodollar rate moves down to 4%:
 You will be able to invest at 6% in the strategy of buying futures,
 and you will be able to invest at 5.6% in the strategy of buying calls.
d. If the Eurodollar rate moves to 8%:
 You will be able to invest at 6% in the first strategy,
 and you will be able to invest at 8.0% 0.4% = 7.6% in the second strategy.
36. The French futures market, MATIF, trades Euribor contracts. The Euribor is the threemonth
interbank interest rate on euros. The contract size is 1 million, and the margin is 3,000. On
January 10, March futures trade at 90.74%. Options on the Euribor futures contract are also listed.
The premiums (in %) on March options are as follows:
Strike Price Call Put
90.40 0.30 0.06
90.80 0.17 0.18
91.00 0.09 0.34
A few days later (January 14), the futures price moves to 89.50.
a. What is the gain or loss, in euros, for someone who sold a futures contract on January 10?
b. What is the return, as a percentage of the initial investment (margin)?
c. Are all option premiums quoted on January 10 reasonable?
d. You know that you will have to borrow 10 million in March and fear a rise in interest rates.
What are the maximum borrowing rates that you can insure using the various options?
e. To cap your borrowing rate, you decide to use options with a strike price of 90.80. How many
calls (or puts) should you buy (or sell)?
On January 14, the premium on the call March 90.80 moves to 0.02, and the premium on the put
March 90.80 moves to 1.33.
f. What is the profit (or loss) on your option position?
g. What is the rate of return on your option position?
146 Solnik/McLeavey Global Investments, Sixth Edition
Solution
a. The futures price moves to 89.50. The total gain or loss on a contract is equal to:
Gain (loss) = (futures price variation/4) size of contract
Gain =
(90.74 89.50)% 1,000,000
4
Gain = 3,100.
b. It is equivalent, in percentage of initial investment, to 3,100/3,000 = 103.33%
c. No, the options intrinsic values are the following:
Call Put
Strike 90.40 0.34 0.00
Strike 90.80 0.00 0.06
Strike 91.00 0.00 0.26
The 90.40 calls premium (0.30) is lower than its intrinsic value (0.34). Thus, the premium is
unreasonably low.
d. In order to insure a maximum interest rate, you have to buy a put. The maximum interest rates
you can insure by using the various options are the following:
Put 90.40: 9.60 + 0.06 = 9.66%.
Put 90.80: 9.20 + 0.18 = 9.38%.
Put 91.00: 9.00 + 0.34 = 9.34%.
e. The contracts size being 1 million, 10 puts must be bought in order to cap your interest rate on
a 10 million borrowing.
f. Profits (losses) in euros are the following:
0.18% 10 1,000,000
Cost 4,500.
4
= =
So, the return is, in percentage of initial investment, to 28,750/4,500 = 638.89%
37. You are currently borrowing 10 million at threemonth Euribor + 75 basis points. The Euribor is
at 3%. You expect to borrow this amount for five years but are worried that Euribor will rise in the
future. You can buy a 4% cap on threemonth Euribor over the next five years with an annual cost of
0.75% (paid quarterly). Describe the evolution of your borrowing costs under various interest rate
scenarios (i.e., above and below 4%).
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 147
Solution
Lets study the net cash flow on each semiannual payment date:
If Euribor < 4%
The cap is worthless.
The annualized borrowing cost = interest rate on loan + premium paid for the option = Euribor +
0.75% + 0.75% = Euribor + 1.5%.
The dollar cost = (Euribor + 1.5%)(10,000,000).
If Euribor > 4%
The cap pays the option holder the difference between Euribor and 4%.
The annualized borrowing cost = interest rate on loan + premium paid for the option + 4%
Euribor = Euribor + 0.75% + 0.75% + 4% Euribor = 5.5%.
The dollar cost = (5.5%)(10,000,000) = 550,000.
Thus, the interest rate cap ensures that borrowing costs are never higher than 5.5% per year.
38. You would like to protect your portfolio of British equity against a downward movement of the
British stock market.
a. What are the relative advantages of stock index futures and options?
b. Should you prefer inthemoney or outofthemoney options?
Solution
a. Futures allow removal of the uncertainty on the future value of the stock index, both up and
down. Put options on the index allow protection of your portfolio of British equity in case of a
fall in the stock market while retaining your upside potential; there is a cost associated with this
asymmetric insurance characteristic.
b. An inthemoney put gives a better downside protection than does an outofthemoney put but it
reduces the upside potential more.
39. The current dollar yield curve on the dollar international bond market is flat at 7% for topquality
borrowers. A company of good standing can issue plainvanilla straight and floatingrate dollar bonds
under the following conditions:
 Bond A: Straight bond. Fiveyear straight dollar bond with a coupon of 7.25%.
 Bond B: FRN. Fiveyear dollar FRN with a semiannual coupon set at LIBOR plus 0.25% and
a cap of 14%. The cap means that the coupon rate is limited to 14% even if the LIBOR passes
13.75%.
An investment banker proposes to a French company to issue bull and/or bear FRNs under the
following conditions:
 Bond C: Bull FRN. Fiveyear FRN with a semiannual coupon set at: 13.75% LIBOR.
 Bond D: Bear FRN. Fiveyear FRN with a semiannual coupon set at: 2 LIBOR 7% and a cap
of 20.5%.
Coupons on all bonds cannot be negative. The investment bank also proposes a fiveyear floor option
at 3.5%. This floor will pay to the French company the difference between 3.5% and LIBOR, if it is
positive, or zero if LIBOR is above 3.5%. The cost of this floor is spread over the payment dates and
148 Solnik/McLeavey Global Investments, Sixth Edition
set at an annual 0.1%. The investment bank also proposes a fiveyear cap option at a strike of 13.75%.
The cost of this cap is spread over the payment dates and set at an annual 0.05%. The company can
also enter into a fiveyear interest rate swap at 7% fixed against LIBOR.
a. Explain why it would be attractive to the French company to issue these FRNs compared to
current market conditions for plainvanilla straight bonds and FRNs.
b. Find out the borrowing cost reduction that can be achieved by issuing bull notes compared to a
fixedcoupon rate of 7.25%.
c. Find out the borrowing cost reduction that can be achieved by issuing bear notes compared to an
FRN at LIBOR plus 0.25%.
Solution
a. There are many ways to combine the bonds to illustrate the advantage of the bull and bear notes
for the issuers. Lets assume that the company issues both notes in similar amounts. As long as
LIBOR stays between 3.50% and 13.75%, the coupon on the sum of a bear and a bull note is:
Coupon
1
= (13.75% LIBOR) + (2 LIBOR 7%) = LIBOR + 6.75%.
This is better than issuing a straight bond plus a FRN:
Coupon
2
= (LIBOR + 0.25%) + (7.25%) = LIBOR + 7.5%.
If LIBOR is above 13.75%, the coupons become:
Coupon
1
= 0 + 20.5% = 20.5%.
Coupon
2
= 7.25% + 14.00% = 21.25%.
If LIBOR is below 3.5%, the bull and bear can become more costly because of the fact that the
coupon on the bear FRN cannot be negative. To cover this risk, the issuer should buy two 3.5%
floor options from the bank, with an annual cost of only 0.2%. This is still cheaper than issuing
Bond A plus Bond B.
b. Lets see how we could use the bull and bear notes to get into a fixedrate borrowing at a cost
inferior to 7.25%.
The idea is to combine a bull FRN plus a swap:
 Issue the Bull FRN,
 and swap to pay LIBOR and receive fixed 7%.
As long as LIBOR remains below 13.75%, the net annual cost will be:
Coupon
3
= (13.75% LIBOR) + (LIBOR 7%) = 6.75%.
To be protected against the risk that LIBOR will go above 13.75%, the company should buy a
LIBOR cap at 13.75% from the bank. The cost of this outofthemoney cap (current LIBOR
around 7%) is extremely low and equal to 0.05%. The net result is a cost of 6.80%, or a cost
reduction of 0.45% compared to a direct issue of a straight bond at 7.25%.
c. To replicate the plainvanilla FRN, the company could:
 Issue a Bear FRN,
 swap to pay fixed 7% and receive LIBOR,
 or buy two LIBOR floors at 3.5%.
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 149
The net annual cost will be:
Coupon
4
= (2 LIBOR 7%) + (7% LIBOR) + 0.2% = LIBOR + 0.2%.
This is a 0.05% cost reduction compared to Bond B. The cost reduction will be even greater if
LIBOR goes over 13.75% because of the cap on a bear FRN coupon.
40. The current yield curve on the international bond market in euro is flat at 4% for topquality
borrowers. A French company of good standing can issue plainvanilla straight and floatingrate
bonds at the following conditions:
 Bond A: Straight Bond. Fiveyear straight bond with a fixed coupon of 4%.
 Bond B: FRN. Fiveyear dollar FRN with a semiannual coupon set at LIBOR.
An investment banker proposes to the French company to issue bull and/or bear FRNs at the
following conditions:
 Bond C: Bull FRN. Fiveyear FRN with a semiannual coupon set at:
7.60% LIBOR.
 Bond D: Bear FRN. Fiveyear FRN with a semiannual coupon set at:
2 LIBOR 4.2%.
The floor on all coupons is zero. The investment bank also proposes a fiveyear floor option at a
strike of 2.1%. This floor will pay to the French company the difference between 2.1% and LIBOR, if
it is positive, or zero if LIBOR is above 2.1%. The cost of this floor is spread over the payment dates
and set at an annual 0.05%. The bank also proposes a fiveyear cap at a strike of 7.60%. The annual
premium on the cap is 0.1%. The company can also enter in a fiveyear interestrate swap 4% fixed
against LIBOR.
a. Assume that the French company issues Bonds C and D in equal proportions. Is it more
advantageous than issuing Bonds A and B in equal proportion and why?
b. Find out the borrowing cost reduction that can be achieved by issuing the bull note compared to
issuing a fixedcoupon straight bond at 4%.
c. Find out the borrowing cost reduction that can be achieved by issuing the bull note compared to
issuing a plainvanilla FRN at LIBOR.
d. Find out the borrowing cost reduction that can be achieved by issuing the bear note compared to
issuing a fixedcoupon straight bond at 4%.
e. Find out the borrowing cost reduction that can be achieved by issuing the bear note compared to
issuing a plainvanilla FRN at LIBOR.
Solution
a. It is more advantageous as the average cost is (3.40% + LIBOR)/2 as opposed to (4% + LIBOR)/2.
However, one must be careful:
 If LIBOR > 7.60% the average cost is (0 + 2 LIBOR 4.2%), which can be larger than
(4% + LIBOR)/2.
 If LIBOR < 2.1% the average cost is (7.6% LIBOR)/2, which can be larger than
(4% + LIBOR)/2.
150 Solnik/McLeavey Global Investments, Sixth Edition
To eliminate these risks the company should issue C + D and buy two floors at 2.1% and a
cap at 7.6%, then the total cost is:
(7.60% LIBOR + 0.1%) + (2 LIBOR 4.2% + 2 0.05%)/2 = (3.40% + LIBOR + 0.2%)/2.
This is still better than A + B.
b. Issue the bull, swap receive fixed pay LIBOR, and buy a cap at 7.6%. Total annual coupon:
(7.60% LIBOR) + (LIBOR 4%) + 0.1% = 3.70% or a 0.30% cost reduction.
c. Issue the bull, swap twice the amount to receive fixedpay LIBOR, and buy a cap at 7.6%.
Total annual coupon:
(7.60% LIBOR) + 2 (LIBOR 4%) + 0.1% = LIBOR 0.30% or a 0.30% cost reduction.
d. Issue the bear note, swap twice the amount to pay fixed and receive LIBOR, buy two floors at 2.1.
Total coupon:
(2 LIBOR 4.2%) + 2 (4% LIBOR) + 2 0.05% = 3.9% or a 0.10% cost reduction.
e. Issue the bear note, swap to pay fixed and receive LIBOR, buy two floors at 2.1. Total coupon:
(2 LIBOR 4.2%) + (4% LIBOR) + 2 0.05% = LIBOR 0.1% or a.10% cost reduction.
41. The Kingdom of Papou issues a verybull bond with a coupon equal to:
14.6 2 LIBOR.
Of course, the coupon cannot be negative.
The Kingdom could have issued a FRN at LIBOR + %, or a straight bond at 5.30%.
The current market conditions for swaps are 5% against LIBOR.
You could also trade in caps and floors with different exercise prices (these are levels of interest
rates). The premium are paid annually.
Exercise
Interest Rate
Annual Premium
Cap Floor
7.3 % 0.2 % 2%
14.6 % 0.1 % 10 %
a. You are a buyer of this verybull bond. Tell us what it is equivalent to, in terms of buying/selling:
FRN, straight bonds, caps or floors.
b. Assume that the Kingdom actually wanted to issue a straight bond (fixed coupon). The bank will
put in place a demining portfolio with swaps and options so that this verybull bond plus the
demining portfolio is equivalent to a straight bond. What is exactly the demining portfolio?
(Be very precise and tell us if the Kingdom must pay fixed, receive LIBOR or vice versa, etc.)
c. What is the cost advantage for the Kingdom compared to issuing bonds at 5.30%?
d. Same question assuming that the Kingdom wanted to issue an FRN at LIBOR + %?
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 151
Solution
a. For the investor, this is equivalent to:
 Long in three straight bonds.
 Short two FRNs.
 Long two caps with a strike of 7.3%.
b. To transform the verybull bond into a straight bond, the issuer needs to do the following:
 Issue the verybull for a capital of 100.
 Swap 200 to pay LIBOR and receive 5%.
 Buy 200 of caps with strike of 7.3% at a cost of 0.4%.
c. The net result is a fixed cost of 5%, or a savings of 30 bp.
d. To transform the verybull bond into an FRN, the issuer needs to do the following:
 Issue the verybull for a capital of 100.
 Swap 300 to pay LIBOR and receive 5%.
 Buy 200 of caps with strike of 7.3% at a cost of 0.4%.
The net cost is LIBOR, or a savings of 25 bp.
42. Bank PAPOUF decides to issue two bonds and wonders what the fair interest rate on these bonds
should be:
A. A oneyear currency option bond. The bond is issued in dollars with a face value of $100. The
bondholder can choose to have the coupon and principal paid in dollars or in SFr, at a specified
exchange rate of SFr/$ = 2, that is, receive either $100 or SFr 200 as principal repayment, and
receive either $C or SFr 2C as interest if C is the coupon set in dollars. The coupon rate is
c = C/100.
B. A twoyear currency option bond. The bond is issued in dollars, with a face value of $100 and
pays an annual coupon C'. The bondholder can choose to have the coupons and principal paid in
dollars or in SFr, at a specified exchange rate of SFr/$ = 2, that is, receive either $100 or SFr 200
as principal repayment, and receive either $C' or SFr 2C' as interest, if C' is the coupon set in
dollars. The coupon rate is c' = C'/100.
Current market conditions are given below:
 Interest Rates 1Year 2Year
Zerocoupon rates
US$ 8% 8%
SFr 4% 4%
 Spot exchange rate: SFr/$ = 2
 Currency options:
SFr call, strike price 50 U.S. cents, expiration one year: 2 U.S. cents.
SFr call, strike price 50 U.S. cents, expiration two years: 5 U.S. cents.
a. Compute the coupon C on Bond A that would be consistent with market conditions at time of
issue.
b. Compute the coupon C' on Bond B that would be consistent with market conditions at time of
issue.
152 Solnik/McLeavey Global Investments, Sixth Edition
Solution
a. The oneyear currency option bond can be valued as the sum of:
 A zerocoupon oneyear bond paying $(100 + C) in one year,
 and a currency option to exchange $(100 + C) for SFr (200 + 2C) in one year.
Hence, buying Bond A is equivalent to buying a zerocoupon oneyear bond paying $(100 + C)
in one year, plus buying 2 (100 + C) SFr calls with a strike of $0.50.
Hence
100
100 2(100 ) 0.02
1.08
$3.53.
C
C
C
+
= + +
=
Then the coupon rate is: c = 3.53%.
b. The twoyear currency option bond can be valued as the sum of:
 A zerocoupon oneyear bond paying $C' in one year,
 a zerocoupon twoyear bond paying $(100 + C') in two years,
 a oneyear SFr call option to exchange $C' for 2C' SFr,
 and a twoyear SFr call option to exchange $(100 + C') for 2 (100 + C' ) SFr.
Hence
100
100 0.04 0.10 (100 )
2
1.08
1.08
' $2.22.
C C
C C
C
' ' +
' ' = + + + +
=
And a coupon rate c' = 2.22%.
43. Titi, a Japanese company, issued a sixyear international bond in dollars convertible into shares of the
company. At time of issue, the longterm bond yield on straight dollar bonds was 10% for such an
issuer. Instead, Titi issued bonds at 8%. Each $1,000 par bond is convertible into 100 shares of Titi.
At time of issue, the stock price of Titi is 1,600 yen, and the exchange rate is 100 yen = 0.5 dollars
($/ = 0.005, /$ = 200).
a. Why can the bond be issued with a yield of only 8%, below the market rate for straight dollar
bonds?
b. What would happen if:
 The stock price of Titi increases?
 The yen appreciates?
 The market interest rate of dollar bonds drops?
A year later, the new market conditions are as follows:
 The yield on straight dollar bonds of similar quality has risen from 10% to 11%.
 Titi stock price has moved up to 2,000.
 The exchange rate is $/ 0.006.
c. What would be a minimum price for the Titi convertible bond?
d. Could you try to assess the theoretical value of this convertible bond as a package of other
securities, such as straight bonds issued by Titi, options or warrants on the yen value of Titi stock,
and futures and options on the dollar/yen exchange rate?
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 153
Solution
a. This low yield is compensated by the conversion option clause.
b. The effects are the following:
 If the stock price of Titi in yen appreciates, so does the dollar price of the convertible bond.
 If the yen appreciates so does the dollar price of the convertible bond.
 If the market interest rate of dollar bonds drop, the dollar price of the convertible bond goes
up.
c. The valuation of such a bond is fairly complex. However, it should sell at least for its conversion
value: 100 2,000 0.006 = $1,200.
d. This is a very difficult exercise. In theory it would require the use of the valuation of options on
options. The problem comes from the fact that the conversion value of the bond is uncertain;
therefore, it is not possible to use conventional currency futures or currency options to hedge the
currency risk. The amount to hedge is variable.
44. Strumpf Ltd. decides to issue a convertible bond with a maturity of two years. Each bond is issued
with a nominal value of 100 and an annual coupon C; of course, C has to be determined. Each bond
can be redeemed for 100 or converted into one share of Strumpf at the option of the bondholder.
The current stock price of Strumpf is 90. The yield curve for an issuer like Strumpf is flat at 6%.
Barings is ready to issue longterm options on Strumpf shares. The premiums on calls with oneyear
and twoyear expirations are given below:
Strike
Price
EuropeanType AmericanType
1Year 2Year 1Year 2Year
90 11 16 12 17
100 6 8 6.5 9
a. Americantype calls are more expensive than Europeantype calls. Is it reasonable?
b. Assume that the bond can only be converted at maturity, after payment of the second coupon.
What should be the fair coupon rate C, consistent with the above market conditions?
c. Assume that the bond is issued with the coupon rate determined above. The yield curve suddenly
moves from 6% to 6.1% and the option premiums stay the same. What should be the new market
price of the convertible bond?
d. Assume now that the bond can be converted on two dates (rather than one as above). These dates
are the first year (right after the first coupon payment) and the second year as above. It is not
possible to convert the twoyear bond at any other date. Is it possible to construct an arbitrage
portfolio allowing to price the fair coupon C with the above data? Be precise in your explanation
and state what type of options you would need to price the bond.
Solution
a. Americantype calls give the investor the possibility (but not the obligation) to exercise the
option at any time before maturity. This possibility, which offers additional profit opportunities,
justifies an additional price.
b. The twoyear convertible bond can be valued as the sum of:
 A oneyear zerocoupon bond paying C at maturity,
 a twoyear zerocoupon bond paying (C + 100),
 and a twoyear Europeantype call (strike = 100).
154 Solnik/McLeavey Global Investments, Sixth Edition
As a result, the value of this portfolio must be equal to the value of the newly issued convertible
bond.
2
100
100 8
1.06 1.06
? 1.64.
C C
C
+
= + +
=
Hence, the fair coupon rate, C, is equal to 1.64%.
c. The new market price of the convertible bond is:
2
1.64 101.64
8 99.83.
1.061 1.061
P = + + =
d. The bond is now convertible either after the first coupon (one year) or after the second coupon
(two years). Lets imagine that the bond is converted after one year. Thus, it no longer exists. It
would therefore be incorrect to replicate this convertible bond with a oneyear zerocoupon bond
paying C, a twoyear zerocoupon bond paying 100 + C, a oneyear European type call
(strike = 100), and a twoyear European type call. Besides, if the bond is converted after the first
coupon, the implicit strike price of this conversion right is the value of the bond (without the
conversion right) after the first coupon. This value cannot be known in advance. All we know is
the conversion price after the second coupon, which is 100.
45. In 1990, the French bank, BNP, issued exchangeable bonds denominated in French francs (FF).
These are bonds issued for FF 100 on April 1, 1990, with an annual coupon of FF 5, plus an exchange
right. The bonds can be redeemed for FF 100 on April 1, 1996. The right can be exchanged on
April 1, 1991, with payment of an additional FF 100, for another bond identical to the old bond
(annual coupon of FF 5 and redeemed for FF 100 on April 1, 1996). If you exercise your right, you
will have paid an additional FF 100 on April 1, 1991, but you will then hold two BNP bonds with
maturity in 1996.
a. Under what scenario would you exercise the exchange right (exchange the right plus FF 100 for
an additional bond) on April 1, 1991? What is the attraction of such an exchangeable bond for
investors?
b. On April 1, 1990, the yield curve is flat at 6%. You can buy a call on a fiveyear bond with a
coupon of 5%. The call has a strike price of 100% and expires on April 1, 1991. Its premium is
2%. Construct a replication portfolio to determine at what price the exchangeable bond can be
issued by BNP.
Solution
a. The option is exercised on April 1, 1991, if the current market price of the BNP bond is more
than FF 100. Thus, using such an option is interesting in the case of a sharp fall in interest rates.
This bond allows the investor to speculate on a drop in interest rates with only limited risk.
b. The cash flows of this exchangeable bond can be replicated by a portfolio including a sixyear
5%coupon bond and a oneyear call option on this bond (strike = 100). Consequently, the value
of the newly issued exchangeable bond (P) is equal to the value of this portfolio:
P =
5 6
5 5 105
2 97.082.
1.06 1.06 1.06
+ + + + =
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 155
46. Digital options: Digital (or binary) options can only have two payoffs at maturity. If the strike
condition set in the option is met, the buyer will receive the full prespecified payoff. If not, the buyer
receives no payoff. This is different from a traditional option where there exists an infinite number of
payoffs. For example, we could have a digital option on the French CAC index, stating that the option
buyer will get 200 if the CAC index is above 4,000 at expiration and zero otherwise. On this digital
option, the buyer will get exactly 200 as soon as the CAC index is above the 4,000 level at expiration,
whether it be 4,001, 4,100, or 5,000.
a. Draw the profit and loss curve at expiration as a function of the CAC index for these two options:
 Traditional call on the CAC index: Exercise price: 4,000; premium: 40.
 Digital call on the CAC index: Exercise price: 4,000; payoff if exercised: 200; premium: 40.
b. What are the relative advantages of the two options?
c. Assume that the volatility of the French stock market increases suddenly. Should the premium on
the digital call increase more (or less) than the premium on the traditional call?
Solution
a. Profit and loss simulation at expiration:
4 0 0 0 4 1 0 0 4 2 0 0
 4 0
4 0
1 6 0
8 0
1 2 0
d i g i t a l
t
r
a
d
i
t
i
o
n
a
l
C A C i n d e x a t m a t u r i t y
P r o f i t
b. On a digital option, the fixed 200 payoff will be paid if the CAC index is above 4,000 at maturity.
Thus, the digital option is preferable to a traditional option if a small movement
above 4,000 is expected. However, a traditional option remains preferable if a large upswing
is anticipated.
c. The holder of a traditional option has more to gain from large movements in the index. Hence,
the value of a traditional call will increase more than the value of a digital call if the volatility of
the index increases.
47. Guaranteed note.
You are a young banker offering a client to issue a guaranteed note. The yield curve is flat at 9% for
each maturity. Options on the stock index are offered by banks. A atthemoney call with a twoyear
maturity trades at 12% of the index value, whereas a threeyear call is worth 15% of the index.
You wonder about the characteristics of the bond. If you offer a high coupon, the indexation will be
low. Therefore, you decide to compute the indexation levels in accordance to the current market
conditions for maturities of two and three years and coupon levels of 0%, 2%, and 5%.
156 Solnik/McLeavey Global Investments, Sixth Edition
Solution
The guaranteed note can be regarded as a fixedrate bond paying a coupon C and p calls on the index
(p being the indexation level).
For a twoyear bond we have:
2 2
100
100 15
1.09 1.09 1.09
15.832 1.759
.
15
C C
p
C
p
= + + +
=
For a threeyear bond we have:
2 3 3
100
100 18
1.09 1.09 1.09 1.09
22.782 2.531
.
18
C C C
p
C
p
= + + + +
=
The following table shows the indexation for different coupons and maturities:
Coupon p(2 Years) p(3 Years)
0% 105.55% 126.57%
2% 82.09% 98.44%
5% 46.91% 56.26%
48. You are a young investment banker considering the issuance of a guaranteed note with stock index
participation for a client. The current yield curve is flat at 8% for all maturities. Longterm atthe
money options on the stock market index are traded by banks. Twoyear atthemoney calls trade
at 17.84% of the index value; threeyear atthemoney calls trade at 20% of the index value. You
are hesitant about the terms to set in the structured note. You know that if you guarantee a higher
coupon rate, the level of participation in the stock appreciation will be less. Your boss asks you to
compute the fair participation rate that would be feasible for various guaranteed coupon rates and
maturities. In other words, based on the current market conditions (as described above), estimate the
participation rates that are feasible with a maturity of two or three years, and a coupon rate of: 0%,
1%, 2%, 3%, 5%, and 7%.
Solution
The guaranteed note can be decomposed as the sum of a straight bond with a coupon C plus p times a
call option on the index (p is the participation rate).
For a twoyear note, we have:
2 2
100
100 17.84
1.08 1.08 1.08
C C
p = + + +
hence
14.266 1.7833
.
17.84
C
p
=
Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 157
For a threeyear note, we have:
2 3 3
100
100 20
1.08 1.08 1.08 1.08
C C C
p = + + + +
hence
20.617 2.5771
.
20
C
p
=
The next table gives the fair participation rates for various coupon rates:
Coupon Rate p(2Year Bond) p(3Year Bond)
0% 80% 103%
1% 70% 90%
2% 60% 77%
3% 50% 64%
5% 30% 39%
7% 10% 13%
49. Youre a banker. A client wishes to buy a guaranteed note with a 100% indexation to the stock
indexs growth. In other words, he doesnt want any coupon but requires 100% of the index growth.
You wonder about the maturity of such a note. You check the prices of various index calls traded on
the market for different maturities. Their strike is the current index level and their price is expressed
as a percentage of this level. (For instance if the CAC is worth 3,000, the strike is 3,000 and the one
year maturity call trades at 11% of 3,000. You also check the price of a zerocoupon in percentage for
various maturities. The following graph shows, for each maturity, the price of the option, that of the
zerocoupon, and 100%zero.
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
0 2 4 6 8 10 12 14 16 18 20
Maturity
100Zero
Option
Zero
158 Solnik/McLeavey Global Investments, Sixth Edition
a. What is the maturity of the guaranteed note (coupon = 0%, indexation = 100%)? Justify.
b. If as a banker, you want to make a profit, should you lengthen or shorten the maturity of that note?
Explain why.
c. Everything remaining constant (that is, same volatility and interest rate), should the maturity of
the guaranteed note be shorter or longer if the index pays a low dividend rather than a high one?
Why?
Solution
a. We must take the intersection between the curves option and 100zero, that is, about four
years.
b. To make a profit, a longer maturity should be offered (sold at 100%) for the guaranteed note.
c. The buyer of index options or guaranteed note loses the dividend (compared to a spot buy).
If the dividend yield is high, the option price will be lower. Therefore, a shorter maturity can
be offered.