Investment Management True/false

Answers to Problem Sheet 8

Autumn Term 2013

1. If you hold a diversified portfolio of UK equities, then by entering into an equity index swap of the French equity index you can achieve much the same effect as liquidating the portfolio and buying a diversified portfolio of French shares without actually buying or selling any shares at all. . If a call option on a share expires with the share price below the stri!e, but you thin! it has good prospects, it is worth exercising the option and holding the share to profit from its future increase. ". If you hold an #merican call option on a non$dividend paying share that is in the money and you thin! it is going to fall, you should exercise the option immediately, and then sell the share. %. &y dynamic hedging you can ensure that your portfolio never goes below a certain value, even if the mar!et collapses, but still benefit from the upside if the mar!et rises. '. ()* contract fully protects bond holders against all losses in the value of the bonds.

Problems 1. +he F+*,$1-- index currently stands at '.--. "$month /I&01 is %2. +he dividend yield on the index over the next three months is predicted to be .'2 3continuously compounded annualised rate4. +he F+*,$1-- futures contract trades at 51-6point. +he three month call option with a stri!e of '% ' is trading at a price of "7.. 8hat is the theoretical price of the three month index futures contract9 If the futures contract were trading below the theoretical price, describe how you could trade to exploit the mispricing. *et out the costs and ris!s you are li!ely to face in trying to execute such a strategy. :ou are considering buying the three month put option with a stri!e of '% '. i4 8hat is the fair price of the option9 ii4 *hould the put option with a stri!e of '%.' be trading at a higher or lower price than the '% ' put9 iii4 If you observe the opposite in the mar!et, what trades could you do to ta!e advantage of the mispricing9 iv4 8ould there still be an arbitrage if the options were #merican style9 3c4 :ou hold a diversified portfolio of UK equities with a value of 51-m, a beta of -.7 on the F+*, 1-- index, and idiosyncratic ris! of ;2 annually. :ou are very concerned about the possibility of a sharp fall in the mar!et. If your portfolio value dropped by more than '2 over the next three months it would have very serious consequences. :ou are considering a number of alternative strategies for dealing with this including< i4 buying three month put options with a stri!e of '%.' to protect the portfolio=

3a4

3b4

ii4 liquidating the portfolio if and when its value approaches 57.' million= iii4 using futures contracts to reduce your exposure to the mar!et as the mar!et falls. :ou are required to set out in detail how you might execute the three strategies, and how they compare with each other. . +he futures price of the index with three month maturity is standing at 7 -%. +he annual interest rate, quarterly compounded, is %2. :ou have three month calls and puts on the index at the following prices<
Strik e8600 8700 8800 8900 9000 9100 9200 9300 9400 9500 9600 9700 9800 9900 Call 693 619 549 484 423 368 317 272 231 195 163 136 112 Put 92 95 120 149 183 221 265 314 367 425 488 556 627 702 781

3a4 8hat strategy would you follow if you had an index trac!ing portfolio, and you wanted to protect yourself against losing more than '2 of the value of the portfolio9 3b4 *uppose that you did not want to pay an option premium, so you decided to pay for the options in 3a4 by writing 3ie selling4 options to the same value that would give up any profits above a certain level. 8hich options would you sell9 3c4 +he prices of the options imply that the mar!et foresees annualised volatility as being 1..'2 over the next three months. :ou believe that actual volatility will be much larger. 8hat buy$and$hold strategy could you follow that loo!s attractive given your views9