You are on page 1of 6

# 1. EaseCorp plans to borrow \$50,000,000 in 25 days.

## The loan will have a maturity of 270 days

and carry a rate of LIBOR plus 125 basis points. The company is concerned that interest rates
will raise, so in order to lock in the borrowing rate, it decides to purchase an FRA at a rate of
6.75 percent. Demonstrate that the effective cost of the loan is approximately 8 percent if 270-
day LIBOR in 25 days is 8.25 percent.

2. A bank has committed to lend \$25,000,000 to a corporate borrower in 30 days. The loan will
mature in 180 days and carries a rate of LIBOR plus 150 basis points. The bank is concerned that
interest rates will fall, and in order to lock in the lending rate, it decides to short an FRA with a
rate of 5.5 percent. Determine the effective rate on the loan if 180-day LIBOR in 30 days is 3.25
percent.

3. A \$500 million bond portfolio currently has a modified duration of 12.5. The portfolio
manager wishes to reduce the modified duration of the bond portfolio to 8.0 by using a futures
contract priced at \$105,250. The futures contract has an implied modified duration of 9.25. The
portfolio manager has estimated that the yield on the bond portfolio is about 8 percent more
volatile than the implied yield on the futures contract.
A. Indicate whether the portfolio manager should enter a short or long futures position.
B. Calculate the number of contracts needed to change the duration of the bond portfolio.
C. Assume that on the horizon date, the yield on the bond portfolio has declined by
50 basis points and the portfolio value have increased by \$31,343,750. The implied yield on
futures has decreased by 46 basis points, and the futures contract is priced at \$109,742. Calculate
the overall gain on the position (bond plus futures). Determine the ex post duration with and
without the futures transaction.

4. A \$200 million bond portfolio currently has a modified duration of 6.53. The portfolio
manager wishes to increase the modified duration of the bond portfolio to 9.50 by using a futures
contract priced at \$95,650. The futures contract has an implied modified duration of 12.65. The
portfolio manager has estimated that the yield on the bond portfolio is about 12 percent more
volatile than the implied yield on the futures contract.
A. Indicate whether the portfolio manager should enter a short or long futures position.
B. Calculate the number of contracts needed to change the duration of the bond portfolio.
C. Assume that on the horizon date, the yield on the bond portfolio has increased by
30 basis points and the portfolio value have decreased by \$3,929,754. The implied yield on
futures has increased by 30 basis points, and the futures contract is priced at \$92,616. Calculate
the overall gain on the position (bond plus futures). Determine the ex post duration with and
without the futures transaction.

5. An investment management firm wishes to increase the beta for one of its portfolios under
management from 0.95 to 1.20 for a three-month period. The portfolio has a market value of
\$175,000,000. The investment firm plans to use a futures contract priced at \$105,790 in order to
adjust the portfolio beta. The futures contract has a beta of 0.98.
A. Calculate the number of futures contracts that should be bought or sold to achieve an increase
in the portfolio beta.
B. At the end of three months, the overall equity market is up 5.5 percent. The stock portfolio
under management is up 5.1 percent. The futures contract is priced at \$1 11,500. Calculate the
value of the overall position and the effective beta of the portfolio.

6. A pension fund manager wishes to reduce the beta of the pension portfolio's small cap
component from 0.90 to 0.80 for a period of six months. The small-cap portfolio has a market
value of \$485,000,000. The pension fund manager plans to use a futures contract priced at
\$249,000 in order to adjust the portfolio beta. The futures contract has a beta of 0.93.
A. Calculate the number of futures contracts that should be bought or sold to achieve a change in
the portfolio beta.
B. At the end of six months, the overall equity market is down 8.65 percent. The Small-cap
portfolio is down 7.75 percent. The futures contract is down 8.05 percent and is priced at
\$228,956. Calculate the value of the overall position and the effective beta of the portfolio.

7. Consider an asset manager who wishes to create a fund with exposure to the Russell
2000 stock index. The initial amount to be invested is \$300,000,000. The fund will be
constructed using the Russell 2000 Index futures contract, priced at 498.30 with a \$500
multiplier. The contract expires in three months. The underlying index has a dividend yield of
0.75 percent, and the risk-free rate is 2.35 percent per year.
A. Indicate how the money manager would go about constructing this synthetic index using
futures.
B. Assume that at expiration, the Russell 2000 is at 594.65. Show how the synthetic position
produces the same result as investment in the actual stock index.

8. A money manager wishes to create a fund with exposure to the Nikkei 225 stock average.
The initial amount to be invested is \$650,000,000. The fund will be constructed using the Nikkei
225 futures contract, priced at 11,930 with a \$5 multiplier. The contract expires in three months.
The underlying index has a dividend yield of 1.25 percent, and the risk-free rate is 3.35 percent
per year.
A. Indicate how the money manager would go about constructing this synthetic index using
futures.
B. Assume that at expiration, the Nikkei 225 is at ST. Show how the synthetic position produces
the same result as investment in the actual stock index.

9. An investment management firm has a client who would like to temporarily reduce his
exposure to equities by converting a \$25 million equity position to cash for a period of four
months. The client would like this reduction to take place without liquidating his equity position.
The investment management firm plans to create a synthetic cash position using an equity futures
contract. This futures contract is priced at 1170.10, has a multiplier of \$250, and expires in four
months. The dividend yield on the underlying index is 1.25 percent, and the risk-free rate is 2.75
percent.
A. Calculate the number of futures contracts required to create synthetic cash.
B. Determine the effective amount of money committed to this risk-free transaction and the
effective number of units of the stock index that are converted to cash.
C. Assume that the stock index is at 1031 when the futures contract expires. Show how this
strategy is equivalent to investing the risk-free asset, cash.
10. An equity portfolio manager currently has a \$950 million equity position in the technology
sector. He wants to convert this equity position to cash for a period of six months, without
liquidating his holdings. An equity futures contract that expires in six months is priced at 1564
and has a multiplier of \$100. The dividend yield on the underlying index is 0.45 percent. The
risk-free rate is 5.75 percent.
A. Calculate the number of futures contracts required to create synthetic cash.
B. Determine the effective amount of money committed to the risk-free asset and the effective
number of units of the stock index that are converted to cash.
C. Assume that the stock index is at 1735 when the futures contract expires. Show how this
strategy produces an outcome equivalent to investing in cash at the beginning of the six-month
period.

11. Consider a portfolio with a 65 percent allocation to stocks and 35 percent to bonds. The
portfolio has a market value of \$200 million. The beta of the stock position is 1.15, and the
modified duration of the bond position is 6.75. The portfolio manager wishes to increase the
stock allocation to 85 percent and reduce the bond allocation to 15 percent for a period of six
months. In addition to altering asset allocations, the manager would also like to increase the beta
on the stock position to 1.20 and increase the modified duration of the bonds to 8.25. Assume
that the modified duration of cash equivalents is 0.25. A stock index futures contract that expires
in six months is priced at \$157,500 and has a beta of 0.95. A bond futures contract that expires in
six months is priced at \$109,000 and has an implied modified duration of 5.25. The stock futures
contract has a multiplier of one.
A. Show how the portfolio manager can achieve his goals by using stock index and bond futures.
Indicate the number of contracts and whether the manager should go long or short.
B. After six months, the stock portfolio is up 5 percent and bonds are up 1.35 percent.
The stock futures price is \$164,005 and the bond futures price is \$1 10,145. Compare the market
value of the portfolio in which the allocation is adjusted using futures to the market value of the
portfolio in which the allocation is adjusted by directly trading stocks and bonds.

12. A fixed income money manager has a bond portfolio with a 70 percent allocation to long-
term bonds and a 30 percent allocation to short-term bonds. The portfolio is currently valued at
\$75 million. The manager wishes to reduce the long-term bonds allocation to 55 percent and
increase the short-term bonds allocation to 45 percent for a period of three months. The modified
duration of the long-term bonds is 7.5 and of the short-term bonds is 4.5. A bond futures contract
that expires in three months is priced at \$95,750 and has a modified duration of 6.25. Assume
that the modified duration of cash equivalents is 0.25. Also assume that interest rates that drive
long-term and short-term bond prices have a yield beta of 1 with respect to interest rates that
drive the bond futures market.
A. Show how the manager can achieve his goals by using bond futures. Indicate the number of
contracts and whether the manager should go long or short.
B. After three months, the short-term bonds are down 5.63 percent and long-term bonds are
down 9.38 percent. The bond futures price is \$88,270. Compare the market value of the portfolio
using futures to adjust the allocation with the market value of the same portfolio using direct

13. A portfolio manager has an equity portfolio with a 60 percent allocation to small-cap stocks
and a 40 percent allocation to large-cap stocks. The portfolio is currently valued at \$150 million.
The manager wishes to reduce the small-cap allocation to 45 percent and increase the large-cap
allocation to 55 percent for a period of nine months. The large-cap beta is 1.15, and the small-cap
beta is 1.25. A small-cap futures contract that expires in nine months is priced at \$195,750 and
has a beta of 1.12. A large-cap futures contract that expires in nine months is priced at \$215,570
and has a beta of 0.92.
Assume that both contracts have multipliers of 1.
A. Show how the manager can achieve the reallocation using stock index futures. Indicate the
number of contracts and whether the manager should go long or short.
B. After nine months, the large-cap stocks are up 4.75 percent and small-cap stocks are up 6.25
percent. The large-cap futures price is \$223,762, and the small-cap futures price is \$206,712.
Compare the market value of the portfolio using futures to adjust the allocation with the market
value of the same portfolio using direct stock trading to adjust the allocation.

14. Consider a portfolio with a 65 percent allocation to stocks and 35 percent to bonds.
The portfolio has a market value of \$750 million. The beta of the stock position is 1.20, and the
modified duration of the bond position is 7.65. The portfolio manager wishes to decrease the
stock allocation to 45 percent and increase the bond allocation to 55 percent for a period of six
months. Assume that the modified duration of cash equivalents is 0.25. The portfolio manager
intends to use a stock index futures contract, which is priced at \$272,500 and has a beta of 0.90,
and a bond futures contract, which is priced at \$139,120 and has an implied modified duration of
5.35. The stock futures contract has a multiplier of 1.
A. Show how the portfolio manager can achieve her goals by using stock index and bond futures.
Indicate the number of contracts and whether the manager should go long or short.
B. After six months, the stock portfolio is down 5 percent and bonds are down 1.75 percent. The
stock futures price is \$262,280, and the bond futures price is \$137,420. Compare the market
value of the portfolio using futures to adjust the allocation with the market value of the same

15. A pension fund manager expects to receive a cash inflow of \$50,000,000 in three months and
wants to use futures contracts to take a \$17,500,000 synthetic position in stocks and \$32,500,000
in bonds today. The stock would have a beta of 1.15 and the bonds a modified duration of 7.65.
A stock index futures contract with a beta of 0.93 is priced at \$175,210. A bond futures contract
with a modified duration of 5.65 is priced at \$95,750.
A. Calculate the number of stock and bond futures contracts the fund manager would have to
trade in order to synthetically takes the desired position in stock and bonds today. Indicate
whether the futures positions are long or short.
B. When the futures contracts expire in three months, stocks have declined by 5.4 percent and
bonds have declined by 3.06 percent. Stock index futures are priced at, \$167,559, and bond
futures are priced at \$93,586. Show that profits on the futures positions are essentially the same
as the change in the value of stocks and bonds during the three-month period.

16. Consider a fund manager who expects to receive a cash inflow of \$30,000,000 in two
months. The manager wishes to use futures contracts to take a \$21,000,000 synthetic position in
stocks and \$9,000,000 in bonds today. The stock would have a beta of 1.25 and the bonds a
modified duration of 6.56. A stock index futures contract with a beta of 0.96 is priced at
\$225,130. A bond futures contract with a modified duration of 7.25 is priced at \$105,120.
A. Calculate the number of stock and bond futures contracts the fund manager would have to
trade in order to synthetically take the desired position in stock and bonds today. Indicate
whether the futures positions are long or short.
B. When the futures contracts expire in two months, stocks have risen by 3.75 percent and bonds
have declined by 2.3 percent. Stock index futures are priced at \$231,614, and bond futures are
priced at \$102,453. Show that the profits on the futures positions are essentially the same as the
change in the value of stocks and bonds during the two-month period.

17. GEMCO manages fixed-income portfolios. It would like to alter the composition of a
\$150 million segment of its portfolio for a period of four months. Specifically, the managers
wish to convert \$60 million into cash and reduce the duration on the remaining \$90 million in
bonds from 8.75 to 5.25. A bond futures contract that expires in four months is currently priced
at \$97,250 and has a modified duration of 7.53. Assume that the modified duration of cash
equivalents is 0.25. Also assume that interest rates that drive long-term bond prices have a yield
beta of 1 with respect to interest rates that drive the bond futures market.
A. Show how the manager can achieve his goals by using bond futures. Indicate the number of
contracts and whether the manager should go long or short.
B. After four months, interest rates are up by 1.25 percent and long-term bonds are down 10.94
percent. The bond futures price is \$88,096. Compare the market value of the portfolio using
futures to adjust the allocation with the market value of the same portfolio using direct bond
trading to adjust the allocation. To estimate the change in the portfolio value if the transaction is
done without derivatives, use the duration approximation.

18. A. Consider a U.S. company, GateCorp, that exports products to the United Kingdom.
GateCorp has just closed a sale worth 200,000,000. The amount will be received in two months.
Because it will be paid in pounds, the U.S. company bears the exchange risk. In order to hedge
this risk, GateCorp intends to use a forward contract that is priced at \$1.4272 per pound. Indicate
how the company would go about constructing the hedge. Explain what happens when the
forward contract expires in two months.
B. ABCorp is a U.S.-based company that frequently imports raw materials from Australia.
It has just entered into a contract to purchase A\$175,000,000 worth of raw wool, to be paid in
one month. ABCorp fears that the Australian dollar will strengthen, thereby raising the U.S.
dollar cost. A forward contract is available and is priced at \$0.5249 per Australian dollar.
Indicate how ABCorp would go about constructing a hedge. Explain what happens when the
forward contract expires in one month.

19. Consider a U.S. asset management firm that wishes to allocate 50,000,000 to the
French stock market. This portfolio has a beta of 0.95. The spot exchange rate is \$0.8823 per
euro. The foreign interest rate is 5.75 percent a year, and the domestic interest rate is 6.45
percent a year. A one-year forward contract on the euro is priced at \$0.8881. A stock index
futures contract on the CAC 40 (French stock index) is priced at 46,390, with the multiplier
taken into account. The stock index futures contract has a beta of 1.05.
A. Would the asset manager take a long or short position to hedge the equity market risk?
Calculate the number of contracts needed.
B. Suppose the firm also wished to hedge the currency risk using a forward contract on the euro.
What should be the notional principal of the forward contract?
C. Assume that at the end of one year, the French market is up by 8 percent. The exchange rate
is \$0.8765 per euro, and the futures price is 47,550. Calculate the return if
i. the portfolio is unhedged.
ii. Only the equity position is hedged.
iii. Both equity and currency risks are hedged.

20. A U.S. asset management firm currently has 150,000,000 allocated to the U.K. stock
market. This portfolio has a beta of 1.15. The spot exchange rate is \$1.4194 per pound. The U.K.
interest rate is 6.75 percent a year, and the U.S. interest rate is 5.25 percent a year. Both rates are
quoted in the LIBOR manner of Rate X (DaysI360). A three-month forward contract on the
pound is priced at \$1.4142. A stock index futures contract on the FTSE 100 (U.K. stock index) is
priced at 52,665, with the multiplier taken into account. The stock index futures contract has a
beta of 0.90.
A. Would the asset manager take a long or short position to hedge equity market risk?
Calculate the number of contracts needed.
B. Suppose the firm also wished to hedge the currency risk using a forward contract on the
pound. What should be the notional principal of the forward contract?
C. Assume that at the end of three months, the U.K. equity market is down by 3.25 percent. The
exchange rate is at \$1.4396 per pound, and the futures price is 50,630. Calculate the return if
i. the portfolio is unhedged.
ii. only the equity position is hedged.
iii. both equity and currency risks are hedged