Past Papers - Examiner's Solutions

December 2007
Question 1

A three-month Eurodollar future has a market price of 94.30. The future has 90 days to expiry and
the current three-month eurobor is 5.20%. Six-month eurobor is 5.35%. The borrowing and lending
spread at three months is 2 basis points on either side. For six months the spread is 3 basis points
on either side. (360 day basis is used.)
Required:
a. Establish whether the Eurodollar future is correctly priced or not.
(12 marks)
b. Show if an arbitrage profit can be made from this situation. Explain how you would exploit this
situation.
(14 marks)
c. Explain what factors can affect the basis in futures pricing.
(7 marks)
d. Other than basis risk, explain what the other risks involved in using futures are.
(7 marks)

Question 1
(a) Establish whether the Eurodollar future is correctly priced or not.
(12 marks)
You need to calculate the implied forward rate as follows and the future will be priced off the im-
plied forward rate.

Basis:
360
Days Cash
market
90 0.0520 Spread 0.0002
either
side
180 0.0520 Spread 0.0002
Implied 1.013 this is 1 + 0.0520 ×
forward: (90/360)
1.02675 this is 1 + 0.0535 ×
(180/360)
1.013574 this is 1.02675/1.013
0.013574 subtract 1
0.054294 multiply by (360/90)
5.429%
Implied futures 94.5706 Actual 94.30
price = future =

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(b) Show if an arbitrage profit can be made from this situation. Explain how you would exploit
this situation.
(14 marks)
An arbitrageur could borrow 180 day money and lend 90 day money in the cash market to create an
effective borrowing rate of 5.4294%. Against this the arbitrageur could buy the futures contract, creat-
ing an effective lending rate over the same period of 5.70%. This would give an arbitrage profit of
27.06 basis points. But you have to take into account the spread in the borrowing and lending rates.
The impact of this is to bring the profit down to 11.2 basis points.

90 day Bid rate 0.0518

Offer 0.0522
rate
180 day Bid rate 0.0532
Offer 0.0538
rate
Implied bid 1.0266 six-month bid rate ×
rate: 180/360
1.01305 three-month offer rate ×
90/180
1.013375 this is 1.02055/1.01015
0.013375 Subtract 1
0.053502 Multiply by 360/90
5.350%
Implied offer 1.0269
rate:
1.01295
1.013772
0.013772
0.055087
5.509%
Arbitrage set 0.001585
up costs =
15.848
basis
points
Futures price 94.30
quote =
Arbitrage profit 0.2706
opportunity =
27.058 basis
points
Arbitrage profit 11.210 basis
/ loss = points profit

(c) Explain what factors can affect the basis in futures pricing.
(7 marks)
A number of factors can push the basis away from its theoretically correct level. The theoretical fu-
tures price is calculated by the cost of carry. The actual futures price will diverge from the theoretical
price during the performance of the contract. There may be a positive or negative value basis during
this time. The factors that affect the basis are shifts in the yield curve, both parallel and rotational
shifts. Because of this there will not be a linear decline in the basis towards contract expiry. Difficulties
in short selling can affect the basis, so there are mismatches between hedging and the cash position.
There are also random deviations (noise) that drive the basis from its theoretical value.

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(d) Other than basis risk, explain what the other risks involved in using futures are.
(7 marks)
The risks in using futures other than basis risk can be summarised as: cross asset position risk,
rounding error risk, variation margin risk, timing mismatch risk, and maturity mismatch risk.
Cross asset position risk is where there is a mismatch between the underlying position and the fu-
tures position, i.e. they are not the same. It may be that there is not a futures contract on the
underlying, so a close substitute is used, but the price performance may diverge.
Rounding error is where you cannot hedge exactly because of the nature of the contract specifica-
tions. If there were forwards available on the contract you could match exactly, but with futures you
will have to either over or under hedge.
Variation margin: with forwards there are no intermediate cash flows, but with futures – according
to the performance of the future – the holder of the contract may be due further cash outflows to the
clearing house in the form of maintenance margin or performance (variation) margin.
Maturity mismatches: with futures contracts there are set expiry dates, usually the end of March,
June, September, and December. If your hedging requirements are for mid April, there will be a tim-
ing mismatch with the futures contract.

Question 2

You work for an Italian manufacturing firm. The directors have been worried about the strength of
the euro against the US dollar. The firm has won its first large export order to the US. The directors
would like to protect their dollar receivables. Payment is due to the Italian firm in 80 days, the
current exchange rate is $1.3816 to 1 euro. The interest rates in the US and Europe are 5.25% and
3.75%, respectively. The volatility of the exchange rate is 14.62% annually. The Italian firm is expect-
ing $375 000 when the contract is settled. The US$–euro foreign exchange option contract has a
specification size of 125 000 euros and the tic size is $0.0001 or $12.50 per contract.
a. Price the foreign exchange call option if the exercise price is $1.375.
(15 marks)
b. Price the put option with the same strike price.
(7 marks)
c. If the Italian firm wants to protect itself from a rising US dollar and wants to use an option at this
strike price, outline the action they should take. How much will it cost? Explain what will happen
if the spot rate is $1.45 at expiry.
(12 marks)
d. When would you prefer to use currency options rather than currency futures?
(6 marks)

Question 2
(a) Price the foreign exchange call option if the exercise price is $1.375.
(15 marks)

Variable Euro US$

Exch rate S0 1 1.3816
Volatility v 0.1462
Risk free rate rf 0.0375 0.0525
Time T 0.2191781
Exercise price K 1.375
ln(S0/K) = 0.005 ex price 1.375
vol /2 0.0256872 using $ as base current price 1.3816
(T − t)= 0.2191781 volatility 0.1462

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Variable Euro US$

vol 0.068 interest rates 0.0375 0.0525
time (T − t) 0.2191781
US int rt forn int rt
T t 0.9885591 0.9918145
d1 = 0.1522 using formula e= 2.71828
d2 = 0.0838
N(d1) = 0.5605 0.440 = N(−d1)
N(d2) = 0.5334 0.467 = N(−d2)
Call
Black–Scholes call price = 1.3702909 0.7680372 N d1
1.3592688 0.725008 T t
N d2
Forex call price = 0.0430293

(b) Price the put option with the same strike price.
(7 marks)
Using the figures from the working for part (a), we can work out the put price.

Put
0.6342608 T t
N d2
0.6022537 FX N d1
Put 0.0320071
=

(c) If the Italian firm wants to protect itself from a rising US dollar and wants to use an option at
this strike price, outline the action they should take. How much will it cost? Explain what will
happen if the spot rate is $1.45 at expiry.
(12 marks)
The firm will need to buy call options, i.e. they are buying dollars. If the euro rises from its present
level, the value of the call will rise, as it is priced in $ per euro. So buying the contract at 4.3 cents
when the exchange rate was $1.3816, there will be a profit on the contract at expiry if the spot rate is
$1.45. The Italian exporter will lose on the cash translation of the $375 000 but will gain on the call
options it has purchased. The firm should purchase 3 call options, the cost will be $16 136.

Contract size 125 000

Exposure 375 000
No. of contracts 3
Calls Puts
Price of 1 contract 5 379 4 001
Price of cover 16 136 12 003
11 679 8 688 in euros
Call option price if currency is at $1.45 at expiry = 0.075
Contract value = 28 125
Exercise option or trade option Euros = 19 396.55
Exercise option 272 727
minus cost = 261 048
OR:
Sell option 7 717 euros
Trade at spot 258 621
Value = 266 338 better to trade option and take profit

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If someone buys the call, they have the right but not the obligation to deliver US dollars in exchange
for euros at the exercise price of $1.3750/1 euro.
If the firm decides to exercise they can deliver $375 000 at $1.3750/euro, which will net them
272 727 euros (261 048 euros after deducting the initial cost of the option). If they sell the option at
expiry, it will be worth $28 125 (19 396.5 euros). If they then sell the $ on the spot market, they will
receive 258 621 euros, plus the profit on the option gives 266 338 euros.
(d) When would you prefer to use currency options rather than currency futures?
(6 marks)
A firm should use options when there is uncertainty over the performance of the underlying con-
tract, e.g. if there was a takeover that was subject to shareholder votes and also regulatory scrutiny. It
may be that the bid might not be completed. In that case, the option gives you something that you can
walk away from. With forwards and futures you are legally bound to complete the contract, either by
delivery of the underlying or by reversing the contract in the market.

Question 3
The following zero-coupon rates exist over the next four years:

Period Zero coupon

6 months 3.25%
1 year 3.55%
18 months 3.75%
2 years 3.95%
30 months 4.20%
3 years 4.45%
42 months 4.50%
4 years 4.55%

Required:
a. Calculate the net present value of the expected floating rate payments on the interest rate swap.
(13 marks)
b. What is the rate on the fixed side of the swap?
(7 marks)
c. Calculate the fixed rate on a 2-year swap from the above set of rates.
(6 marks)
d. Compare the use of interest rate swaps with caps, floors, and FRAs. Give a brief outline of each
and give an example of where and how they would be used and how they compare against swaps.
(14 marks)

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Question 3
(a) Calculate the net present value of the expected floating rate payments on the interest rate
swap.
(13 marks)
The present value is obtained by constructing the table below.

Time Zero coupon Floating rate Floating payment PV

0.5 0.0325 1.01612 0.03224 1.61 1.59
1 0.0355 1.019072 0.038145 1.91 1.84
1.5 0.0375 1.020545 0.04109 2.05 1.94
2 0.0395 1.022508 0.045017 2.25 2.08
2.5 0.042 1.0257 0.0514 2.57 2.32
3 0.0445 1.028149 0.056298 2.81 2.47
3.5 0.045 1.023721 0.047442 2.37 2.03
4 0.0455 1.02421 0.048421 2.42 2.03
16.30

(b) What is the rate on the fixed side of the swap?

(7 marks)
The fixed rate is calculated by extending the table.

Time Zero coupon Floating rate Floating payment PV Fixed rate

0.5 0.0325 1.01612 0.03224 1.61 1.59 0.984136
1 0.0355 1.019072 0.038145 1.91 1.84 0.965717
1.5 0.0375 1.020545 0.04109 2.05 1.94 0.946276
2 0.0395 1.022508 0.045017 2.25 2.08 0.925446
2.5 0.042 1.0257 0.0514 2.57 2.32 0.902258
3 0.0445 1.028149 0.056298 2.81 2.47 0.877556
3.5 0.045 1.023721 0.047442 2.37 2.03 0.857221
4 0.0455 1.02421 0.048421 2.42 2.03 0.836958
16.30 7.295568
Fixed rate = 0.044696
4.4696%

(c) Calculate the fixed rate on a 2-year swap from the above set of rates.
(6 marks)
For the two-year fix we just look at the PV and fixed rate columns for the first four periods making
up the two years. The rate can be calculated from these figures.

Time PV Fixed rate

0.5 1.59 0.984136
1 1.84 0.965717
1.5 1.94 0.946276
2 2.08 0.925446
7.46 3.821575 2 year fix = 3.90175

For 2 years add PV col. as far as 2yrs then divide by the sum of fixed rate col. as far as 2yrs
(d) Compare the use of interest rate swaps with caps, floors, and FRAs. Give a brief outline of
each and give an example of where and how they would be used and how they compare
against swaps.
(14 marks)
A cap is basically an insurance policy for a firm wanting to protect itself against a rise in the underly-
ing, for example, protection against a rise in short term interest rates above a certain level. The cap

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retains the benefit of being able to take advantage of a drop in interest rates. The cap, like an interest
rate swap is independent of the firm’s underlying floating rate borrowing. Where it differs from the
swap is that the bank selling the cap, in return for a one off premium from the firm, agrees to com-
pensate the firm by the margin that the interest rate (e.g. libor) exceeds the cap rate on the rollover
dates. So the firm will pay a maximum level for its borrowings.
A floor is the opposite of a cap. It works more for a lender or investor who is receiving the floating
rate. The floor acts to guarantee a minimum rate that they will receive. So the lender is protected from
any fall in rates, but can take advantage of any rises in rates.
A combination of a cap and a floor is known as a collar.
The difference between a cap and a floor, and an FRA is that the payout takes place at the end of the
period with the cap and the floor, whereas with the FRA the payment is at the start. The FRA is a cash
settled forward contract, with credit risk minimised with the settlement at the start. With swaps there
are periodic payments or receipts, usually every six months.
The cap and the floor are option type instruments. They are like a series of options while the agree-
ment is in place; caplets for caps, and floorlets for floors. As such the caps and floors will be valued
using the Black–Scholes model. The value of the swap is obtained by present valuing the floating cash
flows to the swap by the zero-coupon rates.

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