Futures, Options, and Hedging - Assignment Example

There was a change in the basis d) The basis amounted to
=    (20000 - 24000)
(4000) Euros
e) The change was detrimental to the outcome of the hedge.

2A) Strategy 1 is viable for the fund manager because it is less costly compared to strategy 2. The direct purchase of the $9M of equity will cushion the fund's manager against the risk of the futures contract. Therefore, it is better for the manager to remain indifferent rather than incurring losses.

1. B) A profitable arbitrage

Spot price       =          150
Future price    =          156
Dividend yield           =          3%

3% of 150
$4.5

Treasury bills                          6% of 150

                                                           $9

$(4.5 + 9)        =          $13.5

(150+13.5)      =          $163.5

The S&P 500 will be profitable by the end of the six months and will have a value of $163.5. The value of the stock is greater than the current future cost of 156.

c) A profitable arbitrage when the dividend yield is 1%
Spot price       =          150
Future price    =          156
Dividend yield           =          1%
% of 150
$1.5

Treasury bills                          6% of 150
$9

$(1.5 + 9)        =          $10.5
(150+10.5)      =          $160.5

The S&P 500 will be profitable by the end of the six months and will have a value of $160.5. The value of the stock is greater than the current future cost of 156.

3) Copper pounds           =          250, 000
250, 000* $3.5           =          $875000
Spot price       =          $3.5
Future contract price  =          $3.56
Future contract pounds          =          25, 000
Spot copper price change                   =          1.2*change in future prices

The futures contract hedging strategy will help in the hedging against the price fluctuation in copper in Seattle.
Spot price in September         =          $3.7
3.7 * 250, 000            =          $925, 000

Spot copper price in October =          1.2*(3.74-3.56)

                                                           $3.916

Future contract price  = $3.74
3.74 * 250, 000          =          $935, 000.
The loss on the hedge            =          $(935, 000 – 925, 000)

                                                           $10, 000

4.The optimal hedge
7-year coupon =          $10M
Interest rate    =          11%

Hedge strategy:
8% 15-year treasury bonds face value $100, 000
Treasury bonds price  =          $86, 000
Notes Price change     =          0.82 * Treasury bond future prices
The spot price after the specified period       =          0.82*86, 000

                                                                                  $70520

The notes will sell at the spot price although they will sell at a loss of

                                                           $(70520 – 86, 000) = ($15, 480)

B
Futures            =          $80, 000
Received amount       =          $ 93, 000
Bonds issue date        =          March 1
Price    =          0.82 *80, 000

                                   65, 600
Profit received            =          $(80, 000 – 65, 600)

                                                           $14, 400

C) The reasons for the failure of the hedging strategy include wrong timing and the selection of investment items from different investment portfolios (Wegener, 2011). Additionally, the maturity periods of the two instruments, the notes, and the Treasury bill, are different.

5) Design a strategy to bring the portfolio beta down to .90
Equity =          $50, 000, 000
β          = 1.4
New β    =       0.9
S & P stock index future price          =          1500
Future β                                  =          1.0
Asset price determination                  =          500* S & P stock index spot price
The new spot price for the equity assets       =          500*1500

                                                                                              75, 000

The new price will drive the β to 0.9

b) Market decline           =          10%
The market decline will lead to a reduction in β (1.4) to
10% of 1.4      =          0.14
The new β      =          1.4 – 0.14
1.26
(1/1.26)           =   0.9

Β         =          0.9

6) The differential in borrowing opportunities for the two firms
The differential is obtained from the application of LIBOR in the two scenarios
Both firms are considering raising funds from the floating of notes at LIBOR. However, the rate for company A is 4% while company B’s rate is 5%. Therefore, the differential is 1%

b) Company A has an absolute advantage given that it qualifies to obtain funds through bonds. Company B has an absolute advantage because it can borrow funds at fixed rates, which gives sufficient time for paying back the debt.

c) The potential savings in case, the firm's swap lies in their borrowing options. Long-term borrowing attracts high-interest charges while LIBOR borrowing involves low interest rates.

Swapping will result in interest savings.