Problem Set 3 of FINA 3404

Instructor: Dr. Du Du
Select the best answers for questions 1-9 (2.5 pts each for 1-8; 3pt for 9)
1. Suppose you enter into the long position of a Eurodollar interest rate futures with the futures
price of 96. At the expiration date of the futures contract, the spot rate of the three month
LIBOR is 6%. What is your profit/loss from holding this futures position?
A) you lose $50
B) you gain $50
C) you lose $5,000
D) you gain $5,000
Answer: C)
2. Consider both a call option and a put option written on euro. When the euro exchange rate
becomes less volatile, which of the following statements is correct
A) the call option becomes cheaper whereas the put option becomes more expensive
B) the put option becomes cheaper whereas the call option becomes more expensive
C) both the call and the put become cheaper
D) both the call and the put become more expensive.
Answer C)
3. Consider a put futures option written on one euro futures contract, and each euro futures
contract is written on 12,500. Suppose the option premium and the strike price are $0.15/
and $1.5/, respectively. At expiration of the option contract, the spot and the futures
exchange rate are 1.405$/ and 1.4$/, respectively. The total profit/loss for the option writer
is thus
A) $1875
B) $687.5
C) $625
D) $-625
Answer : C). reasoning :The holders pays an option premium of 0.15*12,500=$1875 upfront.
Upon maturity, the holder will exercise the option contract, and get paid by (1.5-1.4)
*12500=$1250. The net P/L for the holder is thus -$625, hence the net P/L for the writer is $625
4. Suppose that your firm is a U.S.-based importer of German automobile accessories. You pay
for them in euros and sell them in dollars. You have just ordered next year's inventory. In one
year your firm owes a payment of 100,000 to your German supplier. Today's spot exchange
rate is 1.00 = $1.20; the one-year forward rate is 1.00 = $1.15. How can you fix the dollar
cost of this order? (Answer: A)
A) Enter into long position in the one-year euro futures contract at 1.00 = $1.15. This will fix the
cost of 100,000 at $115,000.
B) Enter into short position in the one-year euro futures contract at 1.00 = $1.15. This will fix
the cost of 100,000 at $115,000.
C) Since the spot price is more than the forward price, you should trade your dollars for euros
today and pay your supplier early.
D) Sell a call option on the euro with a one-year maturity.
5. Suppose that your firm is a U.S.-based importer of German automobile accessories. You pay
for them in euros and sell them in dollars. You have just ordered next year's inventory. In one
year your firm owes a payment of 100,000 to your German supplier. Today's spot exchange
rate is 1.00 = $1.20, and you buy a one-year call option written on 100,000 with the strike
price of $1.20/ to hedge the risky payable. Suppose the option premium is $0.06/, and in
one year the exchange rate turns out to be $1.30/. What the profit/loss on your hedged
position relative to todays exchange rate? (Answer: C: the simplest way to think about it is to
notice that the hedged position is a synthetic put option with the option premium of $0.06/
and strike price of $1.20/. In one year, the put option finishes OTM, hence the U.S. importer
has lost the all the option premium equaling 0.06*100,000=$6,000)
A) $10,000
B) $4000
C) -$6,000
D) -$10,000
6. The best financial instrument to hedge a recurrent exposure is (Answer: D)
A) forwards
B) futures
C) options
D) swaps
7. Which of the following statements about the portfolio frontier is (are) correct? (Answer: B.
Note portfolio frontier includes both efficient portion and the inefficient portion, the latter of
which minimizes instead of maximizing the expected return)
i) Portfolio frontier includes both the efficient frontier and the inefficient frontier
ii) Given the expected return, a portfolio on the portfolio frontier has the smallest return
variance among all portfolios
iii) Given the return volatility, a portfolio on the portfolio frontier has the largest expected
return.
A) i) only
B) i) and ii)
C) ii) and iii)
D) i), ii), and iii)
8. The mean and standard deviation (SD) of two stocks, A and B, are as follows
Country Mean (%) SD (%)
A 10 18
B 12 20
Suppose the two stocks are not correlated. Consider a portfolio with 30% investment in A
and 70% investment in B. What is the standard deviation for the portfolio return?
A) 13.5%
B) 14%
C) 15%
D) 19.4%
Answer: c) rational: apply the formula,
2 2 2 2
p
0.3 0.18 0.7 0.2 0.15 +
9. In the above question, what is the expected return for the global minimum variance portfolio?
A) 13.67%
B) 13.38%
C) 10.89%
D) 11.11%
Answer: C. First we need to compute the weights assigned to the assets as follows:
2 2
2 2 2 2
0.2
0.5525, 1 0.4475
0.18 0.2
B
A B A
A B
w w w

+ +
. The expected return is thus
0.5525 10% 0.4475 12% 0.1089 +

10. (8pts) Suppose today the (annualized) interest rates on USD and AUD are 0% and 4%,
respectively, and the exchange rate is $1/AU$. Consider the following two strategies.
In strategy A, you borrow one million USD and use the proceeds to buy one million
AUD. In strategy B, you long a one-year forward contract which is written on one
million AUD. The investment horizon is one year and interests are only paid at the end
of the one-year horizon. Suppose the exchange rate changes to $1.1/AU$ in one year.
a) (2 points) Calculate your profit/loss (quoted in USD) from strategy A.
b) (3 points) Calculate your profit/loss (quoted in USD) from strategy B. (Hint: first
determine the forward rate using the strict form of IRP)
c) (3 points) Repeat b) when a forward contract is written on AUD 1,000,000/F instead, where F
denotes the forward exchange rate calculated in b). Compare your result with that in a): what
conclusion can you draw?
Answer:
a) From strategy A, you pay no interests from borrowing USD, and receives interest
payment equaling AU$0.04*1,000,000=AU$40,000=$44,000, where Ive used the
exchange rate in one year. In addition, the AU$1,000,000 in one year can be
converted into to $1,100,000: you earn an extra $100,000 due to the appreciation of
AU$ against $. Thus, the total profit from strategy A is $144,000.
b) In strategy B, we know S = $1/AU$; I
$
= 0%; I
AU$
= 4%. Applying IRP implies:
F=(1+ I
$
)/(1+ I
AU$
) *S=1/1.04=$0.9615/AU$. At its expiration date, the long side of
this forward contract earns
($1.1/AU$-$0.9615/AU$)* AU$1,000,000=$138,500
c) Using F=$0.9615/AU$, we first compute the amount of the underlying which
equals AU$1,000,000/0.9615= AU$1,040,000. At its expiration date, the long side
of this forward contract thus earns
($1.1/AU$-$0.9615/AU$)* AU$1,040,000=$144,000.
By changing the amount of the underlying, we see the profit from strategy B exactly
equals the profit from strategy A. We know that strategy A is the carry trade strategy.
The above result indicates that we can also conduct the carry trade strategy by making
use of the forward market.
11. (10 pts)Use the European option pricing formula to find the value of a six-month at-
the-money (ATM) call option on Japanese yen. The strike price is $1 = 100. The
volatility is 25 percent per annum; r
$
= 5.5% and r

= 6%. (please round the numbers in

the final results to three significant digits only) (hint: convert all exchange rates in
American terms before using the Black-Scholes formula)
Solution: because the option is at the money, the spot exchange rate (dollar price of yen) is
equal to the strike price (1.5 pts)
The annualized length of maturity is 0.5 (0.5 pt)
$
( (.055 .06) 0.5 3
1
9.975 10
100
r r
t t
F S e e

(T- t)
(1.5pts)
2
1
2
ln( / ) 0.5 ( )
1/100.2503
ln 0.5 (0.25) 0.5
0.0025 0.156 1/100
0.074246
0.1768 0.25 0.5
t
F E T t
d
T t

_
+

+
,

(2pts)
2 1
0.074246 0.25 0.5 0.10253 d d T t (1 pt)
1 2
( ) 0.5296; ( ) 0.4592 N d N d
(2 pts)
Hence
[ ]
$
( )
1 2
0.055 0.5 4
( ) ( )
1 1
0.5296 0.4592 $6.72 10 .
100.2503 100
r T t
et t
C F N d E N d e
e



1

1
]
(1.5 pts)
Note that N(d) was calculated using NORMSDIST in excel.
12. (10.5 pts) Suppose firm A can issue fixed-rate debt of the same maturity at 10.3% or
A B
Market/public
floating-rate debt at LIBOR+0.5%. Firm B can issue fixed-rate debt at 9.3% or
floating-rate debt at LIBOR+0.3%.
A B
Fixed 10.3% 9.3%
Floating LIBOR+0.5% LIBOR+0.3%
Suppose that A prefers to issue fixed-rate debt whereas B prefers to issue floating-rate debt.
If you were an investment banker, how could you arrange an interest rate swap between A
and B to make everybody happy? Write in the figure the cash flows with arrows to describe
your answers. In addition, compute the net borrowing position for both firms and the
percentage returns for the international banker. (Hint: you may use the following numbers:
9.7%, 9.6%, LIBOR+0.1%, and LIBOR+0.2%)

Investment banker
A B
Market/public
A B
Market/public
Solution: (correct illustrations in the figure are worth a total of 6 pts)
The net borrowing position of firm A is (LIBOR+0.5%)+9.7%-(LIBOR+0.1%)=10.1%,
which is less than 10.3% without using the swap, hence A is happy (1.5pts)
The net borrowing position of firm B is 9.3%+LIBOR+0.2%-9.6%=LIBOR-0.1%, which is
less than LIBOR+0.3% without using the swap, hence B is happy (1.5pts)
The investment bank earns 9.7%-9.6%+(LIBOR+0.2%)-(LIBOR+0.1%)=0.2%>0, hence
the investment bank is also happy (1.5pts)
13. (8 pts) Suppose you buy a call option with
0
C =$0.03/ and X = $1.5/ , and buy a put
option with
0
P =$0.02/ and X = $1.5/ at the same time. Both options are written on
pounds and will expire in one year. In addition, suppose that contract sizes are 1m
a) (3.5 pts) draw the profit profile on this portfolio one year later
b) (1.5 pt each) what is your profit (loss) when the pound exchange rate one year later is
i) $1.5/; ii) $1.6/; iii) $1.3/
Solution: a) see the follow Figure.
(the maximum loss: 1.5 point; profits on both directions: 2 pts)
Investment banker
A B
Market/public
9.7%
LIBOR+0.1%
9.6%
LIBOR+0.2%
LIBOR+0.5%
9.3%
-$0.03
b) i) if exchange rate one year later is $1.5/ , the investor loses $0.05 per pound, hence a
total loss of $50,000
ii) if exchange rate one year later is $1.6/, the investor gains $0.05 per pound, hence a total
profit of $50,000
iii) if exchange rate one year later is $1.3/, the investor gains $0.15 per pound, hence a total
profit of $150,000
14. (6.5 pts) Suppose that Boeing corporation exported a Boeing 747 to British Airways and
would receive 10 million in one year. Suppose that Boeing decides to use option market
hedge, and it purchased a put option on 10 million pounds with an exercise price of $1.46/
and a one-year expiration. Assume that the option premium was $0.02/
a) assume that the spot exchange rate turn out to be $1.30/ on the expiration date. What is
Boeings dollar denominated receivable net of the option premium?
b) the same question for the scenario when the spot exchange rate turns out to be $1.5/ on the
$1.5
$1.45
$1.55
-$0.05
-$0.02
expiration date.
Solution:
a Since Boeing has the right to sell each pound for $1.46, it will certainly exercise its put
option on the pound if the spot exchange rate turn out to be $1.30/. This way it converts 10
million into $14.6 million (2.5 pts)
It pays a total option premium of 0.02*10 million = $200,000
Hence Boeings dollar denominated receivable net of the option premium in this scenario is $14.4
million (1.5 pts)
b) Since Boeing has no obligation to sell each pound for $1.46, it will not exercise its put option
on the pound if the spot exchange rate turns out to be $1.50/ . It will convert 10 million into
$15 million dollars at the spot exchange rate in one year. Hence its dollar denominated receivable
net of the option premium in this scenario is $14.8 million (2.5 pts)
15. You are considering investing in one or both assets called A and B. Both A and B have
identical expected returns and standard deviations. One of your friends have made the
following comments: (I) No matter how you set up your portfolio between A and B, you will
have the same expected return (II) No matter how you set up your portfolio between A and
B, you will have the same portfolio return volatility.
1) (6pt) Suppose the returns of the two assets have 0 correlation. Evaluate (I) and (II), i.e. are
they true or false and why.
2) (4pt) Now suppose the return correlation between the two assets is 1. Again Evaluate (I) and
(II).
Solution:
1) Since ( ) ( )
A B
E r E r r
, ( ) ( ) ( ) ( )
p A A B B A B
E r w E r w E r w w r r + +
, where
Ive used that weighs always sum up to 1. Hence, (I) is correct. (3pt)
Since
2 2 2
A B
and 0
AB

2 2 2 2 2 2
p A A B B A B A B AB A B
w w 2w w w w + + + , whose value generally
depends on the different choices of portfolio weights. For example,
p

if
( , ) (1, 0)
A B
w w
, and
1
2
p
if
1 1
( , ) ,
2 2
A B
w w
_

,
. Hence (II) is incorrect (3pt)
2) for similar reason, (I) is still correct. (1pt) With
1
AB

,
( )
2 2 2 2 2 2
p A A B B A B A B AB A B A B A B
w w 2w w w w 2w w w w + + + + +
.
Hence, in this case (II) is also correct. (3pt)