M.Sc Derivatives – Valuation and Strategies Sep 2024

Description

Derivatives – Valuation and Strategies

September 2024 Examination

 

 

Q1. Brian holds an asset valued at $250, intending to sell it in six months. To mitigate price risk, he opts for a short position in a forward contract on the asset, given a risk-free rate of 5%. Here are the objectives to address: Determine the no-arbitrage forward price, Calculate the value of both the long and short positions in the forward contract If, during the two- month period preceding the forward’s expiration, the spot price of the underlying asset rises to $262, assess the value of the long position. Furthermore, compute the value of the long position if the forward’s value at expiration amounts to $247 contracts?     (10 Marks)

Ans 2.

Introduction

Derivatives are financial instruments that derive their value from the performance of underlying assets, such as stocks, bonds, commodities, or interest rates. They are widely used for hedging risks, speculating on future price movements, and enhancing investment strategies. Among the most commonly used derivatives are forward contracts, which are agreements to buy or sell an asset at a predetermined price at a future date. Forward contracts are particularly valuable in mitigating price risks, especially when market conditions are volatile.

In this context, understanding the valuation of forward contracts and the strategies involved in managing these instruments is

 

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Q2. A financial institution has decided to hedge its position of interest rate exposure by Swap with a notional principle of $20 Million.Supposed that 6 months ago they entered into an 18-month swap as the fixed-rate receiver. The rate on that swap was 4.836%. Current market Libor rates are: L180(90) = 0.0325, L180(180) = 0.0375 , L180(270) = 0.0425 ,and L180(360) = 0.0460. The current swap fixed rate should equal 4.512%. Determine the value of the swap for financial institution.      (10 Marks)

Ans 2.

Introduction

Interest rate swaps are a type of derivative instrument used by financial institutions and corporations to manage interest rate risk. These swaps involve exchanging cash flows based on different interest rates, typically between a fixed rate and a floating rate. By engaging in interest rate swaps, institutions can hedge against unfavorable movements in interest rates, stabilize cash flows, and potentially reduce borrowing costs. The notional principal in a swap represents the amount on which the interest payments are calculated, although it is never exchanged between

 

 

Q3. XYZ Corporation, a global player in the market, strategically sold €20 million against the USD through a forward contract, locking in a forward rate of $1.15/€ at t = 0. As we fast forward to the present, the current spot exchange rate paints a different picture, hovering at

$1.10/€. Adding complexity to the equation, the annual risk-free rates stand at 0.75% for the USD and 0.35% for the EUR. With three months remaining until the forward contract’s expiration, XYZ Corporation faces a crucial juncture.

1. Determine the current forward exchange rate, considering the prevailing market conditions and interest rate differentials. (5 Marks)

Ans 3a.

Introduction

Foreign exchange (FX) markets play a pivotal role in global finance, allowing corporations to hedge against currency fluctuations. XYZ Corporation, as a global player, has engaged in a forward contract to sell €20 million against the USD, locking in a rate of $1.15/€ at inception. As market conditions have evolved, the current spot rate has shifted to $1.10/€, creating a potential financial impact on the company’s forward contract. This scenario underscores the importance of understanding forward exchange rates and interest rate differentials in managing currency risk. In

 

1. Ascertain the current value of the forward contract position held by XYZ Corporation, factoring in the fluctuating spot exchange rate and interest rate differentials. This analysis will shed light on the financial implications and performance of the forward contract in the present scenario. (5 Marks)

Ans 3b.

Introduction

Forward contracts are essential tools in risk management, allowing corporations like XYZ Corporation to hedge against adverse currency movements. By locking in exchange rates, companies can protect themselves from potential losses. However, the value of these contracts can fluctuate based on changes in spot exchange rates and interest rate differentials. XYZ Corporation, which entered into a forward contract to sell €20 million at a rate of $1.15/€, now faces a different market scenario with a current spot rate of $1.10/€. In this analysis, we will