Item set for 25-March (Derivatives):

Alvaro Rosenbluth Case Scenario

Alvaro Rosenbluth, CFA, is a derivatives analyst in Copernicus Inc. Copernicus Inc. is a fund management company which primarily deals in derivatives to provide excess risk-adjusted returns to its clients. The company also provides consulting and management services to its clients.

One of the clients has come to the company for some advice. Alvaro is dealing with the client. The client, Paparica Drom, plans to enter into an interest rate swap. He has found one trustable counter party for the swap. The swap is for 1 year. Paparica would enter into the swap as fixed rate receiver and floating rate payer. The interest amount is to be paid quarterly. The total amount to be swapped is $100 million.

Paparica will get 6% annual coupon rate from the fixed payer side. The floating rate has been decided as LIBOR plus 1.0% spread. The LIBOR rates are given in Exhibit 1.

Exhibit 1

90 days LIBOR 4.5% 180 days LIBOR 5.0% 270 days LIBOR 5.5% 360 days LIBOR 6.0%

Paparica wants to know the value of swap. Alvaro explains that the value of swap at the beginning is zero if we calculate the swap rate which makes the payments equal to the payments from the floating rate party. However, in case the fixed interest rate is different than the swap rate, the swap will have some value to one of the party.

Paparica inquires about the other methods by which we can simulate the payoffs of a swap contract. Alvaro answers his query by stating the following statements:

Statement 1: The swap is a series of forward rate agreements.

Statement 2: We can simulate the payoffs of swap contract by entering into different forward rate agreements for each settlement period of the swap.

Statement 3: We can simulate each forward rate agreement by entering into the interest rate options. For example, if we are a fixed receiver and floating payer, we can long interest rate call option and short interest rate put option to simulate the payoffs.

Another client, Rose Edmund, is concerned about the future exchange rate of currency. She is expecting to receive GBP 2 million after 6 months. She is a US resident. The current exchange rate between the GBP and USD is 1.8USD/GBP. She wants to sell 6-month forward contracts on the currency so that she can lock in the exchange rate. The interest rates in USA and GBP are given in Exhibit 2.

Exhibit 2

Currency 6-month interest rate (annual) GBP 2.8% USD 4.2%

Alvaro calculates the forward price for her and tells her the price. She takes position into the forward contract. At the end of 6 months, the exchange rate becomes 1.82USD/GBP.

Alvaro is managing portfolio of one of the clients. The client has advised him to take leveraged position by forwards and futures only. He looks at two stocks which are trading at the same price but the volatility and dividend payments are different for both the stocks. One stock (A) is expected to pay a dividend of $2 per share after 200 days and other stock (B) is expected to pay a dividend of $2.05 per share after 300 days. The risk free rate is 6% per annum. He wants to take a position into 6-month futures contract. The volatility of stock A is 30% per annum and that of stock B is 20% per annum.

1. What is the value of the swap to Paparica Drom at the initiation of the swap contract?

a) -$773,947

b) $56,256

c) $142,020

2. What is the annual spread earned by Paparica on entering into the swap?

a) 0.15%

b) -0.80%

c) -0.85%

3. Which of the following statements is least accurate by Alvaro regarding the simulation of payoff of swap contract?

a) Statement 2

b) Statement 3

c) All statements are correct

4. What is the total gain/loss of Rose by entering into the currency forward contract?

a) -$15,569.3

b) -$64,266.0

c) $9,027.2

5. Which of the futures contact of the stocks will have a higher price?

a) Stock A because it has higher volatility

b) Stock B because it has lower present value of dividends

c) Both will have the same futures price

6. What is the forward exchange rate locked in by Rose?

a) 1.7879 GBP/USD

b) 1.8122 GBP/USD

c) 1.8245 GBP/USD

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