Financial Engineering 1


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Q1. “A swap bank has to entail certain risks which are inherent to the swap business and are interrelated” Explain the risks involves in swap business.


Q2. Call options are said to be “At the money “, “In the money” and “Out of the money” depending on whether the exercise price is equal to or less than or greater than the current market price of the stock. In case of Put options, the opposite is true. Explain when a trader realizes profits in case of Call as well as Put options with the help of simple examples.


Q3. Write short notes on

(a) LBO or (b) Corporate restructuring


Q4. “Futures rely on a great deal on expected spot prices. The theoretical’ framework suggests that forward rates reflect the expected spot rates.” How futures differ from forwards? Explain.


Q5. “Arbitrage profits” an investor told are risk less profits. You take simultaneous but opposite positions in two markets to reap gains from pricing disparities. Acting on this belief, his friend tried to find the arbitrage profit by trading simultaneously in futures and stock index.


He has collected to the following information:

• Pricing level of stock index _- 3000

• Index futures priced at 2000

• Risk free rate of return – l0%p.a.

• 50% stocks are to pay dividcnds at 6%

• The index futures has a multiple of 100

• The future has six months to expiration.



(a) Find arbitrage profits, if any.

(b) Discuss the risks associated with arbitrage transactions in futures.







Q1. The following are the requirement of the type of funds and the borrowing rates faced by three companies X, Y, Z in different markets:

Company Requirement LIBOR Rate T-Bill rate Fixed $

X LIBOR based funds LIBOR+.75% T-Bill+.4% 5%

Y T-Bill Based Funds LIBOR+.5% T-Bill+.25% 4.5%

Z Fixed $ LIBOR+1% T-BILL+.5% 5.5%

Three companies approach a bank individually for swap deals so that they can reduce their cost of borrowing. You are required to structure swap transactions between three

parties keeping Bank as an intermediary so that after keeping a margin of 10 basis points V by the Bank for each leg of swap, the rest of the gain is distributed equally between the three parties. Also, calculate the effective cost of borrowing to the three parties.


Q2. There are a variety of option combinations which traders adopt to suit their risk return profile”. Discuss the following option combinations:

(1) straddle

(2) strangle


Q3 . ‘Option value is influenced by the option prices, which in turn depend on a number of factors” What are assumptions made by Black and Scholes option Pricing model? Also discuss how does option premium depends on time to expiration, Interest rates, Spot prices and strike prices.



Case study


(a) The following options are quoted at the market:


Option Expiration Strike Price Premium

Call 1 Month Rs.48.5/$ Rs.0.30

Put 1Month Rs.48.5/$ Rs.0.05


A trader is looking at the above options and planning to adopt long strip or long strap strategy to make profit from the rupee-dollar exchange rate volatility.


You are required to:

I. Show the pay off profile and indicate break even points for strip and strap strategies in a price range of Rs 47- Rs 50 for a dollar.

II. Comment on the desirability of the above two option strategies.


(b)Consider a call option on a stock with the following parameters


Stock price: Rs210

Strike Price: Rs 220

Time to expiration: 167 days

Risk free interest rate: 10 %

Variance of annual stock returns: 20%

Compute price of the call option











1. Futures contracts are:

(a) – the same as forward contracts.

(b) – standardized contracts to make or take delivery of a commodity at a predetermined place and time.

(c) – contracts with standardized price terms.

(d) – all of the above.


2. Futures prices are arrived at by:

(a) – bids and offers.

(b) – officers and directors of the exchange.

(c) – written and sealed bids.

(d) – the Board of Trade Clearing Corporation.

(e) – both (b) and (d).


3. The primary function of the Clearing Corporation is to:

(a) – prevent speculation in futures contracts.

(b) – ensure the integrity of the contracts traded.

(c) – clear every trade made at the CBOT.

(d) – supervise trading on the exchange floor.

(e) – both (b) and (c).


4. Gains and losses on futures positions are settled:

(a) – by signing promissory notes.

(b) – each day after the close of trading.

(c) – within five business days.

(d) – directly between the buyer and seller.

(e) – none of the above.


5. Speculators help to:

(a) – increase the number of potential buyers and sellers in the market.

(b) – add to market liquidity.

(c) – aid in the process of price discovery.

(d) – facilitate hedging.

(e) – all of the above.


6. Hedging involves:

(a) – taking a futures position opposite to one’s cash market position.

(b) – taking a futures position identical to one’s cash market position.

(c) – holding only a futures market position.

(d) – holding only a cash market position.

(e) – none of the above.


7. Margins in futures trading:

(a) – serve the same purpose as margins for common stock.

(b) – limit the use of credit in buying commodities.

(c) – serve as a down payment.

(d) – serve as a performance bond.

(e) – are required only for long positions.



8. You may receive a margin call if:

(a) – you have a long (buy) futures position and prices increase.

(b) – you have a long (buy) futures position and prices decrease.

(c) – you have a short (sell) futures position and prices increase.

(d) – you have a short (sell) futures position and prices decrease.

(e) – both (a) and (d).

(f) – both (b) and (c).


9. Margin requirements for customers are established by:

(a) – the Federal Reserve Board.

(b) – the Commodity Futures Trading Commission.

(c) – the brokerage firms, subject to exchange minimums.

(d) – the Clearing Corporation.

(e) – private agreement between buyer and seller.


10. Futures trading gains credited to a customer’s margin account can be withdrawn by the customer:

(a) – as soon as the funds are credited.

(b) – only after the futures position is liquidated.

(c) – only after the account is closed.

(d) – at the end of the month.

(e) – at the end of the year.



11. Graylon, Inc., based in Washington, exports products to a German firm and will receive payment of €200,000 in three months. On June1, the spot rate of the euro was $1.12, and the 3-month forward rate was $1.10. On June 1, Graylon negotiated a forward contract with a bank to sell €200,000 forward in three months.The spot rate of the euro on September 1 is $1.15. Graylon will receive $_________ for the euros.


A) 224,000

B) 220,000

C) 200,000

D) 230,000


12. Forward contracts:

A) contain a commitment to the owner, and are standardized.

B) contain a commitment to the owner, and can be tailored to the desire of the owner.

C) contain a right but not a commitment to the owner, and can be tailored to the desire of the owner.

D) contain a right but not a commitment to the owner, and are standardized.


13. Which of the following is the most unlikely strategy for a U.S. firm that will be purchasing Swiss francs in the future and desires to avoid exchange rate risk (assume the firm has no offsetting position in francs)?


A) purchase a call option on francs.

B) obtain a forward contract to purchase francs forward.

C) sell a futures contract on francs.

D) all of the above are appropriate strategies for the scenario described.


14. If your firm expects the euro to substantially depreciate, it could speculate by _______ euro call options or _______ euros forward in the forward exchange market.

A) selling; selling

B) selling; purchasing

C) purchasing; purchasing

D) purchasing; selling


15. Assume that a speculator purchases a put option on British pounds (with a strike price of $1.50) for $.05 per unit. A pound option represents 31,250 units. Assume that at the time of the purchase, the spot rate of the pound is $1.51 and continually rises to $1.62 by the expiration date. The highest net profit possible for the speculator based on the information above is:

A) $1,562.50.

B) -$1,562.50.

C) -$1,250.00.

D) -$625.00.


16. Which of the following is true?

A) The futures market is primarily used by speculators while the forward market is primarily used for hedging.

B) The futures market is primarily used for hedging while the forward market is primarily used for speculating.

C) The futures market and the forward market are primarily used for speculating.

D) The futures market and the forward market are primarily used for hedging.


17. A U.S. firm is bidding for a project needed by the Swiss government. The firm will not know if the bid is accepted until three months from now. The firm will need Swiss francs to cover expenses but will be paid by the Swiss government in dollars if it is hired for the project. The firm can best insulate itself against exchange rate exposure by:

A) selling futures in francs.

B) buying futures in francs.

C) buying franc put options.

D) buying franc call options.


18. A firm wants to use an option to hedge 12.5 million in receivables from New Zealand firms. The premium is $.03. The exercise price is $.55. If the option is exercised, what is the total amount of dollars received (after accounting for the premium paid)?

A) $6,875,000.

B) $7,250,000.

C) $7,000,000.

D) $6,500,000.

E) none of the above


19. The existing spot rate of the Canadian dollar is $.82. The premium on a Canadian dollar call option is $.04. The exer¬cise price is $.81. The option will be exercised on the expiration date, if at all. If the spot rate on the expira¬tion date is $.87, the profit as a percent of the initial invest¬ment (the premium paid) is:

A) 0 percent.

B) 25 percent.

C) 50 percent.

D) 150 percent.

E) none of the above


20. Macomb Corporation is a U.S. firm that invoices some of its exports in Japanese yen. If it expects the yen to weaken, it could _______ to hedge the exchange rate risk on those exports.

A) sell yen put options

B) buy yen call options

C) buy futures contracts on yen

D) sell futures contracts on yen


21. A U.S. corporation has purchased currency put options to hedge a 100,000 Canadian dollar (C$) receivable. The premium is $.01 and the exercise price of the option is $.75. If the spot rate at the time of maturity is $.85, what is the net amount received by the corporation if it acts rationally?

A) $74,000.

B) $84,000.

C) $75,000.

D) $85,000.


22. Johnson, Inc., a U.S.-based MNC, will need 10 million Thai baht on August 1. It is now May 1. Johnson has negotiated a non-deliverable forward contract with its bank. The reference rate is the baht’s closing exchange rate (in $) quoted by Thailand’s central bank in 90 days. The baht’s spot rate today is $.02. If the rate quoted by Thailand’s central bank on August 1 is $.022, Johnson will ________ $__________.

A) pay; 20,000

B) be paid; 20,000

C) pay; 2,000

D) be paid; 2,000

E) none of the above


23. Which of the following are true regarding the options markets?

A) Hedgers and speculators both attempt to lower risk.

B) Hedgers attempt to lower risk, while speculators attempt to make riskless profits.

C) Hedgers and speculators are both necessary in order for the market to be liquid.

D) all of the above


24. Your company expects to receive 5,000,000 Japanese yen 60 days from now. You decide to hedge your position by selling Japanese yen forward. The current spot rate of the yen is $.0089, while the forward rate is $.0095. You expect the spot rate in 60 days to be $.0090. How many dollars will you receive for the 5,000,000 yen 60 days from now?

A) $44,500.

B) $45,000.

C) $526 million.

D) $47,500.


25) The annualized dividend yield on the s&p 500 is 1.40%. The continuously compounded interest rate is 6.4%. if the 9-month forward price is $925.28 and the index is priced at 950.46$, what is the profit/loss from a cash and carry strategy?


a. 61.50 gain

b. 25.18 loss

c. 25.18 gain

d. 61.50 loss


26) The manager of a blue chip growth stock mutual fund is trying to fully hedge the $650 million portfolio position during the last two months of the calendar year. the current price of the S&P 500 Index futures contract is 1200. If the mutual fund has a beta of 1.24 how many contracts will be needed to hedge the fund?


a) 541,666





27) Consider an investment in five S&P 500 Index futures contracts at a price of $924.80. the initial margin requirement is 15% and the maintenance margin is 10.0%. If the continuously compounded interest rate is 5.0% what will the futures price need to be for a margin call to occur 10 days from now? Assume no settlement within the 10 days.


a.) $852.64


c.) $898.63



28) The price of an S&P 500 Index futures contract is $988.26 when you decide to enter a long position. When the position is closed the futures price is $930.32. If there are no settlement requirements, what is your percentage gain or loss under a 15.0% margin requirement? (Ignore opportunity costs)


a.) 39% gain

b.) 43% loss

c.) 43% gain

d.)39% loss


29.Which of the following contract terms is not set by the futures exchange?

a. the price

b. the deliverable commodities

c. the dates on which delivery can occur

d. the size of the contract

e. the expiration months


30. Find the forward rate of foreign currency Y if the spot rate is $4.50, the domestic interest rate is 6 percent, the foreign interest rate is 7 percent, and the forward contract is for nine months.

a. $5.104

b. none are correct

c. $4.458

d. $4.532

e. $4.468


31. Margin in a futures transaction differs from margin in a stock transaction because

a. stock transactions are much smaller

b. delivery occurs immediately in a stock transaction

c. no money is borrowed in a futures transaction

d. futures are much more volatile


32. Most futures contracts are closed by

a. exercise

b. offset

c. default

d. none are correct

e. delivery


33 Which of the following is not a forward contract?

a. an automobile lease non-cancelable for three years

b. none are correct

c. a signed contract to buy a house in six months

d. a long-term employment contract at a fixed salary

e. a rain check


34. One of the advantages of forward markets is

a. none are correct

b. the contracts are private and customized

c. trading is conducted in the evening over computers

d. performance is guaranteed by the G-30

e. trading is less costly and governed by more rules


35. Which of the following best describes normal contango?

a. none are correct

b. the futures price is less than the spot price

c. the cost of carry is negative

d. the expected spot price is less than the futures price

e. the spot price is less than the futures price


36 Suppose you sell a three-month forward contract at $35. One month later, new forward contracts are selling for $30. The risk-free rate is 10 percent. What is the value of your contract?

a. $4.55

b. $4.96

c. $4.92

d. $5

e. none are correct


37. Futures prices differ from spot prices by which one of the following factors?

a. the systematic risk

b. the risk premium

c. the spread

d. none are correct

e. the cost of carry


38. Suppose there is a risk premium of $0.50. The spot price is $20 and the futures price is $22. What is the expected spot price at expiration?

a. $21.50

b. none are correct

c. $24.50

d. $22.50

e. $20.50


39.Hedgers who are short in an asset can establish the maximum price they will have to pay for that asset by:


a) Buying a put option on the asset

b) Buying a call option on the asset

c) Writing a call option on the asset

d) Writing a put option on the asset

e) Either the first or fourth answer

f) Either the second or third answer


40.Options have an advantage over futures because:


  1. They provide a more certain hedge
  2. They are less likely to require delivery of the underlying asset
  3. They provide a hedge without removing the opportunity to make a profit
  4. They are likely to be cheaper because all one is buying is the right to do something


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