Download Basis Risk - Economics of Financial Markets - Exam and more Exams Financial Accounting in PDF only on Docsity! 1 Ollscoil na hÉireann, Gaillimh GX_____ National University of Ireland, Galway Autumn Examinations 2009 Exam Code(s) 4FM2 Exam(s) 4th B.Sc. in Financial Mathematics and Economics Module Code(s) EC410 Module(s) Economics of Financial Markets Seminar I Paper No. 1 Repeat Paper Special Paper External Examiner(s) Prof. C. Ryan Internal Examiner(s) Prof. E. O’Shea C. Twomey Instructions: EC410 Students Answer 3 questions If you attempt MORE THAN the correct number indicate clearly those questions which you wish to be graded. The use of calculators is permitted - programmable calculators may not be used. Duration 2hrs No. of Answer Books 1 Requirements: Statistical Tables - Yes Department(s) Economics 2 1. (a) What is meant by basis risk when futures contracts are used for hedging? (b) Explain why a short hedger’s position improves when the basis strengthens unexpectedly and worsens when the basis weakens unexpectedly. (c) A Paris-based fund manager has a portfolio worth €80 million with a beta of 0.80. The manager is concerned about the performance of the French stock market over the next two months and plans to use three-month futures on the CAC 40 to hedge the risk. The current level of the CAC 40 is 5,450, one futures contract is on 250 times the index, the risk-free rate is 4% p.a. with continuous compounding, and the dividend yield on the index is 2% per annum. (i) Write out the theoretical relationship for the futures price. Calculate its value in the above case. (ii) What position should the fund manager take to eliminate all exposure to the market over the next two months? (iii) Suppose that the fund manager wishes to change the portfolio’s beta to 0.45. What position should the manager now take? (iv) Based on your strategy in part (ii), calculate its effects on the fund manager’s returns if the level of the CAC 40 in two months is 5,000 and 6,000. 2. (a) Derive the upper and lower bounds for the price of a European put option on a dividend-paying stock. Using the above bounds, identify the arbitrage opportunities in the following situation: A four-month European put option on a dividend-paying stock is currently selling for €0.70. The stock price is €18, the strike price is €18.50, and a dividend of €0.55 is expected in two months. The risk-free interest rate is 5% per annum for all maturities. (b) The price of a share is €40. The price of a 1-year European put option on the stock with a strike price of €30 is quoted as €7 and the price of a 1-year European call option on the share with a strike price of €50 is quoted as €5. Suppose that an investor buys 100 shares, shorts 100 call options, and buys 100 put options. Draw a diagram illustrating how the investor’s profit or loss varies with the share price over the next year.
