Question 1

a).

S&P500 index is relevant for the pricing of the index futures because it tracks the movement within the market from time to time and it updates its prices on daily basis. The primary reason due to which S&P500 index is used for pricing the index futures is that it contains all the large cap companies within the index and this gives the index a wide market breadth. This makes it relevant for pricing of index futures.

b).

The meaning of basis risk in this context is that there is the risk that the value of the future contract that would be entered by the investor will not move in line with the underlying exposure to which the portfolio of 20 million Euro is exposed. It is also the risk that the cash futures spread would become wide or they might become narrow between the time when the hedge is implemented and then is liquidated. This risk is called as basis risk.

c).

The hedge ratio for the futures compares the value of the position of the investor through the use of the size of the entire position and the hedge. The beta is multiplied with the entire position to compute the total value to be hedged and then it is divided by one future contract to determine the optimal future contracts that would be required to achieve the optimal hedge. These number of contracts must be purchased to hedge the exposure. This hedge ratio is dependent upon the most important assumption that there is correlation between the changes in the futures and the spot prices and also the ratio of the standard deviation of the spot prices to the standard deviation of the futures prices.

Risk Management Assignment Harvard Case Solution & Analysis

Question 2

The computations for the financial loss at the end of year 3 for the financial institution are as follows:

Swap Profit/Savings Computations

Financial Institution

Fixed

2.00%

Company X

Floating L

-0.25%

Financial Institution

Fixed

Floating

Receives

2.00%

0.00%

Frequency

1

4

Pays

0.00%

2.00%

Frequency

1

2

Maturity

5

5

Fees

0

PV OF fixed

9.80%

PV of Floating

0.00%

All in profit PV

9.80%

Principle Amount

20

Million Euro

Quantified Financial Loss

1.959

Million Euro

Question 3

a).

Speculators are the traders that can make a profit in this situation and on the other hand the investors that have to make the payments can make a profit from this situation as the price of 1 call is less than the price of 1 put option.

b).

An investor or speculator can make an arbitrage profit by buying the put options and selling the call options. The arbitrage profit that could be made by using 1 call and 1 put option would be as follows:

Arbitrage Profit CHF

Strike price of Put

30

Stock Price

27

Put Option Payoff

3

Put Option Value

4

Put Option Profit/(Loss)

-1

Call Option Value

2

Arbitrage Profit

1

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