REVIEW FOR FINAL

Question 01: An investor shorts 100 shares when the share price is $52 and closes out the
position six months later when the share price is $45. The shares pay a dividend of $3 per share
during the six months. How much does the investor gain?

Question 02: A one-year call option on a stock with a strike price of $30 costs $3; a one-year
put option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call
options and one put option. The breakeven stock price above (below) which the trader makes
a profit is?

Question 03: An investor takes a long position in two December gold futures contracts on June
5. The contract size is 100 oz. The futures price is US$1,450. The initial margin requirement is
US$6,000/contract (US$12,000 in total). The maintenance margin is US$4,500/contract
(US$9,000 in total).

Make a table of the account of the contract as following the settle price:

Date 3-Jul 8-Aug 9-Sep 5-Oct 3-Nov 2-Dec

Settle price 1,441.00 1,448.30 1,436.20 1,419.90 1,440.80 1,436.90
($)
Question 04: Assuming REE's current share price is $ 60, the option to sell at $ 60 is $
2.0/share. The risk-free rate is 1% per option exercising period.

Investors want to combine covered call options to make a profit.

a. Use balance options to calculate the price call option.

b. Make a spreadsheet and identify the break-even point, maximum loss of strategy.

c. Draw illustrations and footnotes.

Note: A covered call is a kind of options strategy that offers limited return for limited risk. A
covered call involves selling a call option on a stock that you already own. By owning the
stock, you're “covered” (i.e. protected) if the stock rises and the call option expires in the
money.
Question 05: At the beginning of 2016, Company A and B agreed to exchange SWAP currency
pair USD-VND within 2 years. Company A will receive USD and pay VND interest rate for B,
while B will receive VND and pay USD for A. Interest is VND 14% and USD 5%, pay every
6 months. The swap amount is USD 1 million, the exchange rate for the beginning of 2016 is
VND 21.500 / USD

a) Make the actual payment result sheet of A and B.

b) In fact, by the end of 2017, the exchange rate of USD / VND is 23.000 VND, which company
will benefit?

Question 06: An agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 6%
per annum every 6 months for 3 years on a notional principal of $10,000,000 with IBM Co.

Illustrates cash flows that could occur (Day count conventions are not considered) by table for
payment between Microsoft and IBM Co?

Date 1/1/2016 1/7/2016 1/1/2017 1/7/2017 1/1/20 1/7/201

18 8
Rate 5.8% 6.2% 6.0% 6.5% 5.5% 7.0%
Question 07: On March 1 a commodity’s spot price is $60 and its August futures price is $59.
On July 1 the spot price is $64 and the August futures price is $63.50. A company entered into
futures contracts on March 1 to hedge its purchase of the commodity on July 1. It closed out
its position on July 1. What is the effective price (after taking account of hedging) paid by the
company?

Question 08: On March 1 the price of a commodity is $985 and the December futures price is
$1,013. On November 1 the price is $980 and the December futures price is $981. A producer
of the commodity entered into a December futures contracts on March 1 to hedge the sale of
the commodity on November 1. It closed out its position on November 1. What is the effective
price (after taking account of hedging) received by the company for the commodity?

Question 09: Explain the difference between the credit risk and the market risk in a financial
contract.?

Credit risk is the possibility of financial loss due to a counterparty's failure to fulfill its
contractual obligations, such as a borrower defaulting on a loan, and is managed through credit
analysis, collateral, and insurance.
In contrast, market risk arises from adverse movements in market prices, such as interest rates,
stock prices, or exchange rates, affecting the value of assets or liabilities, and is mitigated
through hedging, diversification, and risk modeling. While credit risk focuses on counterparty
default, market risk stems from broader market volatility.

Question 10: Why is the expected loss to a bank from a default on a swap less than the expected
loss from the default on a loan to the counterparty with the same principal? Assume no other
transactions between the bank and the counterparty, that the swap is cleared bilaterally, and that
no collateral is provided by the counterparty in the case of either the swap or the loan.

The expected loss to a bank from a default on a swap is generally lower than the expected loss
from a default on a loan with the same counterparty and principal due to the nature of the
exposures involved in each type of transaction.

In a swap, the bank’s exposure at any given time is limited to the net present value of the future
cash flows owed by the counterparty, which is usually a small fraction of the notional principal.
This is because swaps are financial derivatives where only the net difference between the cash
flows exchanged is at risk, rather than the full notional amount.

Conversely, in a loan, the bank is exposed to the entire outstanding principal amount, which
significantly increases the potential loss in the event of default. Since swaps are cleared
bilaterally and do not involve the transfer of the notional principal, the financial risk at default
is inherently much smaller. This difference in exposure structure explains why the expected
loss from a swap default is lower, despite the lack of collateral or other mitigating transactions.
Question 11: Explain what happens when an investor shorts a certain share.

Borrowing the Shares: The investor borrows shares of the stock from a broker or another
investor. This is typically facilitated through a margin account.

Selling the Borrowed Shares: The investor immediately sells the borrowed shares at the
current market price, generating cash. For example, if the share price is $100, the investor sells
the borrowed shares for $100 per share.

Price Movement:
• If the share price falls, the investor can buy back the shares at a lower price. For
example, if the price drops to $80, the investor can repurchase the shares for $80 each,
return them to the lender, and keep the $20 per share difference as profit.

• If the share price rises, the investor will have to buy back the shares at a higher price.
For instance, if the price rises to $120, the investor must pay $120 per share to
repurchase and return them, resulting in a $20 per share loss.

Returning the Shares: The investor buys back (covers) the shares at some point in the
future and returns them to the lender.

Profit or Loss: The investor’s profit or loss is the difference between the price at which the
shares were sold and the price at which they were repurchased, adjusted for borrowing fees and
transaction costs.

Question 12: Explain why a foreign currency can be treated as an asset providing a known
yield?
A foreign currency can be treated as an asset with a known yield because holding it allows
access to the interest rate in its home country, which provides a predictable return. For instance,
depositing euros in a European bank earns the eurozone's interest rate, acting as the currency's
yield.
This concept is reflected in foreign exchange markets, where forward rates incorporate interest
rate differentials, ensuring arbitrage-free conditions through covered interest rate parity. By
treating a currency's interest rate as its yield, it becomes comparable to assets like bonds with
fixed returns.

This simplifies financial analysis and decision-making, allowing investors to incorporate the
known yield into models for pricing derivatives, assessing risks, and managing portfolios
effectively.

Question 13: What is the difference between the forward price and the value of a forward
contract?

The forward price is the fixed price agreed upon at the initiation of a forward contract,
representing the price at which the underlying asset will be bought or sold at a specified future
date. This price is set such that the contract has no initial value, meaning neither party has an
advantage when the contract is established. The forward price is determined by factors such as
the current spot price of the asset, the risk-free interest rate, and any associated costs or benefits
of holding the asset, such as storage costs or dividends.

In contrast, the value of a forward contract refers to the profit or loss a party would realize if
the contract were settled before its maturity. Initially, the contract's value is zero because the
forward price is set to equalize the positions of both parties. However, as market conditions
change, the value fluctuates based on the difference between the forward price and the market’s
current expectations for the asset's future price. This value reflects how favorable or
unfavorable the contract has become for the parties involved over time.
Question 14: Explain why margin accounts are required when clients write options but not
when they buy options?

“Employee stock options issued by a company are different from regular exchange-traded call
options on the company’s stock because they can affect the capital structure of the company.”
Explain this statement.

Margin accounts are required when clients write options because writing (selling) options
involves significant risk exposure. When an investor writes a call option, they are obligated to
sell the underlying asset at the strike price if the option is exercised, regardless of how high the
market price rises. Similarly, writing a put option obligates the writer to buy the underlying
asset at the strike price, even if its market value falls significantly. These obligations can lead
to potentially unlimited losses for the option writer, depending on market movements. Margin
accounts serve as collateral to ensure the writer can meet these obligations and protect the
broker from the risk of default.

On the other hand, margin accounts are not required for buying options because the buyer's risk
is limited to the premium paid for the option. Whether the underlying asset moves significantly
in the buyer's favor or not, their maximum possible loss is the upfront cost of purchasing the
option. This capped risk eliminates the need for a margin account since no additional collateral
is required to cover potential losses.

Employee stock options (ESOs) differ from exchange-traded call options because ESOs can
affect a company’s capital structure, whereas exchange-traded options do not. When employees
exercise ESOs, the company typically issues new shares to meet the demand, increasing the
total number of outstanding shares. This dilution can impact existing shareholders by reducing
their ownership percentage and can also affect financial metrics like earnings per share (EPS).
In contrast, exchange-traded call options are financial instruments traded between investors,
with no new shares issued or involvement from the company, leaving its capital structure
unchanged.
Question 15: A bank finds that its assets are not matched with its liabilities. It is taking floating-
rate deposits and making fixed-rate loans. How can swaps be used to offset the risk?

The bank faces significant interest rate risk because its liabilities (floating-rate deposits) are
not matched with its assets (fixed-rate loans). If interest rates rise, the cost of servicing floating-
rate deposits will increase, while the income from fixed-rate loans remains unchanged,
potentially squeezing the bank's net interest margin. To mitigate this risk, the bank can use
interest rate swaps to align the cash flows of its liabilities and assets more effectively.

In this scenario, the bank can enter into an interest rate swap agreement where it agrees to
receive floating-rate payments and pay fixed-rate payments. By receiving floating-rate
payments, the bank offsets the rising costs of its floating-rate deposits when interest rates
increase. At the same time, paying fixed-rate amounts through the swap aligns with the fixed-
rate income generated by the loan portfolio, maintaining stability in the bank’s cash flows. The
notional principal of the swap is chosen to match the value of the fixed-rate loans to ensure
effective risk management.

The use of the swap helps the bank hedge against fluctuations in interest rates, ensuring a stable
net interest margin. If interest rates rise, the additional floating-rate income from the swap
compensates for higher deposit costs. Conversely, if rates fall, the lower deposit costs are
balanced by reduced floating-rate income from the swap. This strategy not only stabilizes the
bank's profitability but also provides flexibility, as the swap’s terms can be tailored to meet the
bank’s specific needs.