Alternative Investments: FIN 423 Fall 2019 page Exam 1-1/16

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1. Chapter 1
1.1. Problem 1.1. What is the difference between a long futures position and a short futures position?
a) Long futures have longer maturity that short futures
b) When you buy a futures we call it taking a long position, short when you sell the futures.
c) Actually, short futures have longer maturity that long futures
d) Long futures require margin while short futures do not
e) None of the above
When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for
a certain price at a certain time in the future. When a trader enters into a short forward contract,
she is agreeing to sell the underlying asset for a certain price at a certain time in the future.

1.2. Problem 1.2. Explain carefully the difference between (a) hedging, (b) speculation, and (c) arbitrage.
a) Hedging implies taking extra risk, speculation mean reducing risk and arbitrage means both
increasing and reducing risk at different times.
b) Hedging implies reducing risk, speculation mean increasing risk and arbitrage means buying
and selling the “same” security in two markets.
c) There is no difference between hedging and speculating because both use derivatives to transfer
risk.
d) Hedging implies reducing risk, speculation mean increasing risk and arbitrage means both
increasing and reducing risk at different times.
e) None of the above
A trader is hedging when she has an exposure to the price of an asset and takes a position in a
derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is
betting on the future movements in the price of the asset. Arbitrage involves taking a position in
two or more different markets to lock in a profit.

1.3. Problem 1.3. What is the difference between (i) entering into a long futures contract when the futures
price is $50 and (ii) taking a long position in a call option with a strike price of $50?—Some questions
are a bit more of a stretch than others. We have not mentioned options too much in class.
a) Because you are buying at $50 in both cases it makes no difference.
b) A long futures at $50 means that you have to buy the underlying at $50 while an option means
that you have the option to buy at $50 if you want.
c) There is no difference.
d) It depends on the time of the year.
e) None of the above
In the first case the trader is obligated to buy the asset for $50. (The trader does not have a
choice.) In the second case the trader has an option to buy the asset for $50. (The trader does not
have to exercise the option.)

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-2/16
1.4. Problem 1.4. An investor enters into a Long forward contract to buy 200,000 British pounds for U.S.
dollars at an exchange rate of 1.5000 U.S. dollars per pound. How much does the investor gain or lose if
the exchange rate at the end of the contract is (i) 1.4900 and (ii) 1.5200?
a) i) Loss of $4,000, ii) Gain of $2,000
b) i) Gain of $1,000, ii) Loss of $5,000
c) i) Loss of $2,000, ii) Gain of $4,000
d) i) Gain of $3,000, ii) Loss of $3,000
e) None of the above
i. The investor is obligated to buy pounds for 1.5000 when they are worth 1.4900. The loss is
(1.5000−1.4900) ×200,000 = $2,000.
ii. The investor is obligated to buy pounds for 1.5000 when they are worth 1.5200. The gain is
(1.5200−1.5000)×200,000 = $4,000
1.5.
1.6. Problem 1.6. You would like to speculate on a rise in the price of a certain stock. The current stock
price is $29 and a three-month call with a strike price of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative strategies. Briefly outline the advantages and disadvantages of each.
a) i) You can buy 200 shares with your $5,800 or ii) Buy 2,000 calls with the same money. Because
the stock is too expensive we should just buy the options.
b) i) You can buy 200 shares with your $5,800 or ii) Buy 2,000 calls with the same money. Buying the
options is not a good idea because they seem too cheap compared to the stock.
c) i) You can buy 200 shares with your $5,800 or ii) Buy 2,000 calls with the same money. With
the options you have exposure to more shares (ten times more) but you can lose all your
money.
d) i) You can buy 200 shares with your $5,800 or ii) Buy 2,000 calls with the same money. Since you
would be spending the same amount of money there is no difference.
e) None of the above
One strategy would be to buy 200 shares. Another would be to buy 2,000 options. If the share
price does well the second strategy will give rise to greater gains. For example, if the share price
goes up to $40 you gain [2,000 ×($40 - $30)] - $5,800 = $14,200 from the second strategy and only
200×($40 - $29) = $2,200 from the first strategy. However, if the share price does badly, the second
strategy gives greater losses. For example, if the share price goes down to $25, the first strategy
leads to a loss of 200×($29 - $25) = $800, whereas the second strategy leads to a loss of the whole
$5,800 investment. This example shows that options contain built in leverage.

1.7. Problem 1.7. What is the difference between the over-the-counter and the exchange-traded market?
What are the bid and offer quotes of a market maker in the over-the-counter market?
a) An OTC market is a decentralized market, you basically transact with a bank. An exchange-
traded market is a centralized institution where all orders arrive at the same “location.”
Brokers or market makers provide bid and ask prices at which they are willing to buy and
sell the security respectively.
b) With computers there is no difference between OTC and exchange traded markets.
c) Because they are both shrinking there is no difference between them.
d) You do not need a prescription for an OTC market, for exchange traded markets you do. Bid and
offer prices are the prices quoted at the exchange-traded markets.
e) None of the above
The difference is that OTC markets are decentralized between two parties while an exchange
traded market is centralized. The bid and ask prices apply to OTC markets and represent the
prices at which the market maker (dealer) is willing to buy (is bidding) the security and the price
at which he is willing to sell (asking for) the security.
1.8.
1.9.
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Alternative Investments: FIN 423 Fall 2019 page Exam 1-3/16
1.10.
1.11.
1.12.
1.13.
1.14.
1.15.
1.16.
1.17.
1.18.
1.19.
1.20.
1.21.
1.22.
1.23.
1.24.
1.25.
1.26. Problem 1.26. A put (the right to sell at a given price) allows you to sell at the strike price even if the
price of the stock is lower than the price in the contract. Is the statement true or false: “Buying a put
option on the stock when the stock is owned is a form of insurance.”?
a) True.
b) It depends on the value of the stock.
c) It depends on the value of the put option.
d) False.
e) None of the above
If the stock price declines below the strike price of the put option, the stock can be sold for the
strike price.

2. Chapter 2:
2.1. Problem 2.1. Distinguish between the terms open interest and trading volume.
a) Open interest means how much you are interested in buying and trading volume indicates how
much you have traded in the past.
b) Trading volume means how much you are interested in buying and open interest indicates how
much you have traded in the past.
c) In exchange markets open interest indicates how many positions exist for a specific contract
and volume indicates for a given period of time how many contracts have traded.
d) None of the above.
The open interest of an exchange traded contract at a particular time is the total number of long
positions outstanding. (Equivalently, it is the total number of short positions outstanding.) The
trading volume during a certain period is the number of contracts that traded during this period.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-4/16
2.2. Problem 2.2. What is the difference between a local and a futures commission merchant?
a) A local is a guy from town that complaints about college kids with all the dates.
b) A commission merchant trades locally products from all over the world.
c) A local trades for his/her own account and a FCM is a broker that trades on behalf of clients
bringing order to the “floor”.
d) Locals and FCM do the same thing.
e) None of the above
A futures commission merchant trades on behalf of a client and charges a commission. A local
trades on his or her own behalf.

2.3. Problem 2.3. Suppose that you enter into a short futures contract to sell July silver for $27.20 per ounce.
The size of the contract is 5,000 ounces. The initial margin is $4,000, and the maintenance margin is
$3,000. What change in the futures price will lead to a margin call? What happens if you do not meet the
margin call?
a) Drop to $21.40; the contract is doubled if you do not meet the margin call
b) Increase to $29.40; the contract is doubled if you do not meet the margin call
c) Increase to $27.40; the contract is closed if you do not meet the margin call
d) None of the above
There will be a margin call when $1,000 has been lost from the margin account. This will occur
when the price of silver increases by 1,000/5,000 $0.20. The price of silver must therefore rise to
$17.40 per ounce for there to be a margin call. If the margin call is not met, your broker closes out
your position.
2.4.
2.5.
2.6.
2.7.
2.8. Problem 2.8. The party with a short position in a futures contract sometimes has options as to the
precise asset that will be delivered, where delivery will take place, when delivery will take place, and so
on. i) Do these options increase or decrease the futures price? ii) Why?
a) i) Decrease, ii) Because it favors the seller
b) i) Increase, ii) Because it favors the buyer.
c) i) Decrease, ii) Because it favors the buyer.
d) i) Increase, ii) Because it favors the seller.
e) None of the above
2.9.
2.10.
2.11.
2.12.
2.13.
2.14.
2.15.
2.16.

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2.17. Problem 2.17. The forward price on the Swiss franc for delivery in 45 days is quoted as 1.100000
CHF/USD. The futures price for a contract that will be delivered in 45 days is 0.909091 USD/CHF.
i) Explain these two quotes; ii) which is more favorable for an investor wanting to sell Swiss francs?
a) i) The forward is the price of USD in CHF, and the futures is the price of CHF in USD ii) The
forward is more favorable.
b) i) The futures is the price of USD in CHF, and the forward is the price of CHF in USD ii) The
futures is more favorable.
c) i) The forward is the price of USD in CHF, and the futures is the price of CHF in USD ii)
Neither.
d) i) The futures is the price of USD in CHF, and the forward is the price of CHF in USD ii) The
forward is more favorable.
e) None of the above
The 1.1000 forward quote is the number of Swiss francs per dollar. The 0.909091 futures quote is
the number of dollars per Swiss franc. When quoted in the same way as the futures price the
forward price is 𝟏/𝟏. 𝟏𝟎𝟎𝟎 𝟎. 𝟗𝟎𝟗𝟏. The Swiss franc is therefore has the same price in both
markets so a seller should be indifferent.

3. Chapter 3:
3.1. Problem 3.1. Under what circumstances are (a) a short hedge and (b) a long hedge appropriate?
a) If you own the asset you want a long hedge, and if you owe the asset you want a short hedge
b) If you own the asset you want a short hedge, and also if you owe the asset you want a short hedge
c) If you own the asset you want a short hedge, if you owe the asset you want a long hedge
d) None of the above.
A short hedge is appropriate when a company owns an asset and expects to sell that asset in the
future. It can also be used when the company does not currently own the asset but expects to do so
at some time in the future. A long hedge is appropriate when a company knows it will have to
purchase an asset in the future. It can also be used to offset the risk from an existing short
position.

3.2. Problem 3.2. Explain what is meant by basis risk when futures contracts are used for hedging.
a) When the product described in the futures is not identical to the spot, the hedger will be uncertain as
to the convergence of the futures to the spot at maturity.
b) The basis describes the possible lack of convergence of the futures to the spot at maturity.
c) Answer a) and b).
d) Answer a) or b).
e) None of the above
Basis risk arises from the hedger’s uncertainty as to the difference between the spot price and
futures price at the expiration of the hedge.
3.3.
3.4. Problem 3.4. Under what circumstances does a minimum variance hedge portfolio lead to no hedging at
all?
a) If the coefficient of correlation between the changes in the futures price and the changes of the spot
price is minus 1 (-1).
b) If the coefficient of correlation between the changes in the futures price and the changes of the spot
price is plus 1 (+1).
c) If the coefficient of correlation between the changes in the futures price and the changes of the
spot price is zero (0).
d) None of the above
A minimum variance hedge leads to no hedging when the coefficient of correlation between the
futures price changes and changes in the price of the asset being hedged is zero.
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Alternative Investments: FIN 423 Fall 2019 page Exam 1-6/16
3.5.
3.6.
3.7. Problem 3.7. An equity portfolio manager has a $2 billion portfolio with a beta of 1.1. It would like to
use futures contracts on a well-diversified stock index to hedge its risk. The index futures price is
currently 2080, and each contract is for delivery of $250 times the index. i) How many contracts should
he buy or sell to get to a beta of zero, i) How many contracts should he buy or sell to get to beta of 0.6?
a) i) Buy 3,846 contracts, ii) Sell 1,923 contracts.
b) i) Buy 3,846 contracts, ii) Buy 1,923 contracts.
c) i) Sell 3,846 contracts, ii) Sell 1,923 contracts.
d) i) Sell 3,846 contracts, ii) buy 1,923 contracts.
e) None of the above
The formula for the number of contracts that should be shorted gives
𝟐, 𝟎𝟎𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎
𝟏. 𝟐 𝟑𝟖𝟒𝟔. 𝟏𝟓
𝟐𝟎𝟖𝟎 𝟐𝟓𝟎
Rounding to the nearest whole number, 3,846 contracts should be shorted. To reduce the beta to
0.6, half of this position, or a short position in 1,923 contracts, is required.
3.8.
3.9.
3.10.
3.11.
3.12.
3.13.
3.14.
3.15.
3.16.
3.17.
3.18.
3.19.
3.20.
3.21.

4. Chapter 4:
4.1. Problem 4.1. A bank quotes an interest rate of 14% per annum with quarterly compounding. What is the
equivalent rate with (a) continuous compounding and (b) annual compounding?
a) 14.75 % for annual compounding and 13.76% for continuous compounding.
b) 14.75 % both for annual compounding and continuous compounding.
c) 14.75 % for continuous compounding and 13.76% for annual compounding.
d) None of the above
(a) The rate with continuous compounding is 4 ln [1 + (0.14/4)] = 0.1376, or 13.76%. (b) The rate
with annual compounding is [1 + (0.14/4)]4 = 0.1475, or 14.75% per annum.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-7/16
4.2. Problem 4.2. What is meant by LIBOR?
a) LIBOR is the London interbank offer rate. It is an estimate of the rate at companies can borrow
from their banks for a period of time. The periods of time considered range from one day to one
year.
b) LIBOR is the London interbank offer rate. It is an estimate of the rate at low credit companies can
borrow from their banks for a period of time. The periods of time considered range from one day to
one year.
c) LIBOR is the London interbank offer rate. It is an estimate of the rate at which a AA-rated
bank can borrow from other banks for a period of time. The periods of time considered range
from one day to one year.
d) None of the above
LIBOR is the London interbank offer rate. It is an estimate of the rate at which a AA-rated bank
can borrow from other banks for a period of time. The periods of time considered range from one
day to one year.

4.3. Problem 4.3. The six-month and one-year zero rates are both 10% per annum. For a bond that has a life
of 18 months and pays a coupon of 8% per annum semiannually (with a coupon payment having just
been made), the yield is 10.4% per annum. What is the bond’s price? What is the 18-month zero rate?
All rates are quoted with semiannual compounding.
a) The bond price is $104.72; R = 10.42%
b) The bond price is $96.74; R = 8.42%
c) The bond price is $96.74; R = 10.42%
d) None of the above.
Suppose the bond has a face value of $100. Its price is obtained by discounting the cash flows at
10.4%. The price is [4/(1.052)1] + [4/(1.052)2] + [(104)/(1.052)3] = 96.74. If the 18-month zero rate is
R, we must have [4/(1.05)1] + [4/(1.05)2] + [(104)/(1 + R)3] = 96.74; which gives R = 10.42%.
4.4. Problem 4.4. An investor receives $1,100 in one year in return for an investment of $1,000 now.
Calculate the percentage return per annum with (i) annual compounding, (ii) semiannual compounding,
(iii) monthly compounding, and (iv) continuous compounding.
a) (i) R = 11% with annual compounding; (ii) R = 10.76% with semi-annual compounding; (iii) R =
10.57% with monthly compounding; and (iv) R = 10.53% with continuous compounding.
b) (i) R = 9% with annual compounding; (ii) R = 8.76% with semi-annual compounding; (iii) R =
8.57% with monthly compounding; and (iv) R = 8.53% with continuous compounding.
c) (i) R = 9% with annual compounding; (ii) R = 8% with semi-annual compounding; (iii) R = 8%
with monthly compounding; and (iv) R = 8% with continuous compounding.
d) (i) R = 10% with annual compounding; (ii) R = 9.76% with semi-annual compounding; (iii) R
= 9.57% with monthly compounding; and (iv) R = 9.53% with continuous compounding.
e) None of the above.
i. With annual compounding the return is 1,100/1,000 - 1 = 0.1; or 10% per annum.
ii. With semiannual compounding the return is R, where 1000 [1 + (R/2)2] = 1,100, that is, 1 +
(R/2) = SQRT(1.1) = 1.0488; so that R = 0:0976. The percentage return is therefore 9.76%
per annum.
iii. With monthly compounding the return is R, where1000 [1 + (R/12)12] = 1,100, that is, 1 +
(R/12) = ROOT_12(1.1) = 1:00797, so that R = 0:0957. The percentage return is therefore
9.57% per annum.
iv. With continuous compounding the return is R, where 1,000 eR = 1,100; that is eR = 1.10. So
that R = ln (1.1) = 0:0953. The percentage return is therefore 9.53% per annum.

4.5.
4.6.
4.7.
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Alternative Investments: FIN 423 Fall 2019 page Exam 1-8/16
4.8. Problem 4.8. The cash prices of six-month and one-year Treasury bills are 95.0 and 88.0. A 1.5-year
bond that will pay coupons of $3.5 every six months currently sells for $91. A two-year bond that will
pay coupons of $5 every six months currently sells for $87. Calculate the continuous compounding i)
six-month, ii) one-year, and iii) 1.5-year, zero rates.
a) i) 13.45%, ii) 12.78%, and iii) 10.26%.
b) i) 10.26%, ii) 13.45%, and iii) 12.78%.
c) i) 12.78%, ii) 12.78%, and iii) 12.78%.
d) i) 10.26%, ii) 12.78%, and iii) 13.45%.
e) None of the above
The 6-month/12-month/18-month continuous compounding Treasury bill are –𝒍𝒏 𝟎. 𝟗𝟓 /𝟎. 𝟓
𝟏
𝟏𝟎. 𝟐𝟓𝟖𝟕% per annum; –𝒍𝒏 𝟎. 𝟖𝟖 /𝟏 𝟏𝟐. 𝟕𝟖𝟑𝟑% per annum; and for the 1 year bond we
𝟐
𝟎.𝟏𝟎𝟐𝟓𝟖𝟕 𝟎.𝟓 𝟎.𝟏𝟐𝟕𝟖𝟑𝟑 𝟏 𝟏.𝟓𝑹 𝟏
must have 𝟑. 𝟓𝒆 𝟑. 𝟓𝒆 𝟏𝟎𝟑. 𝟓𝒆 𝟗𝟏; where 𝑹 is the 𝟏 year zero
𝟐
rate. It follows that 𝟑. 𝟑𝟐𝟓𝟎 𝟑. 𝟎𝟖𝟎𝟎 𝟏𝟎𝟑. 𝟓𝒆 𝟏.𝟓𝑹 𝟗𝟏; 𝒆 𝟏.𝟓𝑹 𝟎. 𝟗𝟑𝟓𝟗𝟓𝟎; 𝑹 𝟎. 𝟏𝟑𝟒𝟒𝟔;
or 13.45%.
For the 2-year bond we must have: 𝟓 𝒆 𝟎.𝟏𝟐𝟑𝟖 𝟎.𝟓 𝒆 𝟎.𝟏𝟏𝟔𝟓 𝟏 𝒆 𝟎.𝟏𝟏𝟓 𝟏.𝟓 𝟏𝟎𝟓𝒆 𝟐𝑹 𝟖𝟕;
where 𝑹 is the 2-year zero rate. It follows that 𝒆 𝟐𝑹 𝟎. 𝟖𝟔𝟕𝟔𝟑𝟑; 𝑹 𝟎. 𝟏𝟕𝟔𝟓𝟓 or 17.655%.
4.9.
4.10. Problem 4.10. A deposit account pays 7% per annum with continuous compounding, but interest is
actually paid quarterly, you will withdraw from the account your interest each quarter. How much
interest will be paid each quarter on a $50,000 deposit?
a) $302.45
b) $1,522.73.
c) $219.23.
d) $882.70
e) None of the above
A quarter later the value of the account will be $50,000×e0.25×0.07 = $50,882.7011, so you can
withdraw $882.7011 and be left with just the principal of $50,000 to start the process again.
Alternatively, the equivalent rate with quarterly compounding is R where e0.07 = (1 + R/4)4; or 𝑹
𝟎.𝟎𝟕
𝟎.𝟎𝟕𝟎𝟔
𝟒 𝒆 𝟒 𝟏 𝟎. 𝟎𝟕𝟎𝟔. The amount of interest paid each quarter would be: $𝟓𝟎, 𝟎𝟎𝟎
𝟒
𝟖𝟖𝟐. 𝟕𝟎𝟏𝟏, or $822.7011.
4.11. Problem 4.11. Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero rates are 4%,
4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively. Estimate the cash
price of a bond with a face value of 100 that will mature in 18 months and pays a coupon of 4.5% per
annum semiannually.
a) $100.08.
b) $101.08.
c) $102.08.
d) $103.08.
e) None of the above
The bond pays $2.25 in 6, 12, and $102.25 in 18 months. The cash price is
𝟐. 𝟐𝟓𝒆 𝟎.𝟎𝟒 𝟎.𝟓 𝟐. 𝟐𝟓𝒆 𝟎.𝟎𝟒𝟐 𝟏.𝟎 𝟏𝟎𝟐. 𝟐𝟓𝒆 𝟎.𝟎𝟒𝟒 𝟏.𝟓 𝟏𝟎𝟎. 𝟎𝟖𝟐𝟑; or $100.08;
𝟐. 𝟐𝟓 𝒆 𝟎.𝟎𝟒 𝟎.𝟓 𝒆 𝟎.𝟎𝟒𝟐 𝟏.𝟎 𝒆 𝟎.𝟎𝟒𝟒 𝟏.𝟓 𝟏𝟎𝟎𝒆 𝟎.𝟎𝟒𝟒 𝟏.𝟓 𝟏𝟎𝟎. 𝟎𝟖𝟐𝟑; or $100.08;
𝟐.25×[d1 + d2 + d3] + 100 d3 = 100.0823; or $100.08

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-9/16
4.12. Problem 4.13. Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are 5%, 6%,
6.5%, and 7% respectively. What is the eighteen-month par yield? Verify, pricing a bond with this
coupon.
a) 8.56%.
b) 6.56%.
c) 8.58%.
d) 6.58%.
e) None of the above
Using the notation in the text, 𝑚 2, 𝑑 𝑒 . .
0.9071. Also
. . . . . .
𝐴 𝑒 𝑒 𝑒 2.8242
The formula in the text gives the par yield as
100 100 0.9071 2
6.5787
2.8242
To verify we calculate the value of a bond that pays a coupon of 7.0741% per year (that is 3.5370 every
six months). The value is 3.2894𝑒 . .
3.2894𝑒 . .
103.2894𝑒 . .
100;
verifying that 6.5787% is the par yield.

4.13. Problem 4.14. Suppose that risk-free zero interest rates with continuous compounding are as follows:
Maturity( years) Rate (% per annum)
1 3.0
2 4.0
3 5.0
4 6.0
5 7.0
Calculate forward interest rates (t-1ft) for the i) second (t = 2), ii) third (t = 3), and iii) fourth (t = 4)
years.
a) i) 4%, ii) 5%, and iii) 6%.
b) i) 5%, ii) 7%, and iii) 9%.
c) i) 6%, ii) 8%, and iii) 10%.
d) i) 6%, ii) 7%, and iii) 8%.
e) None of the above
The forward rates with continuous compounding are as follows to: i) year 2: 5.0%; ii) year 3: 7.0%, and
to year 4: 9.0%
4.14.
4.15.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-10/16
4.16. Problem 4.16. A 10-year, 8% Treasury coupon bond currently sells for $90. A 10-year, 4% coupon
Treasury bond currently sells for $80. What is the 10-year zero rate? (Hint: Consider taking a long
position in two of the 4% coupon bonds and a short position in one of the 8% coupon bonds.)
a) 3.57%.
b) 3.67%.
c) 4.57%.
d) 7.54%.
e) None of the above
Taking a long position in two of the 4% coupon bonds and a short position in one of the 8%
coupon bonds leads to the following cash flows Year 0: $90 − 2×$80 = −$70. Year 10: 200 – 100 =
100; because the coupons cancel out. $100 in 10 years time is equivalent to $70 today. The 10-year
𝟏 𝟏𝟎𝟎
rate, R, (continuously compounded) is therefore given by 𝟏𝟎𝟎 𝟕𝟎𝒆𝟏𝟎𝑹 . The rate is 𝒍𝒏
𝟏𝟎 𝟕𝟎
𝟎. 𝟎𝟑𝟓𝟕, or 3.57% per annum.

5. Chapter 5
5.1.
5.2.
5.3.
5.4.
5.5. Problem 5.5. Explain carefully why the futures price of gold can be calculated from its spot price and
other observable variables whereas the futures price of copper cannot.
a) Gold is more expensive than copper
b) Gold is an investment asset while copper is not
c) Humans have used copper for longer than gold
d) Gold has industrial as well as consumption uses while copper only industrial uses
e) None of the above
Gold is an investment asset. If the futures price is too high, investors will find it profitable to
increase their holdings of gold and short futures contracts. If the futures price is too low, they will
find it profitable to decrease their holdings of gold and go long in the futures market. Copper is a
consumption asset. If the futures price is too high, a strategy of buy copper and short futures
works. However, because investors do not in general hold the asset, the strategy of sell copper and
buy futures is not available to them. There is therefore an upper bound, but no lower bound, to
the futures price. In the profession this is the way things are explained for historical reasons, a less
lingo-based description is that gold trades in a very liquid market while copper and many other
products do not. The forward equation only applies to “perfect markets.” Liquid markets are
close to perfect, illiquid ones are not.
5.6.
5.7.
5.8.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-11/16
5.9. Problem 5.9. A yearlong forward contract on a foreign currency (EUR) is entered into when the foreign
currency price is $1.1 per EUR, and the risk-free rates of interest in USD and EUR are 6% and 4% per
annum respectively (continuously compounded) [r = 6% and rf = 4%].
i. What are the forward price
ii. What is the initial value of the forward contract?
iii. Six months later, the price of the EUR is $1.2 and the risk-free interest rates are 6% and 3%
respectively [r = 6% and rf = 3%], what is the price of a six-month forward with the original
maturity (the new contract).
iv. What is the value of the original forward contract six months later?
a) i) The forward price now is F0 = S0 e(r - rf)×T = F0 = 1.1e0.02×1= 1.100; ii) its value is zero; iii) a new
six-month forward contract in six months will be $1.2181 and iv) the value of the existing (old)
forward contract will be $0.0931.
b) i) The forward price now is F0 = S0 e(r - rf)×T = F0 = 1.1e0.02×1= 1.1222; ii) its value is zero; iii) a new
six-month forward contract in six months will be $1.2181 and iv) the value of the existing (old)
forward contract will be $0.1931.
c) i) The forward price now is F0 = S0 e(r - rf)×T = F0 = 1.1e0.02×1= 1.1222; ii) its value is zero; iii) a new
six-month forward contract in six months will be $1.1181 and iv) the value of the existing (old)
forward contract will be $0.0931.
d) i) The forward price now is F0 = S0 e(r - rf)×T = F0 = 1.1e0.02×1= 1.1222; ii) its value is zero; iii) a
new six-month forward contract in six months will be $1.2181 and iv) the value of the existing
(old) forward contract will be $0.0931.
e) None of the above
i. The forward price, F0, is given by equation (5.1) as: F0 = 1.1e0.02×1= 1.1222; or 1.1222
USD/EUR.
ii. The initial value of the forward contract is zero.
iii. The new-forward price is: 1.20e0.03×0.5 = 1.2181; or 1.2181 USD/EUR.
iv. The delivery price K in the contract is 1.1222. The value of the contract, f, after six
months is given by equation (5.5) as: f = 1.20 − 1.1222e−0.03×0.5 = 0.0931; i.e., 0.0931
USD/EUR.
5.10.
5.11. Problem 5.11. Assume that the risk-free interest rate is 4% per annum with continuous compounding
and that the dividend yield on a stock index varies throughout the year. In February, May, August, and
November, dividends are paid at a rate of 5% per annum. In other months, dividends are paid at a rate
of 2% per annum. Suppose that the value of the index on June 30 is 1,300. What is the futures price for a
contract deliverable on December 31 of the same year?
a) $1300.07.
b) $1313.99.
c) $1200.07.
d) $1287.07.
e) None of the above
The futures contract lasts for six months. The dividend yield is 2% for four of the months and 5% for
two of the months. The average dividend yield is therefore 4 2% 2 5% 3.0%
(0.04-0.03)×0.4167
The futures price is therefore: 1300×e = 1313.0652; or $1313.0652.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-12/16
5.12. Problem 5.12. Suppose that the risk-free interest rate is 6% per annum with continuous compounding
and that the dividend yield on a stock index is 3% per annum. The index is standing at 3,000, and a
market maker is quoting a forward price for a contract deliverable in four months at 3,050. i) What is
the synthetic or theoretical price of the forward? ii) What arbitrage opportunities does this create? iii)
How much will you make and iv) When will you make this money?
a) i) 3,050.00, ii) Buy the synthetic forward at 3,050.00, and sell the quoted at 3,050, iii) 0, and iv) you
will make this money in four months.
b) i) 3,020.07, ii) Sell the synthetic forward at 3,020.07, and buy the quoted at 3,050, iii) 29.93, and iv)
you will make this money in four months.
c) i) 3,020.07, ii) Buy the synthetic forward at 3,020.07, and sell the quoted at 3,050, iii) 29.93,
and iv) you will make this money in four months.
d) i) 3,020.07, ii) Buy the synthetic forward at 3,020.07, and sell the quoted at 3,050, iii) 29.93, and iv)
you will make this money right away.
e) None of the above
The theoretical futures price is: 3,000×e(0.06-0.03)×4/12 = 3020.0668.
The quoted price is 3050. This shows that the forward price is too high relative to the index. The
correct arbitrage strategy is
1. Sell quoted forward contract
2. Buy the shares underlying the index.
5.13. Problem 5.13. Estimate the annual difference between short-term interest rates in Japan and the
United States on August 3, 2016 from the information in Table 5.4.

Table 5.4 Futures quotes for a selection of CME Group contracts on foreign currencies on
May 13, 2015
Open High Low Settlement Last trade Change Volume
Japanese Yen, USD per 100 JPY, 12.5 million JPY
Sept. 2016 0.9345 0.9409 0.9338 0.94105 0.9400 +0.0055 125,686
Dec. 2016 0.9354 0.9418 0.9349 0.95320 0.9408 +0.0053 396
a) 1.29%.
b) 0.95%.
c) 5.16%.
d) 0.94%.
e) None of the above
The settlement prices for the futures contracts are
Sept.: 0.94105
Dec.: 0.95320
The December price is 1.2911% above the September price. This suggests that the short-term
interest rate in Japan was less than the short-term interest rate in the United States by about
1.2911% per three months or about 5.1644% per year.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-13/16
5.14. Problem 5.14. The two-month interest rates in Switzerland and the United States are, respectively, 3%
and 6% per annum with continuous compounding. The spot price of the Swiss franc is 1.0500
USD/CHF. A bank is quoting the forward price for a three months contract at 1.0500 USD/CHF. i)
What is the theoretical or synthetic price of the three-month forward?; ii) What arbitrage opportunities
does this create?; iii) How much money would you make per CHF? and iv) When will you make that
money?
a) i) 1.0422 USD/CHF, ii) buy synthetic at 1.0422 USD/CHF and sell the quoted forward at
1.0500 USD/CHF, iii) 0.0078 USD/CHF, iv) in three months.
b) i) 1.0422 USD/CHF, ii) sell synthetic at 1.0422 USD/CHF and buy the quoted forward at 1.0500
USD/CHF, iii) 0.0078 USD/CHF, iv) in three months.
c) i) 1.0422 USD/CHF, ii) buy synthetic at 1.0500 USD/CHF and sell the quoted forward at 1.0422
USD/CHF, iii) 0.0078 USD/CHF, iv) in three months.
d) i) 1.0422 USD/CHF, ii) buy synthetic at 1.0422 USD/CHF and sell the quoted forward at 1.0500
USD/CHF, iii) 0.0078 USD/CHF, iv) right away.
e) None of the above
The theoretical futures price is 1.0500e(0.03-0.06)×3/12 = 1.0422
The quoted three-month forward price is too high. This suggests that a Swiss arbitrageur should
sell Swiss francs for US dollars and buy Swiss francs back in the forward market. You would
make 0.0078 USD/CHF in three months.
5.15. Problem 5.15. The spot price of silver is $18 per ounce. The storage costs are $0.24 per ounce per year
payable quarterly in advance. Assuming that interest rates are 5% per annum for all maturities,
calculate i) the present value of the storage cost (U); and ii) the futures price of silver for delivery in
nine months (F0).
a) i) U = $0.178; ii) F0 = $18.18
b) i) U = $0.24; ii) F0 = $18.18
c) i) U = $0.178; ii) F0 = $18.18
d) i) U = $0.178; ii) F0 = $18.87
e) None of the above
The present value of the storage costs for nine months is 0.06×[1 + e-0.05×0.25 + e-0.05×0.5] = 0.178, or
$0.178. The futures price [equation (5.11) [F0 = (S0 + U) e-r×T] is F0 = (18 + 0.178) e-0.05×0.75 =
18.87; i.e., it is $18.87 per ounce.
5.16.
5.17.
5.18.
5.19.
5.20.
5.21.
5.22.
5.23.
5.24.

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-14/16
5.25. Problem 5.25. Given the following definitions and values in percent per annum continuous
compounding: US risk-free rate (r = 4%); foreign risk-free rate (rf = 2%); dividend yield on a stock
index (d = 1%); storage cost of a commodity (u = 0.2%). What is the cost of carry [percent per annum
value] for (i) a non-dividend-paying stock, (ii) the stock index, (iii) the commodity with storage costs,
and (iv) the foreign currency?
a) i) 4%, ii) 3%, iii) 3.8%, and iv) 2%.
b) i) 4%, ii) 5%, iii) 4.2%, and iv) 2%.
c) i) 4%, ii) 3%, iii) 4.2%, and iv) 2%.
d) i) 2%, ii) 3%, iii) 4.2%, and iv) 2%.
e) None of the above
i) the risk-free rate (4%), ii) the excess of the risk-free rate over the dividend yield (3%) iii) the
risk-free rate plus the storage cost (4.2%), iv) the excess of the domestic risk-free rate over the
foreign risk-free rate (2%).

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-15/16

STUDENT NAME:___________________________________________

STUDENT ID: _____________________________________

IF TRUE WRITE TWO “X’s”:

I HAVE NOT CHEATED TOO MUCH ON THIS QUIZ_______________

SIGNATURE: ______________________________________

Question Chapter Question Answer

1 1.1 B
2 1.2 B
3 1.3 B
4 1.4 C
5 1.6 C
6 1.7 A
7 1.26 A
8 2.1 C
9 2.2 C
10 2.3 C
11 2.8 A
12 2.17 C
13 3.1 C
14 3.2 C
15 3.4 C
16 3.7 C
17 4.1 A
18 4.2 C
19 4.3 C
20 4.4 D
21 4.8 D
22 4.10 D
23 4.11 A
24 4.12 D
25 4.13 B
26 4.16 A
27 5.5 B
28 5.9 D
29 5.11 A
30 5.12 C
31 5.13 C
32 5.14 A
33 5.15 D
34 5.25 C

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Alternative Investments: FIN 423 Fall 2019 page Exam 1-16/16

2 Chapter 2 Mechanics of Future Markets

N/A
3.0 Hedging Using Futures Contracts
Cross Hedging
S: the change in spot price, S, during the life of the hedge.
F: the change in futures price, F, during the life of the hedge.
S: the standard deviation of S
F: the standard deviation of F
: coefficient of correlation between S and F
h*: hedge ratio that minimizes the variance of the hedger’s position
h* =  (S /F).
 F2
Hedge effectiveness is h*2
 S2
Optimal Number of Contracts
To determine the optimal number of contracts, we first define the following variables:
NA: Size of position being hedged (units)
QF: Size of one futures contract (units)
N *: Optimal number of futures contracts for hedging
The futures contracts used should have a face value of h*NA. The number of futures contracts is required is
h* N A
therefore given by N * 
QF
5 Determination of Future and Forward Prices

Symbol Definition Formula

T Time until delivery date in a forward or futures contract (in years)
S0 Price of asset underlying the forward or futures contract today
F0 Forward or futures price today F0 = S0 erT
Zero coupon risk–free rate of interest per annum, with continuous
r
compounding, for an investment maturing at time T
( r  r )T
rf the foreign risk–free interest rate for money invested for time T F0  S0e f
q the average yield per annum on an asset F0 = S0 × e(r – q)T
U The present value of storage costs F0 = (S0 + U) e-r×T
I Equals the present value of the income F0 = (S0 – I )erT

Valuing OUTSTANDING Forward Contracts

Symbol Definition
F0 the current forward price for contract that was negotiated some time ago
K the delivery price in the contract negotiated some time ago
f the value of a long forward contract today negotiated some time ago
( r  r )T
f  ( F0  K )e  rT  f  S0  Ke rT ; F0  S0e f  F0  S0 e( r q )T

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