Academic excellence for business

and the professions

The Business School (formally Cass)

MSc Finance

Module Code Exam Title

SMM200 Derivatives & Risk
Management

April 2021 3 hours 00mins

Answer ALL EIGHT questions

Each question carries equal marks (12.5 marks per question).

It is important that you show clearly, succinctly and legibly the steps used in
your answers.
Answers to each complete question should take less than 1 page of
A4.
You may use bullet points where appropriate.
Begin each answer on a new page

This paper contains EIGHT questions and comprises FIVE pages including
the title page

Additional materials or tables to be provided: None

Your work should be in your own words, it should NOT contain material
copied straight from lecture notes, textbooks, or other resources. If you do rely
on external sources within your answer, these should be properly
referenced/cited.

Students are expected to show all necessary workings to obtain their

final solution. If this is not done, then marks will be deducted even
when the correct numerical solution is obtained.

Internal Examiner(s): Professor Keith Cuthbertson

External Examiner: Professor Pasquale Scaramozzino
Question 1

a).

In the futures market explain the importance of “marking-to-market” and the use of the
margin account. Use the following example to illustrate (part of) your answer.
You enter one short futures contract to sell 5000 bushels of corn for $2 per bushel.
The initial margin is $3000 and the maintenance margin is $2000.

b).

It is 15th June. BigBets currently holds $4m stocks in Apple (with a beta of 0.5).
The current interest rate is r= 4%pa (simple rate), the S&P500 index is currently at
S=980.
A stock index futures (SIF) contract with 6 months to maturity is available and each
index point is worth $250. Over the next month, BigBets thinks the S&P500 will rise
by 10%.

Explain how BigBets can use SIF contracts to “leverage” its position and achieve an
“effective beta” of 1.
If the S&P500 rises by 10% over the next month, calculate the overall dollar change in
BigBets’ position and hence explain whether BigBets has achieved its aims. Briefly
explain the risks in this strategy.

Question 2

a).

A call with a strike of K = 50, costs C = $2 and a put also with K = 50, costs P = $4.
The call and put have the same maturity. Complete the values in the following table
and explain how the payoffs and profits from a short straddle arise. (You may also
use a diagram in your answer).

Payoffs ST < K ST =K ST > K

call

put

= Short Straddle

Option premia

Profit

b). Explain any (qualitative) differences between a short straddle (as in part “a”) and
a short strangle. (You may use a diagram to illustrate your answer).

Page 2 of 5
Question 3

An at-the-money put option has a Black-Scholes price P0=$5, with K=100, ∆ = -0.4
and time to maturity T = ¼ (year, 3-months). The current stock price is S0 = $100 and
the risk-free rate r = 3%pa. Today, M/s Short sells one put and delta hedges.
(Assume you can buy and sell, fractions of a stock).

Assume the stock price falls to S1 = 90 after one-week and the delta is then ∆1 = - 0.5.

M/s Short rebalances the hedge each week. The stock price then falls monotonically
to ST=$10. At T, M/s Short has accumulated a bank deposit of BDT = $100.3.
You may use some or all of the above illustrative data and a diagram to answer the
following questions:

a). Explain what happens in M/s Short’s hedge i) at t= 0, ii) at t = 1-week and iii) at T.

b). Briefly list the risks in the hedge.

c). Briefly explain in practice, the benefit (if any) to the trader who initially sold the put
and then delta hedged.

Question 4

a). Consider the two-period, BOPM. The current stock price S= $105 and the risk-free
rate r = 3% per period (simple rate). Each period, the stock price can go either up by
10 percent or down by 10 percent. A European put option (on a non-dividend paying
stock) expiring at the end of the second period has an exercise price of K = $100.

i). Sketch the stock price and the put premia in the tree (lattice) and calculate the fair
(no-arbitrage) price of the put, P.

ii). Explain how you can hedge 100 long puts at t=0, and calculate the value of the
hedge-portfolio at node-d and node-u.

iii). Suppose the quoted price of the put (at t=0) is Pq =1. Briefly, set out the steps
required to make an arbitrage profit. (Assume the outcomes at t=1 for the stock price
and the put premium are the same as in the lattice above).

b) “I really cannot understand how, in the (one period) BOPM, you assume that the
stock price grows at the risk free rate (of say, 3% pa) which then results in the correct
price for the put option, but we know that the stock price in the real world actually grows
at a much faster rate, of around 10%”.

Page 3 of 5
Explain this statement.

Question 5

a). BigBets (BB) a US investment company holds £2m (GBP) in a well diversified
portfolio of UK stocks, and has data for the last 1000 days.

Clearly explain the steps BigBets would take to calculate the 10-day VaR (at the 5th
percentile) using the variance-covariance (VCV) method and how it could assess the
accuracy of the VaR forecasts. Make any reasonable assumptions you require and
state any assumptions used.

Briefly explain ONE WAY you might amend your calculation of the VaR if BigBets also
held 100,000 call options (on a US stock), with current price C = $10.

b).
You have a portfolio consisting of three UK industry-based equity portfolios: consumer
goods, capital goods and financial services. The local market index is the FTSE All-
Share Index. The market values of your portfolio and the portfolio betas are as follows

Market Value (£) β i, FTA

Consumer Goods 1,000,000 1.0789

Capital Goods 900,000 0.9937
Financial Services 450,000 1.0382

The return on the FTSE All-Share index has a standard deviation of 1.896% per day
(pd).
Assume you can apply the single index model (SIM) to the diversified portfolio of stocks
made up of these three industry sectors. Briefly explain what this implies.

Show the steps required to calculate the daily VaR for this portfolio (at the 5th
percentile) using the VCV method under the assumption that the pairwise correlations
between the returns for the three different sectors are zero.

Question 6

a). By using one specific example in each case, briefly explain why an Asian (average
price) option and a lookback option are “path dependent”.

b). “The way that Heating Degree Days (HDD) and Cooling Degree Days (CDD) are
defined makes them like payoffs to options on temperature”. Briefly explain this
statement.

You own 100 large hotels in California which use Air Conditioning in hot summer
periods. In January the consensus forecast for the average temperature in August is
700F but you believe it will be 850F.
Explain how you might use options on HDD or CDD, to mitigate your potential
energy costs. (Tick value is $100 per 0F). Make any other reasonable assumptions
you may require.

Page 4 of 5
Question 7

a). Explain the concept of “implied volatility” and “volatility smile” and give ONE
example of how each concept may be of practical use.

b). Explain the steps when using Monte Carlo Simulation (MCS) to price an Asian call
option (on a non-dividend paying stock) and how MCS can be used to determine the
vega of the call option. Briefly explain how the use of “control variates” can improve
the accuracy of your MCS.

Question 8

a). Briefly explain how a swap dealer makes a risk-free profit on a matched interest
rate swap.

b). Explain the similarities and differences when using either a plain vanilla interest
rate (IR) swap or a forward (IR) swap and any differences when “pricing” these swaps.
(Make any reasonable assumptions you require).

c). ‘A forward swap and a payer swaption give exactly the same outcomes at maturity,
the only difference is that you have to pay the swaption premium but the forward swap
requires no payments at any time’.
Briefly explain whether you agree or disagree with this statement.

Page 5 of 5