FMV Işık University

Department of Industrial Engineering

INDE4412 – Fundamentals of Financial Engineering
Spring 2024

Assignment 2 - Solutions
Due: April 11, 2021

1. It’s April 1, 2024. A Canadian firm has just signed a deal to sell 2,200,000 board feet of random length
lumber to a U.S. based furniture producer on September 25, 2024, at the prevailing US$ price of lumber.
The spot price of lumber is US$580 per 1000 board feet and the spot CADUSD rate is $0.75. Determine
the number, direction, and settlement dates of the futures positions the firm should take to hedge its lumber
price and currency risk. (https://www.cmegroup.com/markets/fx/g10/canadian-dollar.quotes.html#venue=globex)
(https://www.cmegroup.com/markets/agriculture/lumber-and-softs/lumber.quotes.html#venue=globex)
Since lumber will be sold on September 25th, the firm needs to get into a short position in future contracts
settled at or after this date. Looking at the CME website, we see that contracts are available in a two-month
cycle and the contract that would be appropriate will be the September contract, for which the price
observed today is $579 per 1000 board feet (may differ from what you had observed). Based on the contract
specifications, the unit contract size is 110,000 board feet. This suggests that a short position in
2,200,000/110,000 = 20 September delivery random length lumber contracts should be taken.
The next step is to hedge exchange rate risk. Based on the lumber price the firm has locked into, it will
effectively receive 579×2,200,000/1,000 = 1,273,800 U.S. dollars. The position taken should allow the firm
to buy Canadian dollars using U.S. dollars. CADUSD futures with September delivery trade at a settlement
price of 0.7271 (may differ from what you observed). At this rate, the firm’s U.S. dollar revenue converts
to 1,273,800/0.7271 = 1,751,891 Canadian dollars. As each contract is on 100,000 Canadian dollars and
since the firm will want to buy Canadian dollars using U.S. dollars at the time of the exchange, the firm
will take a long position in 1,751,891/100,000 ≈ 18 CADUSD futures to hedge its exchange rate risk.

2. You manage an equity portfolio that is worth $100 million. The correlation between the monthly returns
of your portfolio and the monthly returns on a broad equity market index is estimated as 0.80, and the
monthly variance of your portfolio’s returns is expected to be four times that of the returns on the market
index. If each index futures contract is a bet on a notional principle of $500,000, what futures position
should you take to eliminate half of your portfolio’s systematic risk over the course of the following month?
Letting σ2 denote the variance of the market, the beta of your portfolio is β1 = 0.8×(4σ2/σ2)½ = 1.6.
Beta is the measure of systematic risk, so you want to reduce the beta of your portfolio to β2 = 0.8.
The optimal hedge ratio is the difference between the initial beta and the desired beta: h* = (β2 – β1) = –0.8.
Based on this ratio and the sizes of the position we are hedging, the number of contracts you need to use is:
N* = –0.8×$100,000,000/$500,000 = –160.
The negative sign here means you need to take a short position in 160 index futures contracts.
3. It is April 1st, 2024, and you observe that the settlement price for four-year futures contracts written on a
stock that trades for $90 in the spot market is $100. If the stock is expected to pay constant annual dividends
at the end of each June over the next four years and the risk-free rate is quoted as 5% in continuously
compounded annual frequency over all maturity horizons, what is the expected size of the firm’s dividends?
The present value of the fixed annual dividends (D) the stock will pay until the contract settlement date is:
I0 = D e–0.05 · 0.25 + D e–0.05 · 1.25 + D e–0.05 · 2.25 + D e–0.05 · 3.25 = 3.671D
Provided that there are no arbitrage opportunities, the futures settlement price that is observed in the market
today should be equal to the theoretical price implied in the presence of known cash dividends. I.e.:
F0 = 100 = (S0 – I0) e r ·T
= (90 – 3.671D) e 0.05 ·4

Solving this equation, the size of the fixed annual dividend is found as: D = $2.21

4. Suppose the semiannually compounded twelve-month and eighteen-month spot rates are observed as
50% and 45%, respectively. Calculate the value today of a six-month forward rate agreement in which you
will receive a fixed rate of 45% compounded semiannually over a six-month period that begins one year
from today and pay the then prevailing six-month spot rate on a notional principal of ₺1,000,000.
First convert the spot rates to continuously compounded form:
0.50 0.45
𝑟12𝑚 = 2 × ln (1 + 2
) = 44.63% 𝑎𝑛𝑑 𝑟18𝑚 = 2 × ln (1 +
2
) = 40.59%

Calculate the six-month forward rate that applies to the forward rate agreement period (starting in 12 months
and ending in 18 months) in continuously compounded form & convert to semiannually compounded form:
1.5×0.4059−1.0×0.4463
𝑓12−18𝑚 = 1.5−1.0
= 32.51% 𝑎𝑛𝑑 𝐹12−18𝑚 = 2 × (e0.5×0.3251 − 1) = 35.3%

The value of the forward rate agreement then is:

0.45 0.353
𝑉𝑓𝑟𝑎 = ₺1,000,000 × ( − ) × 𝑒 −0.4059×1.5 = ₺26,382.84
2 2

5. It is the end of trading on March 31. The spot USDTRY exchange rate is ₺32 and USDTRY futures with
December 31 settlement are priced at ₺42. The continuously compounded risk-free rate is observed as 4.8%
per year for lending and 5.2% for borrowing in the U.S. and 45% for lending and 55% for borrowing in
Turkey over a six-month maturity. Determine whether arbitrage is possible and, if it is, illustrate how.
t=0 Futures t=1
borrow usd 1 Price pay debt -43
invest try -32 Too collect 40
long usd forward 0 Low deliver 0
total 0 total -3.03

The futures price is not too low since arbitrage profits are negative in this scenario.
t=0 Futures t=1
borrow try 32 Price pay debt -42.1
invest usd -1 Too collect 43.0
short usd forward 0 High deliver 0
total 0 total 0.89

It turns out that the futures price is too high: the arbitrage trade yields a profit of 0.89 liras per USD.