Financial Derivatives
Question 1
Teachers Pension Fund has indicated interest in international investments in equity securities and has requested Alpha Seekers to consider the UK equity market. Alpha Seekers has indicated that such a portfolio would also require the use of different derivative contracts to manage risk and that generally it prefers to use exchange-traded derivatives to over the counter (OTC) contracts. Further Alpha Seekers identified Intercontinental Exchange (ICE) and Eurex Exchange as the two potential organised trading markets to consider for trading derivative contracts for managing risk of Teachers Pension Fund’s potential investment portfolio.
Required:
Identify the features of futures on BT Group listed on ICE and Eurex Exchange. Compare the differences between ICE and Eurex options on BT Group. (15 marks)
Assess futures and options listed on both ICE and Eurex markets and the features of available derivative contracts on BT Group & recommend which market should be used for trading. (10 marks)
Question 2
As a junior analyst, you have been tasked by your line manager to prepare supporting calculations in your report for a presentation to be made before Teachers Pension Fund’s management. These calculations should essentially demonstrate derivative pricing using the No Arbitrage Principle. To do so, you choose to demonstrate the pricing of futures and options contract on BT Group listed on Eurex Exchange. The line manager also wants to understand more about risk neutral pricing and expects you to provide some explanation of the underlying concepts.
Required:
Estimate the fair price of any BT Group futures contract on Eurex using the cost of carry model. You are required to cover the following too:
provide (select and make assumptions) any missing inputs.
explain all the inputs in your pricing model and justify each.
compare the price from your cost of carry model against the actual price at the day close and explain any underlying reasons for the under-pricing or over-pricing. (8 marks)
1). Estimate the prices of both a BT Group call and a BT Group put option trading on Eurex Exchange using two and three period binomial option pricing models as well as the BSM model. You must cover the following:
provide (select and make assumptions) any missing inputs.
explain all the inputs in your pricing model and justify each.
evaluate whether the call and the put options are over or under-valued based on the price estimates from your calculations compared to their actual prices on Eurex Exchange. (12 marks)
2). For the two period binomial model, demonstrate that the estimated price of the call is fair using the hedge portfolio calculations over the two period and adjusting the hedge ratio accordingly. (4 marks)
Estimate the value of the risk free bonds from the put-call parity using first the prices of calls and puts from the BSM model in B above and then the actual prices of calls and puts available from Eurex Exchange for the same calls and puts. Discuss the factors that could explain the differences in pricing across the two put-call parity calculations. (6 marks)
Explain Risk Neutral behaviour and describe how it is different than Risk Averse and Risk Seeking behaviours in financial markets. Give relevant examples of each from financial markets. Why is derivatives pricing considered to be risk neutral? Explain. (10 marks)
Question 3
Though Alpha Seekers Investments has a general preference for exchange-traded derivatives, the management of Teachers Pension Fund is interested in knowing more about the use of OTC derivatives particularly forwards and Swaps for managing the risks of their proposed investments in UK equities. Your line manager requires your report to cover this too.
Required:
Explain the mechanics of a Basis Spread with numerical example. (10 marks)
Illustrate the pricing of a hypothetical forward contract on BT Group’s stock and how it can be used to manage the risk of the proposed investment. You will have to consider and choose the required inputs and make reasonable assumptions wherever required. Provide clear descriptions of all the steps in the process and a conclusion. (8 marks)
Illustrate the pricing of a hypothetical swap contract involving Teachers Pension Fund receiving Fixed GBP Rate derived from GBP Libor rate and paying the returns on BT Group’s stock; assume an investment of £2,500,000, payments made quarterly for one year. For any missing Libor term rates, assume that the term structure of interest rates is linear and upward sloping. Provide detail descriptions of each step. (12 marks)
