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Mega Fund
Mega Fund invests in stocks of US companies. With uncertainty in the world economy and in the US economy in particular, the US stock market has been quite volatile. The
current portfolio value of Mega Fund is $120 million. Brian, the portfolio manager is concerned about the volatility of stock prices and is thinking of obtaining portfolio
insurance. He also would like to diversify his holdings. With the downgrading of bonds issued in Europe, he believes that investing in bonds issued in Europe would be a good
investment and also diversify the fund holdings. Accordingly, he wants to borrow $125 million and invest in bonds of European firms for 5 years. The average yield from these bonds is 10%. However, these bonds are denominated in euro and all cash flows will occur in euros. Thus, Brian is concerned about the exchange rate risk he will be
undertaking if he invests in European bonds. He also would like to hedge the exchange rate risk through a currency swap. He has collected the following information:
On 1 April, S & P 500 Index is at 2,350. On the same day S & P futures are trading at 2,400 and S & P call options with exercise price of 2,400 is trading at 30. S & P put
options with exercise price of 2400 are trading at 60. Futures and options have a contract multiplier of 100. The options are American options.
The exchange rate on 1 April is Euro 1 = USD1.25 and the foreign exchange rate used for the beginning and end of a currency swap is the same. The swap rates are 5% USD
and 5% Euro.

Question 1
Brian would like to insure portfolio value at $120,000,000 on 1 April.
(a) Show how he can accomplish this by using S&P futures and how many futures contracts are needed.

(b) Show how he can accomplish this using S&P options and how options contracts are needed.

(c) Which of these methods is preferable? Explain why.

Question 2
If Brian enters into a currency swap contract,
(a) Explain how this helps Mega Funds from facing currency risk.
(b) Show clearly the initial cash flow, periodic cash flows, and terminal cash flow resulting from the currency swap.

Question 3
Consider the firm you work for, or another firm whose operations you are familiar with. Briefly describe its operations. What type of financial risks does that firm face?
How can you hedge against those risks? What are the constraints in hedging against those risks? Do the costs and benefits of the hedging strategy you recommend justify
hedging? Substantiate your response

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Tod Thiel
Tod ThielLv2
28 Sep 2019

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Mini Case: Turkish Lira and the Purchasing Power ParityVeritas Emerging Market Fund specializes in investing in emerging stock markets of the world.Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currentlyinterested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiateits membership in the European Union. If this happens, it will boost the stock prices in Turkey.But, at the same time, he is quite concerned with the volatile exchange rates of the Turkishcurrency. He would like to understand what drives the Turkish exchange rates. Since theinflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing powerparity may be holding at least to some extent. As a research assistant for him, you wereassigned to check this out. In other words, you have to study and prepare a report on thefollowing question: Does the purchasing power parity hold for the Turkish lira-U.S. dollarexchange rate?Among other things, Mr. Mobaus would like you to do the following:

1. Plot past annual exchange rate changes against the differential inflation rates betweenTurkey and the U.S. for the last 20 years.

2. Regress the annual rate of exchange rate changes on the annual inflation rate differential toestimatethe intercept and the slope coefficient, and interpret the regression results.

Data source: You may download the annual inflation rates for Turkey and the U.S., as well asthe exchange rate between the Turkish lira and US dollar from the following source:http://data.un.org. For the exchange rate, you are advised to use the variable code 186AEZF.

Jim has some money to invest for one year. He can choose to invest his money either in a
mutual fund, or in a savings account, or in a combination of both. The guaranteed interest rate
on a savings account is 6%(his bank also accepts to lend money at 6% interest rate). The mutual
fund is a portfolio of stocks. Like an ordinary stock, investors can buy shares of this mutual fund,
which give right to receive dividends and which can be sold at any time. The price of a share of
the mutual fund today is $80.
Based on historical data and his view of the current economic situation, Jim makes the following
scenario. There is a chance that the economy will boom, with rms making high pro ts. In this
case the dividends per share of the mutual fund over the next year will be $5 a share and the shareprice in one year from now will be $115. Jim attributes a probability of 0.3 to this possibility. With
probability 0.5 the economy will follow its current trend. In this case the dividends will $4 a share
and the price next year will be $84. However a downturn is not impossible given that the economy
lacks strength. In this case the dividends will be the same at $4 per share, but the price next year
will be as low as $60 a share. Jim attributes a probability 0.2 to this possibility.
(a) Draw a table with the possible states of the economy, their probabilities, and the rate of
return of the mutual fund in each state.
(b) Compute the expected rate of return on the mutual fund, its standard deviation and its
Sharpe ratio.
(c) Compute the expected rate of return and standard deviation of Jim's portfolio if he invests a
proportion y of his money in the mutual fund and 1-y in the savings account.
(d) What is the proportion y which guarantees an expected return of 10% for the portfolio? What
is the risk (standard deviation) of the portfolio?

The manager of a $35 million portfolio of domestic stocks with a beta of 1.20 would like to diversify internationally. He would like to sell $7 million of domestic stock and purchase $7 million of foreign stock. He learns that the he can do this using a futures contract on a foreign stock index. The index is denominated in dollars, thereby eliminating any currency risk. He would like the beta of the new foreign asset class to be 1.15. The domestic stock index futures contract is priced at $355,000 and can be assumed to have a beta of 1. The foreign stock index futures contract is priced at $285,000 and has a beta of 1.

a. Does the manager need to buy or sell domestic stock index futures?

b. How many contracts are needed to sell $7 million of domestic stock?

c. Does the manager need to buy or sell foreign stock index futures?

d. How many contracts are need to buy $7 million of foreign stock?

Determine the value of the portfolio if the domestic stock increases by 3%, the domestic stock futures contract increases by 2.6%, the foreign stock increases by 1.7% and the foreign stock futures contract increases by 1.9%

e. What is price of one new domestic stock futures contract?

f. What is the profit or loss on the domestic futures contracts (must state if gain or loss and the amount)?

g. What is price of one new foreign stock futures contract?

h. What is the profit or loss on the foreign futures contracts (must state if gain or loss and the amount)?

i. How much does the total domestic stock increase?

j. What is the total value of the portfolio (stock and futures contracts combined)?

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