We have futures contracts on Treasury bonds, but we do not have features contracts on individual corporate bonds. We have cattle and hog futures but no chicken futures. Explain why the market has developed in this manner. What do you think are the most important characteristics for the success of a new futures contract concept?

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Bunny GreenfelderLv2

4 Dec 2018

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T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teen-ager-he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he's young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.
Recently, T. J. has started playing with financial futures-interest-rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn't go wrong with interest-rate futures) and soon set up a trading account with Vinnie's firm, Banano's of Portland.
The other day, Vinnie called T. J. and suggested he get into 5-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most-with the biggest jump in yields.
Accordingly, Vinnie recommended that T. J. short sell some 5-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short 4 contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.
Questions
a. Assume T-note futures ($100,000/contract; 32's of 1%) are now being quoted at 103-16.
1. Determine the current underlying value of this T-note futures contract.
2. What would this futures contract be quoted at if Vinnie is right and the yield does go up by 1 percentage point, to 6.5%, on the date of expiration? (Hint: It'll be quoted at the same price as its underlying security, which in this case is assumed to be a 5-year, 6% semiannual-pay U.S. Treasury note. If necessary, refer to Chapter 11 and review the material on pricing semiannual-pay bonds.)
b. How much profit will T. J. make if he shorts 4 contracts at 103-16 and then covers when 5-year T-note contracts are quoted at 98-00? Also, calculate the return on invested capital from this transaction.
c. What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105-8?

d. What risks do you see in the reccommended short sale transaction? What is your assessment of TJ's new interest in financial futures? How do you think it compares to hsi established commodities investment program?

tantiger591

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

scarleteel467

6. Institutional portfolios can take advantage of what is called "portfolio margining" under the rules of the CBOE and other options exchanges. What IS portfolio margining? Choose only one answer.

A. You only pay attention to the bottom margin of the portfolio.

B. Great leverage is possible, as the intercorrelations and natural offsets (or what we call in English a "wash") are taken into consideration.

C. No margin is required, because these are not individual investors.

7. What does the symbol ^VVIX mean?

A. Apple's volatility.

B. An exchange-traded (ETF) volatility fund.

C. The implied volatility of the VIX options themselves.

8. An example of purchasing a "real" option is a company's opening of a Shanghai office, in order to have the capacity to pursue business in China.

True

False

9. A hedge fund is "short" a portfolio of VIX call options. It's "theta" is $16,788 per day. This means, barring some big market or political or terrorist event, the fund's net asset value will increase by about $16,788 per day.

True

False

10. Imagine an equity-oriented state pension fund (such as the State of Maryland Pension funds). Suppose their equity portfolio is NOT identical to the S&P 500 index. Further, suppose that due to a state budget shortfall, the year's additions to the pension fund are likely to be less than actuarially sound. Thus, the fund is becoming very risk-averse. And it needs to implement this feeling by hedging. CHOOSE THE BEST ANSWER, even though there might be more than one true answer. This is actually a question about hedge ratios. A. If the equity portfolio's beta is close to 0, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

B. If the equity portfolio's beta is close to .4, then they would have a tough time using S&P 500 contracts, so they would instead use foreign exchange contracts.

C. If the equity portfolio's beta is close to 1, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

11. Go to CMEGROUP.COM We are going to hedge ULSD https://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel for a railroad, that uses ultra-light diesel fuel. Choose June 2017 as the underlying future. Let's pretend we are buying ten futures contracts. What would ten contracts cost you, using the last trade as our price? Show your math, i.e., #gallons times price per futures contract. Is this contract in contango, or normal backwardation?

12. Long options positions(long does not mean long-dated) have positive gamma, and short positions have negative gamma.

True

False

13. In valuing credit default swaps, one must estimate default probabilities. A start would be to obtain historical data for default rates from rating agencies such as Standard & Poor's. But a more complete risk profile, or risk prediction, limiting ourselves to the US market (US-based companies) would be to [pick only one choice, the best one, in your opinion]:

A. Also consider the risk of another earthquake in Japan.

B. Also consider the systematic risk associated with an economic downturn in the US, accompanied by a downturn in US stocks.

C. Also consider the possibility that Facebook options are trading at an implied volatility that is not as high as it should be, considering the lofty level of its P/E ratio.

14. A total return swap can be a form of financing vehicle to allow an investor to buy a specific bond, because: (there are two correct answers, you must pick two)

A. The payer (a financial institution) could agree to pay the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

B. The payer (a financial institution) could agree to receive the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

C. The payer retains ownership of the bond for the life of the contract.