Derivatives

HEC Lausanne Homework 1 February 10, 2020

Problem 1
PoorGold, a jewelry manufacturer, will require 1000 troy ounces (t. oz) of platinum on
April 2015. The price for April 2015 delivery is 1415 $/t. oz. Futures contracts are sold
on the New York Mercantile Exchange (NYMEX) and are for the delivery of 50 t. oz of
platinum. While the spot price today (September 2014) is 1400 $/t. oz, PoorGold prefers to
trade futures instead of incurring insurance costs of storing platinum to hedge its price. For
logistic reasons, PoorGold will not have the platinum delivered through the futures contract,
but will close its futures position on the April 2015 spot market and buy platinum at the
spot price.

a) How many contracts should PoorGold buy or sell to minimize its exposure to platinum
price? What is the effective cost of purchasing platinum if April 2015 price would be 1450
$/t. oz, with and without the hedge you propose? What if April 2015 price would be
1350 $/t. oz instead?

b) PoorGold has mandated a market research company to study the possible scenarios for
the platinum market in April 2015. After reading their report, PoorGolds management
believes in the following scenario:

April Platinum
Strong Weak
Probability pS pW
Spot Price 1440 1350

where pS and pW are the probability the firm attaches to the strong and weak market
conditions and the management is trying to evaluate. The company needs to decide how
much of the 1000 t. oz. requirement to purchase on the spot market in April 2015, and
how much with the April 2015 futures. Suppose the firm is risk neutral. What is your
recommendation?

c) PoorGold has recently changed its product offer. For this reason the company would like
to sell its 250,000 t. oz. excess inventory in two batches: B1 t. oz. in January 2015,
and B2 t. oz. in May 2015, by shorting the corresponding silver futures on the COMEX
division of NYMEX. Prices for January and May delivery are 19 $/t. oz. and 19.5 $/t.
oz respectively. The size of both contracts is 5,000 t. oz. To fulfill unexpected production
needs, PoorGold does not want to sell more than 150,000 t. oz. in January 2015. For
each t. oz. stored from January to May, there is a marginally increasing cost c given by

c = βQα

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HEC Lausanne Homework 1 February 10, 2020

where Q is the residual inventory after January’s sale, α = 1.5, β = 9.6225 · 10−4 . What
are B1 and B2 that maximize total revenues from silver sales? How many contracts will
you respectively sell in January and May? Since convenience yields and interest rates are
expected to be approximately the same, the time value of money is negligible and can be
ignored.

Problem 2
The investment fund Rusty Bear enters a short position to sell 10,000 shares of Microsoft
for $50 per share. The initial margin is 80% of the initial stock price and the maintenance
margin is 70% of the current stock price. Rusty Bear trades by putting the minimum amount
of cash on the margin account to satisfy the initial requirement.

a) What is the maximum possible prot the position Rusty Bear can get at maturity? What
is the maximum possible loss? Suppose that if the price falls below $20, Rusty Bear will
be squeezed out and be forced to liquidate its position. What are the maximum prot and
loss in this case?
b) What is the minimum security price pM that will lead to a margin call? Would you receive
a margin call if the price is greater than pM ? Would your answer to the last question
change in the case of a long position in the very same stock?
c) What is the value of pM if the initial amount of cash in the account would be $500,000
instead?
d) On the first two weeks the price of the futures goes down by 10%, and Rusty Bear
interprets this as a bearish sign for Microsoft and is willing to strengthen its position.
The requirements to short a contract are now a 75% maintenance margin, and a 85%
initial margin. What is the minimum amount of cash Rusty Bear needs to add to its
account to short additional 5,000 shares?

Problem 3
A hedge fund manager is analyzing the following two assets: a non-dividend paying stock in
the IT sector listed at S0 = 95$, and a zero-coupon bond with a maturity of one year with
price B0 = 98$ and face value 100$. The six-month LIBOR rate is r = 0.5% . The following
futures contracts are traded:
Underlying Futures Price Maturity
Stock 95.5 6 months
Bond 98.0 6 months

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HEC Lausanne Homework 1 February 10, 2020

a) Show that there are arbitrage opportunities in the market. Propose a trading strategy
that the fund’s manager could use to take advantage of arbitrage opportunities.

b) If the fund’s manager decides not to operate in the bond market and has a borrowing con-
straint such that he cannot borrow more than 9,500,000$, what is the maximum arbitrage
profit the fund can make in the stock market using the strategy at point a)? Suppose the
hedge fund is a marginal trader and extant prices do not significantly move because of its
trading activity.

c) The fund’s manager is offered a long position in a forward structured product with 6-
month maturity for an immediate cash payment. The payout of the product after three
months is the difference between the current stock and bond prices, and at maturity is the
sum of the stock and bond prices. If both the stock and the bond are now (t = 0) traded
at their no-arbitrage prices, what is the no-arbitrage price of the structured product?
Assume the interest rate will be approximately constant in the next six months, and that
forward and futures prices are equivalent.

Problem 4
The SP 500 index is currently quoted at 1950 index points. An index futures on the SP 500
with three-month maturity is quoted at 1941.7 index points. The SP 500 is a value-weighted
index. The three-month LIBOR rate is 0.3%.

a) What is the three-month dividend yield implied by the futures prices?

b) The stock price of Bank of America, a constituent of the SP 500 index, suddenly goes up
by 5%, while all the prices of the other constituents remain roughly unchanged. There
are no news that suggest that the dividend policy of the firms in the SP 500. may change.
The current market capitalization of Bank of America is $ 200 billion, and the current
market capitalization of the SP 500 index is $ 10,000 billion. The index value increases
to 1952, and the index futures value decreases to 1935. Are there arbitrage opportunities
in the market? If this is the case, how could a hedge fund exploit them? Assume there is
an ETF the market which tracks the SP 500 index.

c) Suppose now that after the price increase of Bank of America, the index value increases
to 1960 and the index futures value to 1951.7. Are there arbitrage opportunities in the
market? If this is the case, how could a hedge fund exploit them? Assume there is an
ETF the market which tracks the SP 500 index.

In computing numerical approximations, round all index values, prices, and percentages to
the first decimal digit.

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HEC Lausanne Homework 1 February 10, 2020

Problem 5
Five years from your graduation you are running a trading desk at a Swiss bank. The
spot exchange rate is 0.805 USD/CHF, the 6-month forward CHF/USD exchange rate is
1.25 CHF/USD, and the 6-month CHF risk-free rate 2.50%. All rates are annualized and
continuously compounded.

a) What must the 6-month USD risk-free interest rate be (annualized, continuously com-
pounded) if there is no arbitrage?

b) Suppose that the 6-month USD risk-free interest rate is 2% (annualized, continuously
compounded). Describe exactly what transactions you, as a Swiss trader, would undertake
to generate an arbitrage profit using the contract described above. How much would be
the arbitrage profit in your domestic currency in six months if you can borrow at most
1,000 CHF today?

c) One of the bank’s corporate customers is a US firm operating it the IT sector. The
US firm sells computers to a large Swiss customer for a value on 1,000,000 CHF. The
payment of the computers is due in 90 days (use 360 days per year). The 3-month forward
USD/CHF exchange rate is 0.806. What is the minimum USD amount you would charge
your customer for a forward agreement that allows it to lock the value of its account
receivables to 0.815 USD/CHF?

d) The interest rate in Switzerland increases to 3% and your customer asks for a 10% discount
on the fee at point c) before going to your competitor. Are you willing to accommodate its
request? In the case your answer is positive, what is the minimum fee you would charge?

Problem 6
GreenGas is a company based in Pekin, Illinois, that employs ethanol in its production
process, and needs to purchase 290,000 gallons of it in three months. The three-month
futures price of ethanol contracts traded on CBOT is 1.55 $/gallon, and the spot price of
ethanol is 1.5 $/gallon. The contract size is 290,000 gallons. The three-month interest rate
is 0.25%. Ethanol is stored in steel fuel tanks, and the convenience yield of holding ethanol
in the next three months is negligible.

a) CoolTanks is a company that rents storage services for business clients operating in Illinois.
CoolTanks uses proprietary and patented technologically advanced probes and pumps that
guarantee a higher storage efficiency than traditional technologies. Currently, CoolTanks
can store each gallon of ethanol at a annualized and continuously compounded cost s =
5% of the current spot price. How much could CoolTanks charge GreenGas at most for
storing 290,000 gallons of Ethanol for three months?

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HEC Lausanne Homework 1 February 10, 2020

b) Suppose CoolTanks has a 2.9 mln gallons idle capacity for the next three months. Can
CoolTanks make arbitrage prots in the market? If this is the case, what is the sequence
of transactions that CoolTanks can implement to do so? How much could CoolTanks
potentially gain three months from now?