- “A swap bank has to entail certain risks which are inherent to the swap business and are interrelated” Explain the risks involves in swap business.
“A swap bank has to entail certain risks which are inherent to the swap business and are interrelated. The main risks associated with interest rate swaps, which are the most common type of swap, are interest rate risk and counterparty risk. An interest rate swap is an agreement between two parties to exchange cash flows at a future specific time. Swap agreements involve two legs: the fixed leg and the variable leg. The holder of the fixed leg of the swap makes payments based on a fixed interest rate level. The holder of the variable leg makes payments on a variable interest rate, usually determined by an interest rate index such as LIBOR. Interest rate risk is significant because interest rates do not always move as expected. Both parties have interest rate risk. The holder of the fixed leg risks the floating interest rate going higher, thereby losing interest that it would have otherwise received. The holder of the variable leg risks interest rates going lower, which results in a loss of cash flow since the fixed leg holder still has to make the streams of payments to the counterparty.
The other main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the variable leg is unable to make payments under the swap agreement, the holder of the fixed leg has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed leg was seeking to avoid. Counterparty default for swaps was a driver of the global financial crisis in 2008. The U.S. government has attempted to bring transparency and reduce systematic risk for swaps trading with the passage of the Dodd-Frank Act. Dodd-Frank requires most swaps to trade on swap execution facilities as opposed to over the counter, and it also requires the public dissemination of information for swap trading. This new market structure will help prevent a ripple effect impacting the larger economy in case of a counterparty default.
Interest rate swaps and other hedging strategies have long provided a way for parties to help manage the potential impact on their loan portfolios of changes occurring in the interest rate environment. A standard interest rate swap is a contract between two parties to exchange a stream of cash flows according to pre-set terms. In essence, the transaction involves trading costs associated with two different types of loans—typically swapping the terms of a floating rate loan for those of a fixed rate loan or vice versa. Borrowers may have specific objectives when choosing to participate in an interest rate swap or related hedging strategy. For example, the goal may be to reduce interest expense on a particular loan by swapping a higher fixed rate for a lower floating rate. Alternatively, a borrower may wish to hedge existing interest rate risk related to the potential that rates will move higher in the future. This is accomplished by swapping the terms of an existing variable rate loan for those of a fixed rate loan that will lock in the interest rate on a loan for the loan duration.
An important distinction of an interest rate swap compared to other types of financial transactions is that principal is never exchanged. The swap represents an agreement to exchange interest cash flows over time. Interest rate swaps are completely customizable with flexible terms. The contract is legally separate from the hedged item, and no upfront premium is required to execute a swap. This paper provides an overview of the workings of interest rate swaps and related strategies that individuals or entities may want to consider to help manage interest rate risk. This includes a discussion of how the interest rate environment may affect any decisions made about swaps or related hedging strategies.
2.Call options are said to be “At the money “, “In the money” and “Out of the money” depending on whether the exercise price is equal to or less than or greater than the current market price of the stock. In case of Put options, the opposite is true. Explain when a trader realizes profits in case of Call as well as Put options with the help of simple examples.
In options trading, the difference between "in the money" and "out of the money" is a matter of the strike price´s position relative to the market value of the underlying stock, called its moneyness. An in the money option is one with a strike price that has already been surpassed by the current stock price, meaning the option holder is more likely to turn a profit. An out of the money option is one that has a strike price that the underlying security has yet to reach, meaning the option has little intrinsic value and is likely to yield only marginal returns, if any.
The definition of "in the money" or "out of the money" for a given option chain is dictated by the option type in question. A call option is an investment chosen by those who believe the underlying stock price will continue to rise. An in the money call option, therefore, is one that has a strike price lower than the current stock price. A call option with a strike price of $133, for example, would be considered in the money if the underlying stock is valued at $135 per share because the strike price has already been exceeded, making the option more valuable. A call option with a strike price above $135 would be considered out of the money because the stock has not yet reached this level.
Put options are purchased by investors who believe the stock price will go down. In the money put options, therefore, are those that have strike prices above the current stock price. A put option with a strike price of $75 is considered in the money if the underlying stock is valued at $72 because the stock price has already moved below the anticipated level. A put option with a strike price of $70 would be considered out of the money.
Typically, in the money options carry a higher premium than out of the money options, as they are more likely to yield a profit.
The Basic Call Option
A call option provides an investor with the right, but not the obligation to purchase a stock at a specific price. This price is known as the strike, or exercise price. Other important contract terms include the contract size, which for stocks is usually in denominations of 100 shares per contract. The expiration date specifies when the option expires, or matures. The contract style is also important and can be in two forms. American options let an investor exercise an option any time before the maturity date. European options can only be exercised on the expiration date. The settlement process must also be known, such as delivering the shares in the case of exercise within a certain amount of time. (Read Investopedia´s helpful clarification, "American vs. European Options.")
Writing Call Options for Income
Buying a call option is the same as going long, or profiting from a rise in the stock price. As with stocks, an investor can also short, or write a call option. This lets him or her receive income in the form of receiving the option price, or the opposite of the long position. This means the call writer has the obligation to sell the stock to the call option holder if the stock price rises above the exercise price.
In writing call options, the investor who is short is betting that the stock price will remain below the exercise price during the term of the option. When this happens, the investor is able to keep the premium and earn income from the strategy.
Combining One Call with Another Option
To create a more advanced strategy and demonstrate the use of call options in practice, consider combining a call option with writing an option for income. This strategy is known as a bull call spread and consists of buying, or going long a call option and combining it with a short strategy of writing the same number of calls with a higher strike price. In this case, the goal is for a narrow trading range.
For example, assume a stock trades at $10, a call is purchased at a strike price of $15 and a call is written at $20 for a premium of $0.04 per contract. Assume a single contract for premium income of $4, or $0.04 x 100 shares. The investor will keep the premium income regardless of the situation. If the stock remains between $15 and $20, the investor retains the premium income and also profits from the long call position. Below $15, the long call option is worthless. Above $20, the investor keeps the premium income of $4 as well as a $5 profit from the long call option, but loses out on any upside above $20 as the short position means the stock will be called away from him or her.
The Basic Put Option
A put option provides an investor with the right, but not the obligation to sell a stock at a specific price. This price is known as the strike, or exercise price. Other important contract terms include the contract size, which for stocks is usually in denominations of 100 shares per contract. The expiration date specifies when the option expires, or matures. The contract style is also important and can be in two forms. American options let an investor exercise an option any time before the maturity date. European options can only be exercised on the expiration date. The settlement process must also be known, such as delivering the shares in the case of exercise within a certain amount of time. (See also "What is a Bull Put Spread?" and "What is a Bear Put Spread?")
Writing Put Options for Income
Buying a put option is similar to going short on a stock, or profiting from a fall in the stock price. However, an investor can also short, or write a put option. This lets him or her receive income in the form of receiving the option price and the hope is the stock remains above the strike price. If the stock falls below the strike price, the put writer has the obligation to buy the stock (because it is effectively “put” to him or her) from the put option holder. Again, this occurs if the stock price falls below the exercise price.
When writing put options, the investor who is short is betting that the stock price will remain above the exercise price during the term of the option. When this happens, the investor is able to keep the premium and earn income from the strategy.
Combining One Put with Another Option
To create a more advanced strategy and demonstrate the use of put options in practice, consider combining a put option with a call option. This strategy is known as a straddle and consists of buying a put option as well as going long a call option. In this case, the investor is speculating that the stock is going to have a relatively significant move either up or down.
For example, assume a stock trades at $11. The straddle strategy can be relatively straightforward and consist of purchasing both the put and call at a strike price of $11. Two long options are purchased with the same expiration date and a profit is reached if either the stock moves up or down by more than the cost to purchase both options.
3.Write short notes on (a) LBO or (b) Corporate restructuring
A leveraged buyout (LBO) is a financial transaction in which a company is purchased with a combination of equity and debt, such that the company´s cash flow is the collateral used to secure and repay the borrowed money. The use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. This reduced cost of financing allows greater gains to accrue to the equity, and, as a result, the debt serves as a lever to increase the returns to the equity.
The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are partially funded by bank debt, thus effectively also representing an LBO. LBOs can have many different forms such as management buyout (MBO), management buy-in (MBI), secondary buyout and tertiary buyout, among others, and can occur in growth situations, restructuring situations, and insolvencies. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction – Public to Private).
As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were "over-leveraged", meaning that they did not generate sufficient cash flows to service their debt, which in turn led to insolvency or to debt-to-equity swaps in which the equity owners lose control over the business to the lenders.
LBOs have become attractive as they usually represent a win-win situation for the financial sponsor and the banks: the financial sponsor can increase the rate of returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending, because the interest chargeable is that much higher.
The amount of debt banks are willing to provide to support an LBO varies greatly and depends, among other things, on:
The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard assets, etc.)
The amount of equity supplied by the financial sponsor
The history and experience of the financial sponsor
The overall economic environment
For companies with very stable and secured cash flows (e.g., real estate portfolios with rental income secured with long-term rental agreements), debt volumes of up to 100% of the purchase price have been provided. In situations of "normal" companies with normal business risks, debt of 40–60% of the purchase price are usual figures. The possible debt ratios vary significantly among the regions and the target industries.
Depending on the size and purchase price of the acquisition, the debt is provided in different tranches.
Senior debt: This debt is secured with the assets of the target company and has the lowest interest margins
Junior debt (usually mezzanine): this debt usually has no securities and thus bears higher interest margins
In larger transactions, sometimes all or part of these two debt types is replaced by high yield bonds. Depending on the size of the acquisition, debt as well as equity can be provided by more than one party. In larger transactions, debt is often syndicated, meaning that the bank who arranges the credit sells all or part of the debt in pieces to other banks in an attempt to diversify and hence reduce its risk. Another form of debt that is used in LBOs are seller notes (or vendor loans) in which the seller effectively uses parts of the proceeds of the sale to grant a loan to the purchaser. Such seller notes are often employed in management buyouts or in situations with very restrictive bank financing environments. Note that in close to all cases of LBOs, the only collateralization available for the debt are the assets and cash flows of the company. The financial sponsor can treat their investment as common equity or preferred equity among other types of securities. Preferred equity can pay a dividend and has payment preferences to common equity.
As a rule of thumb, senior debt usually has interest margins of 3–5% (on top of Libor or Euribor) and needs to be paid back over a period of 5 to 7 years; junior debt has margins of 7–16%, and needs to be paid back in one payment (as bullet) after 7 to 10 years. Junior debt often additionally has warrants and its interest is often all or partly of PIK nature.
In addition to the amount of debt that can be used to fund leveraged buyouts, it is also important to understand the types of companies that private equity firms look for when considering leveraged buyouts.
The Corporate Restructuring is the process of making changes in the composition of a firm’s one or more business portfolios in order to have a more profitable enterprise. Simply, reorganizing the structure of the organization to fetch more profits from its operations or is best suited to the present situation.
The Corporate Restructuring takes place in two forms:
Financial Restructuring: The Financial Restructuring may take place due to a drastic fall in the sales because of the adverse economic conditions. Here, the firm may change the equity pattern, cross-holding pattern, debt-servicing schedule and the equity holdings. All this is done to sustain the profitability of the firm and sustain in the market. Generally, the financial or legal advisors are hired to assist the firms in the negotiations.
Organizational Restructuring: The Organizational Restructuring means changing the structure of an organization, such as reducing the hierarchical levels, downsizing the employees, redesigning the job positions and changing the reporting relationships. This is done to cut the cost and pay off the outstanding debt to continue with the business operations in some manner.
The need for a corporate restructuring arises because of the change in company’s ownership structure due to a merger or takeover, adverse economic conditions, adverse changes in business such as bankruptcy or buyouts, over employed personnel, lack of integration between the divisions, etc.
4.“Futures rely on a great deal on expected spot prices. The theoretical’framework suggests that forward rates reflect the expected spot rates.”
How futures differ from forwards? Explain.
The forward exchange rate (also referred to as forward rate or forward price) is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. Multinational corporations, banks, and other financial institutions enter into forward contracts to take advantage of the forward rate for hedging purposes. The forward exchange rate is determined by a parity relationship among the spot exchange rate and differences in interest rates between two countries, which reflects an economic equilibrium in the foreign exchange market under which arbitrage opportunities are eliminated. When in equilibrium, and when interest rates vary across two countries, the parity condition implies that the forward rate includes a premium or discount reflecting the interest rate differential. Forward exchange rates have important theoretical implications for forecasting future spot exchange rates. Financial economists have put forth a hypothesis that the forward rate accurately predicts the future spot rate, for which empirical evidence is mixed.
The forward exchange rate is the rate at which a commercial bank is willing to commit to exchange one currency for another at some specified future date. The forward exchange rate is a type of forward price. It is the exchange rate negotiated today between a bank and a client upon entering into a forward contract agreeing to buy or sell some amount of foreign currency in the future. Multinational corporations and financial institutions often use the forward market to hedge future payables or receivables denominated in a foreign currency against foreign exchange risk by using a forward contract to lock in a forward exchange rate. Hedging with forward contracts is typically used for larger transactions, while futures contracts are used for smaller transactions. This is due to the customization afforded to banks by forward contracts traded over-the-counter, versus the standardization of futures contracts which are traded on an exchange. Banks typically quote forward rates for major currencies in maturities of one, three, six, nine, or twelve months, however in some cases quotations for greater maturities are available up to five or ten years.
5. “Arbitrage profits” an investor told are risk less profits. You take simultaneous but opposite positions in two markets to reap gains from pricing disparities. Acting on this belief, his friend tried to find the arbitrage profit by trading simultaneously in futures and stock index.
He has collected to the following information:
- Pricing level of stock index _- 3000
- Index futures priced at 2000
- Risk free rate of return - l0%p.a.
- 50% stocks are to pay dividcnds at 6%
- The index futures has a multiple of 100
- The future has six months to expiration.
(a) Find arbitrage profits, if any.
(b) Discuss the risks associated with arbitrage transactions in futures.
The following options are quoted at the market:
Option Expiration Strike Price Premium
Call 1 Month Rs.48.5/$ Rs.0.30
Put 1Month Rs.48.5/$ Rs.0.05
A trader is looking at the above options and planning to adopt long strip or long strap strategy to make profit from the rupee-dollar exchange rate volatility.
1.Show the pay off profile and indicate break even points for strip and strap strategies in a price range of Rs 47- Rs 50 for a dollar.
- Strip Strategy
Buy one call at 48.50
Buy two puts at 48.50
Total initial outflow = 0.30 + 2 ´ 0.05 = Rs.0.40
Break-even points are 48.30 and 48.90.
Buy two calls at 48.50
Buy one put at 48.50
Total initial outflow = 2 ´ 0.30 + 0.05 = Rs.0.65.
Break-even points are 47.85 and 48.825.
2.Comment on the desirability of the above two option strategies.
The buyer of strip and strap expects there will be a significant movement in the spot price. Strip strategy is more desirable if the spot price is more likely to fall than to rise and strap strategy is desirable if spot price more likely to rise. Strip will give profit if spot price falls below 48.30 or rises above 48.90. Strip will give profit if price falls below 47.85 or rises above 48.825. So, the trader will buy strip if he expects rupee to appreciate and will buy strap if he expects rupee to depreciate significantly.
3.Consider a call option on a stock with the following parameters
Stock price: Rs210
Strike Price: Rs 220
Time to expiration: 167 days
Risk free interest rate: 10 %
Variance of annual stock returns: 20%
Compute price of the call option
Strike Price (Rs)
Spot Price (Rs)
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Question No. 1 Marks - 10
Standardized futures contracts exist for all of the following underlying assets except
- common stock
- stock indices
- T bonds
Question No. 2 Marks - 10
Which of the following is false?
- Futures contracts trade on a financial exchange.
- Futures contracts are more liquid than forward contracts.
- Futures contracts allow fewer delivery options than forward contracts.
- Futures contracts are marked to market
Question No. 3 Marks - 10
Which one of the following actions will offset a long position in a futures contract that expires in June?
- Sell any futures contract, regardless of its expiration date
- Buy any futures contract, regardless of its expiration date.
- Buy a futures contract that expires in June
- Hold the futures contract until it expires
Question No. 4 Marks - 10
Which of the following does the most to reduce default risk for futures contracts?
- Flexible delivery arrangements.
- High liquidity
- Credit checks for both buyers and sellers
- Marking to market.
Question No. 5 Marks - 10
Which of the following is most similar to a stock broker?
- Pit trader.
- Futures commission merchant.
- Floor broker.
Question No. 6 Marks - 10
Using futures contracts to transfer price risk is called:
Question No. 7 Marks - 10
Which of the following is best described as selling a synthetic asset and simultaneously buying the actual asset?
Question No. 8 Marks - 10
Which of the following causes the futures price of an asset to increase, everything else held constant?
- Higher expected spot price for the underlying asset.
- Lower expected spot price for the underlying asset.
- Lower risk-free rate of interest
- Higher income received while carrying the underlying asset
Question No. 9 Marks - 10
A put option has a strike price of $35. The price of the underlying stock is currently $42. The put is:
- at the money.
- near the money.
- in the money.
- out of the money.
Question No. 10 Marks - 10
A call option with a strike price of $55 can be bought for $4. What will be your net profit if you sell the call and the stock price is $52 when the call expires?
Question No. 11 Marks - 10
Suppose you sell a call and buy one share of stock. What is your cash payoff when the option expires? (Ignore the costs of the call and the share of stock).
- Receive St if St ≤ X and receive X if St > X.
- Receive St if St ≤ X and receive –(St –X) if St > X.
- Receive (St – X) if St ≤ X and receive X if St > X.
- Receive X if St ≤ X and receive St if St > X.
Question No. 12 Marks - 10
Which of the following has the right to sell an asset at a predetermined price?
- A call buyer.
- A put writer.
- A put buyer.
- A call writer.
Question No. 13 Marks - 10
Which of the following is potentially obligated to sell an asset at a predetermined price?
- A call buyer.
- A put writer.
- A put buyer.
- A call writer.
Question No. 14 Marks - 10
Which of the following is not a characteristic of option contracts that trade on the Chicago Board Options Exchange?
- The contracts are standardized.
- Option holders must take physical delivery of the underlying asset.
- Option writers are required to put up collateral
- It is easy to transfer the contracts between investors.
Question No. 15 Marks - 10
Which of the following actions will not close a long position in a call option?
- Allowing the call to expire.
- Exercising the call.
- Selling a call with the same strike price, expiration, and underlying asset.
- Buying a put with the same strike price, expiration, and underlying asset.
Question No. 16 Marks - 10
Which of the following strategies will be profitable if the price of the underlying asset is expected to decrease? (There may be more than one correct response.)
- Buying a put.
- Selling a put.
- Selling a call.
- Buying a call.
Question No. 17 Marks - 10
Which of the following investment strategies has unlimited profit potential?
- Protective put.
- Covered call.
- Bull spread.
- Writing a call.
Question No. 18 Marks - 10
Which of the following is a major difference between swaps and futures contracts?
- Swaps are usually marked to market, whereas futures contracts are not.
- A futures contract involves only one future transaction, whereas a swap typically involves several future transactions.
- Swaps are derivative securities, but futures contracts are not.
- Swaps are typically short term, whereas futures contracts tend to extend over several years.
Question No. 19 Marks - 10
Which of the following contract terms is not set by the futures exchange?
- the price
- the deliverable commodities
- the dates on which delivery can occur
- the size of the contract
Question No. 20 Marks - 10
Find the forward rate of foreign currency Y if the spot rate is $4.50, the domestic interest rate is 6 percent, the foreign interest rate is 7 percent, and the forward
Question No. 21 Marks - 10
Margin in a futures transaction differs from margin in a stock transaction because
- stock transactions are much smaller
- delivery occurs immediately in a stock transaction
- no money is borrowed in a futures transaction
- futures are much more volatile
Question No. 22 Marks - 10
Most futures contracts are closed by
Question No. 23 Marks - 10
Which of the following is not a forward contract?
- an automobile lease non-cancelable for three years
- a signed contract to buy a house in six months
- a long-term employment contract at a fixed salary
- a rain check
Question No. 24 Marks - 10
One of the advantages of forward markets is
- the contracts are private and customized
- trading is conducted in the evening over computers
- performance is guaranteed by the G-30
- trading is less costly and governed by more rules
- none of the above
Question No. 25 Marks - 10
Which of the following best describes normal contango?
- the futures price is less than the spot price
- the cost of carry is negative
- the expected spot price is less than the futures price
- the spot price is less than the futures price
Question No. 26 Marks - 10
Suppose you sell a three-month forward contract at $35. One month later, new forward contracts are selling for $30. The risk-free rate is 10 percent. What is the value of your contract?
Question No. 27 Marks - 10
Futures prices differ from spot prices by which one of the following factors?
- the systematic risk
- the risk premium
- the spread
- the cost of carry
Question No. 28 Marks - 10
Suppose there is a risk premium of $0.50. The spot price is $20 and the futures price is $22. What is the expected spot price at expiration?
- none of the above
Question No. 29 Marks - 10
………..for performing investment or securities accounting services and computing the net asset value
- custody fees
- fund administration fees
- fund accounting fees
- registration fees
Question No. 30 Marks - 10
………...for 24F-2 fees owed to the SEC for net sales of registered fund shares and state blue sky fees owed for selling shares to residents of states
- custody fees
- fund administration fees
- fund accounting fees
- registration fees
Question No. 31 Marks - 10
GROWTH FUNDS INVEST IN
- risky securities
- riskfree securities
- income securities
Question No. 32 Marks - 10
The ………….-end load often declines as the amount invested increases, through breakpoints.
- both of the above
- none of the above
Question No. 33 Marks - 10
The ………...-end load is paid by the shareholder; it is deducted from the amount invested.
- both of the above
- none of the above
Question No. 34 Marks - 10
Income funds are preferred by
- retired investors
- risky investors
Question No. 35 Marks - 10
If the ……..-end load declines the longer the investor holds shares, it is called a contingent deferred sales charges
- both of the above
- none of the above
Question No. 36 Marks - 10
- global deposits record
- global depository rceipts
- gross domestic record
- gross deposit receipts
Question No. 37 Marks - 10
GDR is used to
- invest in assets
- Raise money from public
- Issue stocks
- sell products
Question No. 38 Marks - 10
Loan syndication helps
- stock exchange
Question No. 39 Marks - 10
Mutual funds are sold at
- market Price
- base price
Question No. 40 Marks - 10
Best rating among the following is