Explain Covered Call and Protective Put strategies in the given context of Jack Lu and his investment in King Corporation.     

Question 1

 

Brian Adams is a principal at financial advisory firm Fortune Partners, a financial services firm that specialises in providing advice on risk management as well as derivative trading strategies. The clients of the firm include financial institutions such as banks, hedge funds as well as corporations and high-net-worth individuals.

 

  1. a) Brian has one client Jack Lu who is interested in using options in his portfolio and wants to discuss this with Brian in their meeting. Therefore, Brian has collected information on S&P 500 Index options that is shown below.

S&P 500 Stock Index Options Data

Expiry in Six Months

Multiplier $100

Exercise Call Put
Price Price Price
$1,100 $95.85 $42.60
$1,125 $80.50 $48.00
$1,150 $64.70 $60.00

 

When they met, at the start of the meeting Jack stated that his investment in King Corporation has grown considerably in value over the recent past and he would like to know suggestions on use of options to protect the gains on the investments. Brian suggested two strategies that Jack may wish to consider to protect his position in King Corporation; covered calls or protective puts.

 

Jack asked Brian to provide detailed analysis of the following option strategies:

Butterfly Spread: A butterfly spread strategy using the options information provided for S&P 500 Index options.

Straddle: A straddle strategy using options with an exercise price of $1,125.

Collar: A collar strategy using options information provided for S&P 500 Index.

 

Required:

 

i). Explain Covered Call and Protective Put strategies in the given context of Jack Lu and his investment in King Corporation.                                                                 (6 marks)

 

ii). Calculate Maximum Profit, Maximum Loss and Break-Even Price for the butterfly spread and straddle option strategies. Calculate the maximum profit and maximum loss per contract.                                                                                                                        (10 marks)

 

iii). The decision to implement the Collar strategy is considered to be least affected by the expected volatility of the S&P 500 Index. Explain why this is so.                (5 marks)

 

  1. b) One of Fortune’s client, Royal National Bank (RNB) asked for Brian’s advice on a loan commitment on the 16th of March 2017. RNB had committed to lend $100 million in 30 days i.e. 15th of April 2017 for 180 days due on 12th October 2017. The interest rate was set at 180-day LIBOR + 50 bps and therefore RNB was concerned that the interest rates may fall over the next 30 days.

To manage the interest rate risk, Brian suggested that RNB purchase a $100 million interest rate put option on 180-day LIBOR with an exercise rate of 5.75% that expires on 15 April 2017. The LIBOR rate was 6% on 16th March 2017 and 4% on 15th April 2017. This put option was available at a premium of $25,000. As the option was in the money on 15th April, it was exercised on 15th April 2017 and the payoff from the exercise was received on 12th October 2017. Given this information, RNB asked Brian to evaluate this strategy and determine how effectively it hedged against the risk of a fall in interest rate i.e. LIBOR.

 

Required:

 

  1. Calculate the effective annual interest rate based on Brian’s advice detailing and explaining each step of your calculations. (7 marks)

 

  1. c) TNR Inc. is another client that approached for advice on 15th October 2017 and indicated that it expected to borrow a $25 million on 15th December 2017 for 90 days. The loan rate is 90-day LIBOR + 100 basis points and the loan is due on 14th March 2018 exactly 90 days after the loan is made on 15th December 2017. TNR fears that interest rates might rise over the next two months i.e. till 15th December 2017 when the loan will be taken out. Therefore, it has asked Brian on how to manage this risk. Following Brian’s advice, TNR bought a $25 million interest rate call on 90-day LIBOR with an exercise rate of 3.5%. This call option was purchased for $45,000 and it expired on 15th December 2017. Given the option is in the money on 15th December 2017, the option is exercised and the payoff is received on 14th March 2018. TNR has asked Brian to provide a report on the possible outcomes given different interest rate scenarios.

Required:

  1. Assuming Brian’s advice is followed and LIBOR rates are 5% and 6% on 15 October 2017, and 15 December 2017, respectively, calculate the effective annual interest rate on TNR’s loan. Detail and explain each step of your calculations. (7 marks)       

                                                                                                                                 (35 marks)     

 

 

Question 2

 

  1. a) Chen Li is a portfolio manager for Crescent Investments and manages a $280 million investment portfolio. Recently Crescent’s investment committee has increasingly become more risk averse as it is anticipating a major announcement regarding monetary policy. To reflect the future expectations, Li wishes to temporarily make the following changes to the existing portfolio:

 

  1. reduce the portfolio’s equity allocation and decrease the equity beta of the portfolio;
  2. increase the portfolio’s bond allocation and decrease its modified duration.

 

The portfolio’s current and target characteristics are provided here.

Portfolio Characteristics

                         Current Portfolio                   Target Portfolio
Asset

Class

Modified Duration Equity Beta Allocation

(($ mlns)

Asset

Class

Modified Duration Equity Beta Allocation

($ mlns)

Equities — 1.08 182 Equities — 0.90 154
Bonds 7.2 — 98 Bonds 6.0 — 126

 

Li wants to avoid high trading costs for any temporary reallocation and chooses to use the following future contracts to realise the target portfolio allocations.

Equity Futures – currently priced at $129,000 per contract (after accounting for the multiplier), with an equity beta of 0.97;

Bond Futures – currently priced at $103,000 per contract, with a modified duration of 7.70 and a yield beta of 1.00.

 

Required:

 

i). Determine the action (buy or sell) and the number of futures contracts required to achieve the:

 

  1. Equity targets

 

  1. Bond targets

 

Note: Show your calculations in detail and explain accordingly.          (6 + 6 = 12 marks)

 

  1. b) Li is also responsible for managing the Jackson family investment portfolio with $46 million in equity and $32 million in bonds. As a consequence of change in family circumstances, the Jackson is rebalanced using the transactions shown below.
Transactions for Rebalancing the Peterson Portfolio
Type of Futures Contracts Action Number of Futures Contracts to Buy/Sell Price per Futures Contract (USD)
Equity futures contract Buy 42 160,000
Bond futures contract Sell 35 190,000

 

After three months of these transactions, the market value of the Jackson portfolio’s equities has grown by 3.00%, and the market value of its bonds has reduced by 2.40%. The prices of the equity and bond futures contracts are now $165,000 and $185,250, respectively.

 

Required:

 

ii). Calculate the profit or loss of the Jackson portfolio over the past three months. Show your calculations in detail and explain accordingly.                    (8 marks)                            

 

  1. c) The initial investment for a bull spread created using calls is greater than the initial investment for a bull spread created using puts.

Required:

Explain why the bull spread with calls has higher initial investment than the bull spread created with puts using put-call parity.                                        (4 marks)

 

  1. d) Contango and Backwardation are features of price patterns in futures market. An understanding of both is important with respect to the pricing and valuation of different futures contracts.

 

Required:

 

Explain and contrast Contango and Backwardation in futures market and discuss the underlying causes of each.                                                                                 (6 marks)

                                                                                                                        (30 marks)

 

 

Question 3

 

Tim Rock, FRM, has been assigned the task to assess the level of risk assigned to different business units at Crescent Bank as well as the impact of such risk on the overall stability of Crescent Bank. Crescent Bank operates globally and has a diversified into different business lines. One of the most major and immediate concern pertains to the U.S. Mortgage market and how will it affect the U.S. operations of Crescent Bank. Further the concern is that it may affect other areas of the business and may spread into other countries given it is contagion.

 

Tim is worried about the highly leveraged hedge fund operating in the US which is invested significantly in mortgage backed securities. The current value of this hedge fund stands at around $7 billion with $1400 million investments from high net-worth individuals and institutional investors. Crescent’s executives have contributed $600 million to the hedge fund while the remaining $5 billion has been bank borrowings.

 

At present, the mortgage borrowers with weak credit have been forced to default on their loans by the weak U.S. economy. This has resulted in declining value of mortgage backed securities and hence losing money for their investors. Given this recent trend, investors are divesting from mortgage backed securities to limit their losses and have further put pressure on prices of these securities. This has caused the hedge fund to lose significant amount of value over the several months and report losses.

 

Tim is now working with Mark Hicks who is the country head of the U.S. operations of Crescent Bank to assess the risks involved and manage it subsequently in the most appropriate manner. To monitor the various relevant risks of Crescent Bank in the U.S., Mark has established an enterprise risk management system. They both are discussing these risks within the context of Crescent. Tim said “the hedge fund is suffering from market risk due to the price of the underlying securities in the hedge fund decreasing in value and liquidity risk by not being able to sell the securities at a fair price.” To this mark replied “the hedge fund is also suffering from credit risk because the original borrowers of the mortgages are defaulting on their loans.”

 

The hedge fund is exposed to the risk of going out of business if the mortgage crisis persists and/or gets worse. Tim and Mark have the task on hand to minimise this risk. They have come up with the following alternatives.

  1. Securing a low interest rate line of credit from the Federal Reserve
  2. Pursue a cash infusion from the parent company in England
  • Purchase a credit derivative
  1. Ask for a handout from the U.S. government.

 

After considering these alternatives, they decided to use Credit Derivatives.

 

Required:

Write a report that covers the following contents explicitly (word limit 1300).

 

  1. Determine if the statements made by Tim and Mark are correct. Explain your response in detail.                                                             (7 marks)
  2. List and Explain the risks associated with an enterprise risk management system.                                                             (12 marks)
  3. Explain why Tim and Mark did not consider the other options viable to manage the risk.                                                                         (6 marks)
  4. Evaluate the different types of Credit Derivatives that can be used to manage the risk of the hedge fund and determine the most appropriate Credit Derivative for hedging the risk.                                                             (10 marks)

                                                                                                            (35 marks)

(100 marks total)