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Derivatives and Alternative Investments

A European asset manager is concerned about the possible imminent withdrawal of Central Bank support for asset prices which might result in higher yields on bonds and lower on stock markets during the next 3 months. Consequently, they wish to fully hedge their portfolio against all risks. However, they are mandated to remain fully invested at all times so selling securities is not an option.

Their portfolio currently comprises the following positions.

Notional/Amount    Security    Term
€2,000,000    BTP    Italian 10 year on-the-run
€5,000,000    Euro  Interest Rate swap    5 year Fixed Rate Payer
€50,000,000    German Equities
$50,000,000    USD LIBOR Interest Rate deposit with Bank of America    1 year.

Current data for pricing and obtaining rates can be found at www.ft.com under data archive.

1.    The asset manager wants to fully hedge the interest rate risk on the bonds by using bond futures and to hedge the equity risk by using index futures. Calculate the appropriate number of bond and equity futures that should be sold. You may assume that the portfolio of German equities has a beta of one to the German DAX index (bond and index future data can be found at www.eurexchange.com ). (20 marks)

2.    Explain the risks of the interest rate swap position and should it be hedged in this scenario? What impact might it have on the rest of the portfolio? (20 marks)

3.    The asset manager would like to hedge the receipt of $50,000,000 to be received in one years’ time from the maturity of the one year interbank deposit. Using current data from www.ft.com, calculate a one year €/$ forward rate and explain how it could be used to hedge the currency risk. (20 marks)

4.    The asset manager thinks that there is some possibly that the currency markets could move in their favour and so ideally would like some degree of participation in any favourable move, whilst being fully protected against adverse moves. Discuss alternative hedging choices by using options. Currency option quotes on FX futures can be at www.cmegroup.com. (20 marks)

5.    The interest rate swap counterparty is the same bank (Bank of America) to whom the asset manager lent $50,000,000 via the USD LIBOR deposit. The asset manager is concerned that a default by the Bank could give rise to substantial credit risk. Discuss how derivatives could be used to hedge this risk. (20 marks)

1. Critically assess Options Futures and Derivatives as risk management and speculative tools in investment finance
2. Evaluate the key factors and the interdependence of these factors in the design and use Derivatives instruments as both risk management and speculative tools.
3. Identify and evaluate a range of derivatives tools appropriate for risk management and speculation
4. Apply and assess the effectiveness of derivatives options and futures in finance and investment

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