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Cfm 306 Financial Risk Management (Saturday) Question Paper
Cfm 306 Financial Risk Management (Saturday)
Course:Bachelor Of Commerce
Institution: Kca University question papers
Exam Year:2011
1
UNIVERSITY EXAMINATIONS: 2010/2011
THIRD YEAR EXAMINATION FOR THE DEGREE OF BACHELOR OF
COMMERCE
CFM 306 FINANCIAL RISK MANAGEMENT (SATURDAY)
DATE: DECEMBER2011 TIME: 2 HOURS
INSTRUCTIONS: Answer Question One and Any Other Two Questions
Question One
i. Define hedging and state the circumstances when a short hedge and a long hedge is
appropriate. (5 Marks)
ii. State and explain the fundamental differences between futures and forward contracts (5Marks)
iii. State and explain the main limitations of Black & Scholes valuation model. (5 Marks)
iv. Consider a stock with a current price of sh 100. There is a two thirds probability that
the stock will increase in value by 20% and a one third probability that the stock will
decrease by 10% at the end of the period. Further assume that the exercise price is sh
100 and the risk free rate is 5%.
Required;
Show the movement in stock prices clearly indicating the expected value of the stock and
the option value at the end of the period and use the delta hedge to determine the value of
the combined hedged position (10 Marks)
v. State and explain the factors that affect call options clearly showing the relationship between
the factor and the value of the put option. (5 Marks)
2
Question Two
a) Suppose two companies A and B both wish to borrow sh.20m for five years and have been
offered the rates shown below:
Fixed Floating
Company A 5% 6 month T.B + 0.1%
Company B 6.4% 6 month T.B + 0.60%
Company A prefers floating rate borrowing and company B prefers fixed rate borrowing. Design a
swap that will net a bank acting as an intermediary 0.1% per annum and that will appear equally
attractive to both companies. (10 Marks)
b) State and explain the advantages of using interest rate swaps to hedge against risk. (5 Marks)
c) State and explain the main types of risks associated with swaps (5 Marks)
Question Three
a) Call options on a stock are available with strike prices sh 30, sh 35 and sh 40 and expiration
dates in three months. Their prices are sh 8, sh 4 and sh 1 respectively. Explain how the
options can be used to create a butterfly spread. Construct a table showing how profit varies
with stock price for the butterfly spread. (8 Marks)
b) The shares of ABC Ltd. are currently selling at sh.280 each at the stock exchange. The
exercise price for a six month call option is sh.250. The prevailing risk free rate is 12% p.a.
The variance of ABC Ltd. share price has been 15%.
Required
Using Black and Scholes option valuation model, determine the value of a call option. Also
calculate the value of a put option from the same data. (12 Marks)
3
Question Four
a) Consider a one year futures contract on gold. Suppose that it costs sh 2 per ounce per year
to store gold, with the payment being made at the end of the year. Assume the spot price is ah
450 and the risk free rate is 6 % per annum for all maturities, determine the future price of the
gold. (7Marks)
b) The following rates apply today;
Spot US dollar sh 75
Forward dollar premium (annualized) 6.8%
Washington bankers acceptance (annualized) 10.2%
Local bankers acceptance (annualized) 18.8%
Required:
Does an opportunity exist to engage in a three month risk free arbitrage transaction?
(Ignore transaction costs) Show computations. (6 Marks)
c) Consider a four month forward contract to buy a zero coupon bond that will mature one
year from today. The current price of the bond is sh 930. (Because the bond will have eight
months to go when the forward contract matures, it can regard the contract as an eight month
zero coupon bond.) Assume that the four month risk free rate of interest compounded
continuously at 6% par annum. Determine the forward price. (7 Marks)
Question Five
Consider a two year put option with a strike price of sh 26 on a stock whose current price is sh 25.
Suppose there are two time steps of one year and in each time step the stock price moves up by
20% or down by 20%. Suppose the risk free rate is 5%. Using binomial pricing model, calculate
the value of the put assuming;
i. it is a European option (10 Marks)
ii. it is an American option (10 Marks)
4
AREAS UNDER STANDARD NORMAL CURVE FROM 0 TO Z
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
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