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Cfm 306 Financial Risk Management Question Paper
Cfm 306 Financial Risk Management
Course:Bachelor Of Commerce
Institution: Kca University question papers
Exam Year:2011
UNIVERSITY EXAMINATIONS: 2011/2012
YEAR 3 EXAMINATION FOR THE BACHELOR OF COMMERCE
CFM 306 FINANCIAL RISK MANAGEMENT (SATURDAY)
DATE: APRIL 2012 TIME: 2 HOURS
INSTRUCTIONS: Answer Question One and Any other Two Questions
QUESTION ONE
i. State and explain the limitations of the black and Scholes option pricing model. [5 Marks]
ii. Distinguish between forward and future contracts [5 Marks]
iii. Consider a one year futures contract on gold. Suppose that it costs sh 5 per ounce per year to
store gold, with the payment being made at the end of the year. Assume the spot price is ah 500
and the risk free rate is 10% per annum for all maturities, determine the future price of the gold.
[5 Marks]
iv. State the advantages of interest rate swaps to an investor. [5 Marks]
v. Suppose you enter into a six month forward contract on a non dividend paying stock when the
stock price is sh 100 and the risk free rate with continuous compounding is 12% per annum.
What is the forward rate? [5 Marks]
vi. Call options on a stock are available with strike prices of sh 15, sh 17.5 and sh 20 and expiration
dates in three months. Their prices are sh 4, sh 2 and sh 0.5 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. [5 Marks]
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QUESTION TWO
Consider a call option on an investment with the following characteristics;
Time to expiry of option 5 years
Estimated cost sh 20 million
Present value of net receipts 15 million
Volatility of cash flows 28.3%
Risk free rate 6%
Required
i. Using the Black - Scholes option pricing model, calculate the value of a call option. [15 Marks]
ii. Assume you are to calculate the value of a put option on the same, what value would you quote?
[5 Marks]
QUESTION THREE
Companies A and B face the following interest rates;
A B
U.S Dollars (Floating rate) LIBOR + 0.5% LIBOR + 1.0%
Canadian Dollars (Fixed rate) 5.0% 6.5%
Assume that A wants to borrow US Dollars at a floating rate of interest and B wants to borrow
Canadian Dollars at a fixed interest rate. A financial institution is wiling to arrange the swap and
requires 50 basis points spread.
Required;
i. If the swap is to appear equally attractive to A and B, what rates of interest will A and B end
up paying? [5 Marks]
ii. Draw a diagram showing how the swap will be designed. [5 Marks]
iii. Assume that the financial intermediary adjusted his charge to 70 basis points. Would it be
still tenable to pursue the swap? If so give the appropriate diagram for the swap showing how
it will be designed. [8Marks]
iv. Differentiate between an interest rate swap and a currency swap. [2 Marks]
QUESTION FOUR
i. A stock price is currently sh 100. Over each of the next two six month periods, it is expected to
go up by 10% or down by 10%. The risk free rate is 8% per annum with continuous
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compounding. What is the value of a one year European call option with a strike price of sh 105.
[12 Marks]
ii. Consider a stock with a current price of sh 5. 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 5 and the risk free rate is 5%.
Required;
i. Show the movement in stock prices clearly indicating the expected value of the stock and the
option value at the end of the period. [4 Marks]
ii. Calculate the option delta of a call option and explain how an investor can use this
information to create a perfectly hedged position. [4 Marks]
QUESTION FIVE
a. Suppose that spot interest rates are as follows:
Maturity (years) Rate (per annum)
1 7
2 7.4
3 7.1
4 6.9
5 6.8
Calculate forward interest rates for the second, third, fourth and fifth years. [9 Marks]
b. Suppose that the risk-free interest rate is 11 percent per annum and that the dividend yield on a
share index is 5 percent per annum. The index is standing at 410, and the futures price for a
contract deliverable in four months is 415. Describe the arbitrage opportunities here.
[5 Marks]
c. Under which circumstances is a short hedge appropriate and under which circumstances is a
long hedge appropriate? [3 Marks]
d. Explain why a short hedger’s position improves when the basis strengthens unexpectedly and
weakens when the basis weakens unexpectedly? [3 Marks]
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