# Options, Futures and Risk Managements

Assume that you are one of the highly skilled specialists in ANZ Market Solutions team, which was formed to develop the right advice on risk management solutions and the implementation of derivative strategies for ANZ’s customers. You have been asked by the Director to prepare a report that addresses all the tasks required in the following five scenarios. Note that scenarios are independent of each other.

__SCENARIO 1: HEDGING WITH STOCK FUTURES [25 MARKS]__

On 31st August 2019, a long-term client, Mr Robin Baldwin, constructed a stock portfolio that consists of any __five __Australian stocks among __ten__ stocks listed in ** Exhibit 1**. He intended to hold the portfolio for one year and sell it on 31st August 2020.

Stock name / Symbol |
Number of shares held |

Afterpay Limited (APT.AX) | 15,000 |

Xero Limited (XRO.AX) | 11,000 |

Webjet Limited (WEB.AX) | 18,000 |

Zip Co Limited (Z1P.AX) | 20,000 |

CSL Limited (CSL.AX) | 9,000 |

Telstra Corporation Limited (TLS.AX) | 25,000 |

Commonwealth Bank of Australia (CBA.AX) | 15,000 |

Woodside Petroleum Ltd (WPL.AX) | 12,000 |

Nanosonics Limited (NAN.AX) | 20,000 |

Woolworths Group Limited (WOW.AX) | 13,000 |

*Exhibit 1: List of stocks *

On 25th February 2020, Australia confirmed its first four Covid-19 cases – one in Victoria and three in NSW. Globally, eleven countries confirmed coronavirus cases with a total of 1,320 cases, and 41 people had died (The Guardian, 2020). Mr Robin was concerned about the spread of the new coronavirus outbreak and how badly coronavirus would hurt the Australian stock market. He asked you to set up a hedge against his portfolio’s market risk using September ASX SPI 200 index futures. He expected the hedge to be in effect at the close of trading on 25th February 2020, on which day the September futures contract was traded at 6,826. The contract multiplier is AUD 25 per index point.

** Task 1.1:** The goal of this task is to investigate how index futures can be used to minimise the market risk from holding the stock portfolio. In particular, you need to determine the number of futures contracts for the hedge and report the position in futures contracts to be taken.

**[15 marks]**

** Task 1.2: **Determine the outcome of the hedge on 31st August 2020, on which day the September contract was priced at 6,030. Based on this outcome, discuss whether your client regretted having the stock portfolio hedged or not?

**[10 marks]**

__Hints:__

- Note that the selection of five stocks included in Mr Robin’s portfolio is your own choice. Naturally, each student will end up with a different portfolio of five stocks. The number of shares for each stock chosen must follow
For example, if Afterpay Limited is selected, Mr Robin would hold 15,000 shares of this stock in his portfolio.*Exhibit 1.* - Daily stock prices can be obtained from Yahoo Finance website: https://au.finance.yahoo.com/ (Search the company name/symbol => Select “Historical

Data” Tab => Choose the relevant time period then click “Apply” and “Download”.

Please use “adjusted close price”.)

- To complete the tasks, you will need to self-calculate beta for each stock at the start of the hedge (on 25th February 2020). Beta is a measure of systematic risk of a security or portfolio compared to the market as a whole. Steps to compute beta for any stock using Excel is as follow:

(1) Download 2-year historical daily prices for a stock whose beta you want to measure. (2) Download historical daily prices for the market index S&P/ASX 200 (**^AXJO)** (3) Calculate the daily returns (i.e. % change) of (1) and (2).

(4) Find beta of the stock by using the Excel function = SLOPE (Y, X) where Y is the daily returns series of the stock, and X is the daily returns series of ASX 200 index, calculated in step (3).

** **

__SCENARIO 2: FINANCIAL RISK MANAGEMENT [30 MARKS]__

Qantas Airways Limited (QAN.AX), the world’s second-oldest airline, started its operations in 1920. It has grown remarkably to be Australia’s largest domestic and international airline, and widely regarded as the world’s leading long-distance airline. As of 30th June 2018, it carried more than 55 million passengers and employed over 30,000 staff globally. Qantas is an Australian public company that listed on the ASX under the code QAN.

As of 25th February 2020, Mr Noah Kennedy (your client)’s portfolio consists of 100,000 shares of Qantas (QAN.AX) stock and 70,000 shares of Afterpay Limited (APT.AX) stock. Their stock prices can be obtained from Yahoo Finance website: https://au.finance.yahoo.com/.

** Task 2.1:** Your task is to identify and discuss the primary financial risks that Qantas is exposed to. Since Qantas is listed on the Australian Securities Exchange (ASX), the company research can be accomplished through its financial reports and documents, which are publicly available on the company’s website.

**[10 marks]**

** Task 2.2: **State and discuss the reasons why Qantas should hedge and why it shouldn’t hedge its fuel costs.

**[5 marks]**

** Task 2.3:** Explain to your non-technical client how the practice of financial risk management is similar to hedging, and how is it different

**. [5 marks]**

** Task 2.4: **Calculate 5% and 1% one-day VaR of Mr Noah’s portfolio using the historical method. Discuss the disadvantages of this method and interpret the value at risk results calculated so that your client would easily understand them. Assume that there is no change in the number of shares in the portfolio.

**[10 marks]**

** **

__SCENARIO 3: OPTIONS TRADING STRATEGY AND PRICING MODEL [20 MARKS]__

*Note: Task 3.1 and 3.2 are independent of each other. *

** Task 3.1** Mrs Susan Martinson has been trading options such as call and put options. She is looking for a more advanced and profitable strategy such as Strangle. She requests you to provide her with a brief overview of a long strangle strategy (e.g. how the strategy is constructed, when it should be used, benefits and risks associated with the strategy). You are also required to derive the profit equations for a strangle. Determine the maximum and minimum profits and the breakeven stock price at expiration.

**[10 marks]**

** Task 3.2** Mrs Susan Martinson observes a $72 price for a non-dividend-paying stock. The stock can go up by 35.6% or down by 45.9% in each of two binomial periods. The European call option on this stock has two years to mature. The annual risk-free interest rate is 3%, and the exercise price is $75. Mrs Susan asks you to:

- Find the value of the option today.
- Construct a hedge by combining a position in the stock with a position in the call. Show that the return on the hedge is the risk-free rate regardless of the outcome over both periods. You are also required to draw the tree with stock price, hedge ratio, value of a call and a hedge portfolio showing at each node. Assume that the call sells for the theoretical value.
- Advise what she would do if the call is overpriced and if it is underpriced?

**[10 marks] **

** **

__SCENARIO 4: DESIGN AN INTEREST RATE SWAP [15 MARKS]__

LXN Corporation and Musgrave Minerals Limited (MGV) both wish to invest $20 million in 5 years and have been offered the rates shown in ** Exhibit 2**. LXN wishes to invest at a floating rate of interest, while MGV requires a fixed-rate investment.

Fixed Rate | Floating Rate | |

LXN | 3% | LIBOR-0.6% |

MGV | 3.8% | LIBOR+0.8% |

*Exhibit 2: Interest rates *

** Task 4.1: **This task requires you to design a vanilla swap that will appear equally attractive to LXN and MGV. Assume that a financial institution, acting as an intermediary, is planning to charge a 0.2% premium.

**[8 marks]**

** Task 4.2:** Assume that today is 15th June 2020, the two companies enter to the $20 million 5year swap you have designed in Task 4.1. The payments of the swap are made semi-annually, on 15th December and June each year. Note that LIBOR is determined on the previous settlement date. The accrual period is the actual number of days divided by 360. Your task is to complete the

**below, which demonstrates the cash flows on the swap from the perspective of LXN.**

*Template (Exhibit 3)***[7 marks]**

Date | LIBOR (%) | Days in period | LXN pays
($) |
LXN receives
($) |
Net cash flow to LXN
($) |

15/06/2020 | 3.45 | ||||

15/12/2020 | 3.32 | ||||

15/06/2021 | 3.40 | ||||

15/12/2021 | 2.82 | ||||

15/06/2022 | 2.68 | ||||

15/12/2022 | 3.72 | ||||

15/06/2023 | 3.54 | ||||

15/12/2023 | 2.43 | ||||

15/06/2024 | 2.02 | ||||

15/12/2024 | 1.98 | ||||

15/06/2025 |

*Exhibit 3: Template of CFs on the swap*

** **

** **

__SCENARIO 5: VALUE A CURRENCY SWAP [10 MARKS]__

90 days ago, the mutual fund entered into a one-year currency swap by agreeing to swap US dollars for euros at the fixed rates. The annualised fixed rate in dollars and euros are 7.84% and 6.48%, respectively. The exchange rate at the start of the swap was $0.75. The new exchange rate today is $0.70. Assume that the notional dollar amount is $20,000,000. The payments are made semi-annually based on the assumption of 30 days per month and 360 days in a year. The adjustment Current LIBOR and Euribor rates are shown in the ** Exhibit 4**.

Term | LIBOR (%) | Euribor (%) |

90 days | 7.1 | 5.5 |

270 days | 7.4 | 6.0 |

*Exhibit 4: Current LIBOR and Euribor rates*

**Task 5:** Your task is to determine the market value of the swap today from the mutual fund’s perspective, who pays dollars and receives euros. **[10 marks]**

* *

*ASSIGNMENT GUIDELINE*

*Due date: **Friday, 30th October 2020, 5 pm Melbourne Time (Week 14).*

A late penalty will apply for late submissions where special consideration has not been granted.

**General requirements **

- The report should follow a proper format with an executive summary followed by subsections addressing all tasks required in each scenario.
- To complete the tasks in Scenario 1 and 2, you are required to download relevant stock price data from Yahoo Finance Website: https://au.finance.yahoo.com/. For other scenarios (3-5), please use the information given only, no additional data is needed.
- This is an individual assessment. All of your answers should be your own work without discussing the solution with others. All
**plagiarism**, both deliberate and accidental, is viewed**seriously**by the University and will incur penalties. - Students should not expect the lecturer to provide direct assistance on any questions. Any questions of a general nature should be posted on the discussion board rather than emailed to the lecturer so that the response is available for all students to see.
- Marking rubric for the assignment is provided on Canvas.
- Remember to show your workings/detailed steps (e.g. formulae) that lead to the final answers.

**Submission Instructions **

- The report must be entirely typed in the Word document for it to be recognised by the Turnitin. Hand-written parts will not be marked while Excel screenshots are allowed. The assignment should not exceed 3,000 words (show the word count on the first page of the assignment).
- The report is to be prepared in MS Word and submitted in either Word or PDF format on the Canvas in the name with the following form:
*BAFI2081_Student ID_Your name.* - You also need to submit an EXCEL file that contains the stock data downloaded for Scenario 1 and 2 and the workings/formulas for relevant tasks (if any).
- Ensure to attach the RMIT’s Assignment Cover Sheet (with all details filled) to the front page of your submitted document. The Cover Sheet can be downloaded from this link: https://www.rmit.edu.au/students/student–essentials/forms/assessment–forms
- Upload the submission files to the Turnitin/Canvas submission link under
**Assignment**tab =>**Assessment Task 3: Individual Assignment**=>**Submit Assignment**before the deadline.

**Late Submissions**

All assignments will be marked as if submitted on time. Late submissions of assignments without special consideration or extension will be automatically penalised at a rate of 10% of the total marks available per day (or part of a day) late.

**Assessment Feedback**

You will normally receive marks and feedback on in-course assessment tasks within ten working days of the deadline for submission of that work, or, where an extension has been granted, within ten working days of agreed extended due date.

**Reference **

Chance, D. M. and Brooks, R, *An Introduction to Derivatives and Risk Management*, tenth edition, Thomson South-Western.

The Guardian, 2020, “Coronavirus: three cases in NSW and one in Victoria as infection reaches

Australia”, viewed 30^{th} August 2020,

<https://www.theguardian.com/science/2020/jan/25/coronavirus–five–people–in–nsw–beingtested–for–deadly–disease>

Data source for September ASX SPI 200 index prices: Eikon.

Qantas Group, 2020, “About the Qantas Group*”, *viewed 30^{th} August 2020

<https://investor.qantas.com/home/?page=about–the–qantas–group>