Question 1 a)

Crude Oil Future Prices 27 Feb 08

100 99.5 99 98.5 98 97.5 97 96.5 96 95.5 95 Future Price 27 Feb 08

Oct-08

May-08

Dec-08

Mar-09

Apr-08

Aug-08

As illustrated in the above graph, the forward curve is downward-sloping. The longer to the maturity, the lower the future prices with correspondent maturity dates. This market is known as inverted market or in backwardation. Futures prices are expected to trade lower than spot prices. This reflects a high convenience yield for the commodity. In the oil market, the cost of carry which includes transportation and storage cost are relatively low since oil has a global market. The combination of low cost of carry and a high convenience yield which lead to futures prices to trade lower than spot prices is a typical situation in oil market. The reasoning behind this could also be explained due to supply and demand law. It could be crude oil market was in substantial shortage. Since it was at 27 Feb 2008, the spot price at that time should be very close to Future Price on April 08 (convergence of spot and future prices). It is observable that current spot price at 27 Feb 08 was high but it was also expected that the prices would be eventually pushed to decrease in later times due to modification in supply and demand in physical market.

Nov-08

Feb-09

Sep-08

Apr-09

Jun-08

Jan-09

Jul-08

According to Keynes and Hick arguments, hedgers tend to hold short futures positions while speculators tend to hold long futures positions (expect to gain on average)

Crude Oil Future Price 10 Feb 12

103 102 101 100 99 98 97 Future Price 10 Feb 12

Mar-12

May-12

Mar-13

Apr-12

Nov-12

Dec-12

Aug-12

Sep-12

As shown on the above graph, the forward curve is upward-sloping from March 2012 to December 2012 and then starts to decline afterward. The futures prices for near months are lower than for distant months: the more time left to maturity, the higher the futures price. This indicates a normal market. Futures prices are traded higher than spot prices; this market is known as in contango. This reflects a high cost of carry with a relatively low convenience yield for the commodity. The premium is attributed to a carrying charge that is added to the value of the contract to account for the transportation, storage and financing cost of holding crude oil. This situation is also expected in period of substantial supply of the commodity. Spot price of oil is expected to trade lower than the current futures price. After December 12, it is estimated that the market is at its peak and tends to go back to typical situation as explained in the first graph. According to Keynes and Hicks arguments, hedgers tend to hold long futures positions while speculators tend to hold short futures positions (expect to gain on average)

b)
Convenience yield can be calculated as follows:

Ft=(St+Ut)e^(r-y)(T-t)

Feb-13

Apr-13

Oct-12

Jul-12

Jun-12

Jan-13

Ut = 0.24 + 0.24e^(-0.057*1/12) + 0.24e^(-0.057*2/12)

= 0.7166 The convenience yield for crude oil for three month contract on 27 February 2008 using the information provided is:

99.38 = (101.20+0.7166)e^(5.7% - y)(3/12)

=> y = 15.782%

Present value of storage cost in February 2012:

Ut = 0.45 + 0.45e^(-0.042*1/12) + 0.45e^(-0.042*2/12)

= 1.3453

Similarly, the convenience yield for crude oil for three month contract on 10 February 2012 using the information provided is:

100.00= (98.25+1.3453)e^(4.2% - y)(3/12)

=>y = 2.5779%

c)
Convenience yield measures the benefits of holding the physical commodity, also describes the relationship between spot and future prices as well as storage pattern. Moreover, convenience yield can be used to point out whether supply of commodity tends to be at shortages or surplus. As calculated above, convenience yield for crude oil over a period of 3 month in 27 Feb 2008 was relatively high (15.782%). Since this yield reflects the market expectations on future availability of the commodity, it was expected that there would be substantial shortage. This implies that users of crude oil have reasons to store and utilize crude oil in the next 3 months to earn a better return rather than sell and buy later. Since this happened, owners of commodity will short more future contracts with longer maturity (to hedge against the risk that price will decrease). However, this created pressure to push the futures prices down and the curve would go downwardsloping. In addition, expectation that more crude oil will be sold in the future also pull commoditys future prices down creates declining trend of Futures prices with longer maturity. Market is in backwardation.

In contrast to the convenience yield for crude oil over a period of 3 months in 27 Feb 2008, the same period convenience yield in 10 Feb 2012 is very low (2.5779%). Since this yield reflects market expectations on future availability of the commodity, it was expected that there would be surplus. This implies that users of crude oil better sell crude oil now rather than store and sell later. Since this happens, owners of commodity will not go short on future contracts with longer maturity and there are not much futures contracts being written. Due to this reason, this created pressure to push the futures prices up and the curve would go upward-sloping. In addition, expectation that crude oil should be sold now less crude oil will be sold in the future also push commoditys future prices up, creates increasing trend of Futures prices with longer maturity. Market is in contango.

d)
Since the airline company plans to purchase jet fuel oil in 3 months, they will suffer more expenses in case fuel oil prices increase in the next 3 months. Due to this reason, they would have to go long in futures contracts to hedge against priceincrease risk. To minimize basis risk, the company will enter a contract with delivery month that is as close as possible but later than the end life of the hedge- the four month futures contract. The actual commodity is different to the commodity specified in futures contracts and this means the airline company has to use cross hedging. To calculate the optimal number of contract required to long, first, we identify the minimum variance hedge ratio.

h= *s/F
=>h= 0.773*1.94/1.21=1.239355372 By tailing the hedge, the number of contract required is: N = h*VA/VF =1.23936*(12,000,000*3.21)/(3.0623*42000) = 371.18 ~ 371 contracts The airline company should enter long position in 371 heating oil 4-month futures contracts and close out their positions in 3-month time.

e)

In 20th of April, the airline company will purchase 12 million gallons of jet fuel at spot price at USD 2.47 per gallon. Amount they have to pay in physical market is: 2.47*12,000,000=29,640,000 (USD) This amount of payment is the outcome without hedging. Clearly, the effective purchasing price without the hedge is markets spot price, which is USD 2.47 per gallon. Since the one month heating oil future price is 2.83 USD per gallon (smaller than 3.0623), the airline company makes a loss in closing out their position. The amount loss from the long position in the futures market is: (3.0623-2.83)*42,000*371= 3,619,698.60 (USD) Net amount the airline company has to pay if they hedge is: 29,640,000 + 3,619,698.6 = 33,259,698.60 (USD) As shown above, if the airline company did not hedge, they would not have to pay the extra amount loss in the future market (USD 3,619,698.60). The favourable movement in market price turns out to be unfavourable in future market. This sort of regret is the nature of hedging. The effective purchasing price with the hedge is: 33,259,698.60/12,000,000 = 2.77 (USD per gallon) The main objective of the recommended hedge is to offset any unfavourable movements in the price of jet fuel which is around a determined level. When price of jet fuel goes up, we will make a gain in Futures Market to offset the loss in our physical market. The hedging strategy is set up with attempt to limit the effective purchasing price at somewhere close to the price specified in our 4-month futures contract (3.0623 USD per gallon in this case). As a hedger in this scenario, this is not what we expect to happen. As demonstrated, when jet fuel price goes down to USD 2.47 per gallon, we incur a loss of USD 3,619,698.60 in the futures market. The hedging strategy gives out bad result in case of favourable markets movement appears.

f)
In the example above, the airline company needs to purchase jet fuel oil in 3 months but it enters long positions in 4 month heating oil future contract (to avoid complexity of taking delivery). Since it has to close out the position in 3 month time, basis risk arises due to maturity mismatch and this is the nature of realistic hedging. In a long hedge, weaken basis improves the hedgers position (since we can reduce effective

purchasing price) and vice versa. In our hedging strategy, a negative basis risk will reduce the effective price that the airline company has to pay even though we still incur a loss in the futures market.

Question 2 a)
To decrease the beta of the equity portfolio from 1.4 to 0.95 and decrease the duration from 4 year six month to 1 year six month, we need to enter in to a short position in CME S&P 500 index contract and a short position in six month U.S. Treasury bond future contract. Denote Ft as CME S&P 500 Futures price with t months to maturity. CME S&P 500 6-month Future price is F6= 1,350*e(4.9%-1.8%)*6/12 = 1,371.08801 The number of six month CME S&P 500 index contract needed to be shorted is: N = (-*)P/F N = (1.4-0.95)*12,000,000/(1,371.08801*250) N = 15.75 ~ 16 (contracts)

The number six-month U.S. Treasury bond future contracts needed to be shorted is: N = 12,000,000*(4-1)/[1,000*(142+25/32)*8.5] = 29.66 ~ 30 (contracts) After five months we close out all futures contract position.

b)
Bond Component The bond component loses 1 million due to the increase in interest rate; since we enter into a short position we will make a gain on our Treasury bond six-month future contracts. This amount is:

30*(142+25/32-113-28/32)*1000 = 867187.5 The U.S Treasury Bond futures short position in this case helps to offset the loss in value of our bond component. Equity component Futures contracts were entered in February; it is now July so 5 months have passed Continuous compounding risk-free rate per 5 months is: Rf = (4.9%)*5/12 = 2.04166667% The return on the S&P 500 index is RM=(1,500-1,350)/1350 + (1.8%)* 5/12 = 11.8611111% Under CAPM: E(RP) =Rf + *(RM-Rf) E(RP) =2.04166667% + 1.4*(11.8611111% - 2.04166667%) ~ 15.78889% Value of equity component is expected to be: VE = 12,000,000*(1+ 15.78889%) = $ 13,894,666.8 S&P 500 1-month future price is: F1= 1,500*e(5.8%-2.3%)*1/12 = 1,504.381386 Since we entered short position and F1>F6, the loss on closing out S&P 500 futures position would be: 16*250*(F6-F1) = 16* 250 *(1,371.08801 1,504.381386) = - $ 533,173.50

The expected value of the combined position in this scenario is: 13,894,666.8 + 11,000,000 + 867187.5 533,173.50 = $ 25228680.8

c)
We can use the same result for risk-free return in the last 5 months as calculated in 2-b. Bond component

The bond component gains 1 million due to the decrease in interest rate; since we enter into a short position we will make a loss on our U.S. Treasury bond six-month future contracts. This amount is: 30*(162+10/32-142-25/32)*1000 = 585937.5 The short future contracts have decreased our gains in the bond component and we should have regretted implementing the hedging strategy.

Equity component The return on the S&P 500 index is RM=(1,100-1,350)/1350 + 1.8% * 5/12 = -17.76851852% Under CAPM: E(RP) =Rf + *(RM-Rf) E(RP) =2.04166667%+1.4*(-17.76851852%- 2.04166667%) ~ - 25.6925926% Value of equity component is expected to be: VE = 12,000,000*(1- 25.6925926%) = $ 8,916,888.89 S&P 500 1 month future price is: F1= 1,100*e(3.7%-1.4%)*1/12 = 1,102.110355 Since we entered short position and F1<F6, the gain on closing out S&P 500 futures position would be: 16*250*(F6-F1) = 16* 250 *(1,371.08801 -1,102.110355) = $ 1075910.62

The expected value of the combined position in this scenario is: 8,916,888.89 + 13,000,000 + 1075910.62 - 585937.5 = $ 22,406,862.01

d)
The optimal strategy to eliminate risk in both portfolios would be to reduce the beta in the equity component to zero, while in the bond we would reduce the average duration of the bond component to zero. This can be achieved by taking a short position in both six month S&P 500 index futures and six-month U.S. Treasury bond futures.

The number of six month S&P 500 index futures required to be shorted is: N = (-0)P/F N =(1.40)12000000/(1,371.08801*250) N = 49.01 49 contracts The number of six month U.S. Treasury bond futures required to be shorted are: N = 12,000,000*(4-0)/[1,000*(142+25/32)*8.5] = 39.550 ~ 40 (contracts) We will close out all positions in 5-month time. Expected values of equity component and bond component will be kept the same as calculated in question 2-b and 2-c. Only the gain and loss in futures market have changed. Optimal hedge against part b) The loss on closing out the S&P 500 futures position would be as follows: 49* 250 *(1,504.381386-1,371.08801) = $ 1,632,843.86 The gain on closing out the six month Treasury bond futures is: 40*(142+25/32-113-28/32)*1000 = $1,156,250 Therefore the expected value of the combined position in this case is: 13,894,666.8 -1,632,843.86 +11,000,000 +1,156,250=$ 24,418,072.94 Optimal hedge against part c) The gain made on closing out the S&P 500 futures position would be as follows: 49*250*(1,371.08801 -1,102.110355) = 3,294,976.27 The loss on the bond futures is: 40*(162+10/32-142-25/32)*1000= 781,250 Therefore the expected value of the combined position is this case is: 8,916,888.89 + 13,000,000+3294976.27-781250 =$ 24,430615.16

The expected value of the combined position falls in line with the use of derivatives in order to hedge against an unfavourable outcome for the portfolio. It is easily observed that the combined position is not very different from our initial portfolio

value ($ 24,000,000), which illustrates how effectively our hedging strategy has worked.

e)
A perfect hedge cannot be achieved due to 4 main reasons. Firstly, the client either has an account through futures broker or individual account registered under Future Merchant and therefore unable to enter into a commodity pool which meets his need. Hence, he/she is required to enter a whole contract and problem of rounding arises. We either overhedge or underhedge and this affects the amount the client can offset by closing out futures positions. Secondly, since there is a maturity mismatch with 6-month future contract and 5month time to close out positions in this case, basis risk is unavoidable and it will affect the expected value that we want to achieve by hedging for our portfolio. Thirdly, the underlying assets in this case are not identical with the assets specified in the futures contracts. We have used S&P 500 futures and U.S Treasury bond futures to hedge against unfavourable movements in clients own portfolio and the composition of clients portfolio is of course, hardly be the same with what futures contracts specify. As a result, this practice cannot perfectly hedge against movement in the clients portfolio. The use of duration based hedge ratio is itself another problem. The hedge of bond portfolio with a duration hedge ratio is based on the assumption that there are parallel shifts in the zero-coupon curve, which is not what we observe in practice. This result implies that our hedging will not be as effective as expected.

f)
The idea of derivatives is to help against unfavourable movements of market prices on underlying assets in the future. In 2nd questions scenario; we are afraid of fluctuation in interest rates and equity returns in the capital market so we use Futures contracts with the hope to mitigate and minimize unfavourable changes in our portfolio value. For part b and c Not believing that the market will go well in 5-month time, we try to reduce the beta of our equity component by entering short position in 6-month S&P 500 Futures contracts. Similar with the bond component, the fact that interest rate increasing in 5

month time will cause harm to our bonds value prompts us to enter short position in 6-month US Treasury Bond futures. However, we did not intend to eliminate the risk by 100%, what we were trying to do is to reduce the risk to some extents because if the market goes well, it will turn out that we can make more profit compared to an optimal hedge. 16 six-month S&P Futures are shorted and 30 six-month U.S Treasury bond futures are shorted in order to achieve this goal. In scenario 2-b, share market goes well, stock indices increase in values but bond market suffer increases in interest rates. The equity futures incur a loss but bond futures make a gain. These gains and losses offset gains and losses in our equity component and bond component. Since we did not use the optimal hedge strategy, the combined position turns out that our portfolio has made good returns with values increased up to $ 25,228,680.8 compared to the original $ 24 million. In scenario 2-c, share market goes ill, stock indices decrease in values but bond market is blessed with decreases in interest rates. The equity futures make a gain but bond futures incur a loss. These gains and losses offset gains and losses in our equity component and bond component. We did not use the optimal hedge strategy, however, this scenarios result turns out not similar to 2-b scenario. Our portfolio combined position now decreases its value to $ 22,406,862.01, much lower than the original $ 24 million. In summary, the strategy used in question 2-b and 2-c has its goal to limit the risk of our portfolio to some certain extents. This strategy has its advantages when markets go well, we can enjoy the profit much more than an optimal hedge strategy. However, because the risk wasnt planned to be eliminated completely, when markets go ill, heavier losses also incur compared to an optimal hedge.

For part d The risk-tolerance level that we have in this question is much lower than part b and c. We want a secured portfolio, more gain is not important than losses, that is why we aim for an optimal hedging strategy. The objective in this case is to make sure our portfolios value will not be dependent on markets movement or at least at a minimum level since perfect hedge is impossible in practice (explained in 2-e). Set the desired beta to zero and average bonds duration to zero, we can recalculate the number of futures needed to be shorted, ended up with 49 six-month S&P Futures are shorted and 40 six-month U.S Treasury bond futures are shorted. Clearly these numbers are much greater than what we have in 2-b and 2-c. This time, we aim to eliminate the risk completely (at least) and do not really consider potential gain. Same things happen as explained previously, gains and losses in futures market and stock market, bond market offset each other. Yet, since we have implemented an optimal hedge strategy, the volatility of markets should not affect much of our

portfolios value. In both scenarios b and c, our final combined positions are $ 24,418,072.94 and $ 24,430,615.16 respectively. It is easy to see that it does not matter how ill or how well those markets go, our portfolios value does not vary a lot. This is an advantage when markets go ill. However, if markets go well, the amount we gain will not be much as without hedging or in 2-b and 2-c strategy; and we should regret hedging obviously.

Question 3 a).
Company A has comparative advantage in AUD fixed rate since it pays (8.7%-7.2%) = 1.5% less than company B Company B has comparative advantage in USD floating rate since it only pays LIBOR+1.8% -LIBOR -1.1%= 0.7% more than company A. Hence, if A wants to borrow USD at floating market and B wants to borrow AUD at fixed market, total gain they can have is: 1.5%-0.7%=0.8% Since financial institution acts as intermediary and net 15 basis points in the gain, and the Swap contract appears equally attractive to both companies, the net gain for each company is: (0.8%-0.15%)/2 = 0.325% The Swap contract is designed as followed:

7.2% AUD
7.2%AUD

8.375% AUD
LIBOR+ 1.8% USD

A
LIBOR + 0.775% USD
Company A
AUD (7.2%) USD (LIBOR + 0.775%) AUD 7.2% USD (LIBOR + 0.775%)

FI
LIBOR+ 1.8% USD

FI
LIBOR + 1.8% (LIBOR + 0.775%) (8.375%) 7.2% 0.15%

Company B
USD LIBOR + 1.8% AUD (8.375%) USD (LIBOR + 1.8%) AUD (8.375%)

Company A borrows AUDs from the market that they have comparative advantage at 7.2% per annum compounded quarterly. It enters a Swap contract and receives 7.2% in AUD but pay at LIBOR + 0.775% in USDs Company B borrows USDs from the market that they have comparative advantage at 3-month LIBOR +1.8% per annum compounded quarterly. It enters a Swap contract and receives this 3-month LIBOR +1.8% in USDs but pay at 8.375% in AUDss As shown in the chart: Effective rate that company A has to pay is: LIBOR+0.775% in USD Effective rate that company B has to pay is: 8.375% in AUD Each company pays 0.325% less in the markets that they do not have comparative advantages, in this case USD floating for A and AUD fixed rate for B. This design prevents all exposure to foreign exchange risk for both parties.

b)
If both companies wish to bear foreign exchange risk (1.4%) in their local currency, we subtract 1.4% from the payments received in swap contract. To keep the effective rates unchanged, 1.4% will also be deducted to the rate they pay in the other currency in swap contract. The new Swap design is illustrated as followed:

5.8% AUD
7.2% AUD

6.975% AUD
L IBOR+ 1.8% USD

A
LIBOR 0.625% USD
Company A
AUD (7.2%) USD (LIBOR 0.625%) AUD 5.8% USD (LIBOR 0.625%) AUD (1.4%)

FI B
LIBOR+ 0.4% USD

FI
LIBOR + 0.4% (LIBOR 0.675%) (6.975%) 5.8% 0.15%

Company B
USD (LIBOR + 1.8%) AUD (6.975%) USD LIBOR + 0.4% AUD (6.975%) USD (1.4%)

As explained above, the total rate company A has to pay is LIBOR -0.625% + 1.4% = LIBOR+0.775%, same as part a) but since it has to pay 1.4% in AUD, it has to face foreign exchange risk at this 1.4%

Total rate company B has to pay is 6.975% + 1.4% = 8.375%, same as part a) but since it has to pay 1.4% in USD, it has to face foreign exchange risk at this 1.4%

c)
Nominal principal in AUD: 18,000,000/1.1260 = 15,985,790.41 (AUDs) The Swap contract has 3-year life, 26 months have passed, so the remaining life of the swap is 10 months. Set the time we are at right now is zero. Therefore, the next payment will be one-month ahead (if we count back the last payment is in 10th month). Fixed AUD payments that company A receive is: 15,985,790.41*(7.2%)*(3/12) = 287,744.2274 (AUDs) Floating USD payments that company A pays is: 18,000,000*(3.78%+0.775%)*3/12= 204,975 (USDs) Value of AUD fixed bond: Bfix= 287,744.23*e-0.0487*(1/12)+ 287,744.23*e-0.0487*(4/12) +287,744.23*e-0.0487*(7/12) (15,985,790.41+ 287,744.23)*e-0.0487*(10/12) = 16,475,696.83 (AUDs) Value of USD floating bond: Bfloat = (18,000,000+204,975)*e-0.0346*(1/12) = 18152559.59USD Vswap = Bfix Bfloat* S0 AUD/USD = 16,475,696.83 - 18152559.59*(1/1.2300) = 1,717,518.302 (AUDs) Since the value of Swap to company A is greater than zero, financial institution faces credit risk if A goes bankrupt. If company A defaults, the financial institution is liable to lose the whole of the positive value it has in this contract.

d)
First, we calculate the theoretical forward exchange rate: Ftheoretical USD/AUD= 1.2300 * e(0.0346-0.0487)*1 =1.212778696 Since 1.2128 USD/AUD < 1.2785 USD/AUD, the USD is paid too low compared to expected exchange rate. Therefore, arbitrage opportunity exists. Steps to exploit this arbitrage: Borrow USD 100,000 e-0.0346 = USD 96,599.17357 at US market rate 3.46%.

Convert this amount of USD to AUD at the market spot exchange rate, we have the amount: 96,599.17357/1.2300 = 78,535.91 (AUDs) Invest this amount of AUDs with Australian interest rate, after 1 year we would have: 78,535.91*e 0.0487 = 82,455.27 (AUDs) We enter a currency forward contract, promise to exchange 82,455.27 AUDs for USD at 1.2785 USD/AUD, the rate that the financial institution offered. After 1 year, we convert 82,455.27 AUDs to USD at the forward exchange rate specified in the contract, we have: 82,455.27*1.2785 = 105,419.07 (USDs) Now we pay 100,000 USD loans with this proceed, the residual will be our risk-free profit. This amount is: 105,419.07- 100,000 = 5,419.07 (USDs) As demonstrated, for every 100,000 USDs borrowed, we make an arbitrage profit of USD 5,419.07