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Global Financial Management

Learning Module 4
Due May 5

The objective of this learning module is to familiarize ourselves with futures and options. Question 1 explores the relation between futures and spot prices. Notice that the futures price is greater than the spot price. There is a discussion question about this for the LM4 Bulletin Board.

Question 2 and Question 3 examine interest rate and FX hedging applications. In the first of these questions, we try to identify the type of interest rate risk that the firm has taken on. In the second question, you need to determine the impact of changes in foreign exchange rates on the bottom line.

You are introduced to the Java Options Relations program in Question 4, in order to analyse the payoffs of different types of options. A discussion question for the LM4 Bulletin Board is included.

1. Futures Arbitrage

The S&P 500 Stock Index is at 701.50 and the S&P futures contract on the index is at 702.15. The current futures contract expires in exactly one month. The current S&P 500 dividend yield is 2.5% annually. The 3 month Treasury bill rate is 5.04% annually (this rate can be used in the natural exponential).

a) Is the futures price over, under or correctly priced in relation to the cash index?

b) Support your answer in part (a) by demonstrating a set of transactions that result in either a zero or a positive profit. Be sure to illustrate the timing of each cash flow. Asssume that you can lend or borrow at 5.04%. Assume that you receive all proceeds of any short sales of stock.

c) In words, briefly explain the logic underlying the transactions listed in part (b).

d) Immediately after you initiate the arbitrage (i.e., the time 0 transactions) a large blue
chip company unexpectedly announces that they are cutting their dividend payment by 75%. As a result, market expectations of the S&P 500's yield drop to 2.3% annually. How will
this unexpected change affect the value of your terminal positions one month from now? Is this good news or bad news?

Discussion Question for the LM4 Bulletin Board

Does the futures price exceeding the spot price mean that people expect the market to rise? Is it possible for the futures price to be below the spot ptice? Look at The Wall Street Journal. Are there any futures prices that are below the spot price? Why?

2. Interest Rate Hedge

It is currently August 1996 and one of your retail customers wants delivery of 2 million dollars worth of goods at the end of September in preparation for the holiday season. This customer does not want to submit a cash payment until three months after the product has been delivered (i.e., the end of December) due to cash flow constraints. After negotiations, you agree that the customer can defer cash payment for three months after delivery. The customer will pay the cost of the goods plus interest three months after delivery. The interest rate will be fixed at LIBOR + 200 basis points at the end of September. Current Eurodollar futures prices are as follows:

a) You are concerned about interest rate risk. In what direction do interest rates need to move for you to benefit from the agreement with your customer? Over what period are you concerned about interest rate movements and why?

b) Construct a hedge using the current Eurodollar futures contract to eliminate your interest rate risk. Demonstrate the hedge's effectiveness if interest rates increase or decrease by 1%.

3. Exchange Rate Hedge

Furniture Express, Inc. (FEI) is a Malaysian firm with a U.S. customer base. Production facilities are located in Kuala Lumpur. The firm is going to raise 50 million dollars of capital in the U.S. in two months in order to develop distribution facilities. FEI's primary investors are Japanese and FEI is concerned with consistent profitability in yen terms. FEI does not want exposure to yen/dollar exchange rate volatility over the two months preceding issuance of US dollar denominated debt.

The current Japanese yen futures price is 0.008903 ($/¥) and two months remain to expiration. The notional amount underlying the futures contract is ¥12,500,000. Round to the nearest number of whole contracts to set up your hedge. Construct a hedge to stabilize the value of the capital raised in yen terms.

4. Options

a) Construct a terminal payoff diagram consisting of a long position in Compaq stock and a long position in a Compaq put option with an exercise price of 70. Also include a table showing the terminal value of the stock, the option and the portfolio value for a range of stock prices between $50 and $100, in $5 increments.

b) Construct a terminal option payoff diagram consisting of a long position in the following two options on Compaq stock. Also include a table showing the terminal value of each option and the portfolio value for a range of stock prices between $50 and $100, in $5 increments.

You may use the Options Relations Java program to help you with the calculations. To copy the Java output to a Word document, use the alt/prtscn keys to copy the screen, then paste into your document. To enter the amount of stock in your position in Part A, enter the unber of shares in the UA box (UA stands for Underlying Asset). You may also do this problem using Excel, instead.

Discussion Question for the LM4 Bulletin Board

Consider buying puts and calls at the same time on the same underlying stock. Why might you do this? Why would you simultaneously bet on the stock price going up and down?