Forward, Futures, and Swaps
Comparing currency forward and futures contracts, which of the two (or both) usually eliminates all exchange rate risk of a position you have in foreign currency?
Forward contracts. Futures usually contain basis risk, because the timing and the asset (or currency) may not coincide perfectly with your position.
True or False: The payoffs of the buyer and the writer of a call or put option always sum to zero.
True
Explain what is meant by Distance to Default of a firm or bank. What does it allow us to calculate?
Distance to default is the difference between the value of assets and liabilities (or the distress point). Importantly, it is expressed as a multiple of the standard deviation of assets.
That is, it tells us how by many standard deviations the firm is from default. Therefore, it allows us to calculate the probability of default.
A long position in a swap contract is equivalent to holding a portfolio consisting of i) long position in a fixed coupon bond and a short position in a floating rate note, ii) long position in a floating rate note, and a short position in a fixed coupon bond, iii) none of the above.
The correct answer is ii) long position in a floating rate note, and a short position in a fixed coupon bond.
Explain the protective put strategy.
It involves buying the underlying asset along with a put option on the asset to put a floor on the price of the asset. The investor can exercise the put option when the price falls below the strike price to avoid larger losses.
What are the two factors affecting the expected loss?
Likelihood of default and loss given default
In a swap contract, the PV of the fixed rate payments is ----- the PV of the floating rate payments at inception.
i) larger than
ii) less than
iii) equal to
The correct answer is iii) equal to
Which positions produce positive profits if stock price increases? 1- long call 2- long put 3- short call 4- short put
1 and 4
Explain how the Credit Metrics approach can be used to calculate the 95% VaR of the credit risk of a loan to a rated firm.
Hint: three steps
1- Use the transition matrix to determine the minimum downgrade that the firm could suffer with 5% probability.
2- Using the forward curve for bonds of different ratings, find the YTM for the bond of the rating found in the first step.
3- Discount the value of the loan using this rate. The difference between this value and the current value of the loan will be the VaR.
True or False: An interest rate swap of 5-year maturity is equivalent to a portfolio of 5 interest rate forward contracts.
False. Unlike a swap, interest rate forwards can imply different forward interest rates for different years.
Explain the Put-Call Parity.
Put-Call Parity states that a protective put strategy is equivalent to combining a long call and a risk-free bond that pays the strike price K at the expiration date of the option. This relationship is the result of the no arbitrage condition and implies the following relationship between the price of put and call options: PE+S=CE+PV(K)
What is the Credit Migration Matrix?
It gives you the probability that a credit rating of any given debt security will change during the credit horizon.
The delivery price of a forward contract with one-year maturity is 70$. The underlying asset is a stock, with initial price equal to 65$. The interest rate is 10%. Compute the no-arbitrage forward price? Design a strategy to exploit the arbitrage opportunity.
The no-arbitrage forward price is equal to 65* (1+0.1) =71.5.
Strategy: long position on the forward, short sell the stock, invest 65
Payoff: 65 (1.1)-70=1.5
Using options only, how can we create a portfolio that replicates a forward contract? Hint: use the payoff schedule chart.
Combining a long call and a short put with the same strike price is equivalent to a long forward.
The KMV model uses the idea behind option pricing. Explain the type of option that equity resembles, that is call or put, and what the strike price for that option is.
Equity resembles a call option on the value of assets of the firm with a strike price equal to the firms’ total debt.