Derivatives Risk and Portfolio analysis
Description
The paper comprises six question and you can choose to answer 4 out of six questions. Only, 4 questions will be marked. Any extra question answered will be discarded.
Overall, word count should not be more than 3,000 words. Moreover, make sure to reference sources which you use to prepare answers. And do not share your answers with other students, as the submissions will be checked for similarity. If your assessment is found to be copied or it matches other submissions, then you will be accountable for plagiarism.
Note: All processes that lead to the answers must be presented. Marks will be given for both processes and answers. The final exam must be neatly presented, or marks may be lost.
Question 1
You are advising a client to construct a portfolio worth £20 million. You’re considering constructing combining a risk-free asset with a portfolio of risky assets. Consider the data given and answer the subsequent questions:
American Express
(Amex) Coca-Cola
(Coca) The Gillet Company
(Gillet) T-Bills
Expected Return 16% 16.1% 17.6% 5%
Standard Deviation 29% 24.7% 27.3% 0%
Weights 32% 51% 17%
Correlations
Amex & Coca 0.61
Amex & Gillet 0.317
Coca & Gillet 0.548
a) Calculate the portfolio returns and standard deviation, if no investment is made in T-Bills. 05 Marks
b) Calculate the risk premium demanded by investors for buying one unit of risk.
05 Marks
c) If the target risk (standard deviation) is 15%; then what should be the weightage distribution between T-Bills and the portfolio. Also calculate the expected return of the combined portfolio for these weights.
05 Marks
d) Given your client’s target return is 25%; then what should be the weightage distribution between T-Bills and the portfolio. Do they need to borrow any money and if yes then how much they need to borrow? 05 Marks
e) Explain how Capital Allocation Line differs from and Capital Market Line.
05 Marks
(Total 25 Marks)
Question 2
Capital Asset Pricing Model (CAPM) is noted as a simple and popular approach for portfolio creation,
a) Explain CAPM for risk analysis and investment management. 10 Marks
b) Comment on the validity of assumption underlying the CAPM model and their implications for CAPM empirical strengths. 15 marks
(Total 25 Marks)
Question 3
Gamma airlines is currently considering a) to fix the price for their future jet fuel purchases; and, b) fix the exchange rate for their future international receipts. As a financial advisor of the firm you have advised them:
1. for the first (a) to buy a future on crude oil (cross-hedging)
2. For the latter (b) you suggest a currency future.
Assuming Delta Airline is a USA based firm and it receives and pay in $. Explain to the board of directors using the above scenarios as an example that:
i. What are the costs of making a futures contract in terms of settlement, delivery for both events if price fell below the agreed price and rise above the and who guarantees the fulfilment of contracts?
10 Marks
ii. How cross hedging will enable the firm to fix the price for jet fuel.
05 Marks
iii. Explain the uses of futures for speculating and arbitraging activities. Given the efficient market hypothesis why the chances of making arbitrage profits are said to be rare.
10 Marks
