Question #21

The fixed-rate payer has profits when short rates rise and losses when short rates fall, equivalent to writing puts and buying calls. (Module 30.6, LOS 30.e) Craig Champion, CFA, manages portfolios of U.S. securities for European investors. His clients have each hold different kinds of securities, and each has differing views with respect to hedging exchange rate risk. Francois Levisque is a Belgian investor who holds a large diversified portfolio of U.S. equities. Levisque has a reputation for some success in timing the U.S. equity market. For example, he has often locked in gains on his portfolio with derivatives shortly before a market correction. Sometimes he also hedges his portfolio's currency risk. Levisque has just instructed Champion to take a large short position in S&P 500 index, either with futures or with a forward contract. Champion notices that the futures price is less than the current spot price and consults with his colleague Danielle Silvers, CFA. Champion says he thinks that the futures price is less than the spot price because the dividend yield of the S&P 500 is greater than the Treasury Bill rate. Silvers says that it could just be backwardation. Silvers also notes that the use of a forward contract might be a good idea because the contract will not attract the attention of other market participants who might react to Levisque's move. Champion tells Silvers that the reason Levisque wants to hedge his equity position is that he thinks all U.S. interest rates will increase soon. This, he believes, is bearish for equities. Ragnar Hvammen is a Norwegian investor with a large investment in oil-related assets that he often hedges with futures contracts. Champion notices that the price of an oil futures contract is usually higher than the spot price. Hvammen uses short-term borrowings in dollars, from both European and U.S. banks, to meet the liquidity needs of his oil investments, and he has Champion hedge these loan positions with Eurodollar futures. Silvers suggests that Champion should consider using T-bill futures to hedge the loans from U.S. banks, and use Eurodollar futures only for the Eurodollar loans. Champion says he will look into that, as well as forward rate agreements, as alternative hedging tools for Hvammen. Typesetting math: 100% Champion is also evaluating pricing of Euro-bund futures. Specifically, he is looking for pricing on a 1.2-year contract. The CTD is a 2.5% 10-year, semi-annual coupon bond issued 1 year ago (just paid coupon) currently quoted at €104.10. The conversion factor for the bond is 1.08. At contract expiration, the underlying will have accrued interest of €0.42. Assume that the risk-free rate over the contract period is 1%.