Exotic Futures and Options Strategists (EOS), is a firm that engages in derivative strategies for institutional investors with either speculation or hedging motives. Shaun Pollock is a financial strategist at the firm, with considerable experience in the implementation of derivative strategies.

Quick Algo Team (QAT) has instructed Pollock, to sell a stock

currently worth $154.87 in ten months time. QAT is concerned with the amount it would

receive at that time and wants to hedge this risk. Pollock has advised QAT to enter into a

forward contract to achieve this purpose. After ten months, the price of the stock rises to

$155.99. The risk free rate is 7.645%.

When QAT asked Pollock about what rate of return it earned over this time period, Pollock made the following comment:

If you entered the contract at a price of $164.675, the value of the forward contract to

you is $8.685, but the rate of return that you earn cannot be higher or lower than

7.645%.

QAT is expected to receive British pounds from the sale of its subsidiary operating in

England. A large multinational firm established in Britain is likely to buy the subsidiary

in about one years time. To hedge the exchange rate risk associated with the

dollar/pound exchange rate, QAT has entered a forward contract at the no-arbitrage price.

The current spot exchange rate is $1.886/. The U.S. risk free rate is 5.5% and the U.K.

risk free rate is 6.3%. After two months the exchange rate rose to $1.861/. During a

meeting with Adrian Finch, QATs CEO, Pollock stated that the value of the contract (per

unit) to QAT after the exchange rate movement is -$0.000715.

Pollock will receive a performance-based bonus in 167 days and will use it to purchase the stock of Peloton Bikes (PB). The stock is currently selling for

$120.39 and is expected to pay a dividend of $1.36 in 65 days and another $1.03 in 135

days. The risk free rate is 5.0%. To lock in a fixed purchase price, Pollock has decided to

go long a forward contract on the stock. 80 days later, the stock price rises to $125.79.

Finch held a meeting with Pollock to understand the relative benefits of trading in futures

markets as well as the operations of suchmarkets. Pollock made the following comments:

Statement 1: A greater number of producers of a given asset relative to consumers will

most likely result in a situation called normal backwardation for the asset.

Statement 2: Advantages of trading in the futures market over the forward market

include liquidity and transparency.

PB is establishing a division for marketing, research and development in Alabama.

The division will cost them $35 million and PB plans to borrow this amount for 180

days, 60 days from now. To hedge the risk of interest rates rising, PB is entering a

forward rate agreement. The term structure of LIBOR is given below.

Exhibit 1

60 day LIBOR 5.45%

120 day LIBOR 5.85%

180 day LIBOR 6.01%

240 day LIBOR 6.10%

Vijay, a hedge fund manager in EOS is pricing a futures contract with the spot price of the underlying equal to $67.

The contract expires in eighteen months. The underlying is expected to earn a positive

cash flow during this time period, and the future value of this cash flow is $1.3. The

future value of storage costs net of convenience yield is $1.83. The risk free rate is 8.0%.

1. Is Pollock accurate with respect to the stock forward contract and currency forward contract that QAT entered into? (0.5 mark)

A. Only with respect to the stock forward contract.

B. Only with respect to the currency forward contract.

C. Both with respect to the stock forward contract and the currency forward

B) What is the value of the PB stock forward contract to Pollock after 80 days? (1 mark)

C) Pollock is most accurate with respect to: (0.5 mark)

A. Statement 1 only.

B. Statement 2 only.

C. Both statements 1 and 2.

D) What is the rate on the forward rate agreement that PB is entering into? (1.5 marks)

E) What is the appropriate futures price for the future contract Vijay is pricing is closest to: (1.5 marks)