Derivative Benefits, Risks, and Issuer and Investor Uses — MCQs

Sterling Ridge Global Fund reports performance in USD and holds EUR-denominated assets. Currency manager Leah Morgan is reviewing hedges for two mandates. Foreign exchange rates are quoted as USD per EUR, so EUR is the base currency and USD is the price currency. Positive exposure to EUR therefore gains value in USD terms when the quoted exchange rate rises. The first mandate holds an unhedged EUR 10 million equity position that is expected to be sold in three months. The investment committee wants to eliminate uncertainty about the USD value of the expected EUR proceeds. The sale amount and timing are sufficiently certain, and the committee is willing to forgo gains caused by EUR appreciation over the hedge horizon. Morgan considers using a forward under which the fund exchanges EUR for USD at maturity. For a separate pricing review, the current spot exchange rate is 1.1000 USD per EUR. The six-month annualized simple interest rate is 4.00% in the United States and 2.00% in the euro area. Both rates use an actual six-month fraction of 0.5, and covered interest parity applies. There are no transaction costs, taxes, or capital controls. The fund also has an existing short forward on EUR 5 million. The contract requires the fund to sell EUR at 1.1200 USD per EUR in three months. A new three-month forward with otherwise identical terms has a rate of 1.0900 USD per EUR. The appropriate annualized simple USD discount rate for the remaining three months is 4.00%, using a time fraction of 0.25. The contract is valued in USD from the fund's perspective. The second mandate is for an endowment that owns EUR-denominated securities but has a USD spending obligation. The endowment wants protection against EUR depreciation over the next six months while retaining gains if the EUR appreciates. Its policy permits exchange-traded or over-the-counter options, and it is willing to pay an upfront premium for asymmetric protection. The endowment will continue holding the underlying EUR securities throughout the option horizon, so the recommended option must offset losses on an existing long EUR exposure rather than establish additional speculative exposure.

Halcyon Technologies is a US-based manufacturer whose functional currency is USD. It has completed a sale to a European customer and will receive a fixed EUR amount in three months. Because the receivable is denominated in EUR, its USD value will decrease if EUR weakens against USD before payment. The treasurer wants to eliminate this uncertainty for the contracted receivable and has authority to use foreign exchange forwards and options. All exchange rates in the case are quoted as USD per EUR, making EUR the base currency and USD the price currency. Interest rates are annualized simple rates for the exact three-month horizon. Transaction costs, bid–ask spreads, taxes, and counterparty credit adjustments are ignored. The no-arbitrage forward rate should be calculated using covered interest parity with USD as the price currency. Halcyon previously sold EUR forward at the delivery rate shown in Exhibit 1. The contract has the same notional principal and remaining maturity as the receivable. The treasurer now requires its mark-to-market value from Halcyon's perspective. The current replacement forward rate must first be determined from the current spot rate and interest rates. The difference between the contracted delivery rate and the replacement forward rate represents a payoff at maturity and must therefore be discounted using the USD interest rate. A positive value indicates an asset to Halcyon. The company may also bid on another European contract. If Halcyon wins, it will receive an additional EUR payment; if it loses, no foreign currency transaction will occur. Management does not want an unconditional forward obligation for this potential receipt because the underlying exposure is uncertain. It nevertheless wants protection against a decline in EUR if the contract is awarded, while preserving gains from an increase in EUR. Exhibit 2 summarizes the treasurer's instructions. Any option recommendation should specify the option on the base currency: a EUR put against USD gives the holder the right to sell EUR for USD, whereas a EUR call gives the holder the right to buy EUR with USD. Premium costs are acceptable for the uncertain exposure and need not be calculated.

Hightower Securities is reviewing the consistency of option and commodity derivative quotations. An analyst begins with a non-dividend-paying share currently priced at USD 100. Over the next year, the share price is assumed to follow a one-period binomial process: it will either increase to USD 125 or decline to USD 80. The effective annual risk-free rate is 5.00%, and borrowing and lending are available at that rate. Markets are frictionless, short selling is permitted, and the absence of arbitrage is assumed. The analyst values a one-year European call with a strike price of USD 100. The call pays USD 25 in the up state and zero in the down state. She is instructed to use either risk-neutral valuation or a replicating portfolio and to recognize that both methods must produce the same current value. When constructing the replicating portfolio, the number of shares is determined from the difference in option payoffs divided by the difference in terminal share prices. The remainder of the replication is a risk-free borrowing or lending position. Hightower also wants to value a one-year European put on the same share with the same strike. Both options may be exercised only at expiration. The analyst will use European put–call parity, with the strike price discounted at the effective annual risk-free rate. All quoted option values are per share, and no option premiums other than the calculated current values are relevant. For illustrative comparison, Hightower's research team notes that the real-world (physical) probability of the up-state is estimated at 70.00%, distinct from the risk-neutral probability derived for valuation purposes. This real-world probability is used only to illustrate the expected future share price under actual investor expectations and does not affect the no-arbitrage valuation of the call, put, or forward contract. In a separate commodity review, the firm observes a commodity spot price of USD 70 per unit. A storage charge of USD 2 per unit must be paid at initiation by an investor who purchases and carries the physical commodity. The one-year financing rate is 4.00% with continuous compounding, and the commodity provides a continuously compounded convenience yield of 1.00%. The forward contract requires no payment at initiation and has a one-year maturity. The analyst treats the initial storage expenditure as part of the amount invested in the cash-and-carry position and applies the net financing cost after allowing for convenience yield. Taxes, bid–ask spreads, default risk, and other transaction costs are ignored. Each requested result can be calculated directly from Exhibit 1 and does not depend on another question's selected answer.

Meridian Global Pension Plan operates a derivatives overlay covering interest-rate, equity-market, and foreign-currency exposures. Overlay manager Daniel Cho values each position from Meridian's perspective and uses positive values for assets and negative values for liabilities. All contracts are free of default risk and transaction costs. The plan's interest rate swap requires Meridian to receive a fixed annual payment and pay a floating annual payment. The valuation date is immediately after the latest floating payment and rate reset, and only one settlement remains. Cho treats the receive-fixed swap as a long fixed-rate bond combined with a short floating-rate bond. Immediately following a reset, the floating-rate bond is worth its notional principal. The fixed-rate bond includes both its final coupon and repayment of principal. Meridian also owns a diversified UK equity portfolio and uses stock index futures to alter systematic exposure without selling the underlying securities. The futures index is sufficiently similar to the portfolio that basis risk may be ignored. Contract counts are rounded to the nearest whole contract. A negative calculated contract number represents a short futures position. Cho's objective is to reduce, but not eliminate, the portfolio's equity beta. The currency forward in Exhibit 1 was initiated previously and now has two months remaining. Exchange rates are quoted as USD per EUR, with EUR as the base currency. Because Meridian agreed to sell EUR, the position increases in value when the current forward rate falls below the contracted delivery price. Any maturity cash-flow difference must be discounted over the remaining two months using the stated simple USD rate. Separately, the plan owns EUR-denominated assets and reports performance in USD. Its currency policy requires protection against EUR depreciation for the next three months but allows the plan to benefit fully from EUR appreciation. Cho may use forwards or European currency options with matching maturities. For option descriptions, buying an EUR put against USD gives the holder the right to sell EUR and receive USD at the exercise rate. Exhibit 1 provides the independently sufficient data for each analysis.

Alpine Global Fund reports performance in USD and holds investments and contractual cash flows denominated in several foreign currencies. The risk committee permits currency derivatives for hedging but requires each hedge proposal to identify the foreign-currency exposure, contract direction, maturity, and residual risks. Counterparty default, transaction costs, taxes, and bid–ask spreads are ignored. The fund will receive a EUR-denominated cash payment in three months. Because the USD value of this receivable falls when the euro depreciates against the US dollar, the portfolio manager considers selling euros forward. The available contracts have the same maturity as the receivable and are sized in units of EUR. The committee is also considering an option-based hedge because its central expectation is that the euro will appreciate. Although the committee wants protection against a substantial decline in the euro, it would prefer to preserve gains if the expected appreciation occurs. The option premium is payable immediately and is accepted as the cost of retaining this upside. Alpine also owns a GBP-denominated equity portfolio. No sufficiently liquid futures contract precisely matches the portfolio, so the manager proposes selling futures on another foreign equity index whose returns have historically been positively, but not perfectly, correlated with the GBP portfolio's returns. The proposed futures position is sized using the estimated relationship between the two return series. The committee recognizes that this approach may reduce equity market exposure without perfectly offsetting changes in the value of the GBP portfolio. During the meeting, committee members review the statements in Exhibit 2. They distinguish the initial value or margin requirement of a derivative from its economic exposure. A forward generally has zero value at initiation but commits both parties to transact at maturity. A futures position requires margin rather than payment of the underlying asset's full value, but daily price changes create gains or losses and variation-margin cash flows. An option is a contingent claim: the buyer may exercise when advantageous but is not obligated to do so. All quotes in Exhibit 1 are expressed as USD per unit of foreign currency, making EUR and GBP the base currencies and USD the price currency.