Reference no: EM13196624

Question

As a European Asset Manager one is concerned about possible imminent withdrawal of Central Bank support for asset prices which might result in higher yields on bonds and lower on stock markets during next 3 months.

Consequently the Asset Manager wants to fully hedge his portfolio against all risks.

However, assume he is mandated to remain fully invested at all times so selling securities is not an option.

Current portfolio comprises following positions:

Notional/amount	Security	Term
€ 2mln	BTP	Italian 10 year on-the-run
€ 5 mln	Euro Interest Rate Swap	5 year Fixed Rate Payer
€ 50 mln	German Equities
$ 50 mln	USD Libor Interest Rate deposit with Bank of America	1 year

It was suggested to find current data for pricing and obtaining rates at www.ft.com under data archive.

Questions:

1: Assume that the Asset Mgr wants to fully hedge the interest rate risk on the bonds by using bond futures and to hedge the equity risk by using index futures.

a: Calculate the appropriate number of bond and equity futures that should be sold.

Assume that the portfolio of German equities has a beta of one to the German DAX index (whereby bond and index future data can be found at www.eurexchange.com).

2: a: Explain the risk of the interest rate swap position and should it be hedged in this scenario?

b: What impact might it have on the rest of the portfolio?

Pls use an example to illustrate.

3: The Asset Manager would like to hedge the receipt of $50mln to be received in 1 years' time from the maturity of the one year interbank deposit.

a: Using the data of www.ft.com, calculate a one year €/$ forward rate.

b: explain how it could be used to hedge the current risk.

4: The Asset Manager thinks there is some possibility that the currency markets could move in their favour and so ideally would like some degree of participation in any favourable move, whilst being fully protected against adverse moves.

a: Discuss alternative hedging choices by using options (explain these choices).

There are some strategies like strip strap, straddle, strangle, EUR/USD fx option etc. (though it has to be figured which are the correct ones).

Currency option quotes on FX futures can be found at www.cmegroup.com.

5: Assume the interest rate swap counterparty is the same bank (Bank of America) to whom the Asset Manager lent $50mln via the USD Libor deposit. The Asset Manager is concerned that a default by the bank could give rise to substantial credit risk.

a: Discuss how derivatives could be used to hedge this risk. Explain and provide examples if possible.