1) Assume you are managing a RM7,000,000 million portfolio of common stock and were bearish about the next four months. The portfolio beta is 1.2. During the next four months, you expect a correction in the market that will take the market down about 5%. The FBMKLCI futures contract with six months to expiration is available and priced at 1692 with a multiplier of RM50 and the FBMKLCI spot is currently at 1650. The risk-free rate is 5% per annum.

(i) How can you advantageously use your bearish expectations to hedge your long position in the stock market? [10%]

(ii) What will happen to the overall value of the portfolio if it has been fully hedged and the FBMKLCI futures price turns out to be 1581 at the end of four months? [30%]

(iii) How close did you come to the desired result? [20%] (b) What factors prevent hedges from being a perfect hedge? Explain. [40%]

(2a) One use for futures markets is "price discovery", that is, the futures price mirrors the current consensus of the future price. Suppose that the current price of a nondividend paying stock is $2.00 and the risk-free rate is 7% pa, continuously compounded. Explain what an investor would do if futures price of the stock were $2.40. Is the investor at risk? What if the futures price of the stock were $2.00? [40%]

(2b) You manage an equity portfolio worth RM15,000,000. The portfolio beta is 1.2. During the next five months, you expect a correction in the market that will take the market down about 5%. The FBMKLCI futures contract with six months to expiration is priced at 1641 with a multiplier of RM50. The risk-free rate is 5% per annum.

(i) Should you buy or sell futures? How many contracts should you use? [10%]

(ii) If you expect the market to fall by 5%, calculate the expected return on your portfolio at the end of five months. What is the expected value of the portfolio? [20%]

(iii) Calculate the gain or loss on the futures position if the futures price turns out to be 1526 at the end of five months. [10%] (iv) Calculate the expected value of the hedged position in five months. What is the percentage change in the hedged portfolio? How close did you come to the desired result? [20%]