All questions are numbered, I filled in some answers, however, its still incomplete, Professor wants more detail and structure. This is exactly how my final will look like, preferably, if possible to structure the answers in a story telling way so I can remember all the answers.

Thank you.

1. What are conversion factors? Why were conversion factors developed? How do they impact on which bond is cheapest to deliver? Under what conditions would there be no cheapest to deliver? Explain in detail. Conversion factors are a mathematical tool that is used to convert units of measurement. Conversion factors were developed to convert other securities that are acceptable for deliveries. The conversion factor impacts the cheapest to deliver by adjusting for the varying grades that may be under consideration is designed to limit certain advantages that may exist when selecting between multiple options of bonds and notes. No cheapest to deliver exists if the yield curve is flat and if the YTM is constant across all maturities, then the CFs will be proportional to the bond's market price. Since, the market value will equal to invoice price, there will be NO cheapest to deliver. 2. What information do we discover when we look at the June17 S&P 500 futures price and the Sept17 S&P 500 futures price? Explain in detail. Theres June and September, I don't know what explanation are you looking for. 3. Why does a full carry model apply so well to the US treasury bond and S&P 500 contracts? Explain in detail. Simplify the 5 fingers and explain why all 5 fingers apply. The only modification required is to adjust for the dividends received if you hold the stock. The dividends received reduce the cost of holding the cash stock position. Bonds cost of carry is the implied repo rate which is the interest rate somebody can earn from buying and selling a bond. Supply relative to demand - these two will always correlate Storability free to store in fact you get paid if you hold on to the bond Non-seasonal production no particular seasonality preferred for bonds and contracts Non-seasonal consumption - no particular consumption preferred for bonds and contarcts Transportation yes, we electronically deliver the bonds and contracts A futures market in which the price difference between contracts with two different delivery months equals the full cost of carrying the commodity from the delivery month of the first contract to the next. Us treasury bond is cash settled and SP500 is dividend. 4. What is an optimal hedge and how do we calculate it? Compute the number of contracts we need in the hedge. How do we decide if we should implement the hedge? Why? Explain in detail. Suppose you have a long cash position 200,000 ounces of gold. One gold futures contract is 100 troy ounces. Gold Price= 0.60 + 0.66 ( Gold Futures Price) + , R2=0.48 Or we can find HR using simple regression analysis D Cash = a + b (D Futures) +e Difference in spot price/difference in future price Number of contracts = HR*200,000/100 Hand out 3, pg 12 5. Compare and contrast selling Eurodollar futures and being a fixed rate payer in a swap as a risk management technique. Explain in detail. A futures contract is the most common derivatives used to hedge against risk, it is the obligation to deliver the underlying asset, as opposed to the forward swap which is a contract between two parties to exchange a series of cash flows (fixed) for another series of cash flow (float rate) on a notional amount that was agreed upon. The main factor of less risk in buying future contracts is the locking in the price. Eurodollar futures are based off deposits of US dollars that are held within foreign banks or foreign branches. The yield on these contracts are usually baded off LIBOR. Eurodollar futures is time yielding deposit with a maturity date. At the time of settlement, the contracts are marked to the cash settlement price. If we were to take out a loan with a variable rate, we could sell Eurodollar futures to lock in our interest payments. If interest rates were to rise, we would have to pay more to the bank we took the loan out from but would make up all the difference from the gains on the Eurodollar contract. Another way to mitigate interest rate risk from a variable rate loan would be to enter into a interest rate swap agreement. Unlike Eurobond futures, interest rate swaps are less standardized and are traded on the OTC market. The transfer of interest payments is also slightly different than Eurobond futures Eurodollar futures provide an effective means for companies and banks to secure an interest rate for money it plans to borrow or lend in the future. The Eurodollar contract is used to hedge against yield curve changes over multiple years into the future. For example: Say a company knows in September that it will need to borrow $8 million in December to make a purchase. Recall that each eurodollar futures contract represents a $1,000,000 time deposit with a three month maturity. The company can hedge against an adverse move in interest rates during that three month period by short selling 8 December Eurodollar futures contracts, representing the $8 million needed for the purchase. The price of eurodollar futures reflect the anticipated London Interbank Offered Rate (LIBOR) at the time of settlement, in this case, December. By short selling the December contract, the company profits from upward movement in interest rates, reflected in correspondingly lower December eurodollar futures prices. Let's assume that on September 1, the December eurodollar futures contract price was exactly $96.00, implying an interest rate of 4.0%, and that at the expiry in December the final closing price is $95.00, reflecting a higher interest rate of 5.0%. If the company had sold 8 December Eurodollar contracts at $96.00 in September, it would have profited by 100 basis points (100 x $25 = $2,500) on 8 contracts, equaling $20,000 ($2,500 x 8) when it covered the short position. In this way, the company was able to offset the rise in interest rates, effectively locking in the anticipated LIBOR for December as it was reflected in the price of the December Eurodollar contract at the time it made the short sale in September. 6. What is a long only commodity fund, describe its main features. Long only commodity fund have generated returns similar to diversified equity funds. What are the components of the returns from a long only commodity fund? Are commodities a separate asset class? Discuss in detail. Commodities are a separate asset class. Generally the returns of equities are highest, late in a recession and early in an economic expansion. The returns of commodities are highest late in an economic expansion, and remain positive early in recessions when equity returns are lowest. A commodity fund is a mix of difference commodities. The components of the returns are positively correlated to inflation. There is change in the spot price, which can make you profit. 7. Do futures prices contain information about future spot prices? Explain in detail. Indeed, future price is the spot price plus or minus any charges such as premium, discount, investment sentiments, expectations, carry model. The future prices contain spot prices in them with the cost of carry model. If the cost of carry model doesn't apply then there is additional information in the future spot prices. The idea that futures contain information about the future spot price is explained by the law of demand and supply as well as the arbitrage. This mostly happens toward the delivery month of a futures contract. It happens regardless of the contract's underlying asset. 8. Should a corporation hedge? Why might it increase firm value? Are there any reasons why a firm would not want to hedge? Explain in detail. A corporation should hedge because it reduces or eliminates the price risk associated with the underlying asset. You can profit from the change in the basis. Firm should hedge if hedging increases firm value. Firms should hedge to reduce the possibility of financial distress. Hedging makes sense if it adds value to the firm. Remember what you learned in corporate finance. Hedging must either increase cash flow or help mitigate financial distress. The first three reasons are examples of legitimate reasons for corporations to hedge. Make money by hedging. Trade the basis well ( Cash flow) Reduction in the expected transaction cost of financial distress, see figure 1 (Mitigate financial distress) Allow the firm to take more NPV positive project ( Cash flow) Reduce the risk to poorly diversified managers (you can only have one job at a time) Focus analysts on core business; hedging reduces volatility of floating rate debt by locking in a rate 9. Compare and contrast the commitments taken on by a futures contract seller versus a buyer of a put option. Explain in detail. Future contract seller is obligated to deliver if the position is not offset vs. a buyer of a put option who has the right, not an obligation to sell the underlying asset at strike price. Long making a profit from an increase in prices. Short - making a profit from a decrease in prices. Options require a premium, which is the maximum that the purchaser of the option can lose and futures have no upfront costs. The final major difference between these two financial instruments is the way the gains are received by the parties. The gain on a option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price. In contrast, gains on futures positions are automatically 'marked to market' daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day - but a futures contract holder can realize gains also by going to the market and taking the opposite position. If prices tend to decrease below the contract price that the buyer agreed to, he is still obligated to pay the seller the higher contract price on delivery date. 10. Why is it important for a commercial firm to have a derivative position qualify as a hedge? Explain in detail. Once you qualify as a hedge you have lower margin requirements, which increases your working capital (more money to use elsewhere, more liquid). Also you take on a lower risk position. 11. You have a stock index portfolio with a beta of 1.0 and a market value of $10,000,000. If you sell $10,000,000 nominal value of S&P 500 futures contracts, what is the return of the combined stock and stock index futures contract? What have you done to the original $10,000,000 stock market position? Explain in detail. Negated my returns by establishing a position in the futures market representing an equivalent nominal value of your portfolio to the short side, in effect your portfolio has $10m of beta=1 and a future position that represents $10m at beta= 1, therefore you have established a market neutral position. 12. The recent financial crisis has exposed a need to strengthen the risk management process in financial institutions. Part of these efforts is redesigning the risk management framework. What are the three lines of defense in effective risk management and how do we distinguish among their functions? How do they help manage the risk throughout the organization? Explain in detail