Derivative Markets

Derivative securities play a large and increasingly important role in financial markets. These securities whose prices are determined by, or derive from, the prices of other securities are also called contingent claims because their payoffs are contingent on the prices of other securities.

1. In relation to derivative markets, explain the following: call option, put option, exercise price, strike price, premium,in the money, out of the money, at the money, American option, European option, (10 marks)
2. Several investment committee members have asked about interest rate swap agreements and how they are used in the management of domestic fixed-income portfolios.
3. Define an interest rate swap and briefly describe the obligation of each party involved
4. Cite and explain two examples of how interest rate swaps could be used by a fixed-income portfolio manager to control risk or improve return. (5 marks)

(c). As corporate treasurer, you will purchase K1 million of bonds for the sinking fund in three months you believe rates will soon fall and would like to repurchase the companys sinking fund bonds, which currently are selling below par, in advance of requirements. Unfortunately, you have to obtain approval from the board of directors for such a purchase, and this could take up to two months. What action can you take in the futures market to hedge any adverse movements in bond yields and prices until you actually can buy the bonds? Will you be long, or short? Why? (5 marks)

( d ). Consider April 2023 expiration call option on a share of AELZ stock with an exercise price of K95 per share selling on March 2, 2023 for K1.35. Exchange traded options expire on the third Friday of the expiration month, which for this option was April, 20. On March 2, AELZ sells for K90.90. Would you exercise the option?

On April 20, AELZ sells for K96, what would be the value of the option at expiration?

How much profit will the call holder make? (5 marks)

( e ). The April 2007 expiration put option on AELZ with an exercise price of K95 selling on March 2, 2007 for K4.90 . If AELZ sells at K9090 , what will be the net proceeds/

If AELZ sells for K88 at expiration, what will be the value of the option at expiration, and how much profit would the investor make?