Practical traders, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct mathematician. That is what Keynes might have said had he considered the faith placed by some investors in the work of Leonardo of Pisa, a 12th and 13th century number cruncher. Better known as Fibonacci, Leonardo produced the sequence formed by adding consecutive number components of a given series - 1,1,2,3,5,8,13 and so on. Numbers in this series crop up frequently in nature and the relationship between components tends towards 1.618, a figure known as the golden rule in architecture and design. If it works for plants (and appears in The Da Vinci Code), why shouldnt it work for financial markets? Some traders believe that markets will change trend when they reach, say, 61.8% of the previous high, or are 61.8% above their low. Believers in Fibonacci numbers are part of the school known as technical analysis, or Chartism, which believes the future movement of asset prices can be divined from past data. But there is bad news for the numerologists. A new study No Magic in the Dow by Professor Roy Batchelor and Richard Ramyar of the Cass Business School, finds no evidence that Fibonacci numbers work in American stock markets. This research may well fall on stony ground. Experience suggests that chartists defend their territory with an almost religious zeal. But their arguments are often anecdotal: If technical analysis doesnt work, how come so-and-so is a multi-millionaire? This survivorship bias ignores the many traders whose losses from using charts drive them out of the market. Furthermore, the recommendations of technical analysts can be so hedged about with qualifications that they can validate almost any market outcome. If the efficient market theory is correct, technical analysis should not work at all; the prevailing market price should reflect all information, including past price movements. However, academic fashion has moved in favor of behavioral finance, which suggests that investors may not be completely rational and that their psychological biases could cause prices to deviate from their correct level. Technical analysts also make the perfectly fair argument that those who analyze markets on the basis of fundamentals such as economic statistics or corporate profits are no more successful. All that talk of long waves is distinctly mystical and seems to take the deterministic view of history that human activity is subject to some pre-ordained pattern. Chartists fall prey to their own behavioral flaw, finding confirmation of patterns everywhere, as if they were reading clouds in their coffee futures. Besides, technical analysis tends to increase trading activity, creating extra costs. Hedge funds may be able to rise above these costs; small investors will not. As illusionists often proclaim, dont try this at home. Now answer the following questions: (a) Technical analysis is the search for recurring and predictable patterns in stock prices. It is based on the premise that prices only gradually close in on intrinsic value. As fundamentals shift, astute traders can exploit the adjustment to a new equilibrium. Critically explain this statement using an example.[5 marks] (b) Airbus has a foreign-currency denominated payable, it can hedge by buying the foreign currency payable forward. The company can expect to eliminate the exposure without incurring costs as long as the forward exchange rate is an unbiased predictor of the future spot rate. Airbus exported an A380 to a UK company, and was billed the sum of 12,000,000 payable in three months. Currently the spot rate is $1.40/ and the three-month forward rate is $1.36/.The three-month money market interest rate is 12% per annum in US and 8% per annum in UK.So the management of Airbus decided to manage this transaction exposure and use the money market hedge to deal with this pound account payable. (i) Explain how Airbus can eliminate the exchange rate exposure and compute the dollar cost of meeting the pound obligation.[5,5 marks]

(ii) Conduct a cash flow analysis of the money market hedge.[10 marks] (iii) Compare and contrast the cash flow at maturity and the net dollar proceeds if instead the options market hedge is used by Airbus. You may assume a put option of 12,000,000 with an exercise price of $1.36/ with a three-month expiration and an option premium of $ 0.05 per .[10 marks] (c) As investors go increasingly global and market turbulence grows, stock-index futures are emerging as the favorite way for nimble money managers to deploy their funds. Indeed, in most major markets, trading in stock futures now exceeds the buying and selling of actual shares. For instance, by selling futures equal to the underlying portfolio, a manager can completely insulate a portfolio from market moves. Say a manager succeeds in outperforming the market, but still loses 2.75% while the market as a whole falls 12%.Hedging with futures would capture that margin of out-performance, transforming the loss into a profit of roughly 9.25%.You are provided the information outlined as follows: Issue Price Yield to Maturity US Treasury bond 15 4/5% maturing 3 July, 2030 1000 15.8% US Treasury long bond futures contract(contract expiration in 8 months) 65 15.9% Airbus bond 16 11/20% maturing 3 July, 2025(sinking fund debenture, rated AAA) 95 17.55% Volatility of AAA corporate bond yields relative to US Treasury bond yields = 1.35 to 1.0 (1.35 times). One US Treasury bonds futures contract is a claim on $ 1,000,000 par value long-term US Treasury bonds. Scenario 1: A fixed-income manager holding a $25 million market value position of US Treasury 15 4/5% bonds maturing 3 July, 2030, expects the economic growth rate and the inflation rate to be above market expectations in the near future. Institutional rigidities prevent any existing bonds in the portfolio from being sold in the cash market. Scenario 2: The treasurer of Airbus has recently become convinced that interest rates will decline in the near future. She believes it is an opportune time to purchase her companys sinking fund bonds in advance of requirements because these bonds are trading at a discount from par value. She is preparing to purchase in the open market $25 million par value Airbus 16 11/20% bonds maturing 3 July, 2025. A $25 million par value position of these bonds is currently offered in the open market at 95.Unfortunately, the treasurer must obtain approval from the board of directors for such a purchase, and this approval process can take up to 3 months. The board of directors approval in this instance is only a formality. (i) Explain to the management of Airbus how interest rate and currency swaps work.[5 marks] (ii) For each of these two scenarios, demonstrate how interest rate risk can be hedged using the Treasury bond futures contract. Show all calculations.[10 marks]

(d) Airbus is concocting a diversified portfolio of $ 3,000 million. The board of directors is considering an initial investment in emerging market equities. The treasurer has made the following four comments: 1. For an investor holding only developed market equities, the existence of stable emerging market currencies is one of several preconditions necessary for that investor to realize strong emerging market performance. [5 marks] 2. Local currency depreciation against the dollar has been a frequent occurrence for US investors in emerging markets.US investors have consistently seen large percentages of their returns erased by currency depreciation. This is true even for long-term investors across emerging markets. [5 marks]

3. Historically, the addition of emerging market stocks to a US equity portfolio such as the S&P 500 index has reduced volatility; volatility has also been reduced when emerging market stocks are combined with an international portfolio such as the MSCI EAFE index. [5 marks] 4. Although correlations among emerging markets can change over the short term, such correlations show evidence of stability over the long term. Thus, an emerging market portfolio that lies on the efficient frontier in one period tends to remain close to the frontier in subsequent periods. [5 marks] Required: State the relevant content of IFM for each of the underlying comment and assess whether each of the treasurers comments is correct or incorrect.