(i) Explain with your own numerical example what is meant by a Sovereign Credit Default Swap (CDS). (6 marks)
Sovereign CDS contracts are contracts that the government debt is the reference entity, that has continued to grow over the years. Usually this growth is strong for bonds issued by emerging market economies where the risk of credit event is usually higher than that of developed market economies.
(ii) If the perceived risk of a default by Greece falls due to a major credit rating upgrade from CCC to BBB+ what is likely to happen to its quarterly CDS premiums. Explain using your own numerical example. (4 marks)
(i) Explain with the aid of a numerical example using the yen per dollar exchange rate what is meant by covered interest rate parity to calculate a 6- month. (5 marks)
(ii) Assume that you start by borrowing either $100,000 or 10,500,000 Japanese Yen. Using a starting yen per dollar exchange of 105 Yen per dollar and a one-year US interest rate of 5% and one-year Japanese interest rate of 0.5%. Explain how a hedge fund can use the carry trade to make profits or incur losses. In your answer, show the profits or losses in both dollars and yen in the following four cases [(i) to (iv)] making it clear in each case what the profit or loss is in both yen and dollars.
(i) The exchange rate stays the same at 105 yen per dollar.
(ii) The exchange rate moves to 75 yen per dollar
(iii) The exchange rate moves to 125 yen per dollar
(iv) State the breakeven exchange rate for the carry trade. (5 marks)
The pound has appreciated against the Euro from €1.20/£1 to €1.40/£1 due to increased buying of pounds in the foreign exchange market. Explain with the aid of diagrams for the foreign exchange market and UK money market, the difference between non sterilised and sterilised intervention by the Bank of England designed to get the pound back to €1.20/£1. For simplicity, assume that the Bank of England’s foreign exchange reserves are all in euros. Comment on the implication of the two types of intervention for the UK money supply, UK foreign exchange reserves and the short term UK interest rate. Comment on the likely effectiveness of the two types of foreign exchange operations. (10 marks)
You are given the following data on call and put premiums in pence per share for Company ABC shares which are currently priced in the market at 315 pence. Each contract refers to 1000 shares.
Call premiums in pence Put premiums in pence
Strike Prices September September
300 pence 45 35
(i) You expect the share price to rise to 400 pence. Discuss a speculative strategy and the profits/losses at a range of different prices for the underlying share in September. (4 marks)
I could buy the call premium at strike of 300 pence for £450, if the shares rise to 400 pence I would make a profit of
(ii) You are unsure if the share price will either fall or rise so decide to adopt a long straddle strategy. Discuss the total net profit (+) or net loss (-) in pounds of the strategy at the following share prices on expiration of the contract.
(a) 150 pence
(b) 250 pence
(c) 350 pence
(d) 500 pence
(iii) State all share prices on expiration that will lead to zero profits from this strategy. (2 marks)