a long derivatives item set research, investing, following, impressive, investment

dirk01

Wanda Brock works as an investment strategist for Globos, an international investment bank. Brock has been tasked with designing a strategy for investing in derivatives in Mazakhastan, an Eastern European country with impressive economic growth.

One of the first tasks Brock tackles involves hedging. Globos wants to hedge some of its investments in Mazakhastan against interest-rate and currency volatility. After a bit of research, Brock has gathered the following data:


The U.S. risk-free rate is 5.5%, and most investors can borrow at 2% above that rate.

The Federal Reserve Board is expected to raise the fed funds rate by 0.25% in one week.

The current spot rate for the Mazakhastanian currency, the gluck, is 9.4073G/$.

Annualized 90-day LIBOR is 7.6%.

Globos’ economists expect annualized 90-day LIBOR to rise to 7.9% over the next 60 days.

In Mazakhastan, commodities can be bartered at no charge through an ancient and informal trading system, but futures trades cost 3% of the contract value.

The Mazakhastan risk-free rate is 3.75%, and most investors can borrow at 1.5% above that rate.

Using the above data, Brock develops some hedging strategies, and then delivers them to Globos’ futures desk.

Brock then turns her attention to Mazakhastanian commodities. Globos has acquired the rights to large deposits of copper, silver, and molybdenum in Mazakhastan and suspects the futures markets may be mispriced. Brock has assembled the following data to aid her in making recommendations to Globos’ futures desk:

Copper
Spot price: $3.15/pound.
1-year futures price: $3.54/pound.
Silver
Spot price: $12.75/pound.
1-year futures price: $12.82/pound.

Molybdenum
Spot price: $34.45/pound.
1-year futures price: $35.23/pound.

After making some calculations, Brock assesses the arbitrage opportunities in Mazakhastan and passes the information on to the futures desk. Shortly afterward, she is informed that Globos’ Mazakhastan subsidiary uses its silver holdings as collateral for business loans, which allows the unit to obtain a favorable interest rate.

Jonah Mason, one of Globos’ traders, asks Brock for a few details about the Mazakhastan financial markets. Brock sends Mason a short e-mail containing the following observations:

Mazakhastan’s investors don’t like relying on old valuation data because asset values have changed rapidly in the past, so they generally use a mark-to-market valuation system.
Standard & Poor’s just raised Mazakhastan’s sovereign debt to investment grade.
Interest rates tend to move in the same direction as asset values.
New technological innovations and commercial expansion has substantially boosted the income of the average Mazakhastanian.
Before Mason receives the e-mail, he turns his attention to a memo about a futures contract a subordinate is considering. Unfortunately, the memo arrives without the summary page to the notes. Mason must deduce the nature of the hedge based on its characteristics: The risk-free rate used in calculating the futures price, and that price adjusted to account for individual future dividends.

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Based on Brock’s information, how should traders best take advantage of arbitrage opportunities in Mazakhastan?

A) Buy spot copper, do not trade silver, and sell spot molybdenum.

B) Buy spot copper, sell spot silver, and do not trade molybdenum.

C) Buy spot copper, sell spot silver, and sell spot molybdenum.


Your answer: B was correct!


First we must determine whether the futures contracts are mispriced, by multiplying the commodity price by (1 + the risk-free rate), or 1.0375. The basic equation uses the risk-free rate, but we have the actual borrowing rate, and for real-world purposes the actual borrowing rate provides a more accurate price estimate. For practical purposes, we should probably use the borrowing rate, but both rates provide the same answer to the question above. For illustration purposes, we use the risk-free rate in the discussion below.

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Should not we use the U.S risk free rate of 5.5 since these spot prices are quoted in USD....
What they do is go on to multiply a USD spot rate by a gluck interest rate...does not make sense....?

eoin

scared to answer looks like copyright material.. I would recommend taking it out unless its from the CFAI book

Always post a source when you post such questions so you dont get in trouble

senlinlang

This is a copyright violation. I'd ask to get this thread deleted if I were you.

giorgio10

gulfcfa, delete this post, you do not want to mess with copyright thing

needhelp1700

^ Glad to see you back ahmadmadoff!! You just couldn't keep off AF, eh?

Anyway, I don't think posting ONE question from the Qbank is copyright infringement. As long as you don't post like hundreds of them here.

I didn't really read the question yet, but will give it a shot later.

thecfawannabe

@Iginla2010

I am kinda trying to stay bellow the NATO radars here.....