Strategic Financial Mgt

FETE Model Solutions Spring 2012

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Learning Objectives: 3. Derivatives and Pricing Learning Outcomes: (3f) Demonstrate understanding of option pricing techniques and theory for equity and interest rate derivatives. Sources: Hull, John Options, Futures, and Other Derivatives, Chapter 17 – The Greek Letters Hull, John Options, Futures, and Other Derivatives, Chapter 13 – The Black-SholesMerton Method Commentary on Question: This question explores delta and vega hedging in practice. It also tests the candidates’ knowledge of futures contracts including their delta and gain/loss. Solution: (a) Identify the features of Wonka Life’s Equity-Linked GIC product that present risk exposures that may require hedging. Commentary on Question: Many candidates provided a shopping list of typical risks, without identifying any features that present risk exposures. A list of typical risks does not adequately demonstrate a candidate’s ability to recognize and communicate exposures to risks inherent in financial products. Full credit could only be given where these features were explicitly identified. Features requiring hedging: • Return of principal after 5 years as floor • 75% of percentage increase in S&P 500 total return index as S&P participation (b) Recommend which of the following approaches is more appropriate for hedging the Wonka Life’s Equity-Linked GIC block. Justify your recommendation.

FETE Spring 2012 Solutions

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Continued Commentary on Question: A common problem for candidates was to confuse put and call options. Candidates are expected to be comfortable with a variety of derivative products and know when and how they can be used. Many candidates correctly noted that options for the specified period (4.5 years) may not be available. Candidates overall tended to ignore the fact that futures provide only delta hedging. Some answers noted that gamma and vega exposure require frequent rebalancing of the futures position. Overall, justification...