SMM503 Structured Products 2021
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SMM503
Structured Products
April 2021
Question 1
The table below contains information collected from Bloomberg for 1 year maturity European call options on the S&P 500 index. At the time the S&P 500 was trading at 3,800 and the 1-year risk free rate was 0.25%.
In answering the following questions, assume that put-call parity holds, and that the dividend yield is zero.
Strike |
3,000 |
3,200 |
3,400 |
3,600 |
3,800 |
4,000 |
4,200 |
4,400 |
4,600 |
Implied Volatility |
30.2% |
27.8% |
25.5% |
23.3% |
21.2% |
21.7% |
22.3% |
23.0% |
23.8% |
Call Premium |
931 |
763 |
605 |
457 |
325 |
250 |
193 |
151 |
121 |
Call Premium % |
24.5% |
20.1% |
15.9% |
12.0% |
8.6% |
6.6% |
5.1% |
4.0% |
3.2% |
Delta |
82.7% |
77.8% |
71.7% |
64.0% |
54.7% |
45.4% |
37.2% |
30.4% |
25.0% |
a. An Investor believes that the effects of the COVID- 19 pandemic will fade relatively quickly over the coming 12 months and that the market is over estimating volatility. Thus, they are considering selling a straddle with an at-the-money strike. Calculate the premium for this straddle and draw the payoff diagram showing how far the market would have to move before the investor makes a loss at maturity.
(20 marks)
b. The investor wonders if selling a strangle would be less risky. Calculate the premium for a strangle with strikes of 3,400 and 4,200, how far would the market have to move before the investor makes a loss at maturity? What are the advantages and disadvantages of this strategy versus the straddle?
(20 marks)
c. After speaking to his broker, the investor learns that they will not let him execute either of the above strategies because of the credit risk and potentially unlimited losses. Instead, they suggest he uses a butterfly to express his view.
Calculate the premium he would pay to construct a butterfly using call options with strikes of 3,200, 3,800 and 4,400 and draw the payoff diagram.
(20 marks)
d. Show how the same butterfly can be constructed using put options and demonstrate that the total cost would be identical to your answer above.
(20 marks)
e. The data in the table above shows that different strikes have different implied volatilities, briefly outline why this might be the case.
(20 marks)
Question 2
Mr. Hunter believes that inflation is going to rise over the next 3 to 5 years and that commodities should provide a return of 10%-15% per annum. Mr. Hunter recently received a large bonus of $1m from the hedge fund he works for and rather than pay off his mortgage immediately (which is $1m and costs 2% per year) he would like to invest the money in commodity linked notes and pay off his mortgage with the proceeds when they mature.
Mr. Hunter’s private banker has proposed a 3-year 100% capital-protected structured note that pays 65% of the performance of an equally weighted basket of 2 commodities, Gold and Crude Oil. However, Mr. Hunter does not find this structure attractive due to the low participation rate and is looking for alternatives.
a. Assuming that you work for a rival bank, propose 3 significantly different structured notes that would allow Mr. Hunter to improve the participation rate under the above constraints.
Support your answer with graphs and/or payoffformulas
(60 marks)
b. Which of these 3 notes would you recommend and why? Take into account
different elements including participation, downside risk, upside potential, etc .
(20 marks)
c. The chart below shows that in 2020 the price of spot Natural Gas (in blue) rose while the value of United States Natural Gas Fund (in white) which attempts to track Natural Gas prices by investing in futures fell.
Briefly discuss possible reason for the differences in performance between the ETF and spot prices.
(20 marks)
Question 3
A British university endowment is concerned about the recent market volatility and so they have re-evaluated their investment policy. In future the trustees have decided that the endowment wishes to avoid allocating assets to investments that put their capital at risk.
They have considered investing in UK government bonds but are concerned that the 5-year yield of 0.40% is incredibly low, they are also of the view that equities could potentially provide returns of up to 40% over the next 5 years.
The trustees seek the advice of an investment bank as to how they can gain exposure to equities without putting their capital at risk.
a. Assuming you work for the bank and under the above constraints, structure and discuss the details and workings of 3 structured notes that will provide the endowment with exposure to equities without risking their capital.
Support your answer with graphs and/or payoff formulas
(60 marks)
b. Which of these 3 solutions would you recommend and why? Take into account different elements, potential return, risk, etc.
(20 marks)
c. Briefly describe the covered call investment strategy and its associated return properties
(20 marks)
Question 4
A graduate has recently won a lottery prize of £3m and does not want to make any rash decisions or spend the capital. Instead, they have decided to invest the £3m and use the income to travel the world for 5 years which they estimate will cost £75,000 per annum.
The graduate does not want to expose themselves to equity risk and instead is looking to invest in interest bearing securities or derivatives. They have investigated the rates available on deposit accounts, but these are 0.25% which would only provide an income of £7,500 per annum.
The graduate seeks the advice the advice of an investment bank as to how they can improve the yield on their cash using interest rate derivatives and structured products.
a. Assuming you work for the bank and under the above constraints, propose 3 significantly different solutions to the graduate’s problem. In each case outline the details and workings as well as the risks involved.
(60 marks)
b. Which of these 3 solutions would you recommend and why? Take into account different elements, potential return, risk, etc.
(20 marks)
c. Briefly outline the outline the use of structured interest rate products in the investment strategy of Orange County highlighting how these initially produced higher investment returns but subsequently led to bankruptcy.
(20 marks)
Question 5
Prof. Doldrums believes that equity markets are currently at fair value and is of the view that they will not be more than 4% higher or lower than their current levels in 1 years’ time.
Prof. Doldrums currently has all of his cash invested in treasury bills yielding 0.20% but would like to improve this yield and is not averse to putting some of his capital at risk.
Prof. Doldrums seeks the advice of his bankers as to how he can improve the yield on his cash by buying equity-linked notes.
a. Assuming you work for the bank, structure and discuss the details and workings of 3 significantly different yield notes that allow Prof. Doldrums to capitalize on his view of a stable equity market
Support your answer with graphs and/or payoffformulas
(60 marks)
b. Given the following potential underlying assets for each of the three notes proposed above, which underlying would you choose and why?
Name |
Ticker |
Price |
Dividend Yield |
1Y Implied Vol |
1y Historical Return |
FTSE 100 |
UKX |
6,700 |
3.75% |
17.65% |
29.5% |
Easyjet PLC |
EZJ |
940 |
0.00% |
58.78% |
43.0% |
ITV PLC |
ITV |
125 |
5.29% |
27.50% |
22.0% |
SSE PLC |
SSE |
1,420 |
7.98% |
27.00% |
31.2% |
RELX PLC |
REL |
1,771 |
2.65% |
21.10% |
20.9% |
(20 marks)
c. Which of these 3 solutions would you recommend and why? Take into account different elements including price, downside risk, upside potential, etc.
(20 marks)
2022-08-15