Finance Question

College of Administrative and Financial Sciences

Assignment-3
Financial Derivatives (FIN405)
Deadline: (30/11/2024 @ 23:59 PM)

Course Name: Financial Derivatives
Course Code: FIN405

Student’s Name:

Semester: 1st

CRN: 12323

Student’s ID Number:

Academic Year: 2024-25 1st Semester

For Instructor’s Use only:
Instructor’s Name: Dr Jyoti Agarwal
Students’ Grade: /10

Level of Marks: High/Middle/Low

Instructions – PLEASE READ THEM CAREFULLY
• This assignment is an individual assignment.
• The Assignment must be submitted only in WORD format via allocated folder
on Blackboard.
• Assignments submitted through email will not be accepted.
• Students are advised to make their work clear and well presented. This also
includes filling your information on the cover page.
• Students must mention question number clearly in their answer.
• Late submitted assignments will NOT be entertained.
• Avoid plagiarism, the work should be in your own words, copying from
students or other resources without proper referencing will result in ZERO
marks. No exceptions.
• All answered must be typed using Times New Roman (size 12, doublespaced) font. No pictures containing text will be accepted and will be
considered plagiarism).
Submissions without this cover page will NOT be accepted.

Assignment Questions
Q.1 On June 17 of a particular year, an American watch dealer decided to
import 100,000 Swiss watches. Each watch costs SF225. The dealer would like
to hedge against a change in the dollar/ Swiss franc exchange rate. The forward
rate was $0.3881. Determine the outcome from the hedge if it was closed on
August 16, when the spot rate was $0.4434.
(03)

Q.2 For a $100 million equity swap with semiannual payments and an initial
stock index level of 2000, one party pays a fixed rate of 5.5 percent assuming
30 days per month and 360 days in a year. On the first payment date, if the
stock index is at 2173, determine the net swap payment, and specify which
party makes the payment.
(03)

Q.3 Explain how a bank could use a swaption to hedge the possibility that it
will enter into a pay floating, receive-fixed swap at a later date.
(04)

FIN401
Essay Question

Q1. What investment instruments are available to financial firms for short-term and
long-term needs?

Q2. What are the various sources of demand for and supply of liquidity for banks?

College of Administrative and Financial Sciences

Assignment-3
Financial Derivatives (FIN405)
Deadline: (30/11/2024 @ 23:59 PM)

Course Name: Financial Derivatives
Course Code: FIN405

Student’s Name: SEU ELITE

Semester: 1st

CRN: 12323

Student’s ID Number:

Academic Year: 2024-25 1st Semester

For Instructor’s Use only:
Instructor’s Name: Dr Jyoti Agarwal
Students’ Grade: /10

Level of Marks: High/Middle/Low

Instructions – PLEASE READ THEM CAREFULLY

• This assignment is an individual assignment.
• The Assignment must be submitted only in WORD format via allocated folder on
Blackboard.
• Assignments submitted through email will not be accepted.
• Students are advised to make their work clear and well presented. This also includes
filling your information on the cover page.
• Students must mention question number clearly in their answer.
• Late submitted assignments will NOT be entertained.
• Avoid plagiarism, the work should be in your own words, copying from students or
other resources without proper referencing will result in ZERO marks. No
exceptions.
• All answered must be typed using Times New Roman (size 12, double-spaced) font.
No pictures containing text will be accepted and will be considered plagiarism).
Submissions without this cover page will NOT be accepted.

Assignment Questions

Q.1 On June 17 of a particular year, an American watch dealer decided to
import 100,000 Swiss watches. Each watch costs SF225. The dealer would like
to hedge against a change in the dollar/ Swiss franc exchange rate. The forward
rate was $0.3881. Determine the outcome from the hedge if it was closed on
August 16, when the spot rate was $0.4434.
(03)
The exposure is to 100,000(SF225) SF22,500,000. The dealer would like to lock in the cost in
dollars. Thus, he could buy 22.5 million Swiss francs in a forward contract at the rate of
$0.3881 with an expiration of August 16. When the contract expires, it does not matter what
the spot rate is as the 22.5 million Swiss francs are purchased at the contract rate of $0.3881.
Thus, the total cost is (22,500,000) x ($0.3881) =$8,732,250.
Q.2 For a $100 million equity swap with semiannual payments and an initial stock index
level of 2000, one party pays a fixed rate of 5.5 percent assuming 30 days per month and
360 days in a year. On the first payment date, if the stock index is at 2173, determine the
net swap payment, and specify which party makes the payment.
(03)

This is a typical equity swap.
Fixed Payment = National Amount X (Fixed rate) X (Days/360)
Fixed payment: $100,000,000(.055) (180/360) = $2,750,000

Equity Payment = (Notional Amount) (Fixed Rate) q – Return on Stock over Settlement
Period
Equity payment: $100,000,000((2173/2000)– 1)) = 8,650,000
Net Payment = 8,650,000 – 2,750,000
The net payment is that the party paying equity pays $5,900,000

Q.3 Explain how a bank could use a swaption to hedge the possibility that it will enter
into a pay floating, receive-fixed swap at a later date.
(04)

A swaption, or “swap option,” is a financial derivative that provides the holder with the right
but not the obligation to enter into an interest rate swap at a future date. A bank can use a
swaption to hedge against the risk associated with entering into a pay-floating, receive-fixed
interest rate swap in the future. Here’s a detailed explanation of how this strategy would
work, along with examples to illustrate its value.
Why a Bank Might Use a Swaption
Consider a bank anticipating the need to enter a swap in which it will pay a floating rate and
receive a fixed rate. This swap structure could expose the bank to potential risks if interest
rates rise before the swap begins, as this would increase its floating rate payments. By
purchasing a swaption, the bank locks in the terms of the swap today, protecting itself against
adverse interest rate movements while retaining the flexibility to benefit from favorable rates.
Mechanics of a Receiver Swaption
In this scenario, the bank would buy a receiver swaption, granting it the right to enter
into a swap where it receives a fixed rate and pays a floating rate at a predetermined exercise
date. If rates rise by the exercise date, the bank could exercise the swaption and enter the
swap under more favorable terms, receiving a higher fixed rate than might be available in the
spot market.
For example, if the bank expects to need a three-year pay-floating, receive-fixed swap
starting two years from now, it could purchase a two-year receiver swaption with a three-year
swap as the underlying instrument. Suppose the fixed rate agreed upon in the swaption is 5%.
If market rates rise, the fixed rate on comparable swaps in two years might be 6%, and the
swaption would have intrinsic value since the bank could still receive a 5% fixed rate. This
would effectively hedge against rising rates by allowing the bank to secure a lower fixed rate
than it could otherwise obtain.
Scenario Analysis: Exercising the Swaption
Upon expiration, if the swap rate in the market exceeds the swaption’s strike rate, the bank
exercises the swaption and enters the swap at the agreed fixed rate, paying a floating rate in
return. This scenario benefits the bank because it avoids the increased costs of a higher
floating payment. Conversely, if market rates are below the strike rate, the bank can let the
swaption expire and possibly secure better terms directly in the swap market.
Financial Impact of Using a Swaption
The swaption provides a cost-effective hedging solution with upfront premiums as the only
initial cost, compared to the potentially larger financial impact of fluctuating interest rates.

This upfront cost is generally less than the expense of managing unexpected floating rate
increases.
Finally, A swaption serves as a flexible, risk-mitigating tool for banks facing
uncertain future financing needs. By allowing the bank to lock in a fixed rate while retaining
the choice to avoid or accept the swap based on future market conditions, a swaption hedges
potential adverse effects due to rate volatility without the commitment inherent in a forward
swap.

Assignment 3- FY 2024-25 1st TERM

FIN401
SEU | ELITE

SEU | ELITE

1

SEU ELITE

Q1. What is a key characteristic of capital market instruments?
a) They are typically more liquid than money market instruments.
b) They have maturities beyond one year and generally offer higher expected rates of return. ✓
c) They are designed to have very low risk and high marketability.
d) They usually have maturities of less than one year.

Q2. Which one is a source of liquid funds for financial institutions?
a) Operating expenses
b) Customer loan repayments ✓
c) Payment of stockholder dividends
d) Repayment of non-deposit borrowings

Q3. How does the Crossroads Account typically affect a depository institution’s liquidity?
a) It decreases liquidity by tying up funds in long-term assets.
b) It increases liquidity by providing immediate access to cash. ✓
c) It has no impact on liquidity.
d) It requires higher reserves than transaction accounts.

Q4. Which of the following can indicate that a financial institution may be in trouble?
a) Having an abundance of long-term investments.
b) Lack of adequate liquidity to meet immediate fund needs. ✓
c) High levels of customer deposits.
d) Consistent profitability over several quarters

Q5. Which of the following is a key characteristic of transaction (payment or demand) deposits?
a) They typically offer higher interest rates than nontransaction deposits.
b) Providers are required to honor withdrawals immediately. ✓
c) They are designed for long-term savings.
d) They are less costly to process than nontransaction deposits.

Q6. What is one of the main advantages of non-transaction (savings or thrift) deposits compared
to transaction deposits?
a) They allow for immediate withdrawals.
b) They are designed for customers on the move.
c) They generally offer higher interest rates. ✓
d) They are generally for the short term

2

SEU ELITE

Q7. Which of the following statements about the Federal Funds Market is TRUE?
a) Overnight loans are typically secured by specific collateral.
b) Term loans in the Federal Funds Market are usually negotiated for periods of several days to months. ✓
c) Continuing contracts in the Federal Funds Market are not automatically renewed.
d) Immediately available reserves traded in the Federal Funds Market are often held for over a week

Q8. Which of the following statements best describes the trend and use of alternative non-deposit
sources of funds in financial institutions?
a) Non-deposit sources of funds have decreased in usage as larger institutions rely more on traditional
deposits.
b) Larger institutions increasingly depend on non-deposit sources, such as the federal funds market and
commercial paper, for short-term financing. ✓
c) Advances from the Federal Home Loan Bank are the only source of short-term funds for larger
institutions.
d) The Eurocurrency deposit market has no relevance in the context of non-deposit funding sources

Q9. What does the trade-off between liquidity and profitability imply for financial firms?
a) Increasing liquidity always leads to higher profitability.
b) More resources allocated to liquidity typically result in lower expected profitability. ✓
c) There is no relationship between liquidity and profitability.
d) Financial firms should avoid maintaining liquidity to maximize profits.

Q10. Which type of security allows investors to receive only the principal payments from a pool of
mortgages?
a) Mortgage-backed bonds
b) Pass-through securities
c) Stripped -Principal-only (PO) securities ✓
d) Treasury Bonds -Principal-only (PO) securities

3

SEU ELITE

Essay Question
Q11. What investment instruments are available to financial firms for short-term and long-term
needs?
Answer ✓
Financial institutions access a wide range of investment instruments tailored to varying financial goals and
time horizons, categorized into money market instruments for short-term needs and capital market
instruments for long-term investments. Each type has unique features related to risk, yield, inflation
sensitivity, and economic factors, allowing for customized portfolio strategies.
For short-term needs, money market instruments provide high liquidity, low risk, and easy marketability,
making them ideal for managing cash flow. Key options include Treasury Bills, with maturities under one
year, known for low risk and high liquidity, and Short-Term Treasury Notes and Bonds, which offer
slightly longer terms. Other choices include Federal Agency Securities, issued by government-sponsored
agencies, and Certificates of Deposit (CDs) with fixed-term deposits and guaranteed interest. Institutions
may also use Eurocurrency Deposits, Banker’s Acceptances (for international trade), Commercial Paper
(unsecured corporate debt), and Short-Term Municipal Obligations (local government-issued, sometimes
tax-exempt).
For long-term investments, capital market instruments offer higher returns and potential capital gains,
though with increased risk. They suit institutions focused on capital growth. Major options include Treasury
Notes and Bonds (government-issued with maturities from years to decades) for stable income, and
Municipal Notes and Bonds from local governments, which often carry tax advantages. Corporate Notes
and Bonds offer potentially higher returns but come with additional credit risk.
By utilizing both short- and long-term instruments, financial institutions can balance immediate liquidity
with long-term growth, aligning portfolios to their risk tolerance and financial goals.

4

SEU ELITE

Q12. What are the various sources of demand for and supply of liquidity for banks?
Answer ✓
Banks face various sources of demand and supply when it comes to liquidity management.
On the demand side, the most immediate needs typically come from customer deposit
withdrawals and credit requests from valued loan customers, which may involve new loan requests or
draws on existing credit lines. Other demands for liquidity include the repayment of non-deposit
borrowings, which may involve loans from other financial institutions or the central bank, such as the
Federal Reserve System. Additionally, banks need liquidity to cover operating expenses and taxes as well
as payment of dividends to stockholders, which require ready cash.
On the supply side, banks rely on several key sources to meet their liquidity needs. The most
significant source is often incoming customer deposits, which tend to be highest at the beginning of each
month due to business payrolls and may peak again mid-month as bills are paid. Another crucial source is
revenues from the sale of non-deposit services, which provides fee income. Liquidity is also bolstered by
customer loan repayments and sales of bank assets, particularly marketable securities from the
investment portfolio. Additionally, banks can access borrowings from the money market to ensure they
meet short-term liquidity demands.

References
Rose, P. S., & Hudgins, S. C. (2012). Bank management and financial services. McGraw-Hill Education.

5

SEU ELITE

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