Financial Markets and Institutions

Question Paper Title: Financial Markets and Institutions Instructions to Candidates:Answer THREE questions. Each question and each part of a question is equally weighted unless otherwise stated. Only answer THREE questions a) Demonstrate how a butterfly spread can be constructed using either put or call options and discuss the circumstances under which a trader might construct such a strategy. (60 marks) b) Use the put-call parity relationship to demonstrate that a butterfly spread using calls should cost the same as a butterfly spread using puts, when the underlying asset, strike price and maturity dates of each spread are the same. (40 marks) a) Explain, with examples, the terms liquidity risk and operating risk. (30 marks) b) Demonstrate, using examples, how derivative securities can be used to manage market risk and exchange rate risk. (70 marks) Explain, using a relevant diagram, the process of securitisation and discuss the benefits and drawbacks of mortgage backed securities and colleteralised debt obligations. a) On January 1st 2019 one share of BBK plc is priced at $35 and is expected to pay a dividend of $1.25 in 6 months and a further dividend of $1.00 in 1 year. The relevant risk-free rate of interest is 3% per annum with continuous compounding. What should be the price of a forward contract, written on a BBK share, which matures immediately after the second dividend is paid and what is the initial value of the forward contract? (40 marks) b) Explain and discuss your answer to part a. (30 marks) c) BBK shares are included in the RNB500 stock index which is trading at 4,000 index points with a contract multiplier of $10 per full index point. If the annual dividend yield is 2% and the risk-free rate of interest is 3%, what is the value of a futures contract written on the RNB500 that matures in 6 months? (30 marks) Discuss the comparative advantage argument to explain the popularity of interest rate swaps. Support your answer using a relevant diagram and numerical example. a) Explain and discuss the parameters that influence the price of European-style options and the nature of their impact. (60 marks) b) Discuss ways in which a put or a call option may be used in hedging and speculation. (40 marks)

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