Financial Markets Assignment -

The purpose of this assignment is to evaluate students' comprehension of bond pricing and risk management techniques using derivative instruments. The assignment is based on the financial data available in the accompanying spreadsheet (data.xlsx). The data encompasses prices of Treasury Coupon Strips of various maturities (worksheet 'Gilt strips') and the time series of stock prices of selected companies and the FTSE All Share index covering the period from 14 November 2017 to 14 November 2018 ('Companies').

Required -

NOTE: Assume that there are no dividends. Also, all rates of return can be assumed to be annually compounded, unless stated otherwise. When calculating bond yields and zero rates, you can use calendar time to obtain relevant fractions of a year.

1. Extract prices of Treasury zero-coupon securities (Coupon Strips) maturing in quarterly intervals between 7 June 2019 and 7 March 2022 from worksheet 'Gilt strips'. On the basis of these prices, calculate zero rates for each of the 12 available dates, given 14 November 2018 being the current date. Express the calculated zero rates both in terms of quarterly compounded rates as well as in terms of continuously compounded rates (up to 1/100^th of a basis point). Plot the obtained term structure of (continuously compounded) zero interest rates. Which of the term structure theories implies such a shape?

2. Now, generate a series of continuously compounded 3-month forward rates implied by the estimated zero rates. Comment on the relationship between zero rates for maturity t and corresponding forward rates. What if the slope of the term structure curve of zero rates was different?

3. From worksheet 'Companies' extract daily levels of FTSE All Share index and the stock prices of your assigned rm. Subsequently, generate 1-year time series of daily simple returns of the index and the stock.

4. Based on simple daily returns, calculate the annualised (sample) standard deviation of index returns. Subsequently, calculate the annualised standard deviation of daily stock returns and their correlation with the FTSE All Share index (the market). Finally, calculate your firm's stock beta and use the CAPM relationship to calculate the expected return on the stock, assuming that the equity market premium is 6% and the relevant riskless interest rate is equal to 0.076%.

5. Your initial wealth on 14 November 2018, W₁ = £100,000, is invested entirely in the stock of your analysed firm. Your investment horizon is 1-year and your wealth on 14 November 2019 is denoted by W2. Assume that the forward contract on the stock of your firm is available and that the discounted forward price for the 14 November 2019 contract equals the stock price on 14 November 2018. How many one-year forward contracts would you long/short to minimise the variance of W2 assuming that 1 contract is for 10 shares?

6. Now, you want to include a speculative component in your hedging strategy. In other words, simply minimising the variance of your portfolio is not your objective anymore and you take into account the expected return on your portfolio as well. Assume therefore that your objective function is U = E[W₂] - αvar[W₂], where α  = 0.000001 * (10 + y) and y is the penultimate digit of your group number (so if your group number is 23, y = 2; if you are in group 4, y = 0). How many one-year forward contracts on the company's stock would you long/short to maximise the objective function U?

Compare the above risk management strategy with the strategy designed in the answer to Question 5 (focus on the expected returns and the standard deviation of terminal wealth).

Is there an alternative investment strategy that provides similar risk-return characteristics?

7. Subsequently, assume that your entire wealth (W₁ = £100,000) is invested in the firm's stock. How can you minimise the risk of your stock holding over a one-year horizon using index futures contracts? Assume that one futures contract is for ¿10 times the value of the index. (Ignore any effects of the marking-to-market requirement.)

8. Assume that both call and put at-the-money European option contracts on the stock of your firm that mature on 14 November 2019 are available. What (static) hedging strategy would you adopt to ensure that the value of your stock portfolio on 14 November 2019 is at least as high as it is on 14 November 2018? What is the cost of implementing such a strategy?

If your objective is to construct a hedge that makes the value of your stock portfolio insensitive to the uctuations of the stock price, what possible option positions can you adopt? Will you need to adjust your position in option contracts over time? Interpret your findings.

Company allocation - The last digit of your group number corresponds to the number of your assigned company on the list below (so group 16 will choose Marks & Spencer):

1. AstraZeneca

2. Aviva

3. BP

4. BT Group

5. Glencore

6. Marks & Spencer

7. Reckitt Benckiser Group

8. Sainsbury

9. Tesco

10. Vodafone

Attachment:- Assignment Files.rar