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1. Finance Assignment | ExpertsMind.com
Question 1
Suppose Hong Kong Super Airlines Ltd, better known as Superair, is Hong Kong’s third largest
airline. Its passenger service and freighter network covers destinations across the Asia Pacific
region. Because of the rising price of crude oil, Superair suffered a huge loss in the past fiscal
year, so its financial manager is considering using derivatives to hedge the crude oil price. a
Assume Superair has to purchase 5 million US barrels of crude oil on June 1. Using the
information listed in the table below, develop a hedging strategy for Superair to hedge the crude
oil price and explain the effective price paid by Superair for the crude oil per barrel after
incorporating the gain and loss in the futures positions. State clearly the buy or sell futures
position of Superair and the number of contracts required. Crude oil futures trade in units of
1,000 US barrels.
Number of futures required = 5,000,000 / 1,000 = 5,000 futures As they need to purchase the
crude oil, they should purchase future contracts in order to hedge themselves fully. The gain
of future position = (83.5 – 79) * 5,000 * 1,000 = US22,000,000
The spot price has gone up $4, additional cost paid = $4* 50,000,000 = US20,000,000
Effective price paid by Superair =$74 – (83.5-79) = 69.5 per barrel.
b Calculate the bases on April 1 and June 1 and explain whether the hedge by Superair is a
perfect hedge using the concept of basis risk.
The basis on April 1 = futures price – spot price = 79 – 70 = $9
The basis on June 1 = futures price – spot price = 83.5 – 74 = $9.5
The hedge is not a perfect hedge because the buyer is subjected to basis risk. This time the
basis is favourable to the client as it has widened.

2. Question 2
Suppose you are a financial manager of Yuen Cheong Manufacturng Company. Due to the
rising demand of product X, Yuen Cheong Manufacturng Company decides to open a new
production plant in China, so it needs to take a loan of US$1 million. Bank A offers Yuen
Cheong Manufacturing Company the following two choices of loan:
i borrowing cash at 12% per annum, compounded annually
ii borrowing gold at 3% per annum, compounded annually.
Assume the risk-free interest rate is 9.5% per annum and storage costs are 0.5% per annum,
both are expressed with continuous compounding. Evaluate which loan you should choose
from Bank A. Discuss and briefly explain whether the rate of interest on the gold is too high or
too low in relation to the rate of interest on the cash loan.
Let the current spot price of gold by S and the forward price of gold be F
The forward price of gold can be computed as
Where
The forward price of gold, with , can be computed
as
F = S exp(0.13) = 1.1388*S
Cost of borrowing cash = exp(0.12)-1=12.74%
The total cost of borrowing gold is 13.88% where the cost of borrowing cash is 12.74%.
Therefore, the cost of borrowing gold is too high and hence the company should choose
borrowing cash.

3. Question 3
The following are the three-month HIBOR and three-year EFN futures prices for September
2010 contracts.
a Determine the HIBOR in three-months for settling the futures contract using the quotation on
August 16.
The implied HIBOR rate can be computed using the following formula
V=F*e rT
Where V is the face value of bond at maturity, which is 100
F is the current future price
R is the HIBOR rate
T is the time before expiry.
From the question
F = 99.67
V= 100
T=0.25
Solving the equation and we get
r=1.32%
The three-month HIBOR on Aug16 implied by futures is 1.32%
b Suppose an investor sold one contract of three-month HIBOR futures on August 16 and
closed it out on August 20. Evaluate the profit or loss of this investor.
Profit and loss of investor can be computed as
PL = (closing price – opening price) *sign(x) * number of contracts
Where sign(x) denotes the direction of the trade, sign(x)=-1 if it is short and sign(x) = 1 if it is
a long position.
From the question , closing price = 99.7, opening price = 99.67, sign(x) = -1 and number of

4. contracts = 1. Plugging in all these parameters into the equation and we get the P&L is -0.03
for the investor,
c Suppose an investor bought one contract of three-year EFN futures on August 16 and closed it
out on August 20. What would be the profit or loss of this investor?
Similarly, we can apply the same method of part (b) to compute the P&L of three-year EFN
futures.
The P&L is (114.33-114.31)*1*1 = 0.02

5. Question 4
John Chan considers buying a six-month stock futures contract on the shares of Li & Fung
Limited. Shares of Li & Fung Limited are now trading at $50 per share and it is expected that Li
& Fung Limited will pay a dividend of $1 per share in one month and four months. The riskfree
interest rate is 5% per annum with continuous compounding.
a Evaluate the estimated price of the six-month Li & Fung Limited stock futures contract.
The estimated future price can be computed as
F = S exp(rT) – PV(dividend)
Where S is the current spot price
r is the risk-free rate
T is the duration of the future contract, as expressed in number of years
The PV of the dividend can be computed as
1 e-0.05*1/12+1 e-0.05*4/12 =
S= 50
T = 6/12=0.5
r=5%
With all these figures and substituting into the equation, we get
F = 49.286 per contract
b If the actual futures price of Li & Fung Limited shares is $50, is there any arbitrage
opportunity? Outline the steps required to do the arbitrage.
There is an arbitrage opportunity as the current market price of the future is higher than that
of theoretical price. In order to capture the risk-less profit, one has to construct two portfolios
Portfolio A: Short 1 future contract at current market price of $50
Portfolio B: borrow $50 from bank and purchase 1 share of Li and Fung stock
After six-months, the payoff of portfolio A is 50-S(T), where S(T) is the spot price of Li and
Fung on the expiration date of the future contract.
The payoff of portfolio B is S(T) + FV(dividends) – 50*exp(0.05/2)
Summing up the payoff of portfolio A and B and we get
1.9793 – 50* (1-exp(0.05/2) = 0.7135
The sum of investment on portfolio A and B is zero. However, we can obtain a gain of 0.7135
with certainty. Therefore, arbitrage exist if the price is different from the theoretical value of
the future contract.

6. Question 5
Read the article ‘China takes step into futures’ below.
China takes step into futures
SHANGHAI—Stock-market-index futures debuted Friday in China, a much-awaited step to
liberalize markets amid investors’ hunger for new investment products.
Futures for the first time give investors in China the ability to make trades based on their
expectations the overall market will fall, not just rise.
Analysts say the inability to do that has helped fuel Chinese stock-market bubbles because
bears have no choice but to sell, giving disproportionate influence to market bulls.
The index futures will also offer a leading indicator of where investors think prices are headed.
The futures have been a decade in planning, in part because market regulators were reluctant to
allow a product they fear could destabilize stocks. Analysts say the futures mark only a modest
modernization, while limits on who can trade them and how they will trade will blunt their
ability to send price signals.
Regulators have picked a quiet moment to introduce futures, with the benchmark Shanghai
Composite Index down around 3.4% this year. Index futures gained handily in early trading on
the China Financial Futures Exchange, an affiliate of the Shanghai
Futures Exchange, a sign of support for the overall market and
enthusiasm about a new product.
Index futures are tied to the CSI-300, an index of 300 large capitalization
Shanghai- and Shenzhen-listed Class A shares. So
far in 2010, the CSI has lost around 4.6%, ending Thursday’s
session down 0.3%. The index gained about 54% in 2009.
Over the years, analysts often blamed the volatility of China’s
stock market in part on the absence of stock-index futures. The
Shanghai Composite surged 80% last year, fell 65% the previous
year and rose 97% in 2007.
Chinese authorities have embraced futures in major commodities
and liberalized that market enough to make Chinese futures in
copper and sugar among the most traded anywhere.
Authorities have warmed to futures tied to financial products, in
particular to stocks, even as activity in financial futures was
blamed in Wall Street’s 2008 meltdown.
But unlike Wall Street’s complex real-estate-based products,
China’s futures are considered simple.
Also, Beijing is moving cautiously. Many individuals and other
participants, including mutual funds, won’t be permitted to deal
in stock-index futures immediately.

7. About 7,000 investor accounts have been opened to trade the
index futures, compared with 121 million stock-market accounts,
also suggesting trading will be limited.
Last month, Zhu Yucheng, general manager of the China
Financial Futures Exchange, said 98% of those who had opened
accounts to trade futures were individual investors.
Thin, retail-oriented trading in index futures could lead to
dramatic fluctuations in their values initially, analysts say.
Regulators in recent weeks permitted trading of products tied to
selected individual stocks, including margin trading and short
selling. Rules also curtail activity in these products, and volume
has remained small since last month’s debut.
The initial stock-index futures will expire on the third Friday of
each month, starting with contracts in May, June, September and
December.
The exchange set a base price at 3399 for all four contracts,
slightly above Thursday’s close. Analysts said the base price is in
the recent range of the CSI-300 Index and has been chosen as a
lucky number by the regulator. In Cantonese, ‘three’ sounds like
the character for ‘rise’ while ‘nine’ sounds like the one for ‘long.’
‘The exchange probably wants to limit arbitration between the
four contracts by setting the base price at the same level,’ said
Jing Zhuocheng, an analyst at Shanghai Cifco Futures Co.
The contract level will be permitted to rise or fall as much as 10%
in one session, according to rules published by the exchange.
Source: Areddy, J T (2010) ‘China takes step into futures’, The Wall Street
Journal, April 16, http://online.wsj.com/article/NA_WSJ_PUB
:SB10001424052702303950104575185300372850216.html.

8. Answer the following questions:
a According to the above case, China launched trade in its first stock index futures contract on
16 April 2010. It is widely believed that CSI 300 index futures trading can enhance China’s
economic development. Discuss the three economic functions of the financial futures market
relating to China’s economic development?
(10 marks)
The futures market can provide an efficient and effective mechanism for the
management of price risks. Its establishment will help domestic enterprises, especially
those whose products are victims of drastic price changes in the overseas market, have a
clearer judge of price trends. As a developing economy, the equity market of China
serves as an important channel to raise capital. It should engage itself more actively in
the pricing of products in the international market, instead of passively accepting prices
formulated in the international market.
The second function of financial futures is that market participants can make more
rational operational decisions to prevent blind investments, which is favourable to the
stability of the market. Through the hedging mechanism of the futures market, the
manufacturers can also offset or transfer the price risks that they inherit from the cash
market.
Thirdly, introduction of financial futures can attract additional investment flow from
foreign countries. In China's case, if it does not have a hedging instrument like financial
futures, foreign investors will face great risks when investing in its stock market. The
risk will prevent foreigners putting additional capital to China which capital market
attempts to attract. Global exchanges are studying China's stock indices futures.
Introduction of domestic index futures can keep China having a major market position
instead of foreign exchanges.

9. b Discuss the rules and regulations imposed by the China Financial Futures Exchange (CFFEX)
to safeguard the interests of trading parties. Explain whether the rules and regulations you
discussed are enough to ensure that the objective of safeguarding the interests of trading parties
is achieved.
According to CFFEX, in order to safeguard the interests of trading parties, it has adopted the
following measures.
‘CFFEX provides an electronic market with no floor traders. All the trades of financial
futures products are conducted via CFFEX's computer system and are automatically
matched and executed by CFFEX's trading system according to the principles of price
priority and time priority.’ (CFFEX, 2010).
The chart below shows a summary of regulatory framework by CFFEX to protect
investors of financial futures
Source: CFFEX website, http://www.cffex.com.cn/zjs_en/flfg/qhgzhgz/
With the framework outlined above, we outline some trading and clearing rules in

10. detail to illsturate whether these rules are sufficient to protect the interests of market
participants. First of all, CSI300 futures have a position limit of 100 contracts on each
maturity. This position limit can protect investors from holding excessive position in
futures. Secondly the margin requirement is 12%, which is higher than margin level
required by many Asian exchanges. For instance, Singapore Exchange required 7%
margin on MSCI Singapore futures and Hong Kong Futures Exchange requires 8%
margin on Hang Seng Index futures. The above average margin requirement by
CFFEX is actually a good measure to protect mainland Chinese investors from
holding excessively large positions.