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hi sir , im really sorry for all the questions , but im i just get worried and nervous when i see a question and dont understand what its asking and get specially worried when i dont understand the marking scheme. the question i have is from december 2008 paper , question 3 , Aston Co .. how did they compute the answer to part (a), im completely lost! and another simple clarification from the same paper question 5 , whats ” open ” and ” settlement ” mean in the futures contract section .. how do you which to choose , because i had a simple confusion when doing the basis risk..
thanks in advance!Be careful with this exam – it was set by the previous examiner and he set harder and more confusing questions than the current examiner (which is why he is no longer the examiner). So do not let it frighten you too much!
With regard to question 3. It asks you to base things on the annualised cash flow and volatility and so the first thing to do is to convert the monthly figures in the question into yearly figures.
The monthly cash flow is 14,400, but this is before interest. The interest is 8% per year, but is charged monthly. Strictly, to get the monthly interest rate you should use (1 + r)^12 = (1 + R) where r is the monthly rate and R is the yearly rate (and 12 is because there are 12 months in a year). (If you had simply taken 8%/12 = 0.5% per month, then although this is wrong, you would probably only have lost half a mark).
With regard to the volatility, for this you need to know that the variance is the (standard deviation^2) and that we can add up variances.
So…….the yearly variance will be 12 x monthly variance. The monthly variance is 13^2 = 169. So the yearly variance is 12 x 169 = 2028. So the yearly standard deviation is the square root of 2028 which is 45.03%
As you will see from the answer, the problem here is that the 13% is the monthly variance before interest, and really we want the monthly variance after interest. This is where the old examiner really did get ridiculous – I do not believe that there is any chance at all of the current examiner expecting this. I would almost certainly have used 45.03% and I am certain I would still have got full marks (even though it would make the final answer different).The rest of part (a) is value at risk, using normal distribution tables. If you are not sure about this then there is an explanation of how to do it in the revision notes on here.
For question 5, ‘open’ means the price at the start of the day; and ‘settlement’ means the average price for the day. You should really best use the settlement price. (The examiner got heavily criticised at the time for mentioning these terms – again, I do not think that the new examiner will try and confuse things in this way.)
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