Explain the mechanics of a Basis Spread with numerical example.

Feb 15, 2024

Explain the mechanics of a Basis Spread with numerical example.

Question 3

Though Alpha Seekers Investments has a general preference for exchange-traded derivatives, the management of Teachers Pension Fund is interested in knowing more about the use of OTC derivatives particularly forwards and Swaps for managing the risks of their proposed investments in UK equities. Your line manager requires your report to cover this too.

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Required:

Explain the mechanics of a Basis Spread with numerical example. (10 marks)

Illustrate the pricing of a hypothetical forward contract on BT Group’s stock and how it can be used to manage the risk of the proposed investment. You will have to consider and choose the required inputs and make reasonable assumptions wherever required. Provide clear descriptions of all the steps in the process and a conclusion. (8 marks)

Illustrate the pricing of a hypothetical swap contract involving Teachers Pension Fund receiving Fixed GBP Rate derived from GBP Libor rate and paying the returns on BT Group’s stock; assume an investment of £2,500,000, payments made quarterly for one year. For any missing Libor term rates, assume that the term structure of interest rates is linear and upward sloping. Provide detail descriptions of each step. (12 marks)

                                    (30 marks)
                                          (Word limit 600)

Note: There are five marks for report format (3 marks) and Harvard referencing
(2 marks).

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