Practice Questions - provide you with insurance against a decline in...

CHAPTER 1

Introduction

Practice Questions

Problem 1.8.Suppose you own 5,000 shares that are worth $25 each. How can put options be used to provide you with insurance against a decline in the value of your holding over the next four months?

You should buy 50 put option contracts (each on 100 shares) with a strike price of $25 and an expiration date in four months. If at the end of four months the stock price proves to be less than $25, you can exercise the options and sell the shares for $25 each.

Problem 1.9.A stock when it is first issued provides funds for a company. Is the same true of an exchange- traded stock option? Discuss.

An exchange-traded stock option provides no funds for the company. It is a security sold by one investor to another. The company is not involved. By contrast, a stock when it is first issued is sold by the company to investors and does provide funds for the company.

Problem 1.10.Explain why a futures contract can be used for either speculation or hedging.

If an investor has an exposure to the price of an asset, he or she can hedge with futures contracts. If the investor will gain when the price decreases and lose when the price increases, a long futures position will hedge the risk. If the investor will lose when the price decreases and gain when the price increases, a short futures position will hedge the risk. Thus either a long or a short futures position can be entered into for hedging purposes.If the investor has no exposure to the price of the underlying asset, entering into a futures contract is speculation. If the investor takes a long position, he or she gains when the asset’s price increases and loses when it decreases. If the investor takes a short position, he or she loses when the asset’s price increases and gains when it decreases.

Problem 1.11.A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live- cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer’s viewpoint, what are the pros and cons of hedging?

The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, the gain on the futures contract will offset the loss on the sale of the cattle. If the price of cattle rises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Using futures contracts to hedge has the advantage that it can at no cost reduce risk to almost zero.Its disadvantage is that the farmer no longer gains from favorable movements in cattle prices.

(Fundamentals of Futures and Options Markets, 9e John C. Hull) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 3

Problem 1.12.It is July 2016. A mining company has just discovered a small deposit of gold. It will take six months to construct the mine. The gold will then be extracted on a more or less continuous basis for one year. Futures contracts on gold are available on the New York Mercantile Exchange. There are delivery months every two months from August 2016 to December 2017.Each contract is for the delivery of 100 ounces. Discuss how the mining company might use futures markets for hedging.

The mining company can estimate its production on a month by month basis. It can then short futures contracts to lock in the price received for the gold. For example, if a total of 3,000 ounces are expected to be produced in September 2017 and October 2017, the price received for this production can be hedged by shorting a total of 30 October 2017 contracts.

Problem 1.13.Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a long position in the option depends on the stock price at the maturity of the option.

The holder of the option will gain if the price of the stock is above $52.50 in March. (This ignores the time value of money.) The option will be exercised if the price of the stock is above $50.00 in March. The profit as a function of the stock price is shown in Figure S1.1.-5

5 10 15 20

20 30 40 50 60 70

Profit Stock Price

Figure S1.1 Profit from long position in Problem 1.13

Problem 1.14.Suppose that a June put option on a stock with a strike price of $60 costs $4 and is held until June. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option.

The seller of the option will lose if the price of the stock is below $56.00 in June. (This ignores the time value of money.) The option will be exercised if the price of the stock is below $60.00 in June. The profit as a function of the stock price is shown in Figure S1.2.

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10 20 30 40 50 60

0 20 40 60 80 100 120

Profit Stock Price

Figure S1.2 Profit from short position in Problem 1.14

Problem 1.15.It is May and a trader writes a September call option with a strike price of $20. The stock price is $18, and the option price is $2. Describe the investor’s cash flows if the option is held until September and the stock price is $25 at this time.

The trader has an inflow of $2 in May and an outflow of $5 in September. The $2 is the cash received from the sale of the option. The $5 is the result of the option being exercised. The investor has to buy the stock for $25 in September and sell it to the purchaser of the option for $20.

Problem 1.16.An investor writes a December put option with a strike price of $30. The price of the option is $4. Under what circumstances does the investor make a gain?

The investor makes a gain if the price of the stock is above $26 at the time of exercise. (This ignores the time value of money.)

Problem 1.17.The CME Group offers a futures contract on long-term Treasury bonds. Characterize the investors likely to use this contract.

Most investors will use the contract because they want to do one of the following:

a) Hedge an exposure to long-term interest rates.

b) Speculate on the future direction of long-term interest rates.

c) Arbitrage between the spot and futures markets for Treasury bonds.

Problem 1.18.An airline executive has argued: “There is no point in our using oil futures. There is just as much chance that the price of oil in the future will be less than the futures price as there is that it will be greater than this price.” Discuss the executive’s viewpoint.

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