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Chapter 1 - Practice Questions

This document contains practice problems related to options and futures contracts. The problems cover topics such as the differences between forward contracts and call options, selling calls versus buying puts, calculating gains and losses on short futures positions, using options to provide downside protection on stock holdings, and determining profitability of long and short option positions based on the underlying stock price at expiration. Strategies like using options versus direct stock purchases to speculate on price movements are also discussed.

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Siddhant Aggarwal
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427 views

Chapter 1 - Practice Questions

This document contains practice problems related to options and futures contracts. The problems cover topics such as the differences between forward contracts and call options, selling calls versus buying puts, calculating gains and losses on short futures positions, using options to provide downside protection on stock holdings, and determining profitability of long and short option positions based on the underlying stock price at expiration. Strategies like using options versus direct stock purchases to speculate on price movements are also discussed.

Uploaded by

Siddhant Aggarwal
Copyright
© © All Rights Reserved
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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CHAPTER 1

Introduction

Practice Questions

Problem 1.3.
What is the difference between entering into a long forward contract when the forward price
is $50 and taking a long position in a call option with a strike price of $50?

Problem 1.4.
Explain carefully the difference between selling a call option and buying a put option.

Problem 1.6.
A trader enters into a short cotton futures contract when the futures price is 50 cents per
pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or
lose if the cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30 cents
per pound?

Problem 1.7.
Suppose that you write a put contract with a strike price of $40 and an expiration date in
three months. The current stock price is $41 and the contract is on 100 shares. What have
you committed yourself to? How much could you gain or lose?

Problem 1.9.
You would like to speculate on a rise in the price of a certain stock. The current stock price is
$29, and a three-month call with a strike of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative strategies, one involving an investment in the stock and the other
involving investment in the option. What are the potential gains and losses from each?

(Calculate what happens when share price goes up to $40 vs it goes down to $25)

Problem 1.10.
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?

Problem 1.13.
Suppose that a March call option to buy a share for $50 costs $2.50 and is held until March.
Under what circumstances will the holder of the option make a profit? 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.
Problem 1.14.
Suppose that a June put option to sell a share for $60 costs $4 and is held until June. Under
what circumstances will the seller of the option (i.e., the party with a short position) make a
profit? Under what circumstances will the option be exercised? Draw a diagram showing
how the profit from a short position in the option depends on the stock price at the maturity
of the option.

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.

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

Problem 1.17.
A company knows that it is due to receive a certain amount of a foreign currency in four
months. What type of option contract is appropriate for hedging?

Problem 1.21.
“Options and futures are zero-sum games.” What do you think is meant by this statement?

Problem 1.26
Trader A enters into a forward contract to buy gold for $1000 an ounce in one year. Trader
B buys a call option to buy gold for $1000 an ounce in one year. The cost of the option is
$100 an ounce. What is the difference between the positions of the traders?

Problem 1.27
In March, a US investor instructs a broker to sell one July put option contract on a stock.
The stock price is $42 and the strike price is $40. The option price is $3. Explain what the
investor has agreed to. Under what circumstances will the trade prove to be profitable?
What are the risks?

Problem 1.30
The price of gold is currently $1,000 per ounce. The forward price for delivery in one year is
$1,200. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur
do? Assume that the cost of storing gold is zero and that gold provides no income.

Problem 1.31.
The current price of a stock is $94, and three-month call options with a strike price of $95
currently sell for $4.70. An investor who feels that the price of the stock will increase is
trying to decide between buying 100 shares and buying 2,000 call options (20 contracts).
Both strategies involve an investment of $9,400. What advice would you give? How high does
the stock price have to rise for the option strategy to be more profitable?

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