Corporate Finance Module

Questions on Financial Options, Forwards, Futures

15-18. Suppose an investor buys a call option for a $1000 premium on a $100,000 August T-bill futures
contract with a strike price of 120,000. On the expiration date, the T-bill futures contract has a
price of 115,000. What is the individual likely to do?

a. He will buy the asset and make a profit of $5,000

b. He will not buy the asset and thus suffer no loss.
c. He will exercise the option but suffer a loss of $5,000.
d. He will not exercise the option but he will suffer a loss of $1,000.

d. He will not exercise the option but he will suffer a loss of $1,000. Recall the arbitrage will result in
the spot price equalling the futures contract price. So it will be cheaper for him to buy from the spot
market at a price of 115,000 and not exercise the option. But he would have paid $1,000 for the option
which is a loss.

15-20. Suppose a stock is currently trading at $100. There is a futures contract on this stock that matures
in six months. The annual risk-free rate (r) is 5% and the stock has an annual dividend yield (d)
of 1%. What is the price of the futures contract?

Answer: Price of the futures contract F should be

𝑭 = 𝑺(𝟏 + 𝒓 − 𝒅)𝑻 = 𝟏𝟎𝟎 × (𝟏 + 𝟎. 𝟎𝟓 − 𝟎. 𝟎𝟏)𝟎.𝟓 = 𝟏𝟎𝟏. 𝟗𝟖

Note that in the lecture slides the formula given uses the money market convention

F = S(1+(r-d)T) where T represents the fraction of a year

20-1. Explain the meanings of the following financial terms:

a. Option
b. Expiration date
c. Strike price
d. Call
e. Put
a. Option: An option is a contract that gives one party the right, but not the obligation, to buy or sell
an asset at some point in the future.
b. Expiration date: The last date on which the holder still has the right to exercise the option. If the
option is American, the right can be exercised until the exercise date; if it is European, the option
can be exercised only on the exercise date.
c. Strike price: the price at which the holder of the option has the right to buy or sell the asset.
d. Call: An option that gives its holder the right to buy an asset.
e. Put: An option that gives its holder the right to sell an asset.

20-2. What is the difference between a European option and an American option? Are European options
available exclusively in Europe and American options available exclusively in the United States?
 European options can be exercised only on the exercise date, while American options can be exercised
on any date prior to the exercise date. Both types of options are traded in both Europe and America.

20-5. Which of the following positions benefit if the stock price increases?
a. Long position in a call
b. Short position in a call
c. Long position in a put
d. Short position in a put
Long call and short put

20-6. You own a call option on Intuit stock with a strike price of $36. The option will expire in exactly
three months’ time.
a. If the stock is trading at $46 in three months, what will be the payoff of the call?
b. If the stock is trading at $32 in three months, what will be the payoff of the call?
c. Draw a payoff diagram showing the value of the call at expiration as a function of the stock
price at expiration.
Long call option: value at expiration:
a. payoff = $46 – $36 = $10
b. The option is out of the money. Thus, the payoff is $0.
c. Draw graph:

$36

20-7. Assume that you have shorted the call option in Problem 6.
a. If the stock is trading at $46 in three months, what will you owe?
b. If the stock is trading at $32 in three months, what will you owe?
c. Draw a payoff diagram showing the amount you owe at expiration as a function of the stock
price at expiration.
Short call: value at expiration date:
a. payoff = $46 – $36 = $10. Thus, you owe $10.
b. The option is out of the money. Thus, the payoff is $0 and you owe nothing.
c. Draw the payoff diagram:
 $36

20-8. You own a put option on Ford stock with a strike price of $8. The option will expire in exactly six
months’ time.
a. If the stock is trading at $2 in six months, what will be the payoff of the put?
b. If the stock is trading at $21 in six months, what will be the payoff of the put?
c. Draw a payoff diagram showing the value of the put at expiration as a function of the stock
price at expiration.
Long put value at expiration:
a. payoff = $8 – $2 = $6
b. The option is out of the money. Thus, the payoff is $0.
c. Draw payoff diagram:

$8

$8
20-12. You are long both a call and a put on the same share of stock with the same exercise date. The
exercise price of the call is $40 and the exercise price of the put is $45. Plot the value of this
combination as a function of the stock price on the exercise date.

20-14. A forward contract is a contract to purchase an asset at a fixed price on a particular date in the
future. Both parties are obligated to fulfill the contract. Explain how to construct a forward
contract on a share of stock from a position in options.
A forward with price p can be constructed by longing a call and shorting a put with strike p.

20-15. You own a share of Costco stock. You are worried that its price will fall and would like to insure
yourself against this possibility. How can you purchase insurance against this possibility?
To protect against a fall in the price of Costco, you can buy a put with Costco as the underlying asset.
By doing this, over the life of the option you are guaranteed to get at least the strike price from selling
the stock you already have.

20-23. You are watching the option quotes for your favorite stock, when suddenly there is a news
announcement. Explain what type of news would lead to the following effects:
a. Call prices increase, and put prices fall.
b. Call prices fall, and put prices increase.
c. Both call and put prices increase.
a. Good news about the stock, which raises its stock price
b. Bad news, which lowers the stock’s price
 c. News that increases the volatility of the stock

Supplementary question

Explain how the prices of futures contracts are determined.

A futures contract can be used to hedge changes in the value of the underlying asset. If the hedge is
perfect, meaning that the asset-plus-futures portfolio has no risk, then the hedged position must provide
a return equal to that on other risk-free investments. Otherwise, there will be arbitrage opportunities
that investors will exploit until prices are brought back into line. This insight can be used to derive the
theoretical relationship between a futures price and the price of its underlying asset.
Imagine you have a long position in stocks. Your exposure is therefore to any fall in that value between
now and the intended sale date. So, the hedge should be to sell short a futures contract so that any falls
in the cash portfolio will be offset by a profit on the short position in the future. Remember that the
profit from shorting a futures contract is the difference between the futures price F o and the price of the
stock at expiration ST. By definition ST = FT i.e. the spot and futures converge at expiration, so the
profit on the futures position is Fo - FT.
The return from this hedge is the difference between the cost of the original equity position -So and the
locked-in sale price Fo. plus dividends (assumed to be received at the expiration date) divided by the
original investment. For a perfect hedge we said this had to be equal to the risk-free rate Rf:

Rf = (Fo+ D – So) / So

Re-arranging, the futures price must be

Fo = So(1+ Rf) – D.

If we say that D is the product of the dividend yield y and the stock price, we can write:

Fo = So(1+ Rf – y).