Problem 1.5. An investor enters into a short forward contract to sell 100.

000 British pounds for US

dollars at an exchange rate of 1.4000 US dollars per pound. How much does the investor gain o r lose if
the exchange rate at the end of the contract is (a) 1.3900 and (b) 1.4200?

(a) The investor is obligated to sell pounds for 1.4000 when they are worth 1.3900. The gain is (1.4000-
1.3900) x100,000-$1,000.

(b) The investor is obligated to sell pounds for 1.4000 when they are worth 1.4200. The loss is (1.4200-
1.4000)×100,000 = $2,000

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 lase if the
cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30 cents per pound? (a) The
trader sells for 50 cents per pound something that is worth 48.20 cents per pound. Gain=(50.5000-
$0.4820) x 50,000-$900. (b) The trader sells for 50 cents per pound something that is worth 51.30 Loss
(50.5130-$0.5000) x 50,000 $650. 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? You have sold a put option. You have agreed
to buy 100 shares for $40 per share if the party on the other side of the contract chooses to exercise the
right to sell for this price. The option will be exercised only when the price of stock is below $40.
Suppose, for example, that the option is exercised when the price is $30. You have to buy at $40 shares
that are worth $30; you lose $10 per share, or $1,000 in total. If the option is exercised when the price is
$20, you lose $20 per share, or $2,000 in total. The worst that can happen is that the price of the stock
declines to almost zero during the three-month period. This highly unlikely event would cost you $4,000.
In return for the possible future losses, you receive the price of the option from the purchaser.

Problem 1.8. What is the difference between the over-the-counter market and the exchange-traded
market? What are the bid and offer quotes of a market maker in the over-the-counter market? The
over-the-counter market is a telephone- and computer-linked network of financial institutions, fund
managers, and corporate treasurers where two participants can enter into any mutually acceptable
contract. An exchange-traded market is a market organized by an exchange where traders either meet
physically or communicate electronically and the contracts that can be traded have been defined by the
exchange. When a market maker quotes a bid and an offer, the bid is the price at which the market
maker is prepared to buy and the offer is the price at which the market maker is prepared to sell.

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? One strategy would be to buy 200 shares.
Another would be to buy 2,000 options. If the share price does well the second strategy will give rise to
greater gains. For example, if the share price goes up to $40 you gain [2,000x ($40-$30)]-$5,800 =
$14,200 from the second strategy and only 200 × ($40-$29)=$2,200 from the first strategy. However, if
the share price does badly, the second strategy gives greater losses. For example, if the share price goes
down to $25, the first strategy leads to a loss of 200x (S29-$25)= $800, whereas the second strategy
leads to a loss of the whole $5,800 investment. This example shows that options contain built in
leverage.

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?
You could 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 be less than $25, you can
exercise the options and sell the shares for $25 cach.

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? The trader 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 1.18. A US company expects to have to pay 1 million Canadian dollars in six months. Explain
how the exchange rate risk can be hedged using (a) a forward contract; (b) an option The company could
enter into a long forward contract to buy 1 million Canadian dollars in six months. This would have the
effect of locking in an exchange rate equal to the current forward exchange rate. Altematively the
company could buy a call option giving it the right (but not the obligation) to purchase 1 million
Canadian dollars at a certain exchange rate in six months. This would provide insurance against a strong
Canadian dollar in six months while still allowing the company to benefit from a weak Canadian dollar at
that time.

Problem 1.21. "Options and futures are zero-sum games." What do you think is meant by this
statement? The statement means that the gain (loss) to the party with the short position is equal to the
loss (gain) to the party with the long position. In aggregate, the net gain to all parties is zero.

Problem 1.25.

a) In this scenario, an arbitrageur would purchase the 180-day European call option and sell spot to
purchase 180-day forward and sell it for a profit. The arbitrageur would buy 1 USD for $1.42 at a cost of
2 cents and sell it for $1.5518, the 180-day forward rate, earning a profit of 13 cents ($1.5518 - $1.42 =
$0.1318).

b) An arbitrageur would purchase a 90-day European put option and buy spot to purchase 90-day
forward and sell it for a profit. The arbitrageur would sell 1 USD for $1.49 at a cost of 2 cents and buy it
for $1.5556, the 90-day forward rate, earning a profit of 7 cents ($1.5556 - $1.49 = $0.0656).

Problem 1.26. A trader buys a call option with a strike price of $30 for $3. Does the trader ever exercise
the option and lose money on the trade. Explain. If the stock price is between $30 and $33 at option
maturity the trader will exercise the option, but lose money on the trade. Consider the situation where
the stock price is $31. If the trader exercises, she loses $2on the trade. If she does not exercise she loses
$3 on the trade. It is clearly better to exercise than not exercise.

Problem 1.27. A trader sells a put option with a strike price of $40 for $5. What is the trader's maximum
gain and maximum loss? How does your answer change if it is a call option? The trader’s maximum gain
from the put option is $5. The maximum loss is $35, corresponding to the situation where the option is
exercised and the price of the underlying asset is zero. If the option were a call, the trader’s maximum
gain would still be $5, but there would be no bound to the loss as there is in theory no limit to how high
the asset price could rise.

Problem 1.28. ``Buying a put option on a stock when the stock is owned is a form of insurance.'' Explain
this statement.If the stock price declines below the strike price of the put option, the stock can be sold
for the strike price. Purchasing a put option provides a hedge against the risk of the depreciation of the
asset value in the future.

Problem 1.29. On May 8, 2013, as indicated in Table 1.2, the spot offer price of Google stock is $871.37
and the offer price of a call option with a strike price of $880 and a maturity date of September is
$41.60. A trader is considering two alternatives: buy 100 shares of the stock and buy 100 September call
options. For each alternative, what is (a) the upfront cost, (b) the total gain if the stock price in
September is $950, and (c) the total loss if the stock price in September is $800. Assume that the option
is not exercised before September and if stock is purchased it is sold in September. a) The upfront cost
for the stock alternative is $87,137. The upfront cost for the option alternative is $4,160.b) The gain
from the stock alternative is $95,000−$87,137=$7,863. The total gain from the option alternative is
($950-$880)×100−$4,160=$2,840. c) The loss from the stock alternative is $87,137−$80,000=$7,137. The
loss from the option alternative is $4,160.

Problem 1.30. What is arbitrage? Explain the arbitrage opportunity when the price of a dually listed
mining company stock is $50 (USD) on the New York Stock Exchange and $52 (CAD) on the Toronto
Stock Exchange. Assume that the exchange rate is such that 1 USD equals 1.01 CAD. Explain what is
likely to happen to pricesas traders take advantage of this opportunity. Arbitrage involves carrying out
two or more different trades to lock in a profit. In this case, traders can buy shares on the NYSE and sell
them on the TSX to lock in a USD profit of 52/1.01 − 50=1.485 per share. As theydo this the NYSE price
will rise and the TSX price will fall so that the arbitrage opportunity disappears

Problem 1.31 (Excel file) Trader A enters into a forward contract to buy an asset for $1000 in one year.
Trader B buys a call option to buy the asset for $1000 in one year. The cost of the option is $100. What is
thedifference between the positions of the traders? Show the profit as a function of the price of the
asset in oneyear for the two traders. Trader A makes a profit of S T 1000 and Trader B makes a profit
of max ( S T 1000, 0) –100 where S T is the price of the asset in one year. Trader A does better if S T is
above $900 as indicated in Figure S1.4

Problem 1.33. A US company knows it will have to pay 3 million euros in three months. The current
exchange rate is 1.3500 dollars per euro. Discuss how forward and options contracts can be used by the
company to hedge its exposure. The company could enter into a forward contract obligating it to buy 3
million euros in three months for a fixed price (the forward price). The forward price will be close to but
not exactly the same as the current spot price of 1.3500. An alternative would be to buy a call option
giving the company the right but not the obligation to buy 3 million euros for a particular exchange rate
(the strike price) in three months. The use of a forward contract locks in, at no cost, the exchange rate
that will apply in three months. The use of a call option provides, at a cost, insurance against the
exchange rate being higher than the strike price.

Problem 1.34. (Excel file) A stock price is $29. An investor buys one call option contract on the stock with
a strike price of $30 and sells a call option contract on the stock with a strike price of $32.50. The market
prices of the options are $2.75 and $1.50, respectively. The options have the same maturity date.
Describe the investor's position. This is known as a bull spread (see Chapter 12). The profit is shown in
Figure S1.5.

CHAPTER 2 Mechanics of Futures Markets

Problem 2.1. Distinguish between the terms open interest and trading volume. The open interest of a
futures contract at a particular time is the total number of long positions outstanding. (Equivalently, it is
the total number of short positions outstanding.) The trading volume during a certain period of time is
the number of contracts traded during this period.

Problem 2.2. What is the difference between a local and a futures commission merchant? A futures
commission merchant trades on behalf of a client and charges a commission, A local trades on his or her
own behalf.

Problem 2.3. Suppose that you enter into a short futures contract to sell July silver for $17.20 per ounce.
The size of the contruct is 5.000 ounces. The initial margin is $4,000, and the maintenance margin is
$3,000. What change in the futures price will lead to a margin call? What happens if you do not meet
the margin call? There will be a margin call when $1,000 has been lost from the margin account. This will
occur when the price of silver increases by 1,000/5.000 = $0.20. The price of silver must therefore rise to
$17.40 per ounce for there to be a margin call. If the margin call is not met, your broker closes out your
position.

Problem 2.4. Suppose that in September 2012 a company takes a long position in a contract on May
2013 crude oil futures. It closes out its position in March 2013. The futures price (per barrel) is $68.30
when it enters into the contract, $70.50 when it closes out its position, and $69.10 at the end of
December 2012. One contract is for the delivery of 1.000 barrels. What is the company's total profit?
When is it realzed? How is it taxed if it is (a) a hedger and (b) a speculator? Assume that the company
has a December 31 year-end The total profit is (570.50 $68.30) 1,000 $2,200. Of this (569.10-
568.30)×1,000 or $800 is realized on a day-by-day basis between September 2012 and December 31,
2012. A further ($70.50-$69.10)x1,000 $1,400 is realized on a day-by-day basis between January 1,2013,
and March 2013. A hedger would be taxed on the whole profit of $2,200 in 2013. A speculator would be
taxed on $800 in 2012 and $1,400 in 2013.

Problem 2.5. What does a stop order to sell at $2 mean? When might it be used? What does a limit
order to sell at $2 mean? When might it be used? A stop order to sell at $2 is an order to sell at the best
available price once a price of $2 or less is reached. It could be used to limit the losses from an existing
long position. A limit order to sell at $2 is an order to sell at a price of $2 or more. It could be used to
instruct a broker that a short position should be taken, providing it can be done at a price more
favorable than $2.

Problem 2.8. The party with a short position in a futures contract sometimes has options as to the
precise asset that will be delivered, where delivery will take place, when delivery will take place, and so
on. Do these options increase or decrease the futures price? Explain your reasoning. These o ptions
make the contract less attractive to the party with the long position and more attractive to the party
with the short position. They therefore tend to reduce the futures price.
Problem 2.9. What are the most important aspects of the design of a new futures contract? The most
important aspects of the design of a new futures contract are the specification of the underlying asset,
the size of the contract, the delivery arrangements, and the delivery months.

Problem 2.10. Explain how margins protect investors against the possibility of default A margin is a sum
of money deposited by an investor with his or her broker. It acts as a guarantee that the investor can
cover any losses on the futures contract. The balance in the margin account is adjusted daily to reflect
gains and losses on the futures contract. If losses are above a certain level, the investor is required to
deposit a further margin. This system makes it unlikely that the investor will default. A similar system of
margins makes it unlikely that the investor's broker will default on the contract it has with the clearing
house member and unlikely that the clearing house member will default with the clearing house.

Problem 2.11. A trader buys two July futures contracts on frozen orange juice. Each contract is for the
delivery of 15.000 pounds. The current futures price is 160 cents per pound, the initial margin is $6,000
per contract, and the maintenance margin is $4,500 per contract. What price change would lead to a
margin call? Under what circumstances could $2,000 be withdrawn from the margin account? There is a
margin call if more than $1,500 is lost on one contract. This happens if the futures price of frozen orange
juice falls by more than 10 cents to below 150 cents per pound. $2,000 can be withdrawn from the
margin account if there is a gain on one contract of $1,000. This will happen if the futures price rises by
6.67 cents to 166.67 cents per pound.

Problem 2.14. Explain what a stop-limit order to sell at 20.30 with a limit of 20.10 means. A stop-limit
order to sell at 20.30 with a limit of 20.10 means that as soon as there is a bid at 20.30 the contract
should be sold providing this can be done at 20.10 or a higher price.

Problem 2.15. At the end of one day a clearing house member is long 100 contracts, and the settlement
price is $50,000 per contract. The original margin is $2,000 per contract. On the following day the
member becomes responsible for clearing an additional 20 long contracts, entered into ut a price of
$51,000 per contract. The settlement price at the end of this day is $50.200. How much does the
member have to add to its margin account with the exchange clearing house? The clearing house
member is required to provide 20x $2,000-$40,000 as initial margin for the new contracts. There is a
gain of (50,200 50,000) 100-$20,000 on the existing contracts. There is also a loss of (51,000-50,200)x20-
$16,000 on the new contracts. The member must therefore add to the margin account 40,000-
20,000+16,000-$36,000

Problem 2.19. "Speculation in futures markets is pure gambling. It is not in the public interest to allow
speculators to trade on a futures exchange." Discuss this viewpoint. Speculators are important market
participants because they add liquidity to the market. However, contracts must be useful for hedging as
well as speculation. This is because regulators generally only approve contracts when they are likely to
be of interest to hedgers as well as speculators.

Problem 2.23. Suppose that on October 24, 2012, a company sells one April 2013 live-cattle futures
contracts. It closes out its position on January 21, 2013. The futures price (per pound) is 91.20 cents
when it enters into the contract, 88.30 cents when it closes out its position, and 88.80 cents at the end
of December 2012. One contract is for the delivery of 40,000 pounds of cattle. What is the total profit?
How is it taxed if the company is (a) a hedger and (b) a speculator? Assume that the company has a
December 31 year end. The total profit is 40,000 (0.9120-0.8830)=$1,160 If the company is a hedger this
is all taxed in 2013. If it is a speculator 40,000x (0.9120-0.8880)=$960 is taxed in 2012 and 40,000x
(0.8880-0.8830) $200 is taxed in 2013.

Problem 3.1. Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? A short
hedge is appropriate when a company owns an asset and expects to sell that asset in the future. It can
also be used when the company does not currently own the asset but expects to do so at some time in
the future. A long hedge is appropriate when a company knows it will have to purchase an asset in the
future. It can also be used to offset the risk from an existing short position.

Problem 3.2. Explain what is meant by basis risk when futures contracts are used for hedging. Basis risk
arises from the hedger's uncertainty as to the difference between the spot price and futures price at the
expiration of the hedge.

Problem 3.6. Suppose that the standard deviation of quarterly changes in the prices of a commodity is
$0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the
coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a three-
month contract? What does it mean? The optimal hedge ratio is 0.65 0.8x- =0.642 0.81 This means that
the size of the futures position should be 64.2% of the size of the company's exposure in a three-month
hedge.

Problem 3.7. A company has a $20 million portfolio with a beta of 1.2. It would like to use futures
contracts on the S&P 500 to hedge its risk. The index futures is currently standing at 1080. and each
contract is for delivery of $250 times the index. What is the hedge that minimizes risk? What should the
company do if it wants to reduce the beta of the portfolio to 0.6? The formula for the number of
contracts that should be shorted gives 1.2x20,000,000 1080×250 88.9 Rounding to the nearest whole
number, 89 contracts should be shorted. To reduce the beta to 0.6, half of this position, or a short
position in 44 contracts, is required.

Problem 3.10. Explain why a short hedger's position improves when the basis strengthens unexpectedly
and worsens when the basis weakens unexpectedly. The basis is the amount by which the spot price
exceeds the futures price. A short hedger is 17 C2012 Pearson Education long the asset and short
futures contracts. The value of his or her position therefore improves as the basis increases. Similarly, it
worsens as the basis decreases.

Problem 3.16. The standard deviation of monthly changes in the spot price of live cattle is (in cents per
pound) 1.2. The standard deviation of monthly changes in the futures price of live cattle for the closest
contract is 1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is
now October 15. A beef producer is committed to purchasing 200,000 pounds of live cattle on
November 15. The producer wants to use the December live- cattle futures contracts to hedge its risk.
Each contract is for the delivery of 40.000 pounds of cattle. What strategy should the beef producer
follow? The optimal hedge ratio is 0.7x- 1.2 1.4 =0.6 The beef producer requires a long position in
200000×0.6 120,000 lbs of cattle. The beef producer should therefore take a long position in 3
December contracts closing out the position on November 15.

Problem 3.18. On July 1, an investor holds 50.000 shares of a certain stock. The market price is $30 per
share. The investor is interested in hedging against movements in the market over the next month and
decides to use the September Mini S&P 500 futures contract. The index is currently 1,500 and one
contract is for delivery of $50 times the index. The beta of the stock is 1.3. What strategy should the
investor follow? Under what circumstances will it be profitable? A short position in 1.3x- 50,000x30
50x1500 =26 contracts is required. It will be profitable if the stock outperforms the market in the sense
that its return is greater than that predicted by the capital asset pricing model.

Problem 4.1. A bank quotes you an interest rate of 14% per annum with quarterly compounding. What is
the equivalent rate with (a) continuous compounding and (b) annual compounding? (a) The rate with
continuous compounding is 4In (1+0.14)=0.1376 or 13.76% per annum. (b) The rate with annual
compounding is -1-0.1475 or 14.75% per annum.

Problem 4.2. What is meant by LIBOR and LIBID. Which is higher? LIBOR is the London InterBank
Offered Rate. It is calculated daily by the British Bankers Association and is the rate a AA-rated bank
requires on deposits it places with other banks. LIBID is the London InterBank Bid rate. It is the rate a
bank is prepared to pay on deposits from other AA-rated banks. LIBOR is greater than LIBID.

Problem 4.3. The six-month and one-year zero rates are both 10% per annum. For a bond that has a life
of 18 months and pays a coupon of 8% per annum (with semiannual payments and one having just been
made), the yield is 10.4% per annum. What is the bond's price? What is the 18- month zero rate? All
rates are quoted with semiannual compounding. Suppose the bond has a face value of $100. Its price is
obtained by discounting the cash flows at 10.4%. The price is 104 1.052 1.052 1.052 =96.74 If the 18-
month zero rate is . we must have 4 4 104 1.05 1.05 (1+R/2) = 96.74 which gives R-10.42%

Problem 4.4. An investor receives $1,100 in one year in return for an investment of $1,000 now
Calculate the percentage return per annum with a) anual compounding, b) semiannual compounding e
monthly compounding and d) continuous compound ing (a) With annual compounding the retum is