CHAPTER 1 – INTRODUCTION (Question)

I. Short concept question

1.1. What is a derivative? Explain the two main ways that derivatives trade?
1.2. “Options and futures are zero-sum games.” What do you think is meant by this?
1.3. Which is bigger, the exchange-traded market or the OTC market?
1.4. Compare the difference between hedging, speculation, and arbitrage.
1.5. Explain the meaning of bid and ask quotes.
1.6. What is the difference between a long forward position and a short forward position?
1.7. How do (a) forward and (b) futures contracts trade?
1.8. Compare the difference between a forward contract to buy an asset and a call option to buy
the same asset.
1.9. Compare the difference between long a call option and short a put option.
1.10. Explain why a futures contract can be used for either speculation or hedging.
II. Practice questions
1.11. An investor enters into a short forward contract to sell 100,000 British pounds for U.S. dollars
at an exchange rate of 1.3000 USD per pound. How much does the investor gain or lose if the
exchange rate at the end of the contract is (a) 1.2900 and (b) 1.3200?
1.12.A trader enters into a short forward contract on 100 million yen. The forward exchange
rate is $0.0090 per yen. How much does the trader gain or lose if the exchange rate at the
end of the contract is (a) $0.0084 per yen and (b) $0.0101 per yen?
1.13. 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 and (b) 51.30
cents per pound?
1.14.Suppose that you write a put contract with a strike price of $40 and an expiration date in 3
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?
1.15.You would like to speculate on a rise in the price of a certain stock. The current stock price
is $29 and a 3-month call with a strike price of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative investment strategies, one in the stock and the other in an option on
the stock. What are the potential gains and losses from each strategy.
a. If the share price goes up to $40
b. If the share price goes down to $15
c. What is the stock price makes second strategy giving a better outcome at the maturity?
1.16.A speculator has two investment strategies, buying 100 shares of a stock for $50 per share
and buying 1000 European call options on the stock with a strike price of $55 for $5 per
option. What is the stock price makes second strategy giving a better outcome at the maturity?
1.17.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 illustrating how the profit from
a long position in the option depends on the stock price at maturity of the option.
1.18.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 the short position) make
a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating
how the profit from a short position in the option depends on the stock price at maturity of
the option.
1.19. A one-year call option on a stock with a strike price of $42 costs $3; a one-year put option
on the stock with a strike price of $42 costs $4. Suppose that a trader buys one call options
and one put option.
a. What is the profit/loss of the strategy if the share price is $50?
b. What is the breakeven stock price?
1.20. A one-year call option on a stock with a strike price of $90 costs $7; a one-year put option
on the stock with a strike price of $90 costs $8. Suppose that a trader buys three call options
and two put option.
a. What is the profit/loss of the strategy if the share price is $60?
b. What is the breakeven stock price?
1.21. A trader buys a call option with a strike price of $30 for $3. Under what circumstances will
the holder of the option make a profit? Under what circumstances will the option be
exercised? Draw a diagram illustrating how the profit from a long position in the option
depends on the stock price at maturity of the option. What is the trader’s maximum gain and
maximum loss? How does your answer change if it is a put option?
1.22. A trader sells a put option with a strike price of $40 for $5. Under what circumstances will
the holder of the option make a profit? Under what circumstances will the option be
exercised? Draw a diagram illustrating how the profit from a long position in the option
depends on the stock price at maturity of the option. What is the trader’s maximum gain and
maximum loss? How does your answer change if it is a call option?