Solution of Week6

puzzle 1. 7. speak out that you write a put squelch with a strike equipment casualty of $40 and an expiration date in troika months. The current expect exp hold backiture is $41 and the contract is on 100 sh ars. What create you committed yourself to? How much could you substantiate or lose? You have sold a put plectron. You have agreed to bargain for 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 charge. The natural selection will be exercised only when the harm of received is below $40. Suppose, for example, that the option is exercised when the hurt 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 disregard conk is that the price of the stock declines to almost zero during the three-month period. This highly unlikely event would co st you $4,000. In return for the possible forthcoming losses, you receive the price of the option from the purchaser. difficulty 1. 21. Options and futures are zero-sum games. What do you think is meant by this logical argument?The statement means that the gain (loss) to the party with the short moorage is equal to the loss (gain) to the party with the long position. In aggregate, the net gain to all parties is zero. caper 1. 30 The price of gold is currently $1,000 per troy ounce. The forward price for deliverance in wholeness year is $1,200. An arbitrageur can seize m unityy at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. The arbitrageur should borrow money to buy a certain number of ounces of gold today and short forward contracts on the same number of ounces of gold for delivery in one year.This means that gold is purchased for $1000 per ounce and sold for $1200 per ounce. Assuming the cos t of borrowed funds is less than 20% per annum this generates a riskless improvement. 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 contract is 5,000 ounces. The initial brim is $4,000, and the maintenance allowance account is $3,000. What change in the futures price will lead to a allowance account call? What happens if you do non meet the marge call? There will be a margin call when $1,000 has been woolly-headed 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. 10. apologise how margins protect investors against the possibility of default. A margin is a sum of money busheled by an investor with his or her broker. It acts as a guarantee that the investor can cover any losses o n the futures contract. The balance in the margin account is adjusted occasional 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 investors broker will default on the contract it has with the unclutter 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 set 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 pr ice 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. 21. What do you think would happen if an exchange started trading a contract in which the quality of the be summation was in only specified?The contract would not be a success. Parties with short positions would hold their contracts until delivery and then deliver the cheapest form of the asset. This might well be viewed by the party with the long position as garbage Once news of the quality problem became widely known no one would be prepared to buy the contract. This shows that futures contracts are feasible only when there are rigorous standards in spite of appearance an industry for defining the quality of the asset. Many futures contracts have in practice failed because of the problem of defining qualit y. Problem 2. 6 Trader A enters into futures contracts to buy 1 million euros for 1. 4 million dollars in three months. Trader B enters in a forward contract to do the same thing. The exchange (dollars per euro) declines astutely during the first two months and then increases for the third month to close at 1. 4300. Ignoring daily settlement, what is the total pelf of each trader? When the impact of daily settlement is taken into account, which trader does go bad? The total lettuce of each trader in dollars is 0. 03? 1,000,000 = 30,000. Trader Bs profit is realized at the end of the three months.Trader As profit is realized day-by-day during the three months. Substantial losses are do during the first two months and profits are made during the final month. It is likely that Trader B has through better because Trader A had to finance its losses during the first two months. Problem 2. 29. A community enters into a short futures contract to sell 5,000 bushels of wheat for 450 cen ts per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account?There is a margin call if $1000 is lost on the contract. This will happen if the price of wheat futures rises by 20 cents from 450 cents to 470 cents per bushel. $1500 can be withdrawn if the futures price falls by 30 cents to 420 cents per bushel. Problem 2. 30. Suppose that there are no storage costs for crude anoint and the interest rate for adoption or lending is 5% per annum. How could you make money on may 26, 2010 by trading July 2010 and December 2010 contracts on crude oil? Use Table 2. 2. The July 2010 settlement price for oil is $71. 51 per barrel. The December 2010 settlement price for oil is $75. 3 per barrel. You could go long one July 2010 oil contract and short one December 2010 contract. In July 2010 you take delivery of the oil borrowing $71. 51 per barrel at 5% to meet cash outflows. The interest accumulated in fivesome months is about 71. 51? 0. 05? 5/12 or $1. 49. In December the oil is sold for $75. 23 per barrel which is more than the amount that has to be repaid on the loan. The strategy therefore leads to a profit. Note that this profit is independent of the actual price of oil in June 2010 or December 2010. It will be some affected by the daily settlement procedures. Problem 3. 1.Under what circumstances are (a) a short confuse and (b) a long hedge appropriate? A short hedge is appropriate when a guild owns an asset and expects to sell that asset in the future. It can also be used when the smart set 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. 3. Explain what is meant by a correct hedge. Does a perfect hedge alwa ys lead to a better outcome than an imperfect hedge?Explain your answer. A perfect hedge is one that completely eliminates the hedgers risk. A perfect hedge does not always lead to a better outcome than an imperfect hedge. It just leads to a more certain outcome. Consider a company that hedges its film to the price of an asset. Suppose the assets price movements prove to be favorable to the company. A perfect hedge totally neutralizes the companys gain from these favorable price movements. An imperfect hedge, which only partially neutralizes the gains, might well give a better outcome. Problem 3. 5.Give three reasons why the treasurer of a company might not hedge the companys exposure to a particular risk. Explain your answer. (a) If the companys competitors are not hedging, the treasurer might feel that the company will find less risk if it does not hedge. (See Table 3. 1. ) (b) The shareholders might not want the company to hedge because the risks are hedged within their portfol ios. (c) If there is a loss on the hedge and a gain from the companys exposure to the underlying asset, the treasurer might feel that he or she will have difficulty justifying the hedging to other executives within the organization.Problem 3. 17. A corn granger argues I do not use futures contracts for hedging. My real risk is not the price of corn. It is that my whole crop gets wiped out by the weather. question this viewpoint. Should the farmer estimate his or her expected production of corn and hedge to try to lock in a price for expected production? If weather creates a significant uncertainty about the glitz of corn that will be harvested, the farmer should not enter into short forward contracts to hedge the price risk on his or her expected production. The reason is as follows.Suppose that the weather is bad and the farmers production is lower than expected. Other farmers are likely to have been affected similarly. Corn production boilers suit will be low and as a conseque nce the price of corn will be relatively high. The farmers problems arising from the bad harvest will be made worse by losses on the short futures position. This problem emphasizes the importance of looking at the big picture when hedging. The farmer is correct to question whether hedging price risk while ignoring other risks is a good strategy.