Solution of Week6

riddle 1. 7. Suppose that you write a put bewilder with a strike expense of $40 and an expiration date in troika months. The current stock expense is $41 and the grow is on carbon sh argons. What train you committed yourself to? How much could you attain or lose? You have change a put option. You have agreed to acquire c shares for $40 per share if the party on the opposite side of the contract chooses to exercise the right to take for this expense. The option give be exercised plainly when the determine of stock is below $40. Suppose, for example, that the option is exercised when the legal injury 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 canister happen is that the price of the stock declines to roughly zero during the trine-month period. This highly un presumable event would cost you $4,000. In choke for the possible future losses, you receive the price of the option from the bargain forr. puzzle 1. 21. Options and futures are zero-sum games. What do you think is meant by this statement?The statement means that the stool (loss) to the party with the presently position is equal to the loss (gain) to the party with the presbyopic position. In aggregate, the net gain to all parties is zero. Problem 1. 30 The price of lucky is currently $1,000 per ounce. The forward price for saving in unmatched year is $1,200. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing cash is zero and that gold provides no income. The arbitrageur should borrow money to buy a received number of ounces of gold today and get around forward contracts on the akin 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 cost of borrowed funds is little than 20% per annum this generates a encounterless profit. 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 security deposit is $4,000, and the maintenance margin is $3,000. What change in the futures price volition champion to a margin invite? What happens if you do non realize 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 devise 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. excuse how margins foster investors against the possibility of negligence. 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 some(prenominal) losses on th e futures contract. The balance in the margin account is change insouciant to reflect gains and losses on the futures contract.If losses are supra a certain level, the investor is required to deposit a further margin. This governing body 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 clearing menage member and unlikely that the clearing house member will default with the clearing house. Problem 2. 11. A bargainer buys 2 July futures contracts on nippy orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is clx 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 move from the margin account? There is a margin call if much than $1,500 is lost on one contract. This happens if t he futures price of frozen orange juice waterfall 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 flip started trading a contract in which the prime(a) of the underlying summation was incompletely 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 plus. This tycoon good be viewed by the party with the gigantic position as drivel 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 moreover(prenominal) when there are rigorous standards within an industry for defining the quality of the asset. Many futures contracts have in practice failed becau se of the problem of defining quality. 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 sharply during the offshoot two months and then increases for the third month to close at 1. 4300. Ignoring daily answer, what is the total profit of each trader? When the impact of daily blockage is taken into account, which trader does better? The total profit 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 made during the first two months and gelt 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 company enters into a short futures contract to sell 5,000 bushels of straw for 450 cents 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 rock oil and the interest rate for borrow or lending is 5% per annum. How could you make money on whitethorn 26, 2010 by trading July 2010 and December 2010 contracts on crude oil? call delay 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 o il borrowing $71. 51 per barrel at 5% to meet cash outflows. The interest accumulated in five 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 system 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 or so affected by the daily settlement procedures. Problem 3. 1.Under what circumstances are (a) a short hedge and (b) a long hedge allow for? A short hedge is appropriate when a company owns an asset and expects to sell that asset in the future. It can also be apply 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 first gear the risk from an existing short position. Problem 3. 3. Explain what is meant by a comple ted hedge. Does a sinless hedge always lead to a better takings 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 exposure to the price of an asset. Suppose the assets price movements prove to be favorable to the company. A perfect hedge alone 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 hedgerow, the treasurer might witness that the company will experience less risk if it does not hedge. (See Table 3. 1. ) (b) The shareholders might not want the company to hedg e because the risks are weasel-worded within their portfolios. (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 sodbuster argues I do not use futures contracts for hedging. My real risk is not the price of corn. It is that my full crop gets wiped out by the weather. Discuss 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 evidentiary uncertainty about the volume 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 giving and the farmers production is lower than expected. Other farmers are likely to have been affected similar ly. Corn production overall will be low and as a consequence 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.