Chapter 1 Concepts
A company knows that it is due to receive a certain amount of a foreign currency in four months. What type of option contract is appropriate for hedging?
A long position in a four-month put option on the foreign currency can provide insurance against the exchange rate falling below the strike price. It ensures that the foreign currency can be sold for at least the strike price.
Explain carefully the difference between hedging, speculation, and arbitrage.
A trader is hedging when she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is betting on the future movements in the price of the asset. Arbitrage involves taking a position in two or more different markets to lock in a profit.
When first issued, a stock provides funds for a company. Is the same true of an exchange-traded stock option? Discuss.
An exchange-traded stock option provides no funds for the company. It is a security sold by one investor to another. The company is not involved. By contrast, a stock when it is first issued is sold by the company to investors and does provide funds for the company.
Explain why a futures contract can be used for either speculation or hedging.
If a trader has an exposure to the price of an asset, he or she can hedge with futures contracts. If the trader will gain when the price decreases and lose when the price increases, a long futures position will hedge the risk. If the trader will lose when the price decreases and gain when the price increases, a short futures position will hedge the risk. Thus either a long or a short futures position can be entered into for hedging purposes. If the trader has no exposure to the price of the underlying asset, entering into a futures contract is speculation. If the trader takes a long position, he or she gains when the asset's price increases and loses when it decreases. If the trader takes a short position, he or she loses when the asset's price increases and gains when it decreases.
What is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price of $50?
In the first case the trader is obligated to buy the asset for $50. (The trader does not have a choice.) In the second case the trader has an option to buy the asset for $50. (The trader does not have to exercise the option.)
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 from the second strategy and only 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 whereas the second strategy leads to a loss of the whole $5,800 investment. This example shows that options contain built in leverage.
Explain carefully the difference between selling a call option and buying a put option.
Selling a call option involves giving someone else the right to buy an asset from you. Buying a put option involves buying an option from someone else
A U.S. 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 and (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. Alternatively 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.
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 or exchange-traded market?
The over-the-counter market is a network of financial institutions, fund managers, and corporate treasurers who trade directly with each other. An exchange-traded market is a market organized by an exchange where 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.
"Options and futures are zero-sum games." What do you think is meant by this statement?
The statement means that the gain (loss) to one side equals the loss (gain) to the other side. In aggregate, the net gain to the two parties is zero.
What is the difference between a long forward position and a short forward position?
When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the underlying asset for a certain price at a certain time in the future.
