Derivative Final Exam

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Chapter 1

1. A future contract is an agreement to buy or sell an asset at a certain time in the future for a certain price.

2. OTC market, over-the-counter is an important alternative to exchange. It is a telephone- and computer- linked network of dealers. A key advantage of thei over-the-counter market is that the terms of a contract do not have to be those specified by an exchange. A disadvantage is that there is usually some credit risk in an OTC trade.

3. A forward contract is similar to a future contracts in that it is an agreement to buy or sell an asset at a certain time in the future for a certain price. But, forward contracts trade in the OTC market.

4. Options are traded both on exchanges and in the OTC markets. There are two types of option: calls and puts. A call option gives the holder the right to buy an asset by a certain date for a certain price. A put option gives the holder the right to sell an asset by a certain date for a certain price. The price in the contract is known as the exercise price or the strike price; the date in the contract is known as the expiration date or the maturity date. A European option can be exercised only on the maturity date; an American option can be exercised at any time during its life.

5. Hedgers use futures, forwards, and options to reduce the risk that they face from potential future movements in a market variable.

6. Speculators use them to bet on the future direction of a market variable.

7. Arbitrageurs take offsetting positions in two or more instruments to lock in a profit.

Quiz problem

1.1 What is the difference between a long futures position and a short futures position?

A trader who enters into a long futures position is agreeing to buy the underlying asset for a certain price a t a certain time in the future.

A trader who enters into a short futures position is agreeing to sell the underlying asset for a certain price at a certain time in the future.

1.2 Explain carefully the difference between (a) hedging, (b) speculation, and (c) arbitrage.

A company is hedging when it has an exposure to the price of an asset and takes a position in futures or options markets to offset the exposure.

In a speculation the company has no exposure to offset. It 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.

1.3 What is the difference between (a) entering into a long futures contract when the futures price is $50 and (b) taking a long position in a call option with a strike price of $50?

In (a) the investor is obligated to buy the asset for $50 and does not have a choice. In (b) the investor has the option to buy the asset for $50 but does not have to exercise the option.

1.6 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 price of $30 costs $2.90. You have $5800 to invest. Identify two alternative strategies. Briefly outline the advantages and disadvantages of each.