NAME: ___________________________________

ACE 428 Commodity Futures & Options

Fall 2013
ANSWER KEY FOR Exam #2, Versions A/C/E 120 Points Possible
There are 12 (twelve) pages in this exam make sure you have all the pages before you begin.

Write your name at the top of this page

Write your answers in the spaces provided below each question.
If you need additional room for calculations or other work, you can use the back side of these
pages.
Feel free to draw pictures or diagrams to help explain or think about your answers.
If you take apart this exam booklet, be sure to re-assemble and staple it with the pages in the
correct order when you submit your completed exam.
*

Short Answer Questions (17 points total)

Please answer the following questions clearly and concisely. A word or phrase is OK if that is
all it takes to answer the question. If you provide a longer answer, only the first 2 sentences of
your answer for each part of the question will be graded.
QUESTION 1 (3 points)
Name 3 of the 4 components of time value.
ANY 3 of the following:
Time to expiration
Volatility
Distance between strike price and market price
Interest rates

QUESTION 2 (1 point)
What is the maximum profit on any short option position?
Premium (received at the beginning)

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QUESTION 3 (1 point)
What is the maximum profit on any long option position?
Option ITM; change in premium between purchase and sale/exercise/expiration
OR
Option ITM; gain in intrinsic value minus loss of time value
OR
Unlimited for long call; finite for long put because futures price cant go below zero
(may be other correct answers)

QUESTION 4 (1 point)
As the market price moves closer to the strike price of an in-the-money option, what happens to
the premium (all other things constant)?
Premium decreases (because option is moving out of the money)

QUESTION 5 (1 point)
What would be an appropriate trading strategy if you expect volatility to decrease?
Anything short volatility (short premium) short put, short call, etc.
Short straddle
Short strangle

QUESTION 6 (1 point)
Suppose that the futures price closed limit-down, but at the close of trading the premium for a
$150 put is $4.62 and the premium for a $150 call is $4.42. If there had not been any daily price
limits, what would have been the underlying futures price?
Futures price = Call premium Put premium + Strike
= $4.42 $4.62 + $150 = $0.20 + $150 = $149.80

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QUESTION 7 (4 points)
Name 4 ways that swaps differed from futures prior to Dodd-Frank.
ANY 4 of the following:
OTC, not exchange traded
Customized, not standardized
Always cash settled, not physically
delivered
No regular settlements or mark-tomarket
No margins or margin calls

Not fungible
Not regulated
No price transparency
No netting out of positions
No clearing house or recording agency
(may be other correct answers)

QUESTION 8 (4 points)
Suppose that a put option has a delta of -.678. Use this information to answer the following 4
questions:
a) What is the probability that the option will expire worthless?
.322 = 1 ABS(-.678)

b) If the underlying futures price changes by $1.00, how much would the put premium change?
$.678 = .678 x $1.00

c) If you use these put options in a hedge that requires 500 short futures contracts, how many
options would you need to buy (rounded to the nearest whole option contract)?
737 = 500 (.678)

d) What is the delta of a call option with the same strike price as this put option?
+.322 = 1 ABS (-.678)

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QUESTION 9 (1 point)
Suppose that the Federal Reserve announces a change in policy that will allow interest rates to
rise. What will this do to option premiums?
Decrease option premiums (inverse relationship)

PROBLEM 1 (46 points)

Note: This is a two-part problem. Both parts use the information provided in the box
below. However, the answers for Part A do not depend on the answers for Part B and the
answers for Part B do not depend on the answers for Part B.
Suppose you are a candy manufacturer and need to manage the price you pay for sugar, which is
an important ingredient and your biggest expense. Your board of directors wont let you go
unhedged, so you always have used futures contracts for your hedges. Last winter you learned
that there is a worldwide oversupply of sugar, and because this oversupply could drive down the
price of sugar you decide that hedging with options instead of futures might be a good idea.
Since this is your first time using options, you decide to run an experiment and try several
different hedging strategies. You run this experiment for 8 months, from February 1 to October
1, using October futures and options contracts.
You use a standard futures hedge as the experiments control or benchmark against which all
option hedging result will be compared. Your basis is zero, and between February 1 and
October 1 prices fell from 23 cents to 17 cents. Here are your futures hedging results:
Date

Cash

Futures

Basis

Feb

[Short at 20 cents]

Long October at 20 cents

$0

Oct

Long at 17 cents

Short October at 17 cents

$0

-3 cents

$0

Gain/Loss

+3 cents

Net Price Paid for Sugar = 20 cents

Two of the option hedges you use in your experiment are an at-the-money put option and an atthe-money call option, each with a 20-cent strike price.
* * * * *

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A. Construct a hedge using an October 20-cent put option. The premium in February is 1.55
cents and the premium in October is 3.15 cents. (4 points)
Date

Cash
Long or Short? Price?

October 20-cent Put

Long or Short?
Premium?

Feb

[Short at 20 cents]

___ Short___ Put at 1.55 cents

Oct

Long at 17 cents

___ Long___ Put at 3.15 cents

Gain/Loss

+3.00 cents

-1.60 cents

Net Price Paid for Sugar = 18.60 cents = 17 cents cash + 1.60 cents option loss
(show your work)
1) Calculate the difference between the net price paid for sugar with the put option hedge
and the net price paid for sugar with the futures hedge (Hint: See the information in the
box above), and write that difference in the space below. Compared with the futures
hedge, did the put option hedge make you better off or worse off? What type of cash
price trend would have caused the put option hedge to give its best results? (3 points)
1.40 cents = 20 cents with futures hedge 18.60 cents with put option hedge
Better off (by 1.40 cents)
Stable or Rising prices (put option would have expired worthless and seller would
have kept the full premium)

2) You also are interested in knowing the sensitivity of your put option hedging results to
changing sugar prices. Looking back, if the board of directors had allowed you to go
unhedged you would have had a zero gain/loss on the futures/options side of the hedge.
You also know that the standard futures hedge had a 3-cent loss on the futures/options
side of the hedge. Using these results as the best-case and worst-case scenarios:
a. What put premium and what futures price at expiration would have given you a zero
gain/loss on the option side of your put option hedge, so that you would have realized
the full 3-cent gain on the cash side? (2 points)
For zero gain/loss, need October premium on put = 1.55 cents
20-cent strike 1.55 cents = 18.45 cents

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b. What put premium and what futures price at expiration would have given you a 3cent loss on the option side of your put option hedge, so that you would have lost the
entire 3-cent gain on the cash side? (2 points)
For 3-cent loss, need October premium on put = 1.55 + 3.00 = 4.55 cents
20-cent strike 4.55 cents = 15.45 cents

3) Use the steps below to calculate the change in intrinsic value on your put option position
between February and October (5 points)
a. Intrinsic value in February: 0 (at-the-money so there is no intrinsic value)

b. Intrinsic value in October: 3 cents = 20 cents strike 17 cents futures

c. Change in intrinsic value: 3 cents

d. Is this a profit (+) or loss (-) to you as the hedger? Explain your answer.
Loss (-)
Sold option at 0 intrinsic value and bought option at 3 cents
Option sellers dont benefit from gain in intrinsic value
(other answers possible)

4) Use the steps below to calculate the change in time value on your put option position
between February and October: (5 points)
a. Time value in February: 1.55 cents = 1.55 premium 0 intrinsic value

b. Time value in October: 0.15 cents = 3.15 premium 3 intrinsic value

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c. Change in time value: 1.40 cents

d. Is this a profit (+) or loss (-) to you as the hedger? Explain your answer
Profit (+)
Sold option at 1.55 cents time value and bought at 0.15
Option sellers benefit from time value erosion
(other answers possible)

5) Use your answers from Section 3) and Section 4) above to explain your put option
hedging results. (1 point)
Losses from change in intrinsic value (-3 cents) > gains from change in time value
(+1.40 cents)

B. Next, construct a hedge using an October 20-cent call option. The premium in February is
1.06 cents and the premium in October is 0.01 cents. (3 points)
Date

Cash
Long or Short? Price?

October 20-cent Call

Long or Short?
Premium?

Feb

[Short at 20 cents]

___ Long___ Call at 1.06 cents

Oct

Long at 17 cents

___ Short___ Call at 0.01 cents

Gain/Loss

+3.00 cents

-1.05 cents

Net Price Paid for Sugar = 18.05 cents = 17 cents cash + 1.05 cents option loss
(show your work)

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1) Calculate the difference between the net price paid for sugar with the call option hedge
and the net price paid for sugar with the futures hedge (Hint: See the information in the
box above), and write that difference in the space below. Compared with the futures
hedge, did the call option hedge make you better off or worse off? What type of cash
price trend would have caused the call option hedge to give its best results? (3 points)
1.95 cents = 20 cents with futures hedge 18.05 cents with put option hedge
Better off (by 1.95 cents)
Rising prices (call option would have moved into the money)

2) You also are interested in knowing the sensitivity of your call option hedging results to
changing sugar prices. Looking back, if the board of directors had allowed you to go
unhedged you would have had zero gain/loss on the futures/options side of the hedge.
You also know that the standard futures hedge had a 3-cent loss on the futures/options
side of the hedge. Using these results as the best-case and worst-case scenarios:
a. What call premium and what futures price at expiration would have given you a zero
gain/loss on the option side of your call option hedge, so that you would have realized
the full 3-cent gain on the cash side? (2 points)
For zero gain/loss, need October premium on put = 1.06 cents
20-cent strike + 1.06 cents = 21.06 cents

b. What call premium and what futures price at expiration would have given you a 3cent loss on the option side of your call option hedge, so that you would have lost the
entire 3-cent gain on the cash side? (2 points)
For 3-cent loss, need October premium on put = 1.06 + 3.00 = 4.06 cents
20-cent strike + 4.06 cents = 24.06 cents

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3) Use the steps below to calculate the change in intrinsic value on your call option position
between February and October (3 points)
a) Intrinsic value in February: 0 (at-the-money so there is no intrinsic value)

b) Intrinsic value in October: 0 (out-of-the-money so there is no intrinsic value)

c) Change in intrinsic value: 0 cents

4) Use the steps below to calculate the change in time value on the call option between
February and October: (5 points)
a) Time value in February: 1.06 cents = 1.06 premium 0 intrinsic value

b) Time value in October: 0.01 cents = 0.01 premium 0 intrinsic value

c) Change in time value: 1.05 cents

d) Is this a profit (+) or loss (-) to you as the hedger? Explain your answer
Loss (-)
Bought option at 1.06 cents time value and sold at 0.01 cents time value
Option buyers dont benefit from time value erosion
(other answers possible)

5) Use your answers from Section 3) and Section 4) above to explain your call option
hedging results. (1 point)
Option losses entirely due to change in time value (-1.05 cents)

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PROBLEM 2 (32 points)
Suppose that you decide to speculate using one of the option spreads that we discussed in class.
You expect December live cattle futures will move lower in the next few weeks from the current
level of $133, so you decide to use a bear call spread involving the purchase of a $135 call at a
premium of $0.30 and the sale of a $131 call at a premium of $2.70.
A. Complete the payoff table below (25 points)

Futures
Price

Total
Gross
Premium
Net
Gross
Premium
Net
Profit on
Profit on
for
Profit on Profit on
for
Profit on Bear Call
$135 Call $135 Call $135 Call $131 Call $131 Call $131 Call Spread

$129

-$0.30

-$0.30

+$2.70

+$2.70

+$2.40

$131

-$0.30

-$0.30

+$2.70

+$2.70

+$2.40

$133

-$0.30

-$0.30

-$2

+$2.70

+$0.70

-$0.40

$135

-$0.30

-$0.30

-$4

+$2.70

-$1.30

-$1.60

$137

+$2

-$0.30

+$1.70

-$6

+$2.70

-$3.30

-$1.60

B. Use the data in the payoff table to plot a payoff diagram on the grid on the next page, with 3
separate lines showing:

The net profits on the $135 call

The net profits on the $131 call, and
The total profit on the bear call spread

You will not be graded on your artistic ability, but your payoff diagram should show each
line with the proper shape and drawn to scale over a range of futures prices from $129 to
$137 and a range of profits from -$4 to +$4. (3 points).
C. December live cattle options expire in approximately 2 weeks, on December 6. Calculate the
time value today for the $135 call option, and explain how you obtained this answer. (2
points)
$0.30
Out of the money (no intrinsic value), so premium is all time value

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D. Suppose the December futures price remains at $133. What will be the premium for the
$131 call option at expiration? How much time value erosion will have occurred between
now and then? (2 points)
$2 (the intrinsic value)
$2.70 - $2 intrinsic value = $0.70

$4.00

$3.00

$2.00

$1.00

$0.00
$129
$1.00

$2.00

$3.00

$4.00

$131

$133

$135

$137

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PROBLEM 3 (25 points)
In our Homework #6 trading exercise at the Margolis Lab, we saw how a refinery can influence
its profit margin by managing the price of the input (crude oil) and the price of the outputs
(gasoline and heating oil). We also saw in class how cash positions can be substituted for futures
positions and combined with options to create ceilings and floors on profits.
Suppose that you are responsible for the pricing and risk management on all gasoline produced
by a refinery; the crude oil and heating oil are handled by other traders. At current price
relationships, the refinery needs $2.60 to break even on gasoline; the market price is currently
$2.66. You are concerned about the losses that would occur if the price turns lower, but you
dont want to miss out on better profits if the price moves higher. You decide to combine the
refiners cash gasoline position with a gasoline option and create a synthetic cash-option position
that puts a floor under gasoline profits.
Your manager has given you permission to use the following December gasoline options, all of
which have a premium of $0.04:

Long $2.66 Call

Short $2.66 Call
Long $2.66 Put
Short $2.66 Put

First, circle the option you will use to put a floor under the refinerys gasoline profits. (1 point)
Then complete the table below to show the refinerys profits at expiration using a synthetic floor.
(24 points)

Gasoline
Price
$2.54

Gross Profit
on Option
.12

Option
Premium
-.04

Net Profit on
Option
.08

Refinery
Profit Based
on Cash
Gasoline
Price
-.06

$2.58

.08

-.04

.04

-.02

.02

$2.62

.04

-.04

.00

.02

.02

$2.66

.00

-.04

-.04

.06

.02

$2.70

.00

-.04

-.04

.10

.06

$2.74

.00

-.04

-.04

.14

.10

END OF EXAM 2

Refinery
Profit With
Synthetic
Floor
.02