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# GB622 Autumn 2011 There are 5 Homework assignments.

The questions and problems below are the same as in the textbook. Due dates will be announced in class.

HW#1 1. Explain carefully the difference between (a) hedging, (b) speculation, and (c) arbitrage. 2. 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? 3. 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 \$2.9. You have \$5800 to invest. Identify two alternative strategies. Briefly outline the advantages and disadvantages of each. 4. A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmers viewpoint, what are the pros and cons of hedging? 5. Suppose that a March call option on a stock with a strike price of \$50 costs \$2.50 and is held until March. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a long position in the option depends on the stock price at the maturity of the option. 6. Suppose that a June put option on a stock with a strike price of \$60 costs \$4 and is held until June. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option. 7. Options and futures are zero-sum games. What do you think is meant by this statement? 8. The price of gold is currently \$800 per ounce. Forward contracts are available to buy or sell gold at \$1000 for delivery in one year. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. 9. Distinguish between the terms open interest and trading volume. 10. Suppose that in September 2010 a company takes a long position in a contract on May 2011 crude oil futures. It closes out its position in March 2011. The futures price (per barrel) is \$68.30 when it enters into the contract, \$70.50 when it closes out the position and \$69.10 at the end of December 2010. One contract is for the delivery of 1,000 barrels. What is the companys profit? When is it realized? How is it taxed if it is (a) a hedger and (b) a speculator? Assume that the company has a December 31 year end. 11. What are the most important aspects of the design of a new futures contract? 12. Explain how margins protect investors against the possibility of default. 13. The forward price of the Swiss franc for delivery in 45 days is quoted as 1.1000. The futures price for a contract that will be delivered in 45 days is 0.9000. Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss francs? 14. Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? 15. Explain what is meant by basis risk when futures contracts are used for hedging.

16. Suppose that the standard deviation of quarterly changes in the prices of a commodity is \$0.65, the standard deviation of quarterly changes in a futures price on the commodity is \$0.81, and the coefficient of correlation between the two changes is 0.8. What is the optimal hedge ratio for a three-month contract? What does it mean? 17. If there is no basis risk, the minimum variance hedge ratio is always 1.0. Is this statement true? Explain your answer. 18. Companies A and B have been offered the following rates per annum on a \$20 million five-year loan:

Company A: Company B:

19. 20.

21.

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25. 26.

Company A requires a floating-rate loan; company B requires a fixed-rate loan. Design a swap that will net a bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both companies. Explain the difference between the credit risk and the market risk in a financial contract. An investor buys a European put on a share for \$3. The stock price is \$42 and the strike price is \$40. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the maturity of the option. An investor sells a European call on a share for \$4. The stock price is \$47 and the strike price is \$50. Under what circumstances does the investor make a profit? Under what circumstances will the option be exercised? Draw a diagram showing the variation of the investors profit with the stock price at the maturity of the option. An investor sells a European call option with strike price of K and Maturity T and buys a put with the same strike price and maturity. Describe the investors position. Explain why brokers require margins when clients write options but not when they buy options. A trader buys a call option with a strike price of \$45 and a put option with a strike price of \$40. Both options have the same maturity. The call costs \$3 and the put costs \$4. Draw a diagram showing the variation of the traders profit with the asset price. Explain why an American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date. Explain why an American option is always worth at least as much as its intrinsic value.