1.

long forward vs. Short forward

Long forward: Agreeing to buy the UA on delivery date (a right) and the obligation to pay delivery price.
Short forward: Agreeing to sell the UA at delivery price that is agreed upon today and obligation to deliver
Forward contract is binding on both parties.

1.2

Explain carefully the difference between hedging, speculation and arbitrage.

A trader is hedging when she has exposure to the price of an asset and takes a position in derivative to offset the expos
In speculation, the trader has no exposure to offset. Betting on future movement in the price of asset.
In arbitrage, the trader takes position in two or more different markets to lock in a profit.
Market maker takes a position in order to make market. He would hedge the exposure in various ways.

1.3

Entering long forward when F = 50 vs. Taking long call with K = 50

In the former, the trader is obliged to buy the asset at $50. He has that right to buy and shall pay 50 on the maturity date
In the latter, the trader has freedom to walkout of the obligation as he pays premium to get such freedom.
Trader exercises this freedom at the time of contract's expiry date if he would incur loss by exercising the right endowed

1.4

Explain carefully the difference between selling a call option and buying a put option
Both Raghav and Lalit expect market prices to go up. For a given maturity, the call and put premiums are 22 and 17.
Writing a call option involves selling an option to someone else. It gives a payoff of min(K - ST, 0) OR -max( K - ST, 0)
Buying a put option involves buying an option to someone else. It gives a payoff of max(K - ST, 0)

In both cases, the potential payoff is . When you write a call, the payoff is negative or zero. When you buy a put, the pay
On Jan. 1, Raghav took short call position and hence received Rs.22. Lalit took long put option and hence paid Rs. 17
Refer the payoff table for delivery on 31-Mar.
Raghav has unlimited potential liability and limited benefit. Lalit has maximum loss of 17 but potential benefit

1.5

Short forward to sell 100,000 for USD at $1.4000 per . How much does the investor lose or gain
(a) The trader sells 0.1 million pounds at $1.4000 per pound. At maturity of the forward, he would gain 100000 x (1.4000
(b) The trader sells 0.1 million pounds at $1.4000 per pound. At maturity of the forward, he would lose 100000 x (1.4000

1.6

Short cotton futures contract at F = 0.50 with contract size = 50,000 pounds.
(a) The trader sells 50,000 pounds of cotton for $0.5000 per pound. At maturity, he would gain 50000 x ($0.5000 - $0.48
(b) The trader sells 50,000 pounds of cotton for $0.5000 per pound. At maturity, he would lose 50000 x ($0.5000 - $0.51

1.7

Writing a put contract with K = 40 at T = 3/12 on 100 shares. Current market price = $41. What have you commit
You have sold 3-months ago a put @ 40. You have collected the premium then agreeing to buy the 100 shares at $40 a
Since the CMP is 41, your counterparty will not sell the shares to you at 40. Rather, he would sell it in the spot market.
In other words, the put option is out-of-money as ST = 41. The option holder would not exercise an out-of-money option
If the current market price < $40, then the put option would be in-the-money and it would be worthwhile to buy in the ma

1.8

OTC Market vs. Exchange-traded market; bidder and offer quotes

OTC market is market among the dealers for the asset and the asset is thinly traded.
Once it picks sufficient volumes, it would become possible to standardise the trades so as to facilitate the same on publi
The bid is the price quoted buy the market maker for the options you are holding. Offer quote is the price quoted by the d

1.9

Speculation on rise: CMP = 29; 3-month call at K=30 costs $2.90. You have $5,800 to invest.
Identify two strategies, one involving stock and the other involving options.
Strategy1 is to buy 200 shares. This would result in a loss of 200 x (25 - 29) = $800 loss. You have left with a capital of $
Strategy2 is to buy 2000 call options at $2.90 each. You are left with nothing as the call option expired out-of-money.
Strategy2 uses very high leverage viz. 9:1.

1.10

You own 200 shares worth $5,000. How can put be used to provide insurance against decline in value of your ho
Since you hold the Underlying Asset (UA), you can buy put option.
If you wrote the put option and the stock price increased afterwards, the put would be out-of-money and won't be exercis
You are left with future value of the premium and the appreciated stock. However, it would expose you to loss if the shar
If you bought the put option and the stock price decreased afterwards, the put would be in-the-money.
You can sell the shares at exercise price and get assured of the minimum value. The premium paid is the loss to you.

1.11

When first issued, a stock provides funds for a company. Is the same true of a stock option? Discuss.
No. Stock option contracts are entered into two parties via the exchange. It does not provide any cashflows to the compa
These are meant for hedging the exposure to the stock and hence the shareholder gets benefited.

1.12

Explain why a forward contract can be used for speculation or hedging.

If you have exposure to the underlying asset, then the forward contract is provding the hedging against the loss and also
If you do not have exposure to the underlying asset, then the forward contract could provide either loss or profit dependi

1.13

When does the speculator makes money? Under what circumstances, does he exercises call option?
k=
$50
ST
Payoff
Profit
c=
$2.50
46
$0
($2.50)
47
$0
($2.50)
48
$0
($2.50)
49
$0
($2.50)
50
$0
($2.50)
51
$1
($1.50)
52
$2
($0.50)
53
$3
$0.50
54
$4
$1.50
55
$5
$2.50
The holder makes profit when share price increases to $52.50 and beyond.
The option gets exercised once the share price increases to $50.00 and beyond.

1.14

June put option. When does the seller make profit? Under what circumstances, will it be exercised?
k=
$60
ST
Payoff
Profit
p=
$4.00
52
$8
$4.00
53
$7
$3.00
54
$6
$2.00
55
$5
$1.00
56
$4
$0.00
57
$3
($1.00)
58
$2
($2.00)
59
$1
($3.00)
60
$0
($4.00)
61
$0
($4.00)

62
63
64
65

$0
$0
$0
$0

($4.00)
($4.00)
($4.00)
($4.00)

The holder makes profit when share price decreases to $56.00 and below.
The option gets exercised once the share price decreases to $60.00 and below.
The holder's loss is the seller's gain and vice versa.
1.15

Wrote a september call when CMP of UA is $18. Describe the trader's cashflow when held until maturity.
k=
$20
ST
Payoff
Profit
p=
$2.00
16
$0
$2.00
Position: Wrote a call
17
$0
$2.00
Payoff: -Max(S-K, 0)
18
$0
$2.00
19
$0
$2.00
20
$0
$2.00
21
($1)
$1.00
22
($2)
$0.00
23
($3)
($1.00)
24
($4)
($2.00)
25
($5)
($3.00)
26
($6)
($4.00)
27
($7)
($5.00)
28
($8)
($6.00)
29
($9)
($7.00)
If the stock price is $25 at the maturity of the call option, it would get exercised by the holder. The payoff to the holder is
Hence, net loss to the writer is $5 - $2 = $3 assuming no time value for money.

1.16

Wrote a Dec put. Under what circumstances, does the trader makes money?
k=
$30
ST
Payoff
Profit
p=
$4.00
25
($5)
($1.00)
Position: Wrote a put
26
($4)
$0.00
Payoff: -Max(K - S, 0)
27
($3)
$1.00
28
($2)
$2.00
29
($1)
$3.00
30
$0
$4.00
31
$0
$4.00
32
$0
$4.00
33
$0
$4.00
34
$0
$4.00
35
$0
$4.00
36
$0
$4.00
37
$0
$4.00
38
$0
$4.00

If the stock price is $30 or less at the maturity of the put option, it would get exercised by the holder. Whatever the gain t
1.17

Forex receivables are to be hedged with a option contract. What type of option is appropriate for hedging?
If an asset is in place or expected to receive at a future point of time, the firm has to buy the put option or write forward c
Buying a put option gives a minimum price while allowing the firm to retain entire upside potential.
However, a short futures position in the said asset would result in locking up of the asset at the delivery price.

1.18

Expected to pay C$1 million in 6 months. Explain how the exchange rate risk can be hedged using the (a) forwa
If C$ appreciates in dollar terms, the importer has to pay more. He can take long position in future contract or a long pos
A long call appreciates when the UA appreciates (canadian dollar that is priced in US dollars). Hence the amount to be p
Hence the firm has buy to the call options with Canadian dollar as UA and the payoff denominated in US dollar terms.
Taking a long position in forward contract results in looking into a fixed price.

1.19

Short forward on 100 million at F = $0.0080.

(a) The trader sells 100 million yen for $0.0080 per yen. At maturity of the forward, he would gain 100,000,000x(0.00800
(b) The trader sells 100 million yen for $0.0080 per yen. At maturity of the forward, he would lose 100,000,000x(0.00800

1.20

CBOT offers a futures contract on long-term Treasury bonds. Characterize the traders likely to use this contract
Most traders who use the long-term treasury bond futures contracts wish to do one of the following:
(a) Hedge their exposure to long-term interest rates viz. the firm may be holding long-term bonds and wish to hedge them
(b) Speculate on the future direction of long-term interest rates viz. the firm may be expecting the LTIR to decrease and
(c) arbitrage between cash and futures market.
These contracts are discussed in chapter 5 of Hull. Refer relevant chapter in Donald Chance for better understanding.

1.21

"options and futures are zero-sum games." What do you think is meant by this statement?
The statement means that the gain (loss) to the party with a short position in an option is always equal to the loss (gain)
However, it is a best mechanism to transfer risk from one party to another.

1.22

Describe the profit from the following portfolio: long forward + long european put where K = F on same UA with
The terminal value of long forward contract is: S T - F0
The terminal value from the long put is:

max( F 0 - ST, 0)

The terminal value of the portfolio is therefore S T - F0 + max( 0, F0 - ST) = max(0, ST - F0)

This is the same as the terminal value of a european call option with the same maturity as the forward contract and an e

59

52

put
Payoff
$8

$60
$60
$4.00

53
54
55
56
57
58
59
60
61
62
63
64
65

$7
$6
$5
$4
$3
$2
$1
$0
$0
$0
$0
$0
$0

ST
S=
F0 =
k=
p @ 60 =

1.23

Asset
recd from
Futures
$52

put +
futures
$60

$53
$54
$55
$56
$57
$58
$59
$60
$61
$62
$63
$64
$65

$60
$60
$60
$60
$60
$60
$60
$60
$61
$62
$63
$64
$65

forward +
payoff on p @ 60 c @60
c@60
$0
$60
$0
$0
$0
$0
$0
$0
$0
$0
$1
$2
$3
$4
$5

$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60
$60

In 1980s, Bankers Trust developed indexed currency option notes (ICONs). These are bonds in which the amoun
One example was its trade with Long-term Credit Bank of Japan.
The ICON specified that if the yen-USD exchange rate, ST, is greater than 169 yen per USD at maturity (in 1995),
If it is less than 169 JPY per USD, then amount received by the holder is 1,000 - max [ 0, 1000(169/ST - 1) ].

If it is less than 84.5 JPY per USD, then amount received by the holder is 0. Show that this is a combination of r
The payoff from an ICON is the payoff from:
(a) A regular bond
(b) A short position in call option to buy 169,000 yen with an exercise price of 1/169.
(c) A long position in call option to buy 169,000 yen with an exercise price of 1/84.5.
1.24

On July 1, 2011, a company enters into a forward contract to buy JPY10 million on Jan. 1, 2012.
On Sept. 1, 2011, it entered into a forward contract to sell JPY10 million on Jan. 1, 2012.
Describe the payoff from this strategy.
Payoff of the first contract = ST - F1
Payoff of the second contract = F2 - ST
Total payoff from the two contracts is therefore ST - F1 + F2 - ST = F2 - F1

1.25

Suppose the USD-GBP spot and forward rates are as follows:

Spot
1.4580
90-day forward
1.4556
180-day forward
1.4518
What opportunities are open to an arbitrageur in the following situations?
(a) A 180-day European call option to buy 1 for $1.42 costs 2 cents
(a) A 90-day European put option to sell 1 for $1.49 costs 2 cents.
Solution:
(a) Payoff from the 180-day long call and short forward contract = max (ST - 1.42, 0) - 0.02
The profit from the short forward contract is
1.4518 - ST
The profit from the strategy is therefore

max(ST - 1.42, 0) - 0.02 + 1.4518 - ST

max(ST - 1.42, 0) + 1.4318 - ST

====>

1.4318 - ST
0.0118

when
when

ST < 1.42
ST > 1.42

(b) Payoff from the 90-day short put and long forward contract = max ( 1.49 - ST, 0) - 0.020
The profit from the long forward contract is
ST - 1.4556
The profit from the strategy is therefore

max (1.49 - ST, 0) - 0.02 + ST - 1.4556

max (1.49 - ST, 0) + ST - 1.4756

====>

ST - 1.4756
0.0144

when
when

ST > 1.49
ST < 1.49

ay delivery price.
bligation to deliver stated quantity of UA on maturity date and collect cash on that day..

n in derivative to offset the exposure.

price of asset.

in various ways.

shall pay 50 on the maturity date even if the stock price on that date is less than 50.
get such freedom.
s by exercising the right endowed through that option.

put premiums are 22 and 17.

(K - ST, 0) OR -max( K - ST, 0)

ero. When you buy a put, the payoff is zero or positive.

ut option and hence paid Rs. 17

m loss of 17 but potential benefit also presents.

estor lose or gain

, he would gain 100000 x (1.4000 - 1.3900) = $1,000.
, he would lose 100000 x (1.4000 - 1.4200) = $2,000 loss.

uld gain 50000 x ($0.5000 - $0.4820) = $900

uld lose 50000 x ($0.5000 - $0.5130) = $650 loss.

ST

-c@200 p@200

Raghav

Lalit

170

30

22

13

180
190
200
210
220
230

0
0
0
-10
-20
-30

20
10
0
0
0
0

22
22
22
12
2
-8

3
-7
-17
-17
-17
-17

ST
1.38
1.39
1.4
1.41
1.42

- (ST - F) Gain/(loss) on 100,000

0.02 $2,000
0.01 $1,000
0
$0
-0.01 -$1,000
-0.02 -$2,000

ST
- (ST - F) Gain/(loss) on 50,000 lb
0.4820
0.0180 $1,800 <--- gain
0.4900
0.0100 $1,000
0.5000
0.0000
$0
0.5100
-0.0100 -$1,000
0.5130
-0.0130 -$1,300 <-- loss

e = $41. What have you committed yourself to? How much do you gain or lose?
g to buy the 100 shares at $40 a share.
would sell it in the spot market.
exercise an out-of-money option contract.
ld be worthwhile to buy in the market and sell the same shares to put writer at $40 to make profit.

as to facilitate the same on public exchanges (exchange-traded market).

quote is the price quoted by the dealer to sell the options he holds.

800 to invest.

ST
26.0
28.0
30.0
32.0
34.0
36.0

s. You have left with a capital of $4,200.

option expired out-of-money.

ainst decline in value of your holding over next 4 months.

Say, the option premium is Rs.2
out-of-money and won't be exercised.
uld expose you to loss if the share price falls.
e in-the-money.
remium paid is the loss to you.

gain on Return on investment

Gain on
100 shares call @ 30 Stgy 1
Stgy 2
-300
-5800
-5%
-100%
-100
-5800
-2%
-100%
100
-5800
2%
-100%
300
-1800
5%
-31%
500
2200
9%
38%
700
6200
12%
107%
Stock Stock + Return on investment
p@25
p@25
Stgy 1
Stgy 2
17
25 -26%
-7%
21
25
-9%
-7%
25
25
9%
-7%
27
27
17%
0%
29
29
26%
7%
31
31
35%
15%

ST
21
23
25
27
29
31

ock option? Discuss.

ovide any cashflows to the company.
s benefited.

hedging against the loss and also takes away any upside potential. You should take short position in forward contract.
ovide either loss or profit depending on price movement. This is referred to as speculation.

xercises call option?

price at maturity

Long call payoff and profit diagram s

Payoff / profit

12
10
8
6
4
2
0
0

10

12

will it be exercised?
Column F

Long put payoff and profit diagram s

Column G

12
10
8
6
4
2
0
50

52

54

56

58

60

62

64

6
4
2
0
50

52

54

56

58

60

62

64

hen held until maturity.

Column F

Short call payoff and profit diagram s

Column G

12
10
8
6
4
2
0
15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

older. The payoff to the holder is $5 viz. a loss of $5 to the writer.

Short put payoff and profit diagram s

Column F
Column G

12
10
8
6
4
2
0
25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

by the holder. Whatever the gain to the holder would be loss to the writer of the put option and vice versa.

appropriate for hedging?

y the put option or write forward contract.

et at the delivery price. The firm is giving up the entire upside potential for getting protection from loss.

be hedged using the (a) forward contract, and (b) an option.

on in future contract or a long position in call option contract,
ollars). Hence the amount to be paid is capped.
enominated in US dollar terms.

would gain 100,000,000x(0.008000 - 0.007400) = $60,000.

would lose 100,000,000x(0.008000 - 0.009100) = $110,000 loss

aders likely to use this contract.

he following:
erm bonds and wish to hedge them
pecting the LTIR to decrease and hence would buy the T-bond futures contract.

hance for better understanding.

is always equal to the loss (gain) to the party with the long position. The sum of the gains is zero.

t where K = F on same UA with same TTM.

as the forward contract and an exercise price is equal to F 0.

15

10
Colum
nF

0
50

60

put + forward does not help if you use it to buy an asset in future.
(put + forward - call) helps in locking into a fixed price to buy at maturity.

e are bonds in which the amount received by the holder at maturity varies with a foreign exchange rate.

n per USD at maturity (in 1995), the holder of bond receives $1,000.
max [ 0, 1000(169/ST - 1) ].

w that this is a combination of regular bond and two options.

$1,000
2000 - 169,000/ST
0

if
if
if

ST > 169
84.5 < ST < 169
ST < 84.5

n Jan. 1, 2012.

Spot
90-day forward
180-day forward
90-d put
$1.49
180-d call
$1.42

$1.4580
$1.4556
$1.4518
$0.0200
$0.0200

180-day call@1.42 - 180-day F@1.4518

ST
c@1.42 F@1.4518 Call - f
1.39
$0.00 -$0.0618 $0.0418
1.41
$0.00 -$0.0418 $0.0218
1.43
$0.01 -$0.0218 $0.0118
1.45
$0.03 -$0.0018 $0.0118
1.47
$0.05 $0.0182 $0.0118
1.49
$0.07 $0.0382 $0.0118
1.51
$0.09 $0.0582 $0.0118
1.53
$0.11 $0.0782 $0.0118
90-day put@1.49 + 90-day F@1.4556
ST
p@1.49 F@1.4556 p + F
1.39
$0.10 -$0.0656 $0.0144
1.41
$0.08 -$0.0456 $0.0144
1.43
$0.06 -$0.0256 $0.0144
1.45
$0.04 -$0.0056 $0.0144
1.47
$0.02 $0.0144 $0.0144
1.49
$0.00 $0.0344 $0.0144
1.51
$0.00 $0.0544 $0.0344
1.53
$0.00 $0.0744 $0.0544
1.55
$0.00 $0.0944 $0.0744

call on
90-day
180-day

$0.02

put on
$0.02

1.4
100,000

0.5
50,000

0.5
50,000