Chapter 1
Chapter 1
Practice Questions
Chapter 1
Introduction
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1.1. What is the difference between a long forward position and a short forward
position?
1.2. Explain carefully the difference between hedging, speculation, and arbitrage.
1.3. 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?
1.4. Explain carefully the difference between selling a call option and buying a put
option.
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1.5. An investor enters into a short forward contract to sell 100,000 British pounds
for US
dollars at an exchange rate of 1.4000 US dollars per pound. How much does the
investor gain or lose if the exchange rate at the end of the contract is (a) 1.3900
and
(b) 1.4200?
1.6. A trader enters into a short cotton futures contract when the futures price is 50
cents per
pound. The contract is for the delivery of 50,000 pounds. How much does the trader
gain or lose if the cotton price at the end of the contract is (a) 48.20 cents per
pound
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1.7. Suppose that you write a put contract with a strike price of $40 and an
expiration date
in 3 months. The current stock price is $41 and the contract is on 100 shares. What
have
you committed yourself to? How much could you gain or lose?
1.8. 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
market?
1.9. You would like to speculate on a rise in the price of a certain stock. The current
stock
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price is $29 and a 3-month call with a strike price of $30 costs $2.90. You have
$5,800 to
invest. Identify two alternative investment strategies, one in the stock and the other
in
an option on the stock. What are the potential gains and losses from each?
1.10. Suppose that you own 5,000 shares worth $25 each. How can put options be
used to
provide you with insurance against a decline in the value of your holding over the
next
4 months?
1.11. When first issued, a stock provides funds for a company. Is the same true of a
stock
option? Discuss.
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1.12. Explain why a futures contract can be used for either speculation or hedging.
1.13. Suppose that a March call option to buy a share for $50 costs $2.50 and is
held until
March. Under what circumstances will the holder of the option make a profit? Under
what
circumstances will the option be exercised? Draw a diagram illustrating how the
profit
from a long position in the option depends on the stock price at maturity of the
option.
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1.14. Suppose that a June put option to sell a share for $60 costs $4 and is held until
June.
Under what circumstances will the seller of the option (i.e., the party with the short
position) make a profit? Under what circumstances will the option be exercised?
Draw a
diagram illustrating how the profit from a short position in the option depends on
the
1.15. It is May and a trader writes a September call option with a strike price of $20.
The stock
price is $18 and the option price is $2. Describe the traders cash flows if the option
is held
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1.16. A trader writes a December put option with a strike price of $30. The price of
the option
currency in
Explain
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how the exchange rate risk can be hedged using (a) a forward contract and (b) an
option.
1.19. A trader enters into a short forward contract on 100 million yen. The forward
exchange
rate is $0.0080 per yen. How much does the trader gain or lose if the exchange rate
at the
end of the contract is (a) $0.0074 per yen and (b) $0.0091 per yen?
1.22. Describe the profit from the following portfolio: a long forward contract on an
asset and a
long European put option on the asset with the same maturity as the forward
contract and
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a strike price that is equal to the forward price of the asset at the time the portfolio
is set up.
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