Introduction Flashcards
What is the difference between a long forward position and a short forward position?
long forward position = trade agreed to buy the underlying assets for certain amount at certain time;
short forward position = trade agreed to sell the underlying assets for certain amount at certain time;
Explain carefully the difference between hedging, speculation, and arbitrage.
hedging = trader has an exposure to the price of an assets and takes a position in derivative to offset the exposure speculation = trader has no exposure on the assets but betting on the future movement in the price of assets arbitrage = trader aim to lock the profit for taking position in two or more different markets
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?
forward @ $50:
- no entry cost
- obligation to buy the assets @ delivery price $50
- gain/loss = payoff = Spot price - $50
option @ $50 call:
- does not have to exercise the options
- required upfront cost = total loss
- has option to buy the assets for $50
Explain carefully the difference between selling a call option and buying a put option
selling a call option = giving someone else the right to buy an assets from you, it give you a payoff
-max(St - K, 0) = min(K - St, 0)
buying a put option = buying an option from someone else. it gives a payoff
max(K - St, 0)
both potential payoff is max(K - St, 0);
when write a call option, counterparty choose whether to exercise, the payoff is negative or zero;
when buy a put option, you choose whether to exercise, the payoff is zero or positive;
An investor enters into a short forward contract to sell 100,000 British pounds for US dollars at an exchange rate of 1.5000 US dollars per pound. How much does the investor gain or lose if the exchange rate at the end of the contract is (a) 1.4900 and (b) 1.5200?
(a) 1.4900
Profit = (1.5-1.49) x 100K = 1000
(b) 1.5200
Loss = (1.5-1.52) x 100K = -2000
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
and (b) 51.30 cents per pound?
(a) 48.20 cents per pound
(0. 5 - 0.482) x 50000 = 900
(b) 51.30 cents per pound
(0. 5 - 0.513) x 50000 = -650
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?
i have sold a put option contract; i agreed to buy 100 shares @$40 if other side party of the contract choose to exercise the right to sell for this price. the option will be exercise only when the price of stock go below $40;
eg1. When stock price decline to $30, i have to buy the stock @ $40 and loss $10 per share (-$1000);
eg2. When stock price decline to $20, i have to buy the stock @ $40 and loss $20 per share (-$2000);
eg3. When stock price decline to $0 in 3 months, i have to buy the stock @ $40 and lost $40 per share (-$4000)
in return, i receive the price of the option from purchaser
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?
over-the-counter market OTC = financial institutions, fund managers and corporate treasurers where 2 participants to enter into mutually acceptable contract via telephone or computer-linked network;
exchange-traded market = market organized by an exchange, trader and tradable contracts defined by the exchange.
bid quote is the price where market maker prepare to buy;
offer quote is the price where market maker prepare to sell
You would like to speculate on a rise in the price of a certain stock. The current stock 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?
A) in the stock:
200shares @ $29
If stock $40, profit = ($40-$29) x 200 shares = $2200
If stock $20, loss = ($20-$29) x 200 share = -$1800
B) option on the stock:
2000 options @ $2.9
If stock $40, profit = ($40-$30) x 2000 option - $5800 = $14200
If stock $20, loss = $5800 max
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?
buy 50 put option contract with 100 share each with stroke price $25 expiration in 4 months;
If price decline below $25, I can exercise the option and sell the share @ $25
When first issued, a stock provides funds for a company. Is the same true of a stock option? Discuss.
Since the IPO company is not involved in stock options trading, exchange-traded stock options didn’t provide any fund for the company.
Explain why a futures contract can be used for either speculation or hedging.
if an investor has an exposure to the price of an assets, they can hedge with futures contracts;
By using a short future position to hedge the risk, investor will gain when the price increase VS lose when the price decrease;
By using a long future position to hedge the risk, investor will gain when the price decrease VS lose when the price increase;
if an investor has NO exposure to the price of the underlying assets, entering the future contract is speculation;
By taking long position, investor can gain when price increase VS lose when price decrease;
By taking short position, investor can gain when price decrease VS lose when price increase
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.
6 | 4 | / 2 | / |\_\_\_\_\_\_\_\_\_\_\_\_\_/\_\_\_\_ $0 $25 $50 -2 \_\_\_\_\_\_\_\_\_/
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 stock price at maturity of the option.
seller with the short position: profit $4 | ---------------- $2 | / 0 |\_\_\_\_\_\_\_\_/\_\_\_\_\_\_\_\_\_\_ -$2 | $56 /$60 $70 price -$4 | /
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 trader’s cash flows if the option is held until September and the stock price is $25 at that time.
Trader cashflows:
May: inflow $2 by selling option
Sep: outflow $25-$20=$5 by exercise option
Sep: Investor buy the stock @ $25 and sell to option purchaser @ $20
