Week 1: Introduction

Question 1

How can derivatives be used?

Answer 1

• To hedge risks
• To speculate (take a view on the
  future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment
  without incurring the costs of selling
  one portfolio and buying another

Question 2

Explain a futures contract.

Answer 2

• A futures contract is an agreement to buy or
  sell an asset at a certain time in the future for
  a certain price

Question 3

T/F: OTC market trades are usually between financial institutions, corprate treasueres, and fund managers?

Answer 3

True.

Question 4

Explain a forward contract

Answer 4

• Forward contracts are similar to futures except that they trade in the over-the-counter
  market

Question 5

explain a call option

Answer 5

• A call option is an option to buy a certain asset by a certain date for a certain price (the strike price)

Question 6

explain a put option

Answer 6

• A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

Question 7

What is an American option?

Answer 7

• An American option can be exercised at any time during its life

Question 8

What is a European option?

Answer 8

• A European option can be exercised only at maturity or expiration

Question 9

Hedging Examples

An investor owns 1,000 shares currently worth $28 per share. The investor expects that the share price will go down in future. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts. The price of the share at expiration is $25. What’s the outcome?

Answer 9

• Here, total contracts = 1,000/100= 10
• Total cost of puts = 1,000 shares x $1 = $1,000
• Since the share price at expiration ($25) is less than the strike price ($27.50), the investor exercise the option,
  and the investor sells shares at $27.50
• Total proceeds = ($27.50 x 1,000) - $1,000 =
  $26,500
• If the ST < $27.50 => still the investor gets
  $26,500, because he is locked in the stike
  price $27.50
• If ST > 27.50, the investor doesn’t exercise the
  option, rather sell in the spot market at ST.
• By buying a put the investor hedge against
  downside risk while ensuring upside potential

Question 10

Look at Speculation and arbitrage examples in lecture notes

Answer 10

yo

Question 11

Whats a Zero rate

Answer 11

A zero rate (or spot rate), for maturity T is the rate of interest earned on an investment that provides a payoff only at
time T