CHAPTER 1

Introduction

Practice Questions
Problem 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?

(a) The investor is obligated to sell pounds for 1.4000 when they are worth 1.3900. The
gain is (1.4000-1.3900) ×100,000 = $1,000.

(b) The investor is obligated to sell pounds for 1.4000 when they are worth 1.4200. The
loss is (1.4200-1.4000)×100,000 = $2,000

Problem 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; (b) 51.30 cents
per pound?

(a) The trader sells for 50 cents per pound something that is worth 48.20 cents per pound.
Gain = ($05000 − $04820)  50 000 = $900 .

(b) The trader sells for 50 cents per pound something that is worth 51.30 cents per pound.
Loss = ($05130 − $05000)  50 000 = $650 .

Problem 1.7.
Suppose that you write a put contract with a strike price of $40 and an expiration date in
three 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?

You have sold a put option. You have agreed to buy 100 shares for $40 per share if the party
on the other side of the contract chooses to exercise the right to sell for this price. The option
will be exercised only when the price of stock is below $40. Suppose, for example, that the
option is exercised when the price is $30. You have to buy at $40 shares that are worth $30;
you lose $10 per share, or $1,000 in total. If the option is exercised when the price is $20, you
lose $20 per share, or $2,000 in total. The worst that can happen is that the price of the stock
declines to almost zero during the three-month period. This highly unlikely event would cost
you $4,000. In return for the possible future losses, you receive the price of the option from
the purchaser.

Problem 1.9.
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 of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative strategies, one involving an investment in the stock and the other
involving investment in the option. What are the potential gains and losses from each?

One strategy would be to buy 200 shares. Another would be to buy 2,000 options. If the share
price does well the second strategy will give rise to greater gains. For example, if the share
price goes up to $40 you gain [2 000  ($40 − $30)] − $5 800 = $14 200 from the second
strategy and only 200  ($40 − $29) = $2 200 from the first strategy. However, if the share
price does badly, the second strategy gives greater losses. For example, if the share price goes
down to $25, the first strategy leads to a loss of 200  ($29 − $25) = $800 whereas the second
strategy leads to a loss of the whole $5,800 investment. This example shows that options
contain built in leverage.

Problem 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 showing how the profit on a
long position in the option depends on the stock price at the maturity of the option.

The holder of the option will gain if the price of the stock is above $52.50 in March. (This
ignores the time value of money.) The option will be exercised if the price of the stock is
above $50.00 in March. The profit as a function of the stock price is shown in Figure S1.1.

Figure S1.1 Profit from long position in Problem 1.13

Problem 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 a short position) make a
profit? Under what circumstances will the option be exercised? Draw a diagram showing
how the profit from a short position in the option depends on the stock price at the maturity
of the option.
The seller of the option will lose money if the price of the stock is below $56.00 in June.
(This ignores the time value of money.) The option will be exercised if the price of the stock
is below $60.00 in June. The profit as a function of the stock price is shown in Figure S1.2.

Figure S1.2 Profit from short position in Problem 1.14

Problem 1.17.
A company knows that it is due to receive a certain amount of a foreign currency in four
months. What type of option contract is appropriate for hedging?

A long position in a four-month put option can provide insurance against the exchange rate
falling below the strike price. It ensures that the foreign currency can be sold for at least the
strike price.

Problem 1.18.
A US company expects to have to pay 1 million Canadian dollars in six months. Explain how
the exchange rate risk can be hedged using (a) a forward contract; (b) an option.

The company could enter into a long forward contract to buy 1 million Canadian dollars in
six months. This would have the effect of locking in an exchange rate equal to the current
forward exchange rate. Alternatively the company could buy a call option giving it the right
(but not the obligation) to purchase 1 million Canadian dollars at a certain exchange rate in
six months. This would provide insurance against a strong Canadian dollar in six months
while still allowing the company to benefit from a weak Canadian dollar at that time.

Problem 1.23.
In the 1980s, Bankers Trust developed index currency option notes (ICONs). These are bonds
in which the amount received by the holder at maturity varies with a foreign exchange rate.
One example was its trade with the Long Term Credit Bank of Japan. The ICON specified
that if the yen–U.S. dollar exchange rate, ST , is greater than 169 yen per dollar at maturity
(in 1995), the holder of the bond receives $1,000. If it is less than 169 yen per dollar, the
amount received by the holder of the bond is
  169  
1 000 − max 0 1 000  − 1 
  ST 
When the exchange rate is below 84.5, nothing is received by the holder at maturity. Show
that this ICON is a combination of a regular bond and two options.

Suppose that the yen exchange rate (yen per dollar) at maturity of the ICON is ST . The payoff
from the ICON is

1 000 if ST  169
 169 
1 000 − 1 000  − 1 if 845  ST  169
 TS 
0 if ST  845

When 845  ST  169 the payoff can be written

169 000
2 000 −
ST

The payoff from an ICON is the payoff from:

(a) A regular bond
(b) A short position in call options to buy 169,000 yen with an exercise price of 1/169
(c) A long position in call options to buy 169,000 yen with an exercise price of 1/84.5
This is demonstrated by the following table, which shows the terminal value of the various
components of the position

Bond Short Calls Long Calls Whole position

ST  169 1000 0 0 1000
845  ST  169 1000 −169 000 ( 1
ST − 169
1
) 0 2000 − 169ST000
ST  845 1000 −169 000 ( 1
ST − 169
1
) 169 000 ( 1
ST − 8415 ) 0

Problem 1.25.
Suppose that USD-sterling spot and forward exchange 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.
(b) A 90-day European put option to sell £1 for $1.49 costs 2 cents.

(a) The arbitrageur buys a 180-day call option and takes a short position in a 180-day
 forward contract. If ST is the terminal spot rate, the profit from the call option is
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

or
max( ST − 1.42, 0) + 1.4318 − ST

This is
1.4318−ST when ST <1.42
0.118 when ST >1.42

This shows that the profit is always positive. The time value of money has been ignored
in these calculations. However, when it is taken into account the strategy is still likely to
be profitable in all circumstances. (We would require an extremely high interest rate for
$0.0118 interest to be required on an outlay of $0.02 over a 180-day period.)

(b) The trader buys 90-day put options and takes a long position in a 90 day forward
contract. If ST is the terminal spot rate, the profit from the put option is
max(1.49 − ST , 0) − 0.02
The profit from the long forward contract is
ST−1.4556
The profit from this strategy is therefore
max(1.49 − ST , 0) − 0.02 + ST − 1.4556
or
max(1.49 − ST , 0) + ST − 1.4756
This is
ST −1.4756 when ST >1.49
0.0144 when ST <1.49

The profit is therefore always positive. Again, the time value of money has been ignored
but is unlikely to affect the overall profitability of the strategy. (We would require interest
rates to be extremely high for $0.0144 interest to be required on an outlay of $0.02 over a
90-day period.)