Practice Questions
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.
1.5. An investor enters into a short forward contract to sell 100,000 British pounds for
U.S. dollars at an exchange rate of 1.5000 USD 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?
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
and (b) 51.30 cents per pound?
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
or exchange-traded market?
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 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.
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.
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 stock
price at maturity of the option.
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 trader’s cash flows if the
option is held until September and the stock price is $25 at that time.
1.16. A trader writes a December put option with a strike price of $30. The price of
the option is $4. Under what circumstances does the trader make a gain?
1.17. A company knows that it is due to receive a certain amount of a foreign currency
in 4 months. What type of option contract is appropriate for hedging?
1.18. A U.S. company expects to have to pay 1 million Canadian dollars in 6 months.
Explain 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 $0.0090 per yen. How much does the trader gain or lose if the exchange
rate at the end of the contract is (a) $0.0084 per yen and (b) $0.0101 per yen?
1.20. The CME Group offers a futures contract on long-term Treasury bonds.
Characterize the traders likely to use this contract.
1.21. ‘‘Options and futures are zero-sum games.’’ What do you think is meant by this?
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 a strike price that is equal to the forward price of the asset at the time the
portfolio is set up.
1.23. In the 1980s, Bankers Trust developed index currency option notes (ICONs).
These were bonds in which the amount received by the holder at maturity varied 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–USD 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 𝑥 ( − 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.
1.24. On July 1, 2017, a company enters into a forward contract to buy 10 million
Japanese yen on January 1, 2018. On September 1, 2017, it enters into a forward contract
to sell 10 million Japanese yen on January 1, 2018. Describe the payoff from this strategy.
1.25. Suppose that USD/sterling spot and forward exchange rates are as follows:
Spot 1.5580
90 - day forward 1.5556
180 - day forward 1.5518
What opportunities are open to an arbitrageur in the following situations?
(a) A 180-day European call option to buy £1 for $1.52 costs 2 cents.
(b) A 90-day European put option to sell £1 for $1.59 costs 2 cents.
1.26. A trader buys a call option with a strike price of $30 for $3. Does the trader ever
exercise the option and lose money on the trade? Explain your answer.
Further questions
1.27. A trader sells a put option with a strike price of $40 for $5. What is the trader’s
maximum gain and maximum loss? How does your answer change if it is a call option?
1.28. ‘‘Buying a put option on a stock when the stock is owned is a form of
insurance.’’ Explain this statement.
1.29. On May 3, 2016, as indicated in Table 1.2, the spot offer price of Google stock
is $696.25 and the offer price of a call option with a strike price of $700 and a maturity
date of September is $39.20. A trader is considering two alternatives: buy 100 shares of
the stock and buy 100 September call options. For each alternative, what is (a) the upfront
cost, (b) the total gain if the stock price in September is $800, and (c) the total loss if the
stock price in September is $600. Assume that the option is not exercised before September
and if the stock is purchased it is sold in September.
1.30. What is arbitrage? Explain the arbitrage opportunity when the price of a dually
listed mining company stock is $50 (USD) on the New York Stock Exchange and $60
(CAD) on the Toronto Stock Exchange. Assume that the exchange rate is such that 1 U.S.
dollar equals 1.21 Canadian dollars. Explain what is likely to happen to prices as traders
take advantage of this opportunity.
1.31. Trader A enters into a forward contract to buy an asset for $1,000 in one year.
Trader B buys a call option to buy the asset for $1,000 in one year. The cost of the option
is $100. What is the difference between the positions of the traders? Show the profit as a
function of the price of the asset in one year for the two traders.
1.32. In March, a U.S. investor instructs a broker to sell one July put option contract
on a stock. The stock price is $42 and the strike price is $40. The option price is $3. Explain
what the investor has agreed to. Under what circumstances will the trade prove to be
profitable? What are the risks?
1.33. A U.S. company knows it will have to pay 3 million euros in three months. The
current exchange rate is 1.1500 dollars per euro. Discuss how forward and options contracts
can be used by the company to hedge its exposure.
1.34. A stock price is $29. A trader buys one call option contract on the stock with a
strike price of $30 and sells a call option contract on the stock with a strike price of $32.50.
The market prices of the options are $2.75 and $1.50, respectively. The options have the
same maturity date. Describe the trader’s position.
1.35. The price of gold is currently $1,200 per ounce. The forward price for delivery
in 1 year is $1,300 per ounce. An arbitrageur can borrow money at 3% per annum. What
should the arbitrageur do? Assume that the cost of storing gold is zero and that gold
provides no income.
1.36. The current price of a stock is $94, and 3-month European call options with a
strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock
will increase is trying to decide between buying 100 shares and buying 2,000 call options
(1⁄4 20 contracts). Both strategies involve an investment of $9,400. What advice would you
give? How high does the stock price have to rise for the option strategy to be more
profitable?
1.37. On May 3, 2016, an investor owns 100 Google shares. As indicated in Table 1.3,
the share price is about $696 and a December put option with a strike price of $660 costs
$38.10. The investor is comparing two alternatives to limit downside risk. The first
involves buying one December put option contract with a strike price of $660. The second
involves instructing a broker to sell the 100 shares as soon as Google’s price reaches $660.
Discuss the advantages and disadvantages of the two strategies.
1.38. A bond issued by Standard Oil some time ago worked as follows. The holder
received no interest. At the bond’s maturity the company promised to pay $1,000 plus an
additional amount based on the price of oil at that time. The additional amount was equal
to the product of 170 and the excess (if any) of the price of a barrel of oil at maturity over
$25. The maximum additional amount paid was $2,550 (which corresponds to a price of
$40 per barrel). Show that the bond is a combination of a regular bond, a long position in
call options on oil with a strike price of $25, and a short position in call options on oil with
a strike price of $40.
1.39. Suppose that in the situation of Table 1.1 a corporate treasurer said: ‘‘I will have
£1 million to sell in 6 months. If the exchange rate is less than 1.42, I want you to give me
1.42. If it is greater than 1.48, I will accept 1.48. If the exchange rate is between 1.42 and
1.48, I will sell the sterling for the exchange rate.’’ How could you use options to satisfy
the treasurer?
1.40. Describe how foreign currency options can be used for hedging in the situation
considered in Section 1.7 so that (a) ImportCo is guaranteed that its exchange rate will be
less than 1.4700, and (b) ExportCo is guaranteed that its exchange rate will be at least
1.4300. Use DerivaGem to calculate the cost of setting up the hedge in each case assuming
that the exchange rate volatility is 12%, interest rates in the United States are 2%, and
interest rates in Britain are 1%. Assume that the current exchange rate is the average of the
bid and offer in Table 1.1.
1.41. A trader buys a European call option and sells a European put option. The
options have the same underlying asset, strike price, and maturity. Describe the trader’s
position. Under what circumstances does the price of the call equal the price of the put?