CHAPTER 1 Introduction

Tutorial 1 - Practice Questions

Problem 1.1
What is the difference between a long forward position and a short forward position?

When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a
certain price at a certain time in the future. When a trader enters into a short forward contract, she is
agreeing to sell the underlying asset for a certain price at a certain time in the future. erprice at a
certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the
Problem 1.2.
Explain carefully the difference between hedging, speculation, and arbitrage.

A trader is hedging when she has an exposure to the price of an asset and takes a position in a
derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is betting
on the future movements in the price of the asset. Arbitrage involves taking a position in two or more
different markets to lock in a profit.Atrader is hedging when she has an exposure to the price of an
asset and takes a position in a derivative to offset the exposure. In a speculation the trader has no
Problem 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?
n the first case the trader is obligated to buy the asset for $50. (The trader does not have a choice.) In
In the first case the trader is obligated to buy the asset for $50. (The trader does not have a choice.) In
the second case the trader has an option to buy the asset for $50. (The trader does not have to exercise
the option.)
the second case the trader has an option to buy the asset for $50. (The trader does not have to exercise

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

(1.4000-1.3900) ×100,000 = $1,000.

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 . The trader sells for 50 cents per pound something that is
worth 48.20 cents per pound. Gain

Problem 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?

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The over-the-counter market is a telephone- and computer-linked network of financial institutions,
fund managers, and corporate treasurers where two participants can enter into any mutually acceptable
The over-the-counter market is a telephone- and computer-linked network of financial institutions,
fund managers, and corporate treasurers where two participants can enter into any mutually acceptable
contract. An exchange-traded market is a market organized by an exchange where traders either meet
physically or communicate electronically and the contracts that can be traded have been defined by the
exchange. When a market maker quotes a bid and an offer, the bid is the price at which the market
maker is prepared to buy and the offer is the price at which the market maker is prepared to sell.

tract. An exchange-traded market is a market organized by an exchange where traders either meet
Problem 1.10.
Suppose you own 5,000 shares that are 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 four months?

You could buy 50 put option contracts (each on 100 shares) with a strike price of $25 and an
expiration date in four months. If at the end of four months the stock price proves to be less than $25,
you can exercise the options and sell the shares for $25 eachou could buy 50 put option contracts (each
on 100 shares) with a strike price of $25 and an expiration date in four months. If at the end of four
months the stock price proves to be less than $25, you can exercise the options and sell the shares for $
Problem 1.11.
When first issued, a stock provides funds for a company. Is the same true of an exchange-traded stock
option? Discuss.

tAn exchange-traded stock option provides no funds for the company. It is a security sold by one
investor to another. The company is not involved. By contrast, a stock when it is first issued is sold by
the company to investors and does provide funds for the company. o another. The company is not
involved. By contrast, a stock when it is first issued is sold by the company to investors and does
Problem 1.12.
Explain why a futures contract can be used for either speculation or hedging.
an investor has an exposure to the price of an asset, he or she can hedge with futures contracts. If the
inIf an investor has an exposure to the price of an asset, he or she can hedge with futures contracts. If
the investor will gain when the price decreases and lose when the price increases, a long futures
position will hedge the risk. If the investor will lose when the price decreases and gain when the price
increases, a short futures position will hedge the risk. Thus either a long or a short futures position can
be entered into for hedging purposes.
If the investor has no exposure to the price of the underlying asset, entering into a futures contract is
speculation. If the investor takes a long position, he or she gains when the asset’s price increases and
loses when it decreases. If the investor takes a short position, he or she loses when the asset’s price
increases and gains when it decreases. vestor will gain when the price decreases and lose when the
price increases, a long futures position will hedge the risk. If the investor will lose when the price

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 b
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 priceelow
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.

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TThe 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.