Derivatives & Risk Management

ASSIGNMENT-1

Submitted by: Group No. 8

Tejaswi Arekar 18-F-205

Chaitanya Ashra 18-F-207
Vaishnavi
Buchade 18-F-211
Shailesh Gupta 18-F-227
Asmita Malvankar 18-F-245
Ulka More 18-F-306

Q.1. 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?
Ans :

(a) The investor is obligated to sell pounds for 1.5000 when they are worth
1.4900. The gain is (1.5000−1.4900) ×100,000 = $1,000.

(b) The investor is obligated to sell pounds for 1.5000 when they are worth
1.5200. The loss is (1.5200−1.5000)×100,000 = $2,000

Q.2. 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?
Ans : (a) The trader sells for 50 cents per pound something that is worth
48.20 cents per pound.
 Gain = ( $0.50-$0.4820)x50,000 = $900

(b) The trader sells for 50 cents per pound something that is worth 51.30
cents per pound.
Loss = ($0 .5130- $0. 50) x 50 000 = $650 .

Q.3. 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?
Ans: The person who writes the put contract sells the option for a premium
and is obligated to buy the underlying assets before the maturity date should
the buyer of the contract decide to sell.
You are guaranteed to gain the premium at the writing of the contract. That is
yours regardless of the outcome.
Now if at any time within the 3 months the share price goes below $40 such
that it offsets the premium price, it is in the option owners interest to sell the
shares. In which case, I will experience a loss of (40 - spot price) * 100
dollars. The spot price could potentially be 0, hence my maximum loss is
$4000 - premiums. My maximum profit is the premiums.
On the other hand, if the share price remains above ($40 - premium paid), he
has no incentive to sell to me at $40 and I make the profit amounting to the
premiums.
If the current stock price is $41, why would the option buyer want to sell it to
me later at $40. This might be because he wants to get rid of the risk of loss
from the share price going down. Actually, But he can buy the shares later at
the lower price and sale it for $40. The optioner doesn’t need to pre own the
shares.
 Then, the question is why not go lower than $40? For the buyer of the
option going lower might be an unacceptable risk leading to just a loss
of the premium.
 Why not go higher than $40? The writer of the contract will have to
charge higher premiums.
Q.4 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?
Ans : Strategy 1 : Buy 200 shares. Strategy 2 : 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 x ($40- $30)] -
$5,800 = $14 200 from the second strategy and only 200 x ($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 x ($29- $25) x $800 whereas the second strategy leads
to a loss of the whole $5,800investment. This example shows that options
contain built in leverage.

Q.5 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?

Ans : You should 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 each.

Q.6 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.

Ans : Call Option is an option to buy assets at an agreed price on or before a

particular date. 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.
Q.7 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.
Ans : Short Position is the action of selling stocks at a high price and buying
them back at low price.
Whereas Put Position is a contract that obligates selling a security at an
agreed price at a specified date. The buyer of the put option has an option to
sell the security to the put seller at a specified price.

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
Q.8 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.
Ans: The trader has an inflow of $2 in May and an outflow of $5 in
September. The $2 is the cash received from the sale of the option. The $5 is
the result of the option being exercised. The investor has to buy the stock for
$25 in September and sell it to the purchaser of the option for $20.

Q.9. 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?
Ans: The trader makes a gain if the price of the stock is above $26 at the time
of exercise.

Q.10. A US 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.
Ans: The Company could enter into a long forward contract to buy 1 million
Canadian dollars in 6 months. This would have the effect of locking in an
exchange rate equal to the current forward exchange rate. Alternatively, the
firm could buy a call option giving it the right to purchase 1 million Canadian
dollars at a certain exchange rate in 6 months. This would provide insurance
against a strong Canadian dollar in 6 months while still allowing the firm to
benefit from a weak Canadian dollar at that time.

Q.11. 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?
Ans: a) The trader sells 100 million yen for $0.0090/yen when the exchange
rate is $0.0084/yen. The gain is100*0.0006 millions of dollars or $60,000
b) The trader sells 100 million yen for $0.0090/yen when the exchange rate is
$0.0101/yen. The loss is 100*0.0011 millions of dollars or $1,10,000
Q.12. 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–US 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.
Ans: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
 ST 
0 if ST  845
845  ST  169
When 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  S1  169
1
 0 T
2000  169S000 T

ST  845 1000 169 000  1

ST  169
1
 169 000  1
ST  8415  0
Q.13. On July 1, 2011, a company enters into a forward contract to buy 10
million Japanese yen on January 1, 2012. On September 1, 2011, it enters
into a forward contract to sell 10 million Japanese yen on January 1, 2012.
Describe the payoff from this strategy
Ans: Suppose F1 and F2 are the forward exchange rates for the contracts
entered into July 1, 2010 and September 1, 2010, and S is the spot rate on
January 1, 2011. (All exchange rates are measured as yen per dollar).
The payoff from the first contract is(S – F1)million yen and the payoff from
the second contract is (F2- S) million yen.
The total payoff is therefore(S – F1) + (F2- S) = (F2 – F1) million yen.

Q.14. 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.
Ans: (a)The arbitrageur buys a 180-day call option and takes a short position
in a 180-dayforward contract.
If St is the terminal spot rate, the profit from the call option is
Max (St -1.52 ,0) – 0.02
The profit from the short forward contract is 1.5518- St
The profit from the strategy Max (St -1.52 ,0) – 0.02 + 1.5518- St
This is
1.5518- St When St<1.52
0.0118 When St>1.52

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.
IfSt is the terminal spot rate, the profit from the put option is
Max (1.59 - St ,0)-0.02
The profit from the long forward contract is
St −1.5556
The profit from this strategy is Max (1.59 - St ,0)-0.02+ St −1.5556
This is
St -1.5756When St>1.52
0.0144When St<1.52
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 a90-day period.)

Q.15. 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.
Ans : If the stock price is between $30 and $33 at option maturity the trader
will exercise the option, but lose money on the trade. Consider the situation
where the stock price is $31. If the trader exercises, she loses $2 on the trade.
If she does not exercise she loses $3 on the trade. It is clearly better to
exercise than not exercise.

Q.16. 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?
Ans: The trader’s maximum gain from the put option is $5. The maximum
loss is $35, corresponding to the situation where the option is exercised and
the price of the underlying asset is zero. If the option were a call, the trader’s
maximum gain would still be $5, but there would be no bound to the loss as
there is in theory no limit to how high the asset price could rise.