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1. How is entering into a forward contract similar to barter? Can you think of costs associated with forward contracts that minimized or eliminated with futures contracts?
The contract requires the double coincidence of wants. The main problem with the forward contact is the lack of liquidity. By forming a standardized futures contract that can be traded on an exchange, the futures contract has greater liquidity compared to the forward.
2. In spring 2002, an electronically traded futures contract on the stock index, called an E-mini future, was introduced. The contract was one-fifth the size of the standard futures contract, and could be traded on the 24-hour CME Globex electronic trading system. Why might someone introduce a futures contract with these properties?
The size of the contracts allows small investors to purchase it. The fact that the contracts can be traded 24 hours a day makes the contract more liquid and allows investors to speculate using current information from markets around the world. It also makes it more convenient for foreign investors to trade the contracts.
3. A hedger buys a futures contract, taking a long position in the wheat futures market. What are the hedger’s obligations under this contract? Describe the risk that is hedged in this transaction, and give an example of someone who might enter into such an arrangement.
The hedger has taken the long position, promising to
purchase the wheat at a fixed price on a future date, and is hedging against the
risk that the price of wheat will rise.
4. A futures contract on a payment of $250 times the Standard & Poors’ 500 Index is traded on the Chicago Mercantile Exchange. At an index level of $1,000 or more, the contract calls for a payment of over $250,000. It is settled by a cash payment between the buyer and the seller. Who are the hedgers and who are the speculators in the S&P 500 futures market?
Hedgers are investors who own funds composed of stocks from the S&P 500; they will sell futures contracts to hedge against the risk that the market falls. Speculators are trying to profit from movements in the market; they will sell futures if they expect the market to fall, and buy futures if they expect the market to rise.
5. Explain why trading derivatives on centralized exchanges rather than in over-the-counter markets helps reduce systemic risk.
6. What are the risks and rewards for writing and buying options? Are there any circumstances under which you would get involved? Why or why not? (Hint: Think of a case in which you own shares of the stock on which you are considering writing a call.)
Because option buyers incur no obligations, their losses
are limited to the price paid for the option.
Their potential gains, however, can be large.
Sellers must buy or sell the underlying asset at the strike price if the
option is exercised, so their losses are unlimited.
When writing a call option, the seller can lose money if the price of the
underlying asset rises; however, if the seller owns the asset, then he or she is
insured against these potential losses and issuing a call option is not very
risky.
7. How does the existence of derivatives markets enhance an economy’s ability to grow?
The existence of derivative markets increases the economy’s
capacity to carry risk by facilitating the transfer of risk to those best able
to bear it. They allow risks to be
hedged more efficiently and at a lower cost by those who do not wish to carry
them. In the absence of these
mechanisms to deal with risk, resources may not be allocated efficiently,
hindering the ability of the economy to grow.
8. Of the following options, which would you expect to have the highest option price?
a. A European three-month put option on a stock whose market price is $90 where the strike price is $100. The standard deviation of the stock price over the past five years has been 15 percent.
b. A European three-month put option on a stock whose market price is $110 where the strike price is $100. The standard deviation of the stock price over the past five years has been 15 percent.
c. A European one-month put option on a stock whose market price is $90 where the strike price is $100. The standard deviation of the stock price over the past five years has been 15 percent.
Option Price =
intrinsic value + time value of the option
We know that a put
option is in the money if the strike price is higher than the market price and
that the time value of an option increases with the volatility of underlying
asset and the time to expiration.
Option A:
In the money - intrinsic value = $10
Option B:
Out of the money – intrinsic value = 0
Option C:
In the money – intrinsic value = $10
Looking at the
time value of the option, all three options have the same standard deviation.
A has a longer
time to expiration than C, so with the same intrinsic value and volatility, has
a higher option value.
A has the same
standard deviation and time to expiration as B but a higher intrinsic value, so
A has a higher option value than B.
A should have the highest option price.
9. What does the theory of purchasing power parity predict in the long run regarding the inflation rate of a country that fixes its exchange rate to the U.S. dollar?
According to the theory of purchasing power parity, changes in exchange rates
are tied to differences in inflation from one country to another.
If, as in the case of a fixed exchange rate, there are no exchange rate
changes, it predicts that the inflation rate in that country should be the same
as the
10. Can purchasing power parity help predict short-term movements in exchange rates?
Purchasing power parity doesn’t hold on a day-to-day basis – or even on a month-to-month or year-to-year basis. It tells us how exchange rates will move over long periods like decades. In the short run, exchange rates can deviate substantially from their purchasing power parity levels. In the short run, exchange rates are determined by a host of factors affecting supply and demand for currencies and are effectively unpredictable.
11. You need to purchase Japanese yen and have called two brokers to get quotes. The first broker offered you a rate of 125 yen per dollar. The second broker, ignoring market convention, quoted a price of 0.0084 dollars per yen. To which broker should you give your business? Why?
An exchange rate of 0.0084 dollars per yen is equivalent to
119 yen per dollar (¥1/$0.0084 = ¥119/$), so you should get yen from the first
broker.
12. If the price (measured in a common currency) of a particular basket of goods is 10 percent higher in the United Kingdom than it is in the United States, which country’s currency is undervalued, according to the theory of purchasing power parity?
According to the theory of purchasing power parity, the real exchange rate
should equal 1. If we look at the ratio
of the cost of the basket of goods in the United States to the cost in the U.K.,
that ratio (which is the real exchange rate taking the United States to be the
home country), we see that it is less than one.
The U.S. dollar is therefore undervalued.
If the dollar were to strengthen, the dollar price of the
13. Using the model of demand and supply for U.S. dollars, what would you expect to happen to the U.S. dollar exchange rate if, in light of a worsening geopolitical situation, Americans viewed foreign bonds as more risky than before? (You should quote the exchange rate as number of units of foreign currency per U.S. dollar.)
If Americans view
foreign bonds as more risky than before, they will reduce their demand for these
bonds. There will be a fall in the
supply of dollars Americans use to purchase foreign assets, shifting the supply
curve to the left. The exchange
rate, quoted as the number of units of foreign currency per U.S. dollar, will
rise, reflecting an appreciation of the U.S. dollar.