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Chapter 1 Essay

3308 words - 14 pages


Practice Questions

Problem 1.8.
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 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.

Problem 1.9.
A stock when it is first issued provides funds for a company. Is the same true of an exchange-traded stock option? Discuss.

An exchange-traded stock option ...view middle of the document...

The live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer’s viewpoint, what are the pros and cons of hedging?

The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, the gain on the futures contract will offset the loss on the sale of the cattle. If the price of cattle rises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Using futures contracts to hedge has the advantage that it can at no cost reduce risk to almost zero. Its disadvantage is that the farmer no longer gains from favorable movements in cattle prices.

Problem 1.12.
It is July 2010. A mining company has just discovered a small deposit of gold. It will take six months to construct the mine. The gold will then be extracted on a more or less continuous basis for one year. Futures contracts on gold are available on the New York Mercantile Exchange. There are delivery months every two months from August 2010 to December 2011. Each contract is for the delivery of 100 ounces. Discuss how the mining company might use futures markets for hedging.

The mining company can estimate its production on a month by month basis. It can then short futures contracts to lock in the price received for the gold. For example, if a total of 3,000 ounces are expected to be produced in September 2010 and October 2010, the price received for this production can be hedged by shorting a total of 30 October 2010 contracts.

Problem 1.13.
Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a gain? 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 on a stock with a strike price of $60 costs $4 and is held until June. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option.

The seller of the option will lose 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.



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