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

The difference is one of buying versus selling. The party that takes the long forward position agrees to buy the
underlying asset at a specified future date for a specified price. The other party that assumes the short position
agrees to sell the underlying asset at the same specified date for the same price. This forms what is known as a
forward contract.
1.2 Explain carefully the difference between hedging, speculation, and arbitrage.
 Hedgers use derivatives to reduce the risk from variation of a market variable in the future. There is no
gaurantee that the outcome of hedgin will necessarily be better than not hedging. Of course, one must
think of these scenarios in terms of ensembles. Hedging can be done using forward contracts and options.
The former (forward contracts) is designed to reduce risk by fixing the price that the hedger will pay or
recieve for the underlying asset. The latter (options) provide insurance by offering a way for the investors
to protect themselves against adverse price movements in the future while allowing themselves to benefit
from favorable price movements.
 Speculators use derivatives to bet on the future direction of a market variable. The same two financial
instruments (forward and option contracts) can be used to speculate. Speculators wish to take a position
in the market and are betting that either the price of the asset will go up or will go down. When a speculator
uses futures, the potential loss as well as potential gain is large. When options are used, no matter how
bad things get the speculator’s loss is limited to the amount paid for the options.
 Arbitrageurs take ofsetting position in two or more instruments to lock in a profit. They participate in
futures, forward and options markets. Arbitrage involves locking in a riskless profit by simultaneously
entering into transactions in two or more markets. Example: Suppose a stoc price is $140 in New York
and $100 in London when the exchange rate is $1.4300 per pound. Then an arbitrageur can buy 100 shares
of stock in New York and sell them in London to obtain a risk free profit
of 100×[$1.43×100−$140]100×[$1.43×100−$140] or $300. These opportunities are very temporary as
supply and demand would cause the dollar price to rise and the sterling price to drop. Existence of profit
hungry arbitageurs makes it unlikely that a major disparity between the sterling and dollar prices exist.
1.4 Explain carefully the difference between selling a call option and buying a put option.
The party that sells the call option is obliged to buy the stock at the strike price before the expiry date if the
buyer of the call option decides to sell. Note that regardless of the buyers exercise of the option, the seller of the
call option keeps the premiums.
The party that buys the put option has the right, but not the obligation to sell an asset at the strike price before
the expiry date. For this right, he pays a premium.
An unrelated point is that for a call option, the higher the strike price, the lower the premium. For a put option,
the lower the strike price, the lower the premium.
1.5 An investor enters into a short forward contract to sell 100,000 GBP for US dollars at an exchange
rate of 1.4000 USD/pound. How much does the investor gain or lose at the end of the contract if the
exchange rate at t.he end of the contract is (a) 1.3900 and (b) 1.4200?
The investor at the end of the contract will have to sell 100,000 GBP for 140,000 USD.
a. When the spot price is 1.3900 the price of 100,000 GBP is 139,000 USD. Hence, the investor gains 1000
USD for his investment.
b. When the spot price is 1.4200, the price of 100,000 GBP is 142,000 USD. Hence, the investor loses
2000 USD.
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 commited yourself to?
How much could you gain or lose?
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 gauranteed to gain the premium at the writing of the contract. That is yours regardless of the outcome.
Now if at anytime 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.
Now the questions that are nagging at me are the following: * 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, I hadn’t thought of this at first but he can buy the shares later at the lower
price and sale it for $40. The optioner doesn’t need to preown 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.
1.8 What is the difference between the OTC market and the exchange traded market? What are the bid
and offer quotes of a market maker in the over the counter market?
 In an exchange-traded market, individuals are only allowed to trade standardized contracts that have
been defined by the exchange.
 The over-the-counter market is an important alternative to exchanges. Participants are free to make any
mutually attractive deal.
Bid and offer prices at OTC market is a price at which they are prepared to buy and sell the asset.
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 $5800 to invest. Identify two alternative
investment stratedies, ine in the stock and the other in an option on the stock. What are the potential
gains and losses from each?
 One approach is to buy 29 stocks at $29 dollars and if it goes up in 3 months, you can sell it for a profit.
If the stock price goes down, you can potentially lose your entire capital.
 Another approach is to buy a call option or the right to buy stocks at the strike price during a 3 month
period. In this case, he has to pay a premium of $2.90/share or $580. That is his maximum loss on his
capital. Meanwhile, if the spot price goes above (30 + premium) dollars, he has the right to buy 200
shares at 30 dollars and then sell them for a profit. In this case, there is no upper bound to his profits,
though it becomes more unlikely the higher the profit.