Use the three tables below to answer the following questions



Exam #1

Econ 351

Spring 2016

Good Luck!

Name ______________________________________ Last 4 PSU ID __________

Please put the first two letters of your last name on the top right hand corner of this cover sheet. Also, ONLY NON-PROGRAMMABLE CALCULATORS ARE ALLOWED - THERE ARE NO SUBSTITUTES. THANKS FOR YOUR COOPERATION!

GOOD LUCK!!!

1. (40 points total) Use the three tables below to answer the following questions

Table 1

[pic]

Table 2

[pic]

Table 3

[pic]

a) (5 points) Suppose we play a long straddle by purchasing one 97 call option and one 97 put option at Table 1 and close both positions at Table 2. Calculate the profit or loss AND rate of return.

b) (5 points) Suppose that you had a choice to close on Table 2 as above in a) or you could wait and close on Table 3. How much money would you save or lose by waiting until Table 3 to close as compared to closing at Table 2? Please show your work.

c) (5 points) Suppose you inherited 100 shares of AAPL, when the spot price is as it is at Table 1 and decided to hedge this position. Consider the following 2 hedges: i) write a 97 call or ii) buy a 97 put. Calculate the profits / losses with each hedge assuming that you closed at Table 2. Which hedge worked out better?

d) (5 points) In the space below, on the SAME graph, draw the evolution of the premiums of the 97 call and 97 put until expiration assuming we freeze the spot price of AAPL as it is in Table 1. Be sure to label which line is the call and which is the put

e) (20 points) In the space below, plot the profit functions of the two hedges that you played above: one for the 97 call that you wrote and one for the 97 put that you bought. Be sure to label the breakeven points and the two spot prices at expiration where each hedge would work out the same - that is, the profit or loss for each hedge would be the same at these two spot prices at expiration. Label these points as ND for no difference.

2. (40 points total)

a) (30 points for a correct and completely labeled graph) We are now going to graph the profit functions for the long and short straddle as above where we opened up the positions at Table 1. Recall that we are buying one 97 call and one 97 put. The player of the short straddle writes these two options. Along with locating the breakeven points, identify the profit / loss for both players for two points: point A where the spot price of AAPL at expiration is as it is at Table 2 ($95.20) and point B where the spot price of AAPL at expiration is as it is at Table 3 ($101.42).

.

b) (10 points) Consider point B only. Assume that the player of the long straddle is going to exercise the option that is in the money. Go through the costs and the revenue and show that the profit or loss for the player of the long straddle is consistent with point B on your graph (recall, they are exercising the option that is in the money).

3.(40 points total)

a) (30 points for a correct and completely labeled graph) We are now going to plot the profit functions of a long and short strangle. The player of the long strangle buys a 99 call and a 95 put at Table 1. The player of the short strangle writes these two options. Along with locating the breakeven points, identify the profit / loss for both players for two points: point A where the spot price of AAPL at expiration is as it is at Table 2 ($95.20) and point B where the spot price of AAPL at expiration is as it is at Table 3 ($101.42).

b) (10 points) Consider your point B above. Prove that the player of the short strangle, the person who wrote both options, will make a profit or loss associated with point B. Again, assume that the player of the long strangle exercises the option that is in the money. What does player of the short strangle have to do exactly? Provide the math as to why the player of the short strangle makes a profit or loss, whichever applies, associated with point B.

4. (40 points) As we know, Janet Yellen recently finished up her two day Humphrey-Hawkins testimony to lawmakers in Washington DC. On the second day, 2/11/16, the topic of negative interest rates came up and I argued that perhaps, she could have handled it a little better. Note that the article (below) was written Thursday, 2/11 at 11:24 am. In what follows, we are going to take a look at a few of the bets I made that Thursday morning, but I made them exactly one hour before this article was written which would be about an hour before Janet Yellen was discussing negative interest rates ..... I wish I would have waited another hour and we will see why!

I was watching as the stock market was tanking (falling) and there was a significant rally in US government securities (yields on the 10 year GS were plummeting), another typical 'rush to the safe haven' of US Treasuries. I had a hunch that things would reverse so I went long on stocks and short on Treasuries. In particular, I bought 25 March 2016 future contracts on the Dow Mini-sized index and opened with the price as shown in graphic = 15,656. Note that the multiplier on the mini-sized contracts is 5 so that for example, if I opened when the futures price was 16,000 then each contract would be worth 5 x 16,000 = $80,000. The margin requirement for each futures contract in Stock Trak is $2,750.

a) (5 points) What is the leverage ratio when I opened up my position? Recall, I opened at 15,656. Please take the leverage ratio to 2 decimal places.

b) (5 points) Please interpret this leverage ratio.

c) (5 points) Suppose I close this long bet on the Dow when the futures price is 15,925 (as in graphic) as it was at close on Friday, 2/12. What is my profit or loss and rate of return?

d) (5 points) Now calculate the rate of return using the leverage ratio.

e) (5 points) As I mentioned earlier, I took this position about an hour before the topic of negative interest rates came up in Janet Yellen's testimony (this was during the Q & A). As you can see in the graphic of the Dow futures contract, the Dow futures fell shortly (and quite abruptly) after I opened and bottomed out at about 15,500 (this is Chicago time - add an hour for EST). How much more money could have I made, relative to when I originally opened, if I had waited for this futures contract to bottom out at 15,500? Note that I am still closing at 15,925.

[pic]

One of the other bets I made the same morning at the same time was to go short on 10 year GS futures contracts. My thinking was that the rally in these securities was coming to an end. Again, I wish I would have waited another hour or so when Janet Yellen was discussing negative interest rates. Consider the graphic below.

I decided to short the March 2016 futures 10 Year GS buy selling 25 futures contracts when the price was 132. The margin requirement in Stock Trak is $1623 per futures contract. Please answer the following questions.

f) (5 points) What is the leverage ratio when I opened up my short position?

g) (5 points) What is my rate of return? Please use the leverage ratio to calculate the rate of return. Note, I close at 131.

h) (5 points) How much more money could I have made if I had waited until Janet Yellen started talking about negative interest rates? As soon as I opened at 132, there was a rush to the safe haven that I could have exploited if I waited and sold my 25 futures at 132.5 rather than 132 (see graphic). Assume that I still closed at 131.

5) (35 points) In class we went over exactly what happened in the movie 'Trading Places.' Dan Aykroyd (DA) and Eddie Murphy (EM) (pic below) got a hold of the actual orange crop report, altered it, and gave it back to the 'two old guys' - the Duke brothers. Given the altered crop report, the Duke brothers thought that the freeze destroyed a portion of the orange crop and thus, believed that the price of orange juice would skyrocket given the bad orange crop (low supply!). Dan Aykroyd and Eddie Murphy knew the true report which indicated that the orange crop was just fine, the cold weather had a negligible (small if any) effect on the orange crop. Orange juice futures contracts are for 15,000 pounds of orange juice and are priced in cents per pound (i.e. 150 = $1.50 per pound) The margin requirement in Stock Trak is $1,100 per contract. In what follows we will re-create the scene using the April 2016 OJ futures contracts.

a) (5 points) DA and EM open up their position after the Duke brothers bid up the price of OJ futures to 150. When DA calls out "sell 30 April at 150" they are selling 30 April OJ futures contracts at 150. What is their leverage ratio when they opened up their position?

b) (5 points) When DA and EM close by buying 30 futures at 120, how much money did they make or lose?

c) (5 points) What is their rate of return ? Use whichever method you prefer.

Now let's add a little twist to the story. One of the Duke brothers isn't sure about the validity of the orange crop report that they received and thus is concerned that if the orange crop is fine, they can lose a lot of money (as they did in the movie). So he seeks out someone that knows his or her finance and that person is you.....they need to hedge their long position! So you instruct them to take their long position at open by buying 30 April OJ futures when the price is 130. You then tell them to buy 30 April futures options puts on OJ with a strike price of 140. Each put represents one futures contract and costs $1,000 per put. We now compare two scenarios:

d) (5 points) Scenario #1: Assume no hedge and that the Duke brothers bought 30 Futures contracts at open where the price was 130 and closed at 120. How much money did they make or lose?

e) (10 points) Scenario #2: Assume the hedge as above. The Duke brothers bought 30 futures contracts at open where the price was 130 and also bought 30 April put options with a strike price of 140 for $1,000 per put. Both positions are closed when futures price of OJ is 120. Given both bets and assuming that 120 is the price at expiration, how much money did they make or lose?

f) (5 points) Suppose that the Duke brother that sought you out for your financial advice agreed to give you a check for 10% of the money that you saved them with the hedge, but only if the hedge worked. So compare the difference between your answers for Scenario #1 (no hedge) and Scenario #2 (with hedge). How much is the check for!

Suppose you are in charge of an oil refinery which means you, as in your firm, are a user of crude oil and a producer of gasoline. As we know, both crude oil and gasoline are part of a well developed financial market so that futures and futures options markets exist that are extremely liquid for these two commodities. Suppose that you know next to nothing about markets and so you need to hire someone to help you make decisions as to how to the ‘play the game’ and maximize profits. Naturally, you maximize profits by minimizing the cost of the input…oil … and maximizing your revenue…..selling gas. We assume away all costs except for the input oil and we have the following production figures – each oil contract consists of 1000 barrels of crude and with 1000 barrels we can produce 100,000 gallons of gas. Each gas contract is for 50,000 gallons so for every oil contract that we buy we produce the equivalent of two gasoline contracts. We have a contract with BP for 500,000 gallons of gasoline for delivery at the end of May, 2016 (10 gasoline contracts worth) and we need to buy the oil (5 contracts), the input, at the end of April to give us time to refine it in time for delivery. The charts below represent the two futures contracts we consider – the April 2016 oil contract and the May 2016 gasoline contract.

Four different job applicants come in and you interview them….they all advise you a little differently.

1) Future guy (FG)– this person simply plays the futures market – so they would advise you buy oil futures and to sell gas futures.

2) Going naked (GN)– this person doesn’t hedge and would advise you to take your chances in the spot market – think of this person as having a high risk appetite.

3) The option buyer (OB)– this person would advise you to buy futures options calls on oil and futures options puts on gas.

4) The option writer (OW) - this person would advise you to write futures options puts on oil and to write futures options calls on gas.

6) (36 points total) We consider the oil market first (see graph below). Suppose that the futures price of oil is $32 (point A) per barrel and that futures options, both puts and calls, are available at a price of $2,000 each (STRIKE PRICE = $32, EACH CALL AND PUT REPRESENTS ONE FUTURE CONTRACT). We consider two different scenarios with regard to this oil market and you need to figure out which of the job applicants have the best strategy given each scenario.

[pic]

Scenario #1: The spot price of oil is $34 per barrel at expiration (point B on graphic above). Recall, you need to buy 5 contracts or 5000 barrels of oil to make the gas.

a) (8 points) Given Scenario #1, which of the four strategies is the best in terms of minimizing the cost of obtaining the 5000 barrels of oil and which strategy is the worst in terms of the costs of obtaining the oil? Be specific and provide the costs associated with each strategy for full credit. , Please use real numbers and show all work!

FG

GN

OB

OW

Scenario #2: The spot price of oil is $26 per barrel at expiration (point C on graphic above). Recall, you need to buy 5 contracts or 5000 barrels of oil to make the gas.

b) (8 points) Given Scenario #2, which of the four strategies is the best in terms of minimizing the costs of obtaining the 5000 barrels of oil and which strategy is the worst in terms of the costs of obtaining the oil? Be specific and provide the costs associated with each strategy for full credit. Please use real numbers and show all work!

FG

GN

OB

OW

Graphing – In the space below, please graph the futures and futures option profit function for the oil market given each Scenario. Note that we are only graphing the profit functions for you, the refinery and not the oil producer (only one graph) Your graph will have 3 profit functions: FG, OB, and the OW, please label each. Recall, Scenario #1 (LABEL AS POINT A) is when the spot oil price is $34 per barrel at expiration and Scenario #2 (LABEL AS POINT B) is when oil expires at $26 per barrel. Be sure to label diagram completely including the break even points! 20 points for completely labeled graph.

7) (36 points total) We now consider the market for gasoline (see graph below). Suppose that the futures price of gasoline is $1.05 per gallon and that futures options, both puts and calls are available at a price of $4,000 each (STRIKE PRICE = $1.05, EACH CALL AND PUT REPRESENTS ONE FUTURE CONTRACT). We consider two different scenarios with regard to this gasoline market and you need to figure out which of the job applicants have the best strategy in terms of maximizing revenue, given each scenario.

[pic]

Scenario #1: The spot price of gasoline is $1.13 per gallon at expiration (point B on graphic above). Recall, you need to sell 10 contracts or 500,000 gallons (10 X 50,000) of gas to sell to BP.

a) (8 points) Given Scenario #1, which of the four strategies is the best in terms of maximizing your revenue and which strategy is the worst in terms of revenue. Be specific and provide the revenue associated with each strategy for full credit. , Please use real numbers and show all work!

FG

GN

OB

OW

Scenario #2: The spot price of gasoline is $0.90 per gallon at expiration (point C on graphic above). Recall, you need to sell 10 contracts or 500,000 gallons (10 X 50,000) of gas to sell to BP.

b) (8 points) Given Scenario #2, which of the four strategies is the best in terms of maximizing your revenue and which strategy is the worst in terms of revenue. Be specific and provide the revenue associated with each strategy for full credit. , Please use real numbers and show all work!

FG

GN

OB

OW

Graphing – In the space below, please graph the futures and futures option profit function for the gas market given each Scenario. Note that we are only graphing the profit functions for you, the refinery and not BP, the user of the gas (only one graph) Your graph will have 3 profit functions: FG, OB, and the OW, please label each. Recall, Scenario #1 (LABEL AS POINT A) is when the spot gas price is $1.13 per gallon at expiration and Scenario #2 (LABEL AS POINT B) is when gas expires at $0.90 per gallon. Be sure to label diagram completely including the break even points! 20 points for completely labeled graph.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download