Answers to Questions in Chapter 11 Derivative Instruments



Answers to Questions in Chapter 11 Derivative Instruments

1. Both options and forward contracts are considered derivative instruments. Options and forward contracts have a number of similar general characteristics: (1) both instruments specify the type and quantity of the underlying asset, (2) both specify a specific length of time during which the contract is viable, (3) buyers of both instruments are able to lock in a transaction price, and (4) profits or losses depend upon the difference between the asset's spot price and the exercise price at the time the instrument is executed or it expires.

An option gives the investor the right (but not the obligation) to buy or sell an asset at a stated price on or before the expiration date. In a forward contract, the buyer is obligated to purchase the asset and the seller is obligated to sell the asset at the stated price on the stated date.

2. Although forward and futures contracts are generally quite similar in nature, futures contracts have less liquidity risk and default risk. Forward contracts are private arrangements between two parties traded in the over-the-counter markets, they are generally not standardized. Futures contracts are traded on organized futures exchanges with standardized terms and conditions. In order to get out of a forward contract, the buyer or seller needs to find a replacement investor. Futures contracts can be bought and sold in secondary markets. The futures exchange becomes the counterparty to all transactions. Investors in futures contracts are required to deposit funds (margin) with the futures clearinghouse (thus reducing default risk). In the case of a forward contract, an investor could default on the arrangement because of insufficient funds to purchase the asset, etc.

5. A derivative security is defined as an instrument that has its value determined by the value of an underlying instrument. An investor may choose to purchase a derivative rather than the underlying asset, because in many cases derivatives are less expensive. Commissions and required investments (margin requirements) for derivatives are generally lower than in the corresponding cash market.

Problems

4

(a) One July corn contract = 5,000 bu. x $2.4625 per bu.= $12,312.5

(b) Margin = .05 x 5,000 bu. x $2.4625 per bu.= $615.625

(c) Purchase 1 July corn contract @ $2.4625 per bu.

5,000 bu. x $2.4625 = $12,312.5

Sell 1 July corn contract @ $2.75 per bu.

5,000 bu. x $2.75 = $13,750

Gain in futures = $13,750 - $12,312.5 = $1,437.5

Rate of return = $1437/$615.625 = 2.335 or 233.5%

(assuming 5% margin)

8

(a) Purchase Microsoft Oct 60 call

$60

$66.70

-$6.7

(b) Writing (selling) an uncovered Oct 60 call

$6.70

$60

$66.70

(c). Writing (selling) a covered Oct 60 call. Assumes stock initially purchased at $63.20

$3.50

$60

$56.5

9.

(a). Purchase Microsoft Jan 65 put

$65

$58.3

-$6.7

(b). Protective put using Jan 65 put. Assume stock initially purchased at $63.2

$65

$69.9

-$4.9

(c). Writing (selling) Jan 65 put

$6.70

$58.3 $65

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