Derivatives: Futures

1. Suppose you have a diversified portfolio of large cap stocks worth $5 million.
However, you don’t have any confidence that the market is going to stay where
it is (the index is at 1000 points), so you want to hedge some of that risk. In
particular you would like to reduce your exposure by 25%. How could you use
S&P 500 futures to implement this hedge? (recall that the value of a futures
contract is $250 times the S&P 500 index.)

(A) Sell 4 futures

(B) Buy 4 futures
(C) Sell 5 futures

$5, 000, 000 × 25%

=5
$250 × 1, 000
(D) Buy 5 futures

2. Suppose the market-maker wishes to hedge a long forward position.

(A) The market-maker offsets this risk with a reverse cash-and-carry that en-
tails short-selling the index and entering into a long forward position.
TRUE
(B) The market-maker offsets this risk with a cash-and-carry which entails cre-
ating a synthetic long forward position.
(C) The market-maker offsets this risk with a cash-and-carry that entails short-
selling the index and entering into a long forward position.
(D) The market-maker offsets this risk with a cash-and-carry which entails cre-
ating a synthetic short forward position.

1
3. An American investor wants to hold 100 euros six months from today. You are
given the following:

• the spot exchange rate is $1.12 per euro;

• the continuously compounded risk-free interest rate on the euro is 3.0%;
• the continuously compounded risk-free interest rate on the USD is 1.25%.

If the investor does not want to bear the exchange rate risk, what is the forward
price the investor can lock in today?

(A) 108.69
(B) 110.33
(C) 111.02
TRUE : 100 × e(0.0125−0.03)×0.5 1.12 = 111.024
(D) 112
(E) None of these

4. Suppose that copper costs $3.00 today and the continuously compounded conve-
nience yield (e.g., lease rate) for copper is 5%. The continuously compounded
interest rate is 10%. The copper price in 1 year is uncertain and copper can be
stored costlessly. What is the No Arbitrage 1-year forward price?

(A) 3.316
(B) 3.486
(C) 3.150
(D) 3.154
TRUE: The equilibrium forward price is calculated according to our pricing
formula:

F0,T = S0 × e(r−y)×T = $3.00 × e(0.10−0.05)×1 = $3.00 × 1.05127 = $3.1538 .

2
5. The spot price of a commodity is $70.00 per unit. Forward prices for 3, 6, 9,
and 12 months are $70.70, $71.41, $72.13, and $72.86. Is this an example of
contango or backwardation?

(A) Contango
TRUE: The forward curve is upward sloping, thus the prices are in contango.
(B) Bacwardation

6. Assume that the spot price of oil is $30 a barrel and that market participants
expect the price of oil to be $27 in three months. In order to entice investors into
the market, the futures price is set at $25, which is a discount to the expected
future spot price. Now suppose that at the time the contract expires, oil is
trading at the expected price of $26. What is the profit of the investor, and the
break-down of the profit into premium and price change?

(A) The profit is $1, and it can be broken into $2 premium, and −1$ price change.
TRUE:
(B) The profit is $1, and it can be broken into −1$ premium, and $2 price change.
(C) The profit is $1, and it can be broken into $0 premium, and $1 price change.
(D) The profit is $1, and it can be broken into $1 premium, and $0 price change.
(E) The profit is $2, and it can be broken into $2 premium, and $0 price change.
(F) The profit is $2, and it can be broken into $0 premium, and $2 price change.

3
 Derivatives: Options
1. A call option gives the seller [...]

(A) the right to sell the underlying security

(B) the obligation to sell the underlying security
TRUE
(C) the right to buy the underlying security
(D) the obligation to buy the underlying security

4
 2. In figure 1, with a expiration price of 120, the best return is obtained by [...]

(A) buying futures

TRUE : If the index rises, the forward contract is more profitable than
the option because it does not entail paying a premium. If the index falls
sufficiently, however, the option is more profitable because the most the
option buyer loses is the future value of the premium. This difference
suggests that we can think of the call option as an insured position in the
index. Insurance protects against losses, and the call option does the same.
Carrying the analogy a bit further, we can think of the option premium as,
in part, reflecting the cost of that insurance. The forward, which is free,
has no such insurance, and potentially has losses larger than those on the
call. (excerpt from McDonal, Chapter 2)
(B) buying a call option
(C) selling futures
(D) buying a put option
(E) None of these

Figure 1: Profit or loss for buyer of call option and buyer of futures

5
3. The premium on a 1000-strike, 2-month European call option on the market
index is $20. After 2 months the market index spot price is 1075. If the risk-
free interest rate equals 0.5% (discretely compounded) per month, what is the
long-call profit?

(A) 54.90.
(this is WRONG because it uses c.c. rate e0.05×2 )
(B) 54.80

(ST − K)+ − F V0,T [VC,0 ] = (1075 − 1000)+ − 20(1.005)2 = 54.80.

(C) 75.
(D) None of the above.

6
4. Recall that a buyer of commodity has an inherent short position in that asset.
If (s)he decides to use European calls to hedge (s)he should:

(A) write the call option

(B) buy the call option
(TRUE)

5. An investor purchases XYZ at $57 and writes 60 out-of-the money calls at $1.70.
The options have 60 days until they expire. What will be this investor’s return
(in annualized terms, i.e., multiplying daily returns by 365) if the price of the
underlying stock remains unchanged?

(A) 0%
(B) -3.07%
(C) 2.9%
(D) 3.07%
(E) 18.68%
(TRUE): The profit on the strategy, assuming an unchanged stock price,
will be $1.70, the option’s premium. Remember that if the price of the
stock remains unchanged the calls will expire worthless as they will be out-
of-the-money. The investor will still hold the shares of XYZ (still worth
$57) and will have a gain of $1.70 on the expiring options. The static
return will therefore be:

1.70 / ($57 − $1.70) = 3.07%

$ |{z}
| {z }
prof it cost of shares

It is customary to annualize returns calculated for buy/writes. This is

done by dividing the actual return by the number of days until expiration
and multiplying by 365:

(3.07% × 365)/60 = 18.68%annualized

7
6. Determine which of the following positions has or have an unlimited loss po-
tential from adverse price movement in the underlying asset regardless of the
initial premium received.

(I) Short 1 forward contract.

(II) Short 1 call option.
(III) Short 1 put option.

(A) None.
(B) I and II only.
TRUE
(C) I and III only.
(D) II and III only.
(E) The correct answer is not given by (A), (B), (C), or (D).