Futures Contract and Option
tistisSolution: Exercise 1 1. What is the difference between a long forward position and a short forward position?
Ans: When the enters into a long forward contract, he/she is agreeing to buy the underlying asset for a certain price at a certain time in future. When the enters into a short forward contract, he/she is agreeing to sell the underlying asset for a certain price at a certain time in future. 2. Explain carefully the difference between hedging, speculation, and arbitrage.
Ans: A trader hedges when he/she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In the case of speculation, the trader has no such exposure to offset. The trader is simply betting on the future movements of the asset. Arbitrage involves taking a position in two or more markets to lock in a profit. 3. Can you explain the difference between selling a call option and buying a put option?
Ans: Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of -max(St-K-0)=min (K-St,0)
On the other hand, buying a put option involves buying an option from someone else. It gives you a payoff of Max (K-St,0)
It may be noted that in both cases the payoff is K-St. When you write a call option, the payoff is negative or zero since the counterparty chooses to exercise. When you buy a put option, the payoff is zero or positive since you choose whether to exercise or not.
4. What is the difference between entering into a long forward contract when the forward price is Taka 50 and taking a long position in a call option with a strike price of Taka?
Ans: In the first case the trader is obligated to buy the asset at for Taka 50 and he/she has no choice. In the second case the trader has an option to buy the asset for Taka and the trader does not have to exercise the option.
5. An investor enters into a short forward contract to sell 200,000 British Pounds for U.S.
Ans: When the enters into a long forward contract, he/she is agreeing to buy the underlying asset for a certain price at a certain time in future. When the enters into a short forward contract, he/she is agreeing to sell the underlying asset for a certain price at a certain time in future. 2. Explain carefully the difference between hedging, speculation, and arbitrage.
Ans: A trader hedges when he/she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In the case of speculation, the trader has no such exposure to offset. The trader is simply betting on the future movements of the asset. Arbitrage involves taking a position in two or more markets to lock in a profit. 3. Can you explain the difference between selling a call option and buying a put option?
Ans: Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of -max(St-K-0)=min (K-St,0)
On the other hand, buying a put option involves buying an option from someone else. It gives you a payoff of Max (K-St,0)
It may be noted that in both cases the payoff is K-St. When you write a call option, the payoff is negative or zero since the counterparty chooses to exercise. When you buy a put option, the payoff is zero or positive since you choose whether to exercise or not.
4. What is the difference between entering into a long forward contract when the forward price is Taka 50 and taking a long position in a call option with a strike price of Taka?
Ans: In the first case the trader is obligated to buy the asset at for Taka 50 and he/she has no choice. In the second case the trader has an option to buy the asset for Taka and the trader does not have to exercise the option.
5. An investor enters into a short forward contract to sell 200,000 British Pounds for U.S.