Chapter 1

Introduction
to Derivatives
Selected problems
& Solutions

Presented by Dr. Muhammad Khalid Sohail

1-1
1.3 ABC stock has a bid price of $40.95 and an ask
price of $41.05. Assume there is a $20 brokerage
commission.
a. What amount will you pay to buy 100 shares?
b. What amount will you receive for selling 100
shares?
c. Suppose you buy 100 shares, then immediately
sell 100 shares with the bid and ask prices being
the same in both cases. What is your round-trip
transaction cost?

1-2
a. ($41.05 × 100) + $20 = $4,125.00
b. ($40.95 × 100) − $20 = $4,075.00
c. $4,125.00 − $4,075.00 = $50

1-3
• 1.4 Repeat the previous problem supposing that the
brokerage fee is quoted as 0.3% of the bid or ask price

1.3 ABC stock has a bid price of $40.95 and an ask price
of $41.05. Assume there is a $20 brokerage commission.
a. What amount will you pay to buy 100 shares?
b. What amount will you receive for selling 100 shares?
c. Suppose you buy 100 shares, then immediately sell 100
shares with the bid and ask prices being the same in both
cases. What is your round-trip
transaction cost?
• .

1-4
a. ($41.05 × 100) + ($41.05 × 100) × 0.003
= $4,117.32
b. ($40.95 × 100) − ($40.95 × 100) × 0.003
= $4,082.72
c. $4,117.32 − $4,082.72 = $34.6

1-5
1.5 Suppose a security has a bid price of $100
and an ask price of $100.12. At what price can the
market-maker purchase a security? At what price
can a market-maker sell a security? What is the
spread in dollar terms when 100 shares are
traded?

1-6
• It is important to remember that the market
maker provides a service to the market.
He stands ready to buy shares into his
inventory and sell shares out of his
inventory,
• The market maker buys the security at a
price of $100, and he sells it at a price of
$100.10.
• If he buys 100 shares of the security and
immediately sells them to another party,
he is earns a spread of:
• 100 × ($100.12 − $100) = 100 × $0.12 =
$12.00
1-7
1.6 Suppose you short-sell 300 shares of XYZ
stock at $30.19 with a commission charge of
0.5%. Supposing you pay commission charges for
purchasing the security to cover the short-sale,
how much profit have you made if you close the
short-sale at a price of $29.87?

1-8
The proceeds from the sale of the asset, less the
proportional commission charge:
300 × ($30.19) − 300 × ($30.19) × 0.005 = $9,057 ×
0.995 = $9,011.72
To close out the position, we will again incur the
commission charge, which is added to the
purchasing cost:
300 × ($29.87) + 300 × ($29.87) × 0.005 = $8,961 ×
1.005 = $9,005.81
Finally, we subtract the cost of covering the short
position from our initial proceeds to receive total
profits: $9,011.72 − $9,005.81 = $5.91.
The commission charge that we have to
pay twice significantly reduces the profits we can
make 1-9
1.7 Suppose you desire to short-sell 400 shares of
JKI stock, which has a bid price of $25.12 and an ask
price of $25.31. You cover the short position 180 days
later when the bid price is $22.87 and the ask price is
$23.06.
a. Taking into account only the bid and ask prices
(ignoring commissions and interest), what profit did
you earn?
b. Suppose that there is a 0.3% commission to
engage in the short-sale (this is the commission to
sell the stock) and a 0.3% commission to close the
short-sale (this is the commission to buy the stock
back). How do these commissions change the profit
in the previous answer?
c. Suppose the 6-month interest rate is 3% and that
you are paid nothing on the short-sale proceeds. How
much interest do you lose during the 6 months in
which you have the short position? 1-10
400 × ($25.125) − 400 × ($23.0625) = $10,050 − $9,225.00
= $825.00
400 × ($25.125) − 400 × ($25.125) × 0.003 −
(400 × ($23.0625) + 400 × ($23.0625))
= $10,050 × 0.997 − $9,225 × 1.003
= $10,019.85 − $9252.675 = $767.175.
c. The proceeds from short sales, minus the commission
charge are $10,019.85 (or $10,050 if you ignore the
commission charge).
The interest we could earn (and that we now lose) on a
deposit of $10,019.85:
$10,019.85 × (0.03) = $300.5955= $300.60
or, without taking into account the commission charge:
$10,050.00 × (0.03) = $301.50.

1-11
• 1.8 When you open a brokerage account, you
typically sign an agreement giving the broker the
right to lend your shares without notifying or
compensating you. Why do brokers want you to
sign this agreement?

1-12
• Ans: By signing an agreement as
mentioned in the problem, you give your
brokerage firm the possibility to act as an
equity lender, using the shares of your
account. Brokers want you to sign such
an agreement because they can make
additional profits.

1-13
• 1.9 Suppose a stock pays a quarterly dividend of
$3. You plan to hold a short position in the stock
across the dividend ex-date. What is your
obligation on that date? If you are a taxable
investor, what would you guess is the tax
consequence of the payment? (In particular,
would you expect the dividend to be tax
deductible?) Suppose the company
announces instead that the dividend is $5.
Should you care that the dividend is
different from what you expected?

1-14
• A. As the lender is entitled to the dividend on the day
the stock goes ex dividend, but does not receive it
from the company, because we have sold her stock,
we must provide the dividend. This payment is tax-
deductible for us.
• In a perfect capital market, we would expect that the
stock price falls exactly by the amount of the
dividend on the ex-date. Therefore, we should not
care.
• B. However, two complications may arise.
• First, we may have borrowed a large amount of
shares, and the increased dividend forces us to pay
more to the lender, and we may not have the
additional required money.
• Second: an unexpected increase of the dividend is a
strong signal that the company is doing exceedingly
well, and empirically, we observe sharp price
increases after such announcements. Therefore, an
unexpected increase in the dividend is very bad for
our position.
1-15
• 1.11 Suppose that you go to a bank and borrow
$100. You promise to repay the loan in 90 days
for $102. Explain this transaction using the
terminology of short-sales.

1-16
• We are interested in borrowing the asset
“money.” Therefore, we go to an owner (or, if you
prefer, to, a collector) of the asset, called Bank.
• The Bank provides the $100 of the asset money
in digital form by increasing our bank account.
We sell the digital money by going to the ATM
and withdrawing cash.
• After 90 days, we buy back the digital money for
$102, by depositing cash into our bank account.
• The lender is repaid, and we have covered our
short position.

1-17
• 1.12 Suppose your bank’s loan officer tells you
that if you take out a mortgage (i.e., you borrow
money to buy a house), you will be permitted to
borrow no more than 80% of the value of the
house. Describe this transaction using the
terminology of short-sales.

1-18
• borrowing to buy a house. Therefore, we go to an
owner of the asset, called Bank. The Bank provides
the dollar amount, say $250,000, in digital form in our
mortgage account. As $250,000 is a large amount of
money, the bank is subject to substantial credit risk
(e.g., we may lose our job) and demands a collateral.
Although the money itself is not subject to large
variations in price (besides inflation risk, it is difficult to
imagine a reason for money to vary in value), the Bank
knows that we want to buy a house, and real estate
prices vary substantially. Therefore, the Bank wants
more collateral than the $250,000 they are lending. In
fact, as the Bank is only lending up to 80% of the
value of the house, we could get a mortgage of
$250,000 for a house that is worth $250,000 ÷ 0.8 =
$312,500. We see that the bank factored in a haircut
of $312,500 − $250,000 = $62,500 to protect itself
from credit risk and adverse fluctuations in property
prices. We buy back the asset money over a long
horizon of time by reducing our mortgage through
annuity payments.
1-19
• Before next problem:
• widget a small gadget or mechanical device, especially
one whose name is unknown or unspecified. an
application, or a component of an interface, that enables
a user to perform a function or access a service.
• Notional value is the total value of a leveraged
position's assets. This term is commonly used in the
options, futures and currency markets which employ the
use of leverage, wherein a small amount of invested
money can control a large position in the markets.
• Open interest is the total number of open or outstanding
(not closed or delivered) options and/or futures contracts
that exist on a given day, delivered on a particular day.

1-20
1.14 Consider the widget exchange. Suppose that each widget
contract has a market value of $0 and a notional value of $100.
There are three traders, A, B, and C. Over one day, the following
trades occur:
A long, B short, 5 contracts.
A long, C short, 15 contract.
B long, C short, 10 contracts.
C long, A short, 20 contracts.
a. What is each trader’s net position in the contract at the end of
the day? (Calculate long positions minus short positions.)
b. What are trading volume, open interest, and the notional values
of trading volume and open interest? (Calculate open interest as
the sum of the net long positions, from your previous answer.)
c. How would your answers have been different if there were an
additional trade:
C long, B short, 5 contracts?
d. How would you expect the measures in part (b) to be different if
each contract had a notional value of $20?

1-21
 A B C A B C
c Trade 1 5 -5 Trade 1 5 -5
a
Trade 2 15 -15 Trade 2 15 -15
Trade 3 10 -10
Trade 3 10 -10
Trade 4 -20 20
Trade 5 -5 5 Trade 4 -20 20
Total 0 0 0 Total 0 5 -5

a) Trader A’s net position is zero, trader B is long five contracts, and
trader C is short five contracts.
b) Trading volume is equal to 5 + 15 + 10 + 20 = 50.
Open interest is equal to 5.
Notional value of trading volume is equal to 50 contracts ×
$100/contract = $5,000
Notional value of open interest is equal to 5 contracts × $
100/contract = $500.
c) Now all traders have a net position of zero. see excel table.
Trading volume has increased by five contracts to 55. The notional
value of trading volume is equal to 55 × $100 = $5,500. Open
interest and the notional value of open interest are equal to zero.
d) Trading volume and open interest would be identical; the notional
values of trading volume and open interest would be lower. 1-22