Financial Derivatives Lecture 1: Introduction to

Derivatives, Futures and Forwards

Daniele Massacci ([email protected])

King’s College London

MSc Banking & Finance

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Schedule
I Lecture 1: Introduction to Derivatives, Futures and Forwards.

I Lecture 2: Introduction to Options.

I Lecture 3: Trading Strategies Involving Options.

I Lecture 4: Binomial Trees.

I Lecture 5: The Black–Scholes–Merton Model.

I Reading Week.

I Lecture 6: The Greek Letters.

I Lecture 7: Options on Indices and Currencies, and Volatility Smiles.

I Lecture 8 (Patrick Boyle (PB)): Real Options.

I Lecture 9 (PB): Swaps, Forward Rate Agreements, Credit Derivatives.

I Lecture 10 (PB): Exotic Options, Structured Products and Practical

Applications. 2 / 48
O¢ ce Hours

I O¢ ce hours: Thursday, 11:00-13:00, on line or in person.

I Please send me an email to book a 15 min slot.

I O¢ ce hours suspended during reading week.

I Always available by email (but not during reading week).

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Module Structure, Assessment and Tutorials
I Module Structure:
I 2 hour weekly lecture (starting in week 1 of the course).
I 1 hour weekly tutorial (starting in week 2 of the course).

I Assessment:
I Mid-term test (15%).
I 24 hour online: Wednesday 5th March 10am – Thursday 6th
March 10am.
I Covers material up to reading week (Lectures 1, 2, 3, 4, 5).

I Final written exam (85%).

I 2-hour in person assessment.
I After the end of the course.
I Covers material from the entire module.

I Tutorials:
I Each tutorial covers questions from the previous week’s lecture.
I E.g.: Questions for tutorial in week 2 deal with material
covered in lecture in week 1.
I Tutorial questions at the end of each set of lecture notes.
I You should attempt the questions before the tutorial. 4 / 48
Module Academic Team

I Module Leader: Daniele Massacci

([email protected]).

I Tutorial Leader: Mohsen Motahari

([email protected]).

I Administrative Support: mscbanking…[email protected].

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Teaching Material

I Lecture notes:
I Available on KEATS each week before the lecture under
"Lecture Notes".

I Have a look at them before the lecture.

I Solutions to tutorial questions:

I Available on KEATS under "Tutorials" after the tutorial.

I You should attempt the questions before the tutorial.

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Plan

I Introduction.

I Futures and Forward Contracts.

I Short Selling.

I Payo¤ Function.

I Measuring Interest Rates.

I Determination of Forward and Futures Prices.

I Hedging Strategies Using Futures.

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Reading

I Core Reading:
I Lecture notes.

I Questions in the mid-term test and in the …nal exam are based
only on topics that we cover together.

I Additional Reading:
I Hull, J. (2014). Options, Futures, and Other Derivatives (9th
Edition). Prentice Hall, USA. (More advanced).

I Hull, J. (2021). Fundamentals of Futures and Options Markets

(9th Edition). Pearson (Less advanced).

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Introduction
De…nition

I De…nition: A derivative is a …nancial instrument whose value

depends on (or derives from) the value of another underlying
asset.

I Examples of derivatives: futures, forwards, options, swaps.

I Examples of underlying assets:

I Stocks: for example, General Electric, Citigroup, Vodafone.
I Stock indices: for example, FTSE 100 (UK), Hang Seng (Hong
Kong), Nikkei (Japan), S&P500 (US).
I Commodities: for example, Gold, Oil, Silver, Cotton,
Electricity.
I Currencies.
I Cryptocurrencies: for example, Bitcoin.

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Introduction
Types of Traders

I Three categories of traders.

I Hedgers: use derivatives to reduce the risk they face from

potential future movements in a market variable.

I Speculators: use derivatives to bet on the future direction of

a market variable.

I Arbitrageurs: use derivatives to take o¤setting positions in

two or more instruments to lock in a pro…t.

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Introduction
Types of Traders: Arbitrageurs
I Arbitrage: An opportunity to generate a riskless pro…t by
selling an identical asset for a higher price in one venue and
instantaneously buying it for a lower price at another venue.

I Example: Suppose you buy on the New York Stock Exchange

100 shares of a stock at $150 per share and you sell them on
the London Stock Exchange at £ 100 when the exchange rate
is $1.51 per pound. The riskless pro…t (in the absence of
transaction costs) is
100 [($1.51 100) $150] = $100.
I Arbitrage opportunities cannot last for long, as they generate
riskless pro…ts.

I Most of the arguments about futures prices, forward prices,

and the values of option contracts will be based on the
assumption of no arbitrage opportunities. 11 / 48
Introduction
Exchange-Traded Markets
I Question: where are derivatives traded?

I Answer: two types of market.

I Derivatives exchange: a market where individuals trade

standardized contracts that have been de…ned by the
exchange.

I Examples:
I CME group (https://www.cmegroup.com/);
I CBOE (https://www.cboe.com/).

I Features of exchange-traded markets:

I They set the rules that govern trading.
I Products are standardized.
I Products are mostly traded electronically.
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Introduction
Over-The-Counter (OTC) Markets

I Over-the-counter (OTC) market: a market where

derivatives are traded directly between two parties and not
through an exchange.

I Features of OTC markets:

I Once an OTC trade has been agreed, the two parties can
either present it to a central counterparty (CCP) or clear the
trade bilaterally.
I Products can be non-standard.

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Futures and Forward Contracts
Forward Contracts
I De…nition: a forward contract is an agreement between two
parties to buy or sell an asset at a speci…c time in the future
at a speci…c price.

I The buyer of the underlying at that future time and speci…ed

price has a long forward position.

I The seller of the underlying at that future time and speci…ed

price has a short forward position.

I Remark 1: a forward contract can be contrasted with a spot

contract, which is an agreement to buy or sell an asset almost
immediately.

I Remark 2: a forward contract is traded in the OTC market.

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Futures and Forward Contracts
Futures Contracts

I De…nition: a futures contract is a standardized agreement

between two parties to buy or sell an asset at a speci…c time
in the future at a speci…c price.

I The buyer of the underlying at that future time and speci…ed

price has a long futures position.

I The seller of the underlying at that future time and speci…ed

price has a short futures position.

I Remark: unlike forward contracts, futures contracts are

normally traded on an exchange.

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Short Selling

I Short selling, usually simply referred to as "shorting",

involves selling an asset that is not owned.

I Example: selling in the market shares that have been

borrowed from another investor.

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Payo¤ Function
Long Underlying Asset Payo¤
I Long Underlying Asset Payo¤:
Π = ST S0
where S0 is the investor’s entry price and ST is the spot price
of the asset at maturity.

Gains s Entry Price, S0

Investor’

Price of Underlying at Maturity, ST

Losses

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Payo¤ Function
Short Underlying Asset Payo¤
I Short Underlying Asset Payo¤:
Π = S0 ST
where S0 is the investor’s entry price and ST is the spot price
of the asset at maturity.

Gains s Entry Price, S0

Investor’

Price of Underlying at Maturity, ST

Losses

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Payo¤ Function
Long Futures Asset Payo¤
I Long Futures Asset Payo¤:
Π = ST K
where K = F0 is the investor’s entry price and ST is the spot
price of the asset at maturity (we will return to K and F0 ).

s Entry Price, K = F0
Investor’
Gains

Price of Underlying at Maturity, ST

Losses

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Payo¤ Function
Short Futures Asset Payo¤
I Short Futures Asset Payo¤:
Π=K ST
where K = F0 is the investor’s entry price and ST is the spot
price of the asset at maturity (we will return to K and F0 ).

Gains s Entry Price, K = F0

Investor’

Price of Underlying at Maturity, ST

Losses

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Measuring Interest Rates

I Consider the following situation:

I Amount of money A = $100 at a rate of R = 10% per annum.

I If interests are paid m = 1 time a year for n = 1 years then the

terminal value of the investment is

A (1 + R )n = $100 (1 + 0.10) = $110.

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Measuring Interest Rates
I Consider the following situation:

I Amount of money A = $100 at a rate of R = 10% per annum.

I If interests are paid m = 2 time a year for n = 1 years then the

terminal value of the investment is
m 2
R 0.10
A 1+ = $100 1 + = $110.25.
m 2

I If interests are paid m = 2 time a year for n = 2 years then the

terminal value of the investment is
mn 2 2
R 0.10
A 1+ = $100 1 + ' $121.55.
m 2

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Measuring Interest Rates

I In general, the terminal value of an investment is

mn
R
A 1+
m
I Continuous compounding:
m
R
lim 1+ = eR
m !∞ m

which implies that

mn
R
lim A 1 + = Ae Rn
m !∞ m

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Measuring Interest Rates

I Coupon: interest payment made on a bond.

I Zero-coupon interest rate: interest rate that would be

earned on a bond that provides no coupons.

I Example: Consider a 5-year zero rate with continuous

compounding quoted at 5% per annum. If we invest $100 for
5 years we get

$100 e 0.05 5
= 128.40.

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Determination of Forward and Futures Prices
Notation

I T = time to delivery in a forward or futures contract in years.

I S0 = Price of the asset underlying the forward or the futures

contract today.

I F0 = Forward or futures price today.

I r = Zero-coupon risk-free rate of interest per annum,

expressed with continuous compounding, for an investment
maturing at the delivery date (i.e., in T years).

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Determination of Forward and Futures Prices
Example: Selling Stock Futures

I We determine prices through no arbitrage arguments.

I Suppose we have no idea what futures price we should agree

on for a futures contract (analogous arguments hold for
forward contracts).

I We know a share’s price today is S0 = $40.

I Suppose futures are available in the market for you to sell at

$43 with 3 month maturity (i.e., T = 3 /12 ).

I Question: How do we know if this is fair value or not?

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Determination of Forward and Futures Prices
Example: Selling Stock Futures

I Share’s price today is S0 = $40.

I We borrow $40 at r = 5% for 3 months and use these funds

to buy 1 share.

I We sell a futures contract on 1 share.

I At T = 3 /12 years, regardless of what has happened to the

share price between now and maturity, we hand over the 1
share to our counterparty, receive $43 and owe back
$40 e 0.05 3/12 = $40.50.

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Determination of Forward and Futures Prices
Example: Selling Stock Futures

I Paid $40 for the stock.

I Get $43 for the stock via futures contract.

I Owe $40.5 for the funds borrowed.

I Risk-free outcome once the share is bought and the future is

sold.

I The trader earns $43 $40.5 = $2.5.

I Remark: arbitrage opportunity arises.

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Determination of Forward and Futures Prices
Example: Buying Stock Futures

I Suppose futures contract now available at $39.

I Share now trading at S0 = $40.

I We borrow the share, sell it for $40 cash.

I Put $40 in bank account earn r = 5% for 3 months.

I Buy a futures contract for 1 share.

I At T = 3 /12 years, regardless of share price activity, buy 1

futures contract for $39, earn $0.50 interest in the bank
account, or $40 e 0.05 3/12 = $40.50.

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Determination of Forward and Futures Prices
Example: Buying Stock Futures

I Borrowed, then sold share for S0 = $40.

I Received $0.50 interest at end of 3 months.

I Bought share via Futures contract at $39.

I Earns the trader $40 + $0.50 $39 = $1.50.

I Risk-free outcome once the share is sold short and the futures
contract is purchased.

I Remark: arbitrage opportunity arises.

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Determination of Forward and Futures Prices

I In the selling stock futures example, an arbitrage opportunity

arises because

Forward Price = $43 > $40 e 0.05 3/12

= $40.50.

I In the buying stock futures example, an arbitrage opportunity

arises because

Forward Price = $39 < $40 e 0.05 3/12

= $40.50.

I If the futures price is anything other than $40 e 0.05 3/12 ,

then an arbitrage opportunity arises.

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Determination of Forward and Futures Prices

I However, arbitrage opportunities cannot last for long, as they

imply a risk-free return.

I In our examples, S0 = $40, r = 0.05, and T = 3/12.

I Therefore, the price of a futures contract F0 is equal to

F0 = S 0 e rT ,

which relates F0 to S0 .

I Question: When is F0 equal to S0 ?

I Answer: ...

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Determination of Forward and Futures Prices
Convergence of futures price to spot price
I As delivery approaches, T ! 0 and F0 = S0 e rT ! S0 , and
futures prices converge towards the spot price.

I Source: Boyle, P & McDougall, J. (2015). Trading and Pricing Financial

Derivatives: A Guide to Futures, Options, and Swaps. Createspace,
Charleston USA.
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Determination of Forward and Futures Prices
Valuing futures contracts
I Using no arbitrage arguments, the value of a futures contract on an
investment asset is
r T
f = S0 Ke .
I K is the delivery price, Ke r T is the present value of the delivery price.
The delivery price is the agreed price for the underlying asset at the
contract’s maturity, it is set at the contract’s initiation and it is
unchanging.

I Recall the price of the future is

F0 = S0 er T
.
I At the beginning of the contract K = F0 and

f = S0 Ke r T = S0 F0 e r T

= S0 S0 er T e r T

= 0:
the value of futures contract at inception is zero!

I Remark: notice the di¤erence between price and value!

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Determination of Forward and Futures Prices
Pricing futures contracts: extensions

I What happens if:

I The asset underlying the future pays a dividend before maturity?

I The asset underlying the future has storage costs?

I We are pricing currency futures, in which case we have two di¤erent

risk-free rates?

I The user of a consumption asset obtains a bene…t from physically

holding the asset, whereas the bene…t is not obtained from holding
the futures contract (the classical example is heating oil in the
winter). The bene…t from holding the physical asset is referred to as
the convenience yield.

I ) Using no arbitrage arguments, the futures pricing formula changes

slightly to accommodate these extensions.

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Determination of Forward and Futures Prices
Pricing futures contracts: extensions

I If the stock underlying the future pays a dividend before maturity equal
to q, the futures pricing formula extends to

F0 = S0 e (r q) T
.
I If the asset underlying the future has storage costs equal to u, the futures
pricing formula extends to

F0 = S0 e (r +u ) T
.
I If we are pricing currency futures, let S0 be the current spot price in local
currency of the foreign currency, F0 be the futures price in local currency
of the foreign currency, and rf the foreign currency risk-free rate. The
futures pricing formula extends to

F0 = S0 e (r rf ) T

I If the underlying asset carries a convenience yield y , the futures pricing

formula extends to
F0 = S0 e (r +u y) T
.

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Hedging Strategies Using Futures
I Many participants in futures markets are hedgers.

I The aim of hedgers is to use futures to reduce a particular risk

they face, such as the risk related to oil price ‡uctuations,
foreign exchange rates, or the stock market.

I A perfect hedge completely eliminates risk. However, it rarely

exists.

I We therefore study how to hedge using futures contracts so

that they perform as close to perfect as possible.

I At this stage, we consider only hedge-and-forget strategies:

no attempt will be made to adjust the hedge once it has been
put in place.
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Hedging Strategies Using Futures
Cross hedging

I Hedging requires a futures contract with an underlying asset and an asset

whose price is being hedged with the futures contract.

I When the asset underlying the futures contract is di¤erent from the asset
being hedged the cross hedging occurs.

I Example: Consider an airline concerned about the price of jet fuel. Since
jet fuel is not actively traded, it might be easier for the company to
choose heating oil futures contract to hedge its exposure to jet fuel.

I Hedge ratio: the ratio between the size of the position taken in futures
contracts to the size of the exposure.
I Example: when your asset falls 2% in a day, you want to be
reasonably con…dent your hedge will rise 2% in the face of the same
market dynamics.

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Hedging Strategies Using Futures
Cross hedging: minimum variance hedge ratio
I The minimum variance hedge ratio is a function of the relationship
between changes in the spot price and changes in the futures contract
price.

I Let ∆S be the change in spot price S during a time period equal to the
life of the hedge.

I Let ∆F be the change in futures price F during a time period equal to

the life of the hedge.

I The minimum variance hedge ratio is de…ned as

σS
h =ρ ,
σF
where σS is the standard deviation of ∆S , σF is the standard deviation of
∆F , and ρ is the correlation between ∆S and ∆F .

I Therefore, h is the slope of the regression line of ∆S against ∆F (hence,

it is a minimum variance hedge ratio).
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Hedging Strategies Using Futures
Cross hedging: optimal number of contracts

I Question: How many contracts should be used in hedging?

I Recall
σS
h =ρ .
σF
I Let QA be the size of the position being hedged (i.e., the exposure) (in
units).

I Let QF be the size of one futures contract (in units).

I Let N be the optimal number of futures contracts to hedge with.

I The optimal number of futures contracts is

QA
N =h .
QF

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Hedging Strategies Using Futures
Hedging an equity portfolio

I Capital Asset Pricing Model (CAPM): The expected return on an asset

is given by

Expected return on asset = RF + β (RM RF ) ,

where RM is the return on all available investments (i.e., the return on

the market portfolio), RF is the return on the risk-free asset, and β
measures the sensitivity of the expected return on the asset to RM . Since
RM is the return on the market portfolio, the risk associated to RM
cannot be diversi…ed away and it is said to be systematic. According to
the CAPM, only systematic risk matters when pricing an asset, and the
sensitivity of the expected return on the asset to RM is measured by β.
The higher the β, the more sensitive the asset is to systematic risk and
the higher the expected return is.

I A stock index is an index that tracks the value of a portfolio of stocks

(such as the market portfolio).
I Example: S&P500, DJIA, NASDAQ, FTSE100, and many more.

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Hedging Strategies Using Futures
Hedging an equity portfolio

I From the CAPM, β is de…ned as

σA
β = ρAM ,
σM
where σA is the standard deviation of the return RA on asset A, σM is the
standard deviation of RM , ρAM is the correlation between RA and RM .

I Remark: β is a minimum variance hedge ratio.

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Hedging Strategies Using Futures
Hedging an equity portfolio

I If we hedge an equity portfolio with futures contracts, we have

σA
β = ρAF ,
σF
where σA is the standard deviation of the return on the equity portfolio,
σF is the standard deviation of the return on the futures contract, and
ρAF is the correlation between the return on the equity portfolio and the
return on the futures contract.

I The optimal number of futures contracts is

VA
N =β ,
VF
where VA is the value of the equity portfolio and VF is the value of one
futures contract (i.e., the futures prices time the contract size).

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Summary

I Futures and Forward Contracts.

I Payo¤ Function.

I Determination of Forward and Futures Prices.

I Hedging Strategies Using Futures.

I Key concepts: arbitrage and hedging.

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Lecture 1 Questions

I Question 1: A cattle farmer expects to sell in 3 months 120,000 lbs of

live cattle. CME live-cattle futures are for delivery of 40,000 lbs of cattle.
How can the farmer hedge with the contract? What are the advantages
and the disadvantages of hedging?

I Question 2: Consider a long position in a 1 year forward contract on a

stock that pays no dividend. The current price of the stock is S0 = $40,
the risk-free rate is r = 10% on a yearly basis with continuous
compounding.
1. What is the forward price? What is the initial value of the forward
contract?
2. Six months later, the price of the stock is S6 = $45, and the risk
free rate remains r = 10% on a yearly basis with continuous
compounding. What is the forward price? What is the value of the
forward contract?

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Lecture 1 Questions

I Question 3: The expected return on the S&P 500 is 12% and the
risk-free rate is 5%. What does the CAPM tell us if the expected return
on the investment has beta (β) equal to (a ) 0.2, (b ) 0.5 and (c ) 1.4?

I Question 4: A company wants to hedge exposure to a new fuel whose

price changes have a 0.6 correlation (ρAF ) with gasoline futures price
changes. The company loses $1 million for each 1 cent increase in price
per gallon of a new fuel over the next three months. The new fuel’s price
change has a standard deviation 50% greater than that of gasoline
futures prices. If gas futures are used to hedge, what is the hedge ratio?
What is the company’s exposure in gallons of new fuel? What position in
gallons should the company take in gas futures? How many gas futures
contracts should be traded if each contract is for 42,000 gallons?

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Lecture 1 Questions

I Question 5: The standard deviation of monthly changes in live cattle

spot prices (in cents per pound) is σA = 1.2. The standard deviation of
monthly changes in live cattle futures prices is σF = 1.4. The correlation
between futures prices changes and spot prices changes is ρAF = 0.7. On
October 15 a beef producer committed to purchasing 200, 000 lbs of live
cattle on November 15. The producer wants to use the December futures
to hedge. Each contract is 40, 000 lbs cattle. What strategy should the
producer follow?

I Question 6: The risk-free interest rate is r = 7% per annum with

continuous compounding, and the dividend yield on a stock index is
q = 3.2% per annum. The current index value is S0 = $150. What is the
6-month futures price?

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Lecture 1 Questions
I Question 7: Suppose the risk-free rate is r = 10% per annum with
continuous compounding, and the dividend yield on a stock index is
q = 4% per annum. The current index value is S0 = $400 and the
futures price for a contract deliverable in 4 months is $405. What
arbitrage opportunities does this create?

I Question 8: The correlation coe¢ cient between an investment portfolio

and the market is de…ned as
σAM
ρAM = ,
σA σM
where σAM is the covariance between the portfolio and the market, and
σA and σM are the covariance of the portfolio and of the market,
respectively. Show that the minimum variance hedge ratio h when trying
to cross-hedge an asset is equivalent to β.

I Question 9: "Options and futures are zero-sum games." What do you

think it meant by this statement?

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