CHAPTER 1

Introduction

Problem 1.1.
What is the difference between a long forward position and a short forward position?

When a trader enters into a long forward contract, she is agreeing to buy the underlying asset
for a certain price at a certain time in the future. When a trader enters into a short forward
contract, she is agreeing to sell the underlying asset for a certain price at a certain time in
the future.

Problem 1.2.
Explain carefully the difference between hedging, speculation, and arbitrage.

A trader is hedging when she has an exposure to the price of an asset and takes a position in a
derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is
betting on the future movements in the price of the asset. Arbitrage involves taking a position
in two or more different markets to lock in a profit.

Problem 1.3.
What is the difference between entering into a long forward contract when the forward price
is $50 and taking a long position in a call option with a strike price of $50?

In the first case the trader is obligated to buy the asset for $50. (The trader does not have a
choice.) In the second case the trader has an option to buy the asset for $50. (The trader does
not have to exercise the option.)

Problem 1.4.
Explain carefully the difference between selling a call option and buying a put option.

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)
Buying a put option involves buying an option from someone else. It gives a payoff of
max( K − ST  0)
In both cases the potential payoff is K − ST . When you write a call option, the payoff is
negative or zero. (This is because the counterparty chooses whether to exercise.) When you
buy a put option, the payoff is zero or positive. (This is because you choose whether to
exercise.)

Problem 1.5.
An investor enters into a short forward contract to sell 100,000 British pounds for US
dollars at an exchange rate of 1.5000 US dollars per pound. How much does the investor
gain or lose if the exchange rate at the end of the contract is (a) 1.4900 and (b) 1.5200?
 (a) The investor is obligated to sell pounds for 1.5000 when they are worth 1.4900. The
gain is (1.5000−1.4900) ×100,000 = $1,000.

(b) The investor is obligated to sell pounds for 1.5000 when they are worth 1.5200. The
loss is (1.5200−1.5000)×100,000 = $2,000

Problem 1.6.
A trader enters into a short cotton futures contract when the futures price is 50 cents per
pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or
lose if the cotton price at the end of the contract is (a) 48.20 cents per pound; (b) 51.30 cents
per pound?

(a) The trader sells for 50 cents per pound something that is worth 48.20 cents per pound.
Gain = ($05000 − $04820)  50 000 = $900 .

(b) The trader sells for 50 cents per pound something that is worth 51.30 cents per pound.
Loss = ($05130 − $05000)  50 000 = $650 .

Problem 1.7.
You would like to speculate on a rise in the price of a certain stock. The current stock price is
$29, and a three-month call with a strike of $30 costs $2.90. You have $5,800 to invest.
Identify two alternative strategies, one involving an investment in the stock and the other
involving investment in the option. What are the potential gains and losses from each?

One strategy would be to buy 200 shares. Another would be to buy 2,000 options. If the share
price does well the second strategy will give rise to greater gains. For example, if the share
price goes up to $40 you gain [2 000  ($40 − $30)] − $5 800 = $14 200 from the second
strategy and only 200  ($40 − $29) = $2 200 from the first strategy. However, if the share
price does badly, the second strategy gives greater losses. For example, if the share price goes
down to $25, the first strategy leads to a loss of 200  ($29 − $25) = $800 whereas the second
strategy leads to a loss of the whole $5,800 investment. This example shows that options
contain built in leverage.

Problem 1.8.
Suppose that a March call option to buy a share for $50 costs $2.50 and is held until March.
Under what circumstances will the holder of the option make a profit? Under what
circumstances will the option be exercised?

The holder of the option will gain if the price of the stock is above $52.50 in March. (This
ignores the time value of money.) The option will be exercised if the price of the stock is
above $50.00 in March.

Problem 1.9.
Suppose that a June put option to sell a share for $60 costs $4 and is held until June. Under
what circumstances will the seller of the option (i.e., the party with a short position) make a
profit? Under what circumstances will the option be exercised?
The seller of the option will lose money if the price of the stock is below $56.00 in June.
(This ignores the time value of money.) The option will be exercised if the price of the stock
is below $60.00 in June.

Problem 1.10.
A trader writes a December put option with a strike price of $30. The price of the option is
$4. Under what circumstances does the trader make a gain?

The trader makes a gain if the price of the stock is above $26 at the time of exercise. (This
ignores the time value of money.)

Problem 1.11.
A trader buys a call option with a strike price of $30 for $3. Does the trader ever exercise the
option and lose money on the trade. Explain.

If the stock price is between $30 and $33 at option maturity the trader will exercise the
option, but lose money on the trade. Consider the situation where the stock price is $31. If the
trader exercises, she loses $2 on the trade. If she does not exercise she loses $3 on the trade.
It is clearly better to exercise than not exercise.

Problem 1.12.
On May 8, 2013, the spot offer price of Google stock is $871.37
and the offer price of a call option with a strike price of $880 and a maturity date of
September is $41.60. A trader is considering two alternatives: buy 100 shares of the stock
and buy 100 September call options. For each alternative, what is (a) the upfront cost, (b)
the total gain if the stock price in September is $950, and (c) the total loss if the stock
price in September is $800. Assume that the option is not exercised before September and
if stock is purchased it is sold in September.

a) The upfront cost for the stock alternative is $87,137. The upfront cost for the option
alternative is $4,160.
b) The gain from the stock alternative is $95,000−$87,137=$7,863. The total gain from
the option alternative is ($950-$880)×100−$4,160=$2,840.
c) The loss from the stock alternative is $87,137−$80,000=$7,137. The loss from the
option alternative is $4,160.

Problem 1.13 Trader A enters into a forward contract to buy an asset for $1000 in one year.
Trader B buys a call option to buy the asset for $1000 in one year. The cost of the option is
$100. What is the difference between the positions of the traders? Show the profit as a
function of the price of the asset in one year for the two traders.

Trader A makes a profit of ST ̶ 1000 and Trader B makes a profit of max (ST ̶ 1000, 0) –100
where ST is the price of the asset in one year. Trader A does better if ST is above $900 as
indicated in Figure S1.4.
 400
300 Profit
200
100
0 Trader A
-100 700 900 1100 1300 Trader B
-200 Asset Price
-300
-400

Figure S1.4: Profit to Trader A and Trader B in Problem 1.13