01

Nonsystematic risk can be diversified; systematic risk cannot. Systematic riskis

most important to an equity investor. Either type of risk can lead to thebankruptcy
of a corporation.
02
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.
03
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.
04
It may well be true that there is just as much chance that the price of oil in the
future will be above the futures price as that it will be below the futures price. This
means that the use of a futures contract for speculation would be like betting on
whether a coin comes up heads or tails. But it might make sense for the airline to
use futures for hedging rather than speculation. The futures contract then has the
effect of reducing risks. It can be argued that an airline should not expose its
shareholders to risks associated with the future price of oil when there are contracts
available to hedge the risks

07
Discuss the differences in writing covered and naked calls. Are risks involved in the
two strategies similar or different?

Explain.

Answer: Writing a covered call is

selling a call on stock the investor owns. Thus, this strategy is very conservative;
the investor receives the premium income from writing the call.

If the call is

exercised, the stock is called away from the investor; thus the investor has limited
his or her upside potential.

Writing a naked call is a very risky strategy.

The

investor sells a call on a stock the investor does not own. If the price of the stock
increases, the option will be exercised and the investor must go into the open
market and buy the stock at the prevailing market price.

Theoretically, the price to

which the stock can increase is unlimited; thus, the investor's potential loss in
unlimited.

The purpose of this question is to be sure that the student differentiates

between the very common and conservative strategy of writing covered calls and
the risky strategy of writing naked calls.
08
The longer the time to expiration, the higher the premium because it is more likely
that an option will become more valuable (more time for the stock price to change).
The greater the volatility of the underlying stock, the greater the option premium;
the more volatile the stock, the more likely it is that the option will become more
valuable (e. g., move from an out of the money to an in the money option, or
become more in the money). For call options, the lower the exercise price, the more
valuable the option, as the option owner can buy the stock at a lower price. For a
put option, the lower the exercise price, the less valuable the option, as the owner
of the option may be required to sell the stock at a lower than market price.

Feedback: The purpose of this question is to insure that the student understands the
relationships of the variables that determine option prices, and the differences and
similarities of these variables on put and call option prices.
09
The two types of traders are hedgers and speculators. Hedgers use the markets to
protect themselves by limiting their risk. They take long or short positions to lock in
the most favorable purchase price or selling price at the time they enter the
contract. An example of a hedger would be a jewelry company that anticipates a
need for a large quantity of gold in the future. The company will have to purchase
the gold and if it wants to protect itself from large price increases it can take a long
position in a gold futures contract today. If gold prices fall rather than rising, the
company can sell an equivalent contract before the maturity date. If prices rise, the
company can take delivery of the gold at a more favorable price than the spot price
at the time of maturity.
Speculators dominate the futures market. Only 1% to 3% of futures market
participants actually plan to take delivery of the asset. The rest are speculators who
plan to offset their positions prior to expiration of the contract. A speculator will take
a long position if he expects prices to increase. As the value of the futures contract
rises, the holder of the long position gains and the holder of the short position loses.
The speculator can sell the contract for more than he paid in this case. Speculators
buy futures contracts rather than the underlying assets because transaction costs
are much lower. The speculator also benefits from leverage since only a small
percentage of the total contract value is required to be posted as margin.

Feedback: This question tests whether the student understands the main characters
in the futures markets, the reasons they use the markets, and the role each of them
plays in the market's operation.
10
Futures contracts are traded on the organized exchanges and are standardized as to
the contract size, the acceptable grade of the commodity, and the contract delivery
date.
A forward contract is only a commitment to contract in the future. No money
exchanges hands initially. The contract is for a deferred delivery of an asset at an
agreed upon price.
Feedback: The purpose of this question is to insure that the student understands the
basic differences between futures and forward contracts
11
The firm can enter a swap arrangement, committing to pay .06 * $1 million =
$60,000 in exchange for receiving payments equal to $1 million times the LIBOR
rate. If the LIBOR rate is 5, the cash inflow would be $1 million * .05 = $50,000. The
net cash flow would be -$10,000 in this case, which is unfavorable. If the LIBOR rate
is 8%, the firm will have a cash inflow of $1 million * .08 = $80,000. The net cash
flow in this case is $20,000, which is favorable.
Feedback: This is a basic question about the mechanics of a swap agreement.
12

The price of a futures contract for a commodity that must be stored is given by F0 =
P0 * (1 + rf + c), where P0 is the spot price of the commodity, rf is the risk-free rate
that applies to the opportunity cost of holding the commodity, and c is the carrying
cost.
Commodity futures have an extra cost integrated into their price - carrying costs
can be significant. Carrying costs can include interest costs, storage costs,
insurance costs, and an allowance for spoilage of goods in storage. These costs
should be considered on a net basis: costs minus the benefits of carrying the
commodity, such as protection against running out of stock.
An example is a contract on corn. If the producer doesn't sell the corn now, it will
need to be stored for future delivery. There will be explicit costs like insurance and
the marginal cost of silo usage, including the resources used to keep the corn at its
proper moisture level. There may be some spoilage of the corn. An implicit cost is
the opportunity cost of not investing the funds that would have been earned if the
corn had been sold in the spot market.
Feedback: This question tests whether the student recognizes the important
difference in commodities contracts due to carrying costs.