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DERIVATIVES

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Table of Contents
1. Concisely define ‘options’ and ‘futures’, and site their similarities and differences .................. 3

2-Assume the existence of a futures market in human blood. The spot price (today’s market
price) is $200 per pint. (A curious comparison - HP #45 ink cartridges are $355 per pint.) Your
hospital is concerned about rising blood prices because competition and regulation prevents it
from passing the cost along to patients. Explain how to use futures as a hedge against increases
in the price of human blood. ........................................................................................................... 4

3-You own stock in a NYSE exchange-listed healthcare company and have a hedge in place to
lock in capital gains you have made, in case the price falls. Explain the significance of the hedge
ratio to your hedging strategy. HINT: Is an option for 100 shares a perfect hedge against a long
holding of 100 shares of the underlying stock? .............................................................................. 5

4-Calculate your pre-tax rate of return (profit divided by investment) in each of these scenarios: 6

5- Some airlines hedge jet fuel prices and some do not. When oil prices declined, some airlines
that had hedged jet fuel prices were worse off than those that did not hedge. Using a numerical
example, show your understanding of hedging by explaining why they were worse off. Explain
whether or not this situation an argument against hedging? ........................................................... 8

6- Was Warren Buffett right when he called derivatives “financial weapons of mass
destruction”? State your yes or no, followed by a maximum six-line explanation. HINT: Another
way to ask the question: Unlike WMD, do derivatives serve a necessary, useful function?........ 10

References ..................................................................................................................................... 11

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1. Concisely define ‘options’ and ‘futures’, and site their similarities and differences
Stock option is something that is used in the buying and selling of the shares. This is used when
one party sells the stock option to the other party (Asçioglu, et al., 2017). This gives a right to the
option buyer for buying or selling the stock at an agreed rate but there is no obligation for the
person to follow at any cost.

The stocks of the individuals that are an underlying asset, which are financial contracts are
known as Futures (Gao and Süss, 2015). Future stock is a term used when there is an agreement
between two parties where they need to buy or sell the shares of the company on a specified
future date.

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2-Assume the existence of a futures market in human blood. The spot price (today’s market
price) is $200 per pint. (A curious comparison - HP #45 ink cartridges are $355 per pint.)
Your hospital is concerned about rising blood prices because competition and regulation
prevents it from passing the cost along to patients. Explain how to use futures as a hedge
against increases in the price of human blood.
The spot price of human blood is $200 per pint. There is a question in the mind of the hospital is
that the prices of the blood might increase in the future. If there is a high rise in the price of
blood, it will be difficult for the patient to pay. It is necessary for the hospitals to hedge the price
of the human blood. Hedging the blood will result in keeping the price of the product stable. This
will make sure that if there is any rise in the price then there will be no effect of the same on the
price of the blood.

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3-You own stock in a NYSE exchange-listed healthcare company and have a hedge in place
to lock in capital gains you have made, in case the price falls. Explain the significance of the
hedge ratio to your hedging strategy. HINT: Is an option for 100 shares a perfect hedge
against a long holding of 100 shares of the underlying stock?
The option for 100 shares is always a perfect hedge against holding of the long term underlying
stock of 100 shares. This is because hedging means to keep the prices of the product stable so
that if there is any increase in the price of the shares, it does not affect the person holding the
shares. This is the reason behind this question.

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4-Calculate your pre-tax rate of return (profit divided by investment) in each of these
scenarios:
a- Buy 1,000 shares of ABC common stock at $50 and sell at $60 one year later.

Calculation of pre tax

Shares of ABC 100

Purchase price 50

Investment 5000

Selling Price 60

Total Selling Price 6000

Profit 1000

Pre-Tax Rate of Return 0.20

b- Buy 1,000 shares of ABC common stock at $50, borrowing 50% of the amount necessary
to buy it, at a 2% interest rate, sell the stock at $60 one year later, paying back the loan at
the same time.

Calculation of pre tax

Shares of ABC 100

Purchase Price 50

Investment needed 5000

Self Investment 2500

Borrowings 2500

Interest Rate 2%

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Interest Paid 50

Borrowings and Interest 2550

Total Investment 5050

Sales Price 60

Total Sales 6000

Profit 950

Pre-Tax Rate of Return 0.19

c- Buy listed options at $400 for 1,000 shares of ABC, giving you the right but not the
obligation to buy the shares at $50 one year later; you exercise the option one year later
when the stock price is $60. Also, use the Long Call chart (from the CBOE material in this
PDF) to explain what is going on.

Calculation of pre tax

Shares of ABC 100

Purchase price 50

Investment 5000

Selling Price 60

Total Selling Price 6000

Profit 1000

Pre-Tax Rate of Return 0.20

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5- Some airlines hedge jet fuel prices and some do not. When oil prices declined, some
airlines that had hedged jet fuel prices were worse off than those that did not hedge. Using
a numerical example, show your understanding of hedging by explaining why they were
worse off. Explain whether or not this situation an argument against hedging?

The first is that hedging can't be proper where the spot and forward business sectors are
productive. This is on the grounds that nobody can without much of a stretch hold
accommodating data that could make supporting turn out productive for the firm in such cases.
In proficient markets, the gain from supporting is zero. On the off chance that supporting will be
connected in such a case, it will be of no additional esteem, truth be told, it will create
misfortunes to the firm by decrease of the normal money streams. This demonstrates supporting
probably won't build the esteem ofthe firm at all consequently it is pointless. The second
contention against supporting is that the directors trust that the investors can oversee chances
without anyone else. The Modigliani-Miller hypothesis states thatthe chiefs don't have the
capacity of raising the company's an incentive by participating in money related exchanges
which the investors need to attempt themselves

Directors can likewise utilize supporting to secure their interests and not those of the investor.
For a situation where directors are hazard loath, and the sum they procure is straightforwardly
connected to the outcomes, chiefs can utilize supporting tasks to enable them to bring down
income instability, which will at that point bring down their cash chance introduction.
Supporting will in this way help the supervisors even with the investors as the outcomes will
have been kept up. Be that as it may, supporting won't be of an incentive to the firm and the
investor yet it will just benefitthe administrator. This demonstrates supporting isn't a successful
apparatus in enhancing the firm an incentive as itcan be effectively controlled to the advantage of
the directors.

It might build the hazard when an organization participates in supporting while its rivals don't. A
decent case is the place there is just a single contender who supports while others in a similar
industry don't fence. On the off chance that the administration of this contender carryout

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supporting of the crude materials, later on conditions change making the crude material costs fall
which will naturally come full circle in falling of the completed item as well, it will prompt
misfortunes or a decreased net revenue. The equivalent will not be accounted for of unhedged
firms in a similar industry thus the supported firm will lose rivalry.

Hedging is done by the airline company for protecting the fuel prices so that there is no high rise
in the price of the fuel (De Spiegeleer et al., 2018). The meaning of hedging of oil prices is that
locking the cost of the purchase of the future fuel. The fuel cost is 15% of the cost of the airlines.
There are different times where this back fires the company when the cost is lower than that of
the hedging cost. For example, if the hedge price of the oil is fixed at $25 and there is a decrease
in the oil prices to $20. Then there is a loss of $5 per litre of oil for the company. This is the
reason for the companies to not to perform well in spite of the fact that the oil prices are hedged
by the airlines companies.

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6- Was Warren Buffett right when he called derivatives “financial weapons of mass
destruction”? State your yes or no, followed by a maximum six-line explanation. HINT:
Another way to ask the question: Unlike WMD, do derivatives serve a necessary, useful
function?
From the information that can be seen from the research of the topic it can be seen that Warren
Buffett was not right in calling derivatives as a weapon of finance of the mass destruction. This
is because there has been an increase in the GDP in the US economy for the derivatives. Thus, it
can be said that he did not explain it correctly.

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References
Asçioglu, A., Holowczak, R., Louton, D. and Saraoglu, H., 2017. The evolution of market share
among the US options market platforms. The Quarterly Review of Economics and Finance, 64,
pp.196-214.

De Spiegeleer, J., Madan, D.B., Reyners, S. and Schoutens, W., 2018. Machine learning for
quantitative finance: fast derivative pricing, hedging and fitting. Quantitative Finance, 18(10),
pp.1635-1643.

Gao, L. and Süss, S., 2015. Market sentiment in commodity futures returns. Journal of Empirical
Finance, 33, pp.84-103.

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