Download Ch 7: 1.1-4

1.1
Derivatives allow investors to hedge the risk of price changes in underlying assets. Derivatives
also allow investors to speculate on price changes in underlying assets.
1.2
Hedging is an action to reduce risk, such as purchasing a derivative contract that will increase in
value when another asset in an investor’s portfolio decreases in value. Speculating is placing a
financial bet in an attempt to profit from movements in asset prices.
1.3
Speculators play two important roles in derivatives markets: 1) Speculators accept risk
transferred from hedgers; and 2) speculators add liquidity derivatives markets. Because of the
two important roles that speculators play, the derivatives market would be worse off if only
hedgers were in the market.
1.4
a. The risk involves falling corn prices. The derivative would need to increase in value if corn
prices fall.
b. The risk involves rising corn prices because corn is an input into cornbread. The derivative
would need to increase in value if corn prices increase.
c. The risk is the price decline of the bond if interest rates rise. The derivative would need to
increase in value if interest rates rise (bonds prices fall).
2.1
Forward contracts give firms and investors an opportunity to hedge the risk on transactions that
depend on future prices. Forward contracts can also be used to speculate on future prices.
2.2
The person or firm on the other side of the forward contract, the counterparty, may be unable or
unwilling to fulfill the obligation in the contract—the buyer may not fulfill the buyer’s
obligation to the seller, or the seller may not fulfill the seller’s obligation to the buyer.
2.4
The buyer in the oil forward contract has an incentive to default because he or she has to buy oil
at the agreed upon forward price, which presumably is considerably higher than the current spot
price with oil prices having declined by 50%.
3.1
Futures contracts are traded on exchanges, have a price that changes as a result of trading until
the settlement date, and are standardized in terms of the quantity of the underlying asset to be
delivered and the settlement dates for the available contracts. Futures contracts lack the
flexibility of forward contracts, but have reduced counterparty risk, lower information costs,
and greater liquidity. A commodity future is a future that takes a long or short position in the
commodity market. Two examples would be selling corn futures or oil futures to hedge against
falling corn and oil prices. A financial future is a future that takes a long or a short position on
a financial asset. Two examples would be selling Treasury note futures contracts to hedge
against an increase in interest rates, or selling U.S. dollar futures contracts to hedge against a
decline in the exchange value of the dollar.
3.2
No. If a firm has a long position in the spot market, then to hedge risk it must take a short
position in the futures market. Similarly, if a firm has a short position in the spot market, then
to hedge risk it must take a long position in the futures market.
3.3
Hedging is an action to reduce risk, such as purchasing a derivative contract that will increase in
value when another asset in an investor’s portfolio decreases in value. Speculating is placing a
financial bet in an attempt to profit from movements in asset prices. An example of speculating
using commodity futures would be buying wheat futures expecting the future spot price to
exceed the current futures price. An example of speculating using a financial future would be
buying Treasury futures expecting future interest rates to be lower (and the prices on the
Treasury security to be higher) than indicated by the current price of Treasury futures.
3.4
Futures markets originated in agriculture because the supply of agricultural products depends on
weather and can therefore be subject to wide fluctuations. With demand for agricultural
products typically being price inelastic, fluctuations in supply cause large swings in prices. A
farmer will generally sell futures contracts to reduce the risk of agricultural prices falling. By
selling futures contracts the farmer can earn a profit in the futures market to offset his or her
losses in the spot market if agricultural prices fall. General Mills would buy futures contracts in
wheat (or other grains) to reduce the risk of prices rising. By buying futures contracts General
Mills can earn a profit in the futures market to offset its losses in the spot market if wheat prices
rise.
3.9
a. The farmer would want to sell wheat futures. The farmer would sell 10 contracts. The contracts
in total would value (10 contracts  5,000 bushels  $2.75 per bushel)  $137,500.
b. In November, the farmer closes his position in the futures market by buying back the contracts
at the current futures price of $2.85. Therefore, he loses 10  5,000  $0.10  $5,000 (or $142,500
 $137,500). However, he gains in the spot market by selling his wheat at the November spot
price of $2.60: $0.10  50,000  $5,000. This gain is relative to what he would have earned if
the November spot price was the same as the September spot price. The farmer has completely
hedged his risk (leaving aside the transactions costs of carrying out the hedge).
4.1
A call option is a derivative contract that gives the buyer the right to buy the underlying asset at
a set price during a set period of time, and a put option is a derivative contract that gives the
buyer the right to sell the underlying asset at a set price during a set period of time. An option
writer is the seller of the option contract. There would be no options contract to buy without
the option writer.
4.2
With futures contracts, buyers and sellers have symmetric rights and obligations. In contrast,
with options contracts, the buyer has rights, and the seller has obligations. For example, if the
buyer of a call option exercises his or her right to buy the underlying asset, the seller of the call
option has no choice but to fulfill the obligation to sell the asset. However, the buyer of the call
option has no obligation to exercise it and may choose, instead, to allow the option to expire,
unexercised.
4.3
The options premium is the price of an option. The option’s intrinsic value is the payoff to the
buyer of the option from exercising it immediately. The amount of time until the option’s
exercise date and the past volatility of the asset’s price also affect the option premium.
4.4
Options can be used to hedge risk against commodity price, stock price, interest rate, or foreign
currency movements. An investor can hedge against a price decline by buying a put option and
hedge against a price rise by buying a call option. Options are more expensive than other means
of hedging but also do not suffer a loss if the value of the asset moves in the opposite direction of
that being hedged against.
4.6
a. With a put option, the investor can sell at the strike price if stock prices fall.
b. A put option provides insurance against a decline in stock prices, while allowing you to still
gain if stock prices rise, instead of fall. To buy the put option, you will have to pay the option
premium. If you own the stocks and sell them, you cannot benefit if the stock prices rise, and
you no longer receive dividends from stock ownership. If you engage in a short sale (borrow
stocks from a broker and then sell them), you will lose money, possibly a lot of money, if the
price of the stock rises rather than falls, because you will have to buy back the stocks at a higher
price than you sold them for.
c. “Exposure” to the stock market means the chance of realizing gains or losses in stock prices.
The put options remove the exposure to stock price declines, while the call options allow
investors to realize gains if stock prices rise.
5.1
A swap is an agreement between two or more counterparties to exchange sets of cash flows over
some future period. A swap is different from a futures contract because as a private agreement
between counterparties, its terms are flexible. Compared to futures contracts, swaps can be
custom-tailored to meet the needs of the counterparties, offer more privacy, are subject to little
government regulation, and offer longer-term hedging.
5.2
An interest-rate swap is a contract under which counterparties agree to swap interest payments
over a specified period on a fixed dollar amount, called the notional principle. A credit swap is
a contract in which interest-rate payments are exchanged, with the intention of reducing default
risk. A credit swap is similar to an interest-rate swap, but with the intention of reducing default
risk, or credit risk, rather than interest-rate risk.
5.3
A credit default swap is a derivative that requires the seller to make payments to the buyer if the
price of the underlying security declines in value. Unlike the other swap contracts discussed in
this chapter, credit default swaps do not involve exchanges of interest payments or currencies.
Instead, credit default swaps are a type of insurance. Large sellers of credit default swaps
(CDSs), such as AIG, dramatically mispriced the CDSs, and therefore sold “insurance” at
prices far below what turned out to be its true value. When the time came to pay off the buyers
of the CDSs, AIG could not do so and the federal government had to bail out the firm in 2008.