Suggested Solution for Finm2002

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Tutorial 1 Solutions

Your tutor will go through as many questions as possible with you in the tutorial. You should come to class with answers to these questions prepared. Solutions will be posted after the end of the week of the tutorial.

Fundamental Concept Questions

Question One
“Options and futures are zero-sum games.” What do you think is meant by this statement?

The statement means that the gain (loss) to the party with the short position is equal to the loss (gain) to the party with the long position. In total, the gain to all parties is zero.

Question Two
The Chicago Board of Trade offers a futures contract on long-term Treasury bonds. Characterize the investors likely to use this contract.

Most investors will use the contract because they want to do one of the following: a) Hedge an exposure to long-term interest rates.
b) Speculate on the future direction of long-term interest rates. c) Arbitrage between the spot and futures markets for Treasury bonds.

Question Three
Suppose that a March call option on a stock with a strike price of $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a gain? Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a long position in the option depends on the stock price at the maturity of the option.

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. The profit as a function of the stock price is shown in Figure S1.1. [pic]

Figure S1.1 Profit from long position

Question Four
What are the most important aspects of the design of a new futures contract?

The most important aspects of the design of a new futures contract are the specification of the underlying asset, the size of the contract, the delivery arrangements, and the delivery...
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