Derivatives: Futures Contract and Inc. Common Stock
1. (Problem 1.12) Suppose bank’s loan officer tells you that if you take out a mortgage (i.e., you borrow money to buy a house) you will be permitted to borrow no more than 80% of the value of the house. Describe this transaction using the terminology of short-sales.
Answer:
We are interested in borrowing the asset “money” to buy a house. Therefore, we go to an owner of the asset, called Bank. The Bank provides the dollar amount, say $250,000, in digital form in our mortgage account. As $250,000 is a large amount of money, the bank is subject to substantial credit risk (e.g., we may lose our job) and demands a collateral.
Although the money itself is not subject to large variations in price (besides inflation risk, it is difficult to imagine a reason for money to vary in value), the Bank knows that we want to buy a house, and real estate prices vary substantially. Therefore, the Bank wants more collateral than the $250,000 they are lending. In fact, as the Bank is only lending up to 80% of the value of the house, we could get a mortgage of $250,000 for a house that is worth
$250,000 ÷ 0.8 = $312,500. We see that the bank factored in a haircut of $312,500 -
$250,000 = $62,500 to protect itself from credit risk and adverse fluctuations in property prices. We buy back the asset money over a long horizon of time by reducing our mortgage through annuity payments.
2. What do hedge funds do:
(a) Hedge?
(b) Speculate?
(c) Arbitrage?
(d) None of the above
Answer:
(a), (b), (c)
3. During the growing season a corn farmer sells short corn futures contracts in an amount equal to her crop. If after harvesting and selling her crop she maintains the contracts, she is then considered a:
(a) Hedger
(b) Speculator
(c) Arbitrager
(d) None of the above
Answer:
(b)
4. A firm provides a service that benefits from decreasing
Answer:
We are interested in borrowing the asset “money” to buy a house. Therefore, we go to an owner of the asset, called Bank. The Bank provides the dollar amount, say $250,000, in digital form in our mortgage account. As $250,000 is a large amount of money, the bank is subject to substantial credit risk (e.g., we may lose our job) and demands a collateral.
Although the money itself is not subject to large variations in price (besides inflation risk, it is difficult to imagine a reason for money to vary in value), the Bank knows that we want to buy a house, and real estate prices vary substantially. Therefore, the Bank wants more collateral than the $250,000 they are lending. In fact, as the Bank is only lending up to 80% of the value of the house, we could get a mortgage of $250,000 for a house that is worth
$250,000 ÷ 0.8 = $312,500. We see that the bank factored in a haircut of $312,500 -
$250,000 = $62,500 to protect itself from credit risk and adverse fluctuations in property prices. We buy back the asset money over a long horizon of time by reducing our mortgage through annuity payments.
2. What do hedge funds do:
(a) Hedge?
(b) Speculate?
(c) Arbitrage?
(d) None of the above
Answer:
(a), (b), (c)
3. During the growing season a corn farmer sells short corn futures contracts in an amount equal to her crop. If after harvesting and selling her crop she maintains the contracts, she is then considered a:
(a) Hedger
(b) Speculator
(c) Arbitrager
(d) None of the above
Answer:
(b)
4. A firm provides a service that benefits from decreasing