Options and Derivatives Chapter 1 Solutions
CHAPTER 1
Introduction
Practice Questions
Problem 1.1
What is the difference between a long forward position and a short forward position?
When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the underlying asset for a certain price at a certain time in the future.
Problem 1.2.
Explain carefully the difference between hedging, speculation, and arbitrage.
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.
Problem 1.3.
What is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price of $50?
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.)
Problem 1.4.
Explain carefully the difference between selling a call option and buying a put option.
Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of Buying a put option involves buying an option from someone else. It gives a payoff of In both cases the potential payoff is. When you write a call option, the payoff is negative or zero. (This is because the counterparty chooses whether to exercise.) When you buy a put option, the payoff is zero or positive. (This is because you choose whether to exercise.)
Problem 1.5.
An investor enters into a short forward contract to sell 100,000
Introduction
Practice Questions
Problem 1.1
What is the difference between a long forward position and a short forward position?
When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the underlying asset for a certain price at a certain time in the future.
Problem 1.2.
Explain carefully the difference between hedging, speculation, and arbitrage.
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.
Problem 1.3.
What is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price of $50?
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.)
Problem 1.4.
Explain carefully the difference between selling a call option and buying a put option.
Selling a call option involves giving someone else the right to buy an asset from you. It gives you a payoff of Buying a put option involves buying an option from someone else. It gives a payoff of In both cases the potential payoff is. When you write a call option, the payoff is negative or zero. (This is because the counterparty chooses whether to exercise.) When you buy a put option, the payoff is zero or positive. (This is because you choose whether to exercise.)
Problem 1.5.
An investor enters into a short forward contract to sell 100,000