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Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Describe the over-the-counter market, distinguish it from trading on an exchange, and evaluate its advantages and disadvantages. Differentiate between options, forwards, and futures contracts. Identify and calculate option and forward contract payoffs. Calculate and compare the payoffs from hedging strategies involving forward contracts and options. Calculate and compare the payoffs from speculative strategies involving futures and options. Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary


707.1. PlanetZim Financial Bank just entered a position in a derivatives contract. Which of the following features of the derivative position is MOST likely to indicate the trade is a case of SPECULATION, in contrast to a case of a hedge, arbitrage or market-making?

a. If a hedge has no basis risk, then the hedged outcome is always superior to the un-hedged outcome
b. In distinguishing from an arbitrage or a hedge, the key feature of a speculation is the use of high leverage
c. Although put options can be used as a hedge or insurance, a position in call options implies the investor is speculating rather than hedging
d. In Hull, the theoretical price of futures contracts and stock options (per Black-Scholes Merton) depend on an assumption that no riskless arbitrage opportunities exist

707.2. Peter has $10,000.00 to invest (speculate) in an exciting technology company whose stock price currently trades at $20.00 per share. At-the-money call options are priced at $2.50 per option. He wants to compare the difference between buying the stock and buying the call options; in either of the two scenarios, he will invest his entire $10,000. If the stock doubles (from $20.00 to $40.00), what is the ratio of profits between the two alternatives? Please note that option profit equals payoff minus initial cost, and we are unconcerned with the time value of money here.

a. 1.0: 1.0; i.e., no leverage
b. 2.5: 1.0
c. 7.0: 1.0
d. 20.0: 1.0

707.3. The spot price of commodity, S(0), is currently $30.00. For a futures contract on the same commodity, the theoretical futures price assumes the cost of carry (COC) model where this commodity has no storage, income or convenience such that theoretically F(0) = S(0)*exp(r*T) under continuous compounding, or under an assumption of annual compound frequency, F(0)=S(0)*(1+r)^T. The riskfree rate, r, is 1.0% with continuous compounding. If the observed six-month forward price on the commodity, F(0, 0.5), is $30.40 then which of the following is the correct arbitrage trade (i.e., trade that exploits the arbitrage opportunity)?

a. There is no arbitrage opportunity
b. Cash and carry: Buy the commodity at the current spot price and short the futures contract for a future profit of about $0.250
c. Cash and carry: Buy the commodity at the current spot price and short the futures contract for a future profit of about $1.390
d. Reverse cash and carry: Sell short the commodity at the current spot price and buy the futures contract for a future profit of about $0.140

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