Financial Markets

Assignment-I

Submitted by: Indra Adhikari Marketing A Roll No: 35169

Question: A daughter in the family is getting married and her wife wants to buy gold for her daughters wedding. The parents together hold some Fixed deposits and some stock in the form of shares. The wedding is in about 3 months and the parents are discussing how to make the purchase of gold. The wife is insisting to buy the gold immediately by liquidating the current assets. However premature breaking of the FD attracts some penal interest. You are required to suggest the best option for the couple to buy the gold.

Solution: St- Current stock price, K- strike price at maturity of Option F1- date of expiry of futures contract

F0- date of entry into the futures contract Current holdings:

Fixed deposits with bank- to remain as is due to penal interest. Stock holding of share- against which a PUT Option is bought. The value of k or the total holding of shares is to be equal to the value of gold to be bought.

For simplicity, we are assuming the price of gold at Rs. 30,000 for 10 grams. And the value of one stock at Rs 1000, thus PUT option of 30 lots of shares being purchased and which is equal to F0.

There are a possible 4 scenarios

St > k

F1 > F 0 F1< F0

St < k

F1 > F 0 F1< F0

Scenario 1: St > k and F1 > F0

St > k If the stock price is greater than the strike price at the time of expiry of the PUT option, then we will let the option lapse. The shares will be sold at the open market to avail a higher price. At the same time the futures price will be F1 which was the value of k. Now we already have a greater amount than k, so there will be additional funds left at the end after purchasing gold at F0. Example to put it numbers, St is 33000 and k is 30000, so we sell it in open market and get additional funds worth 3000 and buy gold worth 30000 which was the locked price in the futures contract. We are left with additional funds of Rs. 3000 from which we can buy more gold.

Scenario 2: St > k and F1 < F0

If the stock price is greater than the strike price at the time of expiry of the PUT option, then we will let the option lapse. The shares will be sold at the open market to avail a higher price. Gold now is at lower price but we need to honour the contract at F0. Thus we buy at a loss and maybe there are additional funds to buy more gold.

Scenario 3: St < k and F1 > F0

Since Strike price is greater than the spot price we will exercise the option, we will offset the futures contract with the PUT option thereby buying the gold at a rate lesser than the market price, hence making a gain.

Scenario 4: St < k and F1 < F0

Since Strike price is greater than the spot price we will exercise the PUT option. But the price of gold is less in the market however we will have to go the contract long, thus buying gold at a price higher than the market price.