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Short Answer Questions (25 points total)
Please answer the following questions clearly and concisely. A word or phrase is OK if that is
all it takes to answer the question. If you provide a longer answer, only the first 2 sentences of
your answer for each part of the question will be graded.
QUESTION 1: The following exchange is from the Trading Places clip we viewed in class
the Wednesday before Spring Break:
President of the Exchange: Margin call, gentlemen. You know the rules, all accounts
must be settled at the end of the day, without exception.
Randolph Duke: You know perfectly well we do not have $394 million in cash!
President of Exchange: Oh, I am sorry. [To his assistant] Put the Dukes' seats on the
Exchange up for sale and seize all holdings and property of Mortimer and Randolph
Duke.
Mortimer Duke: This is an outrage! I demand an investigation! A Duke has been sitting
on this Exchange ever since it was founded!
[Randolph Duke collapses in shock]
A. What direction did the Dukes expect orange juice prices to move following the USDA
report? What was their market position long or short? (2 points)
Higher (up)
Long
C. By receiving a margin call, were the Dukes trading futures or options? How do you know
this? (2 points)
Futures
No margins or margin calls with long options
D. When a margin call occurs, can the exchange actually sell a traders seat (exchange
membership) and seize a traders other assets to cover the shortfall, or is this just a case of
Hollywood storytelling? (1 point)
Yes, the exchange can do all these things
QUESTION 2: When an option expires out of the money, what does the option buyer receive?
Does the option buyer have a profit, a loss, or is it unclear? How much is the option buyers
profit or loss? (3 points)
Receives nothing
Loss
Premium paid at the outset
QUESTION 3: When an option expires in the money, what does the option seller receive?
Does the option seller have a profit, a loss, or is it unclear? How much is the option sellers
profit or loss? (3 points)
Receives a losing futures position at the strike price
Unclear (depends on premium received versus loss on futures position)
Difference between the premium received and the loss on the futures position
assigned at exercise
C. How would an option premium change (increase or decrease) if there is a decrease in the
number of days to expiration? Explain your answer in terms of the probability that the option
will be exercised. Give an example of an option trading strategy that would profit from a
decrease in the time to expiration. (3 points)
Decrease
Fewer days to expiration means a lesser chance that the option will move
(deeper) in the money and be exercised
Anything short premium
B. What does Hedging Effectiveness measure? What statistic from linear regression is used for
Hedging Effectiveness? (2 points)
Percentage of price risk eliminated by the hedge
Coefficient of variation (R-squared)
C. If you are long this option, would it make economic sense to exercise it now? Why or why
not? (2 points)
Yes
Has intrinsic value (in of the money)
E. If the crude oil futures price goes up 10 cents per barrel, how much would the premium on
the option change? Which way would the premium change (up or down)? (2 points)
-.07201 or -7.2 cents
Goes down
G. How many June $95 put options (rounded to the nearest whole number) would be needed to
obtain similar performance (within a narrow price range and short time frame) as 50 short
June crude oil futures contracts? Should these put options be long or short? (2 points)
69 put options 69.4348 = -50 -.7201 = Number of futures Delta
Long options, because long puts are analogous to short futures
H. Suppose that on May 16 the day when the June options expire the June crude oil futures
price is $93.00. What would be the premium for the June $95 put option at expiration? How
much time value erosion would have occurred since April 12? (2 points)
$2.00 = intrinsic value; time value at expiration = 0
$0.94 = all of the time value on April 12
A. Circle the two items from this list that you will use to create a synthetic long call. (2 points)
B. Complete the payoff table below. (25 points)
Premium for
Option
Position
Profit on
Option
Position
Combined
Profit on
Futures &
Option
Positions
Futures
Price
Profit on
Futures
Position
Value of
Option
Position at
Expiration
$4.20
-$0.18
+$0.20
-$0.15
+$0.05
-$0.13
$4.30
-$0.08
+$0.10
-$0.15
-$0.05
-$0.13
$4.40
+$0.02
$0
-$0.15
-$0.15
-$0.13
$4.50
+$0.12
$0
-$0.15
-$0.15
-$0.03
$4.60
+$0.22
$0
-$0.15
-$0.15
+$0.07
C. Use the data in the payoff table to plot a payoff diagram on the grid on the next page, with 3
separate lines showing the profits at expiration for:
You will not be graded on your artistic ability, but your payoff diagram should:
Show each line with the proper shape and drawn to scale (6 points)
Be properly labeled to show which axis is the profit and which axis is the underlying
future price (2 points)
Cover the range of future prices from $4.20 to $4.60 (1 point)
SyntheticLongCall
$0.25
$0.20
$0.15
Profit
$0.10
$0.05
SyntheticLongCall
$0.00
LongCashat$4.28
$0.05
Long$4.40Putat$0.15
$0.10
$0.15
$0.20
$4.60
$4.50
$4.40
$4.30
$4.20
FuturesPrice
PROBLEM 3 (4 points)
Using the put-call parity formula, calculate the missing values in the table below:
Commodity
Futures
149.80
Call Premium
4.42
Strike Price
150.00
Put Premium
4.62
1566.00
34.75
1600.00
68.75
Feb Butter
171.00
5.00
176.00
10.00
May Lumber
333.8
37.9
300.1
4.2
Cash
Futures
Basis
Feb
Short at $1,520
$0
July
Long at $1,585
$0
-$65
+$65
$0
Gain/Loss
A. Construct a hedge using a July $1,520 call option. The premium in February is $76 and the
premium in July is $66. (6 points)
Date
Cash
Long or Short? Price?
Feb
Short at $1,520
July
Long at $1,585
Gain/Loss
-$65
-$10
2) Use the steps below to calculate the change in intrinsic value on the call option between
February and July (4 points)
a) Intrinsic value in February: $0
b) Intrinsic value in July: $65 = $1,585 futures price - $1,520 strike price
c) Change in intrinsic value: $65
d) Is this a profit (+) or loss (-) to the hedger? Profit (+)
3) Use the steps below to calculate the change in time value on the call option between
February and July: (4 points)
a) Time value in February: $76 = $76 - $0
b) Time value in July: $1 = $66 - $65
c) Change in time value: $75
d) Is this a profit (+) or loss (-) to the hedger? Loss (-)
4) Use your answers from Part 2 and Part 3 to explain the jewelry manufacturers call option
hedging results. (1 point)
Loss in time value > Gain in intrinsic value, so call option hedge wasnt effective
Cash
Long or Short? Price?
Feb
Short at $1,520
July
Long at $1,585
Gain/Loss
-$65
+$75
2) Use the steps below to calculate the change in intrinsic value on the put option between
February and July (4 points)
a) Intrinsic value in February: $0
b) Intrinsic value in July: $0
c) Change in intrinsic value: $0
d) Is this a profit (+) or loss (-) to the hedger? Any answer OK
END OF EXAM #2