Spring 2017
Assignment 3
Due: January 30, 2017
Derivatives Securities

  1. Select a commodity for which futures contracts exist and two futures contract on that commodity with different expiration dates (preferably dates that are at least six months apart). Select a long position in one contract and a short position in the other.

Long Position
A trader purchases 100 IBM put options for $3 which are exercised after six months. The IBM shares are trading at $100.
Short Position
A trader purchases 100 IBM call options for $3, which are exercised after six months. The IBM shares are trading at $6.

  1. What is this combination of trades called? Long Straddle.
  2. Record the change in value of each contract and the net change in value of the aggregate position (based on last trade or settlement prices) reflected by the two contracts for 5 days. (This can be done on a per unit basis or total contract value basis.)

If the stock has a fluctuation of 10%, such that its price rises to $110 or falls to $90, the trader will have a profit of $4. ($10 sale option- $3 purchase of call-$3 purchase of put.)

  1. Discuss what the results suggest about this trading strategy using these two contracts.

This trading strategy enables an investor to make profits if there are large movements in the price of stocks. Changes of 6% will not result in any gain for the investor.

  1. Select two different foreign currencies for which futures contracts exist and an expiration date at least 3 months from now on which both expire. Ignoring the actual size of the contract, determine how many units of the foreign currency would be required for the notional value of the contract to be $1m.  Select a long position in one currency futures and a short position in the other.

An individual has a July Yen futures at 1.125. He agrees to sell, 10,000,000 Yen in July 1st 2017 at $1.100 per 100 Yen ($1 for 90.9091Yen).
Notional value of $1,000,000 is 90,909,909 Yen
An individual has a July USD dollar ($) futures at 1. He agrees to buy 10,000,000 Yen in July 1st 2017 at $1.10 per100 Yen ($1 for 90.9091Yen).

  1. What is this combination of trades called? Synthetic future contract
  2. Record the change in value of each contract and the net change in value of the aggregate position (based on last trade or settlement prices) reflected by the two contracts for 5 days.

(This can be done on a per dollar basis or total dollar value basis.) 
Put Option
Sells: 10,000,0000Yen /1.1= $9,090,909
Call Option
Buys: $9,090,909*1.1= 10,000,000Yen

  1. Discuss what the results suggest about this trading strategy using these two contracts.

These results in the trader retaining his position before exercising the contract. As such, he/she is able to avoid losses that are caused by changes in the exchange rate. The net effect of this contract is zero

  1. Diagram the payoffs at expiration of the following combinations of options as a function of value of the underlying asset. (Ignore the option premiums):
  2. A bull spread composed of a purchased call with a strike price of 20 and a written call with a strike price of 35.

Call Option
Purchased Call With Strike Price of 20 and 35
Value at Expiry
 
 

 
 
 
            0                                                                                  Underlying Stock Price
 

 
 
                                       $20          $35                      
                       
 
 
 
 

  1. A bear spread composed of a written call with a strike price of 15 and a purchased call with a strike price of 25.

Written Call With Strike Price of 15 and 25
Value at Expiry
 
 

 
 
 
            0                                                                                  Underlying Stock Price
 

 
 
                                       $15          $25                      
                       

  1. A straddle (long or short) with a strike price of 20. Specify the options used.

Value at Expiry

 
 
 
 
 
 
 
 
                                                     $20                         Underlying Price
 

  1. A strangle (long or short, same as 3c) with strike prices of 15 and 25. Specify the options used.

Value at Expiry

 
 
 
 
 
 
         0
     -5
                                       $15    $20         $25              Underlying Price
 
 
 
 
 
 
 
 
 
 

  1. A ratio spread (use a ratio of 2 to 1 with your choice of calls or puts and the position (purchaser or writer) take for each portion of the spread) with strike prices of 15 and 20.

 
Profits ($)
 
 

 
 
 
 
 
 
 0
 
 

 
 
 
 
                                    $15               $20                                 Underlying Price
 
 
 
 
 

  1. A collar with strike prices of 15 and 20 (your choice of type of option and position taken in each).

Profits ($)

 
 
 
 
 
 
          0

 
 
           
 
 

 
 
                                                     $15             $20                  Underlying Price
 
For questions 4-8, include premiums paid by an option owner and received by an option writer, together with the applicable payoff profile from question 3, in your answer.
4a. Explain how an investor that is “bullish” on the underlying asset would expect to make money with the spread in 3b after premiums are accounted for as well as the final payoff on the options.
A “bullish” investor will exercise his/her call option by buying stocks that he/she believes will increase in value and selling the already appreciated stocks.

  1. Identify how a similar payoff profile can be obtained using put options instead of call options.

Using the put option, an investor can exercise the sell options to prevent losses due to a fall in value of an asset. If the asset with a sell option fails to appreciate to his expected levels, he will sell the asset under the put option.
5a. Explain how an investor that is “bearish” on the underlying asset would expect to make money with the spread in 3b after premiums are accounted for as well as the final payoff on the options.
An investor can exercise his call option by buying stocks at a lowly priced call options. If the options are below the market price of the assets, the investor will exercise his/her option and sell the stocks in the market (Brigham and Houston, 2014).

  1. Identify how a similar payoff profile can be obtained using put options instead of call options.

Using the put option, an investor can determine the price that he/she will sell an asset in futures. Therefore, if the price of an asset falls below the striking price of the sell option, he/she will exercise it and avoid losses.
6a. Explain the expectations that would lead an investor to enter the position described in 3c.
An investor can exercise this option if he/ she believes the asset will be more volatile than the entire market.

  1. Why would an investor with the same expectations decide to enter the position described by 3d instead.

This method reduces the high premium cost associated with a strangle
7a. Explain the expectations that would lead an investor to enter the position described in 3e
The investor expects to profit from the decline in the underlying stock by writing another put with the same expiration but one that has a lower striking price in order to offset some of the costs (McDonald, 2013).

  1. Why would the investor choose to enter a ratio spread rather than a simple bull or bear spread.

An investor uses this method if he/she expects the asset to have little volatility in the near term. This is a neutral method in which an investor buys some options and sells more option of the same underlying stock and expiration date for a different strike price.

  1. Explain the expectations that would lead an investor to enter the position described in 3f.

An investor uses the position in 3f when the premiums of calls and put offset one another.
 
 
 
 
 
 
 
 
 
 
 
Works Cited
Brigham, E., and Houston, J. Fundamentals of Financial Management (8th Ed.). Cengage Learning. 2014.
McDonald, R. Derivatives Markets (3rd Ed.). Pearson. 2013.