Difference Between the Positions of the Traders - Assignment Example

1.24 Difference between the positions of the traders’ Since Trader A has entered into a forward contract, he is obligated to buy the gold at the prefixed price. This is in contrast with Trader B who has undertaken to buy a call option and thus he is not obligated and rationally speaking will only buy Gold if he gains by exercising the option. In other words, in the case of the forward contract, if the price falls to $900 per price before the expiration day, then, Trader A must pay the $1000 agreed earlier on implying a loss of $100 per ounce to him. In the case of the call option, if the price falls to $900 per ounce, Trader B will automatically lose $100 per ounce and thus will not exercise the option. If the reverse happens, Trader B will exercise the option since he will gain. Profit per ounce as a function of the price of Gold: Trader A: Long Profit (P) = S (T)> F (O, T) where, S (T) is spot price at delivery and F(O,T) is original forward price.(Chance, 4) Trader B: Short Profit (P) = (Strike price + Premium)> Stock Price 1.25 The Investor is the seller of the put option. This means that he has agreed to buy from the buyer of the option an agreed quantity of stock at $40. The buyer of the put option will have to pay him a premium (option price) of $3 in order to enjoy the benefit of the option. The investor being the seller of the put option is bullish on the stock. The trade will only prove to be profitable to the investor if the price of the stock rises. The risk is that if the price of stock rises the buyer of the put option may opt not to sell the stock at the strike price since it will make him incur a loss. 2.24 Total Profit for each trader ignoring daily settlements Trader A: $1,430,000- $1,400,000=$30,000 Trader B:$1,430,000- $1,400,000=$30,000 Ignoring daily settlements trader A will have done better since his exchange is formally settled and there exists a clearing house to compensate incase of default. 3.22 Since the company will lose $ 1 million for each one cent increase in the price per gallon of the new fuel over the next three months , the company’s exposure measured in gallons of the new fuel is computed as follows: (1000000*0.6)/50%= 1200000 gallons. Measured in gallons, the company should take the following position in gasoline futures: (50%*1*10000000)/0.6 =833333 gallons The total number of gasoline futures that should be contracted are: 1200000-833333=377777 gasoline futures 4.21 Forward rate agreement is a contract between two counterparties to exchange a fixed interest payment for a floating interest payment on a single date. The exchange of a floating rate of interest for a fixed rate of interest is called a swap. A swap is therefore equivalent to FRA since each swap cash flow is the cash flow of an FRA with fixed rate equal to the swap rate. 4.22 This statement implies that agreeing to pay cash flows equal to a predetermined interest rate (5%) on a notional principal of 100 million for a period of six months against the other party paying a floating rate based on LIBOR as the index is the cash flow of FRA.(Overdahi & Kolb, 707) 5.24 To estimate the six month euro interest rate, the following computation is done: (1.4/1.01)6 = (1.3950/n)6 7.09 = (1.3950/n)6 =1.41% 6.26 The arbitrage opportunities open to the bank would be realised if the discounted future price of the contract maturing in 90 days as stated to be 89.5 is higher than the present value of the money borrowed or lent in the Libor Market 7.9 a. The floating rate necessary to swap this fixed rate into is 9.6% b.5% (YEN1M+LIBOR)=9.6%(DOLLAR1M+LIBOR75BPS) =10.6% SWAPING RATE 7.20 a. The company can swap 5.0% floating rate into the 6.45% fixed rate b. = Yen 1m (5.0%+9.6%+6.5%+10%)5=Dollar 1M Libor +50 Bps = 7.5% 9.23 Where an investor buys 100 shares, shorts 100 call options and buys 100 put options, the diagram appears as follows: Incase the investor buys 100 shares, shorts 200call options and buys 200 put options, the diagram changes to resemble the figure below: 10.25 a. If the value of the company is greater than the value of the debt, then my position would be to pay off the debt. If the value of the company is less than the value of the debt, my position would not be to pay of the debt since this would lead to bankruptcy declaration of the company.Instead I would opt for a merger with a financially healthy company thus allowing for the easier payment of the debt and avoiding bankruptcy. b. Incase the company is unable to pay the debt the position of the debt holders would be to own the company through a declaration of bankruptcy. c. I would increase the value of my position by merging my company with a financially healthy company thus leading to easier payment of debt and hence avoiding bankruptcy in the short run. 11.21 Diagram showing the variation of an investor’s stock profit and loss with the terminal stock price given the portfolios stated in the question and assuming that the call option has an exercise price equal to the current stock price 12.14 Future value = 25 (1+r)n = 25 (1.1)2 =30.25 Value of derivative Pay off = 25 (1.1)2 – 27 = 30.25-27 =3.25 13.19 Use of the DerivaGem software to translate a table of European call options on the stock into a table of implied volatilities assuming no dividends: 20.7 Assumptions underlying a. The historical simulation approach of calculating VaR: The first simulation trail assumes that the percentage changes in all the market variables are as on the first day. The second simulation trial assumes that the percentage changes in all market variables are as on the second day. This assumption continues as the simulation trials increase in number. b. Model building approach of calculating VaR: This approach makes assumptions about the probability distributions of return on the market variables i.e. Risk factors are normally distributed The correlation between risk factors is constant Price sensitivity to changes in a risk factor of each portfolio constituent is constant Works cited Don Chance, An introduction to Derivatives and Risk Management 6th ed. New Jersey: John Wisley & Sons, Inc 2008. Robert Wolb & James Overdahi, Features, Options and Swaps, 5th ed. Victoria: Blackwell Publishing 2007. Read More