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Derivatives Code: 515A

General Instructions:

 The Student should submit this assignment in the handwritten form (not in the typed format)

 The Student should submit this assignment within the time specified by the exam dept

 The student should only use the Rule sheet papers for answering the questions.

 The student should attach this assignment paper with the answered papers.

 Failure to comply with the above Four instructions would lead to rejection of assignment.

Specific Instructions:

 There are four Questions in this assignment. The student should answer all the four questions. Marks allotted 100.
 Each Question carries equal marks (25 marks) unless specified explicitly

Question No 1:
It is March 1, and you are a new derivatives trader making a market in forward contracts in Commodity W. One
month ago (February 1), you began your operations with the following transactions, which are described from your
perspective:

• With Client A: (1) Short a June 1 forward for 10,000 units at a contract price of Rs.25.50/unit. (2) Long a
September 1 forward for 15,000 units at a contract price of Rs.26.20/unit.

• With Client B: (3) Short a September 1 forward for 25,000 units at a contract price of Rs.26.40/unit. Your current
(i.e., March 1) contract price quotes are as follows:

Contract Bid Ask

June Rs.24.95 Rs.25.15


September Rs 25.65 Rs.25.85

The appropriate discount is 9 percent per annum.

a. If Client A just called you wanting to unwind both of its contracts, calculate a fair cash amount that can be used in
settlement today. Would you pay or receive this amount?
b. .If these contracts had been exchange-traded futures contracts instead of OTC forward contracts, how would this
settlement amount need to be adjusted (assuming the same March 1 contract prices)?
c. Calculate the dollar amount you would lose if Client B called you to default its contractual obligation.
(Hint: Compute this amount in the same manner you calculated the net settlement in Part a.).
d. At the time you negotiated the three original agreements (i.e., February 1) did you have any price exposure on
the September contracts? If so, what type of future price movements would be harmful to your net profit on the
expiration date?
Question No 2:

(i) Suppose the current contract price of a futures contract on Commodity Z is Rs.46.50 and the expiration
date is in exactly six months (i.e., T = 0.5). The annualized risk-free rate over this period is 5.45 percent
and the volatility of futures price movement is 23 percent, which is equal to that of the underlying
commodity.

a. Calculate the values for both a call option and a put option for this futures contract, assuming both
have an exercise price of Rs.46.50 and a six-month expiration date.

b. Suppose the market prices for these contracts agree with the values you computed in Part a. You
decide to buy the call option and sell the put option. What sort of position have you just created?
Under what circumstances (i.e., for what view of subsequent market conditions) would it make sense
for an investor to create such a position?

(ii) Compare and contrast the gain and loss potential for investors holding the following positions: long
forward, short forward, long call, short call, long put, and short put. Indicate what the terms symmetric and
asymmetric mean in this context.

Question No 3:

a) When comparing futures and forward contracts, it has been said that futures are more liquid but forwards
are more flexible. Explain what this statement means and comment on how differences in contract liquidity
and design flexibility might influence an investor’s preference in choosing one instrument over the other.
b) It has been shown empirically that stock volatility decreases as a stock’s price increases. Comment on how
this phenomenon would tend to bias the call and put option values generated by the Black-Scholes model,
which assumes that volatility remains constant.

Question No 4:

(i) Explain why the difference between put and call prices depends on whether or not the underlying
security pays a dividend during the life of the contracts

(ii) You are a coffee dealer anticipating the purchase of 82,000 Kgs of coffee in three months. You are
concerned that the price of coffee will rise, so you take a long position in coffee futures. Each contract
covers 37,500 Kgs, and so, rounding to the nearest contract, you decide to go long in two contracts.
The futures price at the time you initiate your hedge is 55.95 Rs. per kilogram. Three months later, the
actual spot price of coffee turns out to be 58.56 Rs. per Kilogram and the futures price is 59.20 Rs. per
kilogram.
a. Determine the effective price at which you purchased your coffee. How do you account for the
difference in amounts for the spot and hedge positions?
b. Describe the nature of the basis risk in this long hedge.

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