Question

In: Finance

(a) Hedgers and speculators are needed in order for a derivatives market to function most efficiently....

(a) Hedgers and speculators are needed in order for a derivatives market to function most efficiently. Differentiate between the two.

(b) Consider a put option contract with the size of € 300,000, the November put with a strike price of $1.1525 are now quoted at $0.0275.

i. What is the right of contract buyer in the above option contract?

ii. Calculate the premium for the above put option? What happen to this premium?

iii. Will the buyer of the put option contract exercise the option if the spot rate is $1.2320/€? What is the gain in this case?

(c) Consider a call option contract with the size of €180,000, the November call with a strike price of $1.2160 are now quoted at $0.02815.

i. What is the obligation of the contract writer in the above call option?

ii. Will the buyer of the call option contract exercise the option if the spot rate is $1.2400/€? What is the gain in this case?

Solutions

Expert Solution

a]

Hedgers take positions in derivatives to protect their assets/portfolio/income from fluctuations arising due to changes in the market value of assets. For example

  • a firm expecting a foreign currency payment may wish to hedge against an appreciation of its domestic currency.
  • A portfolio manager may wish to hedge against fall in the market to protect the portfolio value

Speculators take positions in derivatives to profit from a view that they have on the underlying asset. For example, a speculator in stock options may buy a call option on a stock because they believe that the stock price will rise.

Thus, hedgers trade derivatives for risk management, whereas speculators trade derivatives for profit.

b]

(i)

The contract buyer has the right to sell €300,000 and receive $ at the exchange rate of $1.1525/€

(ii)

Total premium = contract size * premium per €

Total premium = 300,000 * $0.0275

Total premium = $8,250

This amount will be paid by the option buyer to the option seller

(iii)

No, the option will not be exercised because the spot rate at expiration is higher than the option strike price.

Loss = premium paid =  $8,250

(c)

(i)

The contract writer has the obligation to sell €180,000 at the exchange rate of $1.2160/€

(ii)

Yes, the option buyer will exercise the option because the spot price at expiry is above the option strike price.

gain = (spot price at expiry - option strike price - premium) * contract size

gain = ($1.2400 - $1.2160 - $0.02815) * 180,000

gain = -$747 (loss)

jeff jeffy answered 2 years ago
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