Question

In: Accounting

Suppose that the pension you are managing is expecting an inflow funds of $100 million next...

Suppose that the pension you are managing is expecting an inflow funds of $100 million next year and you want to make sure that you will earn the current interest rate of incoming funds in long-term bonds.

(i) How would you use the options market to accomplish this goal?

(ii) What are the advantage and disadvantage of using an options contract rather than a futures contract?

400 words

Solutions

Expert Solution

(i) You would buy $1 billion worth (10000 contracts) of the call long-term bond option with a delivery date of one year in the future and with a strike price that corresponds to a yield of 5%. This means that you would have the option to buy the long bond with the 5% interest rate, thereby making sure that you can earn 5%.

(ii)

Advantages:

  • prevent downside if the opportunity cost upside.
  • No time decays
  • Remain the price unchanged for many years.

Disadvantages:

  • Futures are not ideal when trading stocks.

Future contract advantages:

  • it is harder for anyone to corner the market;
  • it is protected from losses through margin requirements and making to market;
  • in most cases, it does not result in delivery of the underlying asset on the expiration date - traders are allowed to cancel their contracts and lower the cost of conducting trades.

Future contract disadvantages:

  • They require money to change hands daily when a contract is marked to market. In contrast, the option contract requires money to change hands only when it is exercised.

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