(a) Explain briefly the difference between hedging and speculating using financial derivatives. (b) Suppose that a...

(a) Explain briefly the difference between hedging and speculating using financial derivatives.

(b) Suppose that a European put option to sell a share for €50 costs €6 and is held until maturity. Under what circumstances will the seller of the option (the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option.

(c) A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the variation of the trader’s profit with the asset price. What trading strategy is being described here?

(d) Suppose that put options on a commodity with strike prices $30 and $35 cost $4 and $7, respectively. How can the options be used to create (i) a bull spread and (ii) a bear spread? Construct a table that shows the profit and payoff for both spreads.

Expert Solution

(a) Difference between Hedging and Speculating

Hedging is performed as a measure to protect against the risk or to reduce the risk of the changes in the price of the underlying asset.

On the contrary, speculation, is an attempt to earn profit from the changes in the difference between derivative price and spot price. Hence, the risk is taken intentionally to reap profits.

jeff jeffy answered 2 years ago

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