Question

Q1.

Can you give three reasons to use derivatives? Explain

Q2.

An investor sells 10 futures contracts on day 1 for $ 500 each. The initial margin is 40% and the maintenance margin is 30%. If the pattern of prices is as given in the table below, work out the margin account of the investor for each day until the position is closed out on day 7. Suppose that:

1. The margin call restores the margin account to its maintenance proportion

2. Instead that the investor is obliged to restore the account to its initial proportion.

Day Price Gain (loss) Margin Account Maintenance Margin Margin Call

1 500

2 480

3 490

4 530

5 580

6 520

7 490

Q3.

You went for a short sale of 2,000 shares. The price was $50 per share when you initiate the contract. This initial margin rate is 50% and the maintenance margin requirement of 30%. Suppose that the stock price changes is as in table 1 (price increase) and table 2 (price decrease) below.

a. What is the Initial Margin and the Price Margin call for both cases?

b. Fill in the two tables.

Table 1: Price increase

At time of short sale Shares Share Price Short Sale Value Initial Margin Requirement Total Maintenance Margin Requirement

2000 $50

As Stock Price Increase Shares Share Price Short Sale Value Additional Margin Requirement Total Maintenance Margin Requirement Margin Call

2000 $55

2000 $60

2000 $75

Table 2: Price decrease

At time of short sale Shares Share Price Short Sale Value Initial Margin Requirement Total Maintenance Margin Requirement

2000 $50

As Stock Price Increase Shares Share Price Short Sale Value Additional Margin Requirement Total Maintenance Margin Requirement Margin Call

2000 $45

2000 $40

2000 $35

Answer 1

Answer 1:
There are many reasons of using derivatives. Some of the most important reasons of using derivatives are:
i) Risk Management
ii) Price Discovery of the underlying
iii) Improving Market Effeciency

i) Risk Management

Risk management is the most important purpose of derivatives. The investors who are averse to risk can lower their risk by hedging, whereas the investors who like to take risk can increase their risk in order to earn more return by speculation. Derivatives helps investors in hedging and speculation.
For example, Viditi bought 100 shares of ABC Company for $10 each a month ago. Now, the current price of shares of ABC is $15. Now Viditi thinks that the quartely result of ABC might not be upto the mark, the stock price might fall. In this case, Viditi can hedge her position against the risk of price fluctuations by buying put option contracts on ABC.

ii) Price discovery of the underlying

Derivative contracts are based on the spot and future prices of the underlying assets. These prices are based on the supply and demand of the asset, which depends on a number of factors - social, political, environmental, etc. The price of an underlying is keeps changing due to these factors, and the way people react to this change. Thus, derivative market helps in discovering the price of the underlying and the sentiments of investors rearding the future price of the underlying.

iii) Improving Market Efficiency

Sometimes there are arbitrage opportunities present in a market. Transactions in a derivative market are easy and of low cost, so that investors can easily act on these arbitrage opportunities. This leads to rapid price adjustments and the arbitrage opportunity vanishes, leaving the prices to be more accurate to the underlying asset's true value. Thus, derivatives help in improving the effeciency of market.