Question

Comparative Advantage

There are two countries in the world. There are also only two different types of goods produced, food and clothing. Each country has the same amount of “inputs” (i.e. labor, capital, raw materials, etc.), which amounts to 100,000 units of input. Below is a chart that lists out how many units of output each country could create if they created just one type of good. For example, if Country A produced ONLY food, then with 100,000 units of input they could produce 300,000 pounds of food.

Country	Clothing (yards)	Food (lbs)
A	180,000	300,000
B	240,000	900,000

1. Ignoring the numbers in the above chart (i.e. think conceptually) if the slope for country B’s food production is steeper than country A’s food production, then which country has the relative comparative advantage in producing food? 


Options

1. If you strongly believe the market is about to go down, which option should you buy or sell?

2. Use the below information to calculate your profit/loss if you own a long call and the option just matured (reached its expiration):


Spot: 99


Strike: 100

Call premium: $3 


Answer 1

Comparative advantage

If the slope of country B's food production is steeper i.e. it is able to produce more food per unit of input than country A, then the relative comparative advantage in producing food lies with country B because it is more efficient at it.

Options

1. If you believe the market is about to go down, you either buy a put option or you sell a call option.

Put options give the buyer of the option the right to sell the underlying asset at a predetermined strike price to the seller of the option . If you buy a put option and the market price of underlying goes below the strike price, you can buy the asset in the spot market and sell it at the predetermined strike price, earning a profit.

Call options, on the other hand, give the buyer of the option the right to buy the underlying asset at a predetermined strike price from the seller of the option. The option buyer will only exercise his/her right if the spot price of option exceeds the strike price because then he can buy the underlying asset at the strike price which is lower. So, if the market is going to go down, the option will be worthless to the buyer and the seller will get to keep the premium.

2. In this case the spot price is less than the strike price meaning that the option is not exercisable or it is out-of-money. So, the option holder makes a loss which is equal to the premium paid in acquiring the option which is $3.

So, the investor makes a loss of $3