Question

(a) If you have an option on a stock, how do you measure the price sensitivity of the option premium to the price of the stock? Would that sensitivity be positive or negative? Explain

(b) Do derivative securities provide leverage? Explain

(c) Briefly, enumerate the steps in a proper risk management process?

(d) What would you do if you buy a futures contract on oil and before two months from expiration, your expectations become opposite to those when you originally bought the futures contract?

(e) From an academic (and logical as well as practical) point of view, you cannot buy an asset on spot and, at the same time, selling it with a futures contract and make a sizable profit. Why this statement is true?

(f) What is the main reason of conducting an interest rate swap?

Answer 1

(a) Price Senstitivty of an option to the price of the underlying stock is measured by Delta. Delta indicates by how much the price of an option would change for unit change in price of the underlying. Delta is negative for Put options and positive for call options.

(b) Yes - derivatives do provide leverage. While buying or selling derivatives, the full price of buying or selling the undelyng stock need not be traded but only the option premium. Hence, derivatives magnify the outcome and increase the levarage.

(c) First step in risk management is identifying the risk that needs to be managed. Once the same is identified a corresponding derivative instrument can be bought or sold to hedge the risk. As an example, a manufacturer that needs certain commodity as raw material may wish to buy suitable options to hedge the risk of significant fluctuations in the price of the underlying commodity in the future.

(d) Easiest alternative would be to close the long position and book the profit / loss and then enter into a fresh short position by selling the futures contract.

(e) Assuming an efficient market, the futures contract would be priced appropriately factoring in the cost of carry and risk free rate. Hence, there would be no arbitrage left in doing this trade.

(f) Interest rate swaps are used to hedge the interest rate risk. For instance, one party might be receiving payments at variable interest rate in the future and may want to swap it with a fixed interest rate and vice versa.