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Question 4 Financial Derivatives (10 marks) 4.1To construct a hedge against price risk, futures contracts are...

Question 4 Financial Derivatives

4.1To construct a hedge against price risk, futures contracts are better than forward contracts. Explain THREE reasons?

4.2 Explain the following:

a. A firm’s cash flows are risky for various reasons. Explain THREE sources of risk or volatility in firm cash flows.

b. How does a call option differ from a put option? (1 mark)

4.3 Currently, a call option on Minelli Enterprises Limited’s ordinary share is selling for $1.20 (option premium). The exercise price is $21.00. Assuming the stock price at expiration is $25.50, calculate the breakeven point, profit, or loss, the option holder makes at the expiration date.

Solutions

Expert Solution

Answer : (4.1)

Reason for future contract are better than forward contract

1)The Structure and Purpose
The Forward contracts can be customized as per the needs of the customer. There is no initial payment required and this is mostly used for the process of hedging. The Futures contracts on the other hand are standardized and traders need to pay a margin payment initially.

2)The Risk and Guarantees
The Forward contracts include a high counter party risk and there is also no guarantee of asset settlement till the maturity date. The Futures contract involves a low counterparty risk and the value is based on the market rates and is settled daily with profit and loss.

3)The Risk Factor
When an agreement happens between two different parties, there can be a risk that any one party can renege on the agreement terms. Any of the party can be unwilling or be unable to follow the terms during the time of settlement. This risk is termed as the counterparty risk.
In Futures, the clearing house of the stock exchange acts as counterparty for both parties. This reduces the credit risk and the risk is redued further as all the positions taken in futures are marked to market every day. With such features, there is absolutely no counterparty risk when it comes to a trade in futures.
On the other hand, the Forward contracts do not have any such mechanisms. The Forwards are always settled during the time of delivery and thus the profit or a loss can only be known during settlement. Hence, the loss can be more for the participants in Forwards which can be due to a default.

Answer (4.3)

Difference between call option and Put Option :

Call Option Put Option
Definition Buyer of a call option has the right, but is not required, to buy an agreed quantity by a certain date for a certain price (the strike price). Buyer of a put option has the right, but is not required, to sell an agreed quantity by a certain date for the strike price.
Costs Premium paid by buyer Premium paid by buyer
Obligations Seller (writer of the call option) obligated to sell the underlying asset to the option holder if the option is exercised. Seller (writer of a put option) obligated to buy the underlying asset from the option holder if the option is exercised.
Value Increases as value of the underlying asset increases Decreases as value of the underlying asset increases
Analogies Security deposit – allowed to take something at a certain price if the investor chooses.

Insurance – protected against a loss in value.


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