Question

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.

Answer 1

4.

4.1. Futures contracts are better than forward contracts because:

• Futures are traded on the exchange while forwards are traded over the counter.
• Futures are traded in regulated market so default risk is negligible while forwards are traded in unregulated market so default risk is high.
• Futures contracts are standardized while forward contract's terms can be negotiated privately.

4.2.

a. Three sources of risk or volatility in firm cash flows are:

• Financing decisions as use of equity is less risky but difficult to obtain while use of debt is more risky because it has to be repaid even in case of loss.
• Credit sales as high amount of doubtful receivables can be risk for firm's cash flow.
• Unwanted inventory can block the funds so it is important to have optimum level of inventory.

b. Call option (holder) gives us the right to buy but not the obligation to buy underlying security at strike price while put option (holder) gives us the right to sell but not the obligation to sell underlying security at strike price.

4.3. Profit / (loss) at expiry = Spot price - strike price - premium

= 25.50 - 21 -1.20

Profit    = $3.30

At break even,

Spot price - strike price = premium

25.50 - 21.00 = premium

4.50 = premium

So, at break even premium should be $4.50