Question

NSTRUCTIONS: This question contains three (3) parts. Answer all parts of the questions. Clearly label your response to each part using bold text. For example: Part a): Your response...

(a) Briefly outline two differences between futures and options contracts.

(b) In August, a wheat farmer decided to hedge her entire anticipated 1,000 tonne wheat harvest with January wheat futures that were trading at a price of $290 per tonne.

In January, the farmer harvested 1,000 tonne of wheat and sold this wheat at auction for $270 per tonne. She then closed out her January wheat futures contracts for $272 per tonne.

From this information and using a standard wheat futures contract size of 20 tonne per contract, calculate the overall value of the harvested crop including the profit or loss from futures trading.

(c) On 11 April 2018, Commonwealth Bank of Australia (CBA) shares were trading at $74.00 while the October 2018 CBA Call and Put options with exercise prices of $80.00 were trading at $0.80 and $5.00, respectively.

Given this information and the fact that the standard option contract size is 100 shares per contract, outline an option arbitrage trading strategy, demonstrate that the strategy is profitable and briefly discuss the effect your arbitrage trading has on your ability to continue to make arbitrage profits.

Answer 1

A) two difderences between future and options are as follows:

Under futures, an obligation is created for the buyer to buy an asset and for the seller to sell an asset at a future date whereas under options, the buyer has a right and not an obligation to buy an asset and the seller has an obligation to sell the asset id the buyer excercises the option.

Under futures there is no upfeont fees that is to be paid to enter into a future contract. Whereas in option contract there ia likely to be paid an upfront fees called premium.

B) overall value of the harvested crop wheat will be as sale value on auction plus the profit on hedging

= (1000 tonne sold * 270) + {(290-272)*1000}

= 270000 + 18000

= 288000

Where 1000 tonne is the quantity of wheat

270 is the actual auction price

290 is the sell price under for hedging

272 is the buy price to complete the contract entwred for hedging.

C) let us assume price traded in october is same as today = 74

Since price on expiry is less hence call buyer will not excercise and put buyer will ezxerciae the option.

Profit earned = (80-74)*100 - (100*.8) - (100*.5)

= 600 - 80-50

= 470

Upfeont fees on options has to be paid for both call and put being the premium amount.