Treasury and Risk Management Derivatives

Questions: 1.Why futures and options contracts are generically referred to as derivatives?2.What is the difference between a European and an American option, as far as the buyer and the writer are concerned?3.You are a speculator and you think stock prices will increase. Should you buy a call or a put option?4. Under what circumstances would you make a profit at maturity from a long position in a futures contract on live hogs?5.Who might find a futures contract on (the price of) orange juice, useful? Answers: 1. Futures and options are two most general forms of derivatives. A derivative is commonly stated as the financial instrument that receives its significance from the worth of an underlying instrument. The contract prices of futures and options are also determined by the worth of underlying instrument. Therefore, they are commonly referred as derivatives (Golez 2014). 2. The buyer of the put or call option is in a position to take decision about whether to exercise the option or not. On the contrary, the writer holds the passive position and is obliged to go with the decision of the person having long position. In Europe, the option can be exercised only after the maturity date, that is, the expiry date. On the other hand, the person with long position, that is, the holder at any time, can exercise the American option. Therefore, if the person with long position exercises the option only with consideration to his own profit, the writer may have to bear huge losses. The person with long position of a call or put will never bear loss at the maturity of the contract as he always has the option of not exercising the option. However, he has to make the upfront payment for option premium, and if the contract is held to the date of maturity, he will have to bear the maximum amount of loss (Wang, Zhang and Fang 2015). 3. As a speculator, it will be a better option to buy a call as the price of the stock are expected to increase beyond the strike price and will generate profit for the speculator. Here, the seller of the stock fixes the strike price (Schwager and Etzkorn 2017). 4. Suppose, the price of future at the beginning (t = 0) for the contract of futures, which is also known as the delivery price is F0 = $500 per hog. At the expiry date, suppose the hog price is ST = $310. At this point, there are two options. Firstly, the delivery for the hog under the future contract can be taken and payment can be made as F0 = $500. This amount will go for short under the future contract. On the same day, the hog can be taken to the local market can be sold on Spot for ST = $310 and will earn a profit of ($500 - $310) = $190. 5. It is beneficial for the farmers to use the future contract on dealing of orange juice. The reason behind this is that most of the oranges are grown in Florida, where the weather is of disastrous nature. Due to this, the prices of oranges may raise and make it costly for the buyers, which in turn, may results into high supply and low demand. If the weather is favourable and there is no disaster, the price will decrease for the oranges. The competitors from other counties may also lead to price fall. To protect themselves from loss, the farmers will opt for future contract at a fixed price that will prevent them from losses (Glinberg and Landa 2014). References: Glinberg, D. and Landa, F., Chicago Mercantile Exchange Inc., 2014.Option pricing model for event driven call and put options. U.S. Patent 8,756,139. Golez, B., 2014. Expected returns and dividend growth rates implied by derivative markets.Review of Financial Studies,27(3), pp.790-822. Schwager, J.D. and Etzkorn, M., 2017. An Introduction to Options on Futures.A Complete Guide to the Futures Market: Technical Analysis and Trading Systems, Fundamental Analysis, Options, Spreads, and Trading Principles, pp.477-485. Wang, S., Zhang, S. and Fang, Z., 2015. A superconvergent fitted finite volume method for BlackScholes equations governing European and American option valuation.Numerical Methods for Partial Differential Equations,31(4), pp.1190-1208.