Derivatives

Question 1

State the factors that determine the price of an option (5)

Answer 1

• market value of the underlying asset
• strike price
• expiry date
• expected volatility
• type of option US/ European

Question 2

For someone about to sell house for €200k who is worried about rising sterling value, what type of option would they want and how would it achieve their objective (6)

Answer 2

• sterling call option
• allows them to BUY sterling
• at a fixed pre-determined price
• at a fixed date
• with no obligation
• the gain in option price would help offset potential currency loss on sale of house

Question 3

What is a long future and what is a short future?

Answer 3

Long = person committed to buying

Short = person committed to selling

If you are wanting to sell gold in the future then you want a SHORT contract

Question 4

State the type of futures contract you should enter into (if you own gold) to compensate for a drop in gold prices and explain how it achieves the objective. (7)

Answer 4

• SHORT futures contract
• involves obligation
• to sell
• at a specific price
• at a certain date
• if the gold price falls then can sell at higher price
• and buy back at a lower price
• covering any losses from the price drop

Question 5

Why may a futures contract not be best way to hedge against a price fall/rise (6)

Answer 5

• market may move the opposite way
• volatile asset
• needs constant monitoring
• usually limited to Proffessional investors
• complex investment
• potential unlimited loss
• underlying asset must be delivered / can’t cancel contract

Question 6

Give alternative derivatives to using futures (5)

Answer 6

• spread betting
• contracts for difference
• options
• covered warrants
• ETFs

Question 7

Options/ covered warrants

Answer 7

• right to buy or sell a pre determine amount of an asset
• at a pre determined price
• at a pre determined time/date
• pay a premium for that right
• if not used the contract expires
• people who buy call options are gambling on price rising (seller on price dropping)
• people who buy put options are gambling in prices falling (seller on price rising)