Options, Futures, and Other Derivatives, 9th Edition Solution Manual

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CHAPTER 1IntroductionPractice QuestionsProblem 1.8.Suppose you own 5,000 shares that are worth $25 each. How can put options be used toprovide you with insurance against a decline in the value of your holding over the next fourmonths?You should buy 50 put option contracts (each on 100 shares) with a strike price of $25 and anexpiration date in four months. If at the end of four months the stock price proves to be lessthan $25, you can exercise the options and sell the shares for $25 each.Problem 1.9.A stock when it is first issued provides funds for a company. Is the same true of an exchange-traded stock option? Discuss.An exchange-traded stock option provides no funds for the company. It is a security sold byone investor to another. The company is not involved. By contrast, a stock when it is firstissued is sold by the company to investors and does provide funds for the company.Problem 1.10.Explain why a futures contract can be used for either speculation or hedging.If an investor has an exposure to the price of an asset, he or she can hedge with futurescontracts. If the investor will gain when the price decreases and lose when the price increases,a long futures position will hedge the risk. If the investor will lose when the price decreasesand gain when the price increases, a short futures position will hedge the risk. Thus either along or a short futures position can be entered into for hedging purposes.If the investor has no exposure to the price of the underlying asset, entering into a futurescontract is speculation. If the investor takes a long position, he or she gains when the asset’sprice increases and loses when it decreases. If the investor takes a short position, he or sheloses when the asset’s price increases and gains when it decreases.Problem 1.11.A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000pounds of cattle. How can the farmer use the contract for hedging? From the farmer’sviewpoint, what are the pros and cons of hedging?The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, thegain on the futures contract will offset the loss on the sale of the cattle. If the price of cattlerises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Usingfutures contracts to hedge has the advantage that it can at no cost reduce risk to almost zero.

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