1.11.

A cattle farmer expects to have 120000 lbs of live cattle to sell in three
months. The live cattle futures contract on the Chicago Mercantile Exchange is for delivery of 40000 lbs. of cattle. How can the farmer use the contract for hedging ? From farmer's viewpoint, what are the pros and cons of hedging ? 1 contract = delivery of 40.000 lbs of cattle Time to maturity = 3 months Let's say price of 40.000 lbs of cattle is C today, The farmer can short 3 contracts, which is 3C. If the price of 40.000 lbs of cattle is (C-L) at the time of maturity, then his loss will be 3L from the cattle sales, but he will offset this loss by selling the contract. The money will be gained from the contract sales will be 3C as well. This is like an insurance to the farmer ( seller ) in case the cattle prices go down.

If the price of 40.000 lbs of cattle is (C+L) at the time of maturity, then his gain will be 3L from the cattle sales, but he will lose 3C from the contract, because it is not an option. It has to be exercised no matter what the price is, but as a result the outcome will be zero loss. Both situations are no gain no pain type of positions. This is like an insurance to the buyer in case the cattle prices go up. Let's say if the price of 40.000 lbs of cattle is C+5L at the time of maturity, then his gain will be 15L from the cattle sales, if he did not buy a futures contract he would have taken that 15L gain and put it in his pocket, but since he bought the contracts he has to give up from that profit. Disadvantages of hedging are : the farmer ( seller ) won't be able to make profit from price increase in the market. On the other hand let's say if the price of 40.000 lbs of cattle is C-5L at the time of maturity, then his loss will be 15L from the cattle sales, but it will not be a problem because he will cover his loss by the contracts. Advantages of hedging are : the farmer ( seller ) won't lose money because of the price changes in the market.

1.14. Suppose that a June put option on stock with the strike price of $60
cost $4 and is held until June . Under what circumstances will the holder of the option make a gain? . Under what circumstances will the option be exercised? Draw a diagram showing how the profit on a short position in the option depends on the stock price at the maturity of the option. From the point of buyer of put option, if the stock price is less than the exercise price plus the option premium, than the option holder will make profit. If the price of stock drops less than $56, then the option holder ( buyer ) will start making profit.

If the investor sells the put, which is writing a put option, he can keep the premium unless the stock price falls below $56. If the price of the stock falls below $56 and the writer of the option will lose money. $56 is the breakeven point for the two parties. Option will be exercised below this point.

1.18. An airline executive has argued: There is no point in our using oil futures. There is just as much chance that then price of oil in the future will be

less than the futures price as there is that it will be greater than this price. Discuss the executives viewpoint. First of all, I dont think that the executive knows what he is talking about. It sounds like Mr. McClandon several years ago talking about the natural gas prices. He thinks that hedging on oil prices is not essential. Airline company should just speculate the oil prices and he does not want to hedge. I think it is very dangerous for an airline company which strictly relies on oil to fly the planes. Speculating would be a very big risk in case the oil prices goes up like it happened in 2008. On the other hand even if the oil prices go down the airline company will not make too much profit from the oil. I think they should use oil futures to offset their position in the future.

1.27. A stock price is $29. An investor buys one call option contract on the
stock with the strike price of $30 and sells a call option contract on the stock with a strike price of $32.50. The market prices of the options are $2.75 and $1.50, respectively. The options have the same maturity date . Describe the investors position .

1.30. The current price of a stock is $94, ans the three-month European call
options with a strike price of $95 currently sell for $4.70. An investor who feels

that the price of the stock will increase is trying to decide between buying 100 shares and buying 2000 call options (20 contracts). Both strategies involve an investment of $9400. What advice would you give? How high does the stock price have to rise for the option for the option strategy to be more profitable? If the investor invests on shares and the price of stock remains the same or goes up, he will be making profit, his gain with this strategy would be fairly limited. A dollar raise in the stock prices will only create a $100 raise in the total investment. But on the other hand if the stock price goes below $94, his loses might not be a disaster. It is very unlikely that he will lose all the investment, which is not very common, but possible. Like a market crash or a meteor might hit the company which he invested. If the investor invests on call options, $4.70 for each option, a total of 2000 options, the situation will be a lot riskier. If the stock price does not go above $95, he will unfortunately lose all the initial investment. The breakeven point is $99.70. This situation is very likely, but on the other hand if stock price goes over $99.70 his profit will be $2000 for every dollar raise in the stock price. Lets say if the stock price go up $109.70 the he will make a profit of $20000, which is very attractive. It all depends on the risk aversion of the investor to make the choice. I would invest on options and hold my breath, if these are the only options that I have, but I think we should cover our position when investing on options in case the stock price does not increase.