Question 18 By using the future contract: If you buy 50 000 of $1.9/1, you will get 50 000 in a year time.

If your expectation of the spot rate on expiry in September 2013 is correct at $2.1/1, you can sell the 50 000 for $ 105 000 and get profit of 105 000- 1.9 * 50000 = $10000 which is equivalents 10 000/2.1= 4761.9. If however you are wrong and the spot rate is $ 1.7/1 in a years time you will lose $10 000 or $5882.35 By using the option contract: You can pay a call premium of 50000*0.08= $4000 for the right to buy sterling at $1.9/1 in a years time. If sterling is $2.1/1 in a years time you will exercise your right to buy 50 000 at $1.9/1 then sell it for $2.1/1 giving profit of $10 000 less $4000 premium a net profit of $6000 which is equivalent of 6000/2.1 = 2857. If the rate is $1.7/1 in a years time the speculator will not exercise the option but they will lose the premium of $4000 which is equivalent to 4000/1.7 = 2352.9 It is difficult to say which the best for speculation, because by using the future contract, the profit/ losses are symmetric. On the other hand, by using the option contract, the upside is large but the downside loss is limit to the $4000 option premium. At certain exchange rate, the future leads to most profit while the option contract dominates at other exchange rates. The option contract is however useful if you wish to restrict your potential losses Question 19 The appropriate futures prices is given by the equation

F = S*

Where F is future price ( dollar per pound), S is the spot exchange rate (dollars per pound) S = $1.9/1, rus is the interest rate on the US dollar rus=5%, ruk is the interest rate on the pound ruk=7%, T is the number of days of duration of the contract T= 180, t is the number of day into the contract ;t= 120. T-t is the number of days remaining to delivery of the contract

F= $1.9/1 * F= $1.894/1 b, The appropriate arbitrage model for the pricing of the future index is given by the equation = +( *( )* ) Where is the stock index future price at time t with a settlement date T;

is the price of cash stock index at time t; = 6300 is the annualized cost of finance for the period between t and T ; = 6% is the expected average dividend yield on the stocks that make up the cash index during the holding period; = 1.5% So = 6300 + ( 6300* (0.06-0.015)*145/360)= 6412.6 Question 20 The pricing of interest rate future contracts is based on arbitrage conditions. In particular the price of a future interest rate contract is determined by the so-called forward/forward rate, given by :

Z% = ((

-1) * 365/(

Where Z% is the interest rate implicit in the futures contract is the interest rate on the distant forward/forward period is the interest rate on the near forward/ forward period is the number of days remaining to the distant forward/forward period is the number of days remaining to the near forward/ forward period Z% =( Z% = 0.0444 or 4.44% Therefore the appropriate 3 months ahead future price is 100-4.44= 95.56 Question 21 a, You could buy the put premium at say, a strike of 400 pence for 350 , if the share price decrease to 300 pence you will make profit of 650 ( 1000share * ( 400-30035)). In addition, if share price goes down more 200 pence, you make more profit of 1650. Even of the share increase to 500, they will not exercise the option; hence, the loss is restricted to the premium paid of 350 b, Assumes that you fear that the share price might fall to 300 pence, the hedging strategy is to buying the put premiums contract at a strike of say 400 pence for 350, if the share falls to 300 pence, you will make a profit of 650 which partially offset the fall in value your share from 3900 to 3000, that is, the partially hedge position is worth 3650. Should the share rise to 500 pence then your share are worth 5000 but you losses of 350 from premium giving you a hedge position worth 3650 Question 22 Call premiums that are in the money when current price above exercise price

-1)

In this case, the currently price is 290 pence, and the exercise price is 300 and 330 pence which is higher than current price. Hence, there is not call premium that are in money in this case The put premium that are in the money in which current price is below exercise price Hence put premium that in the money is to strike 300 pence April (14) June (35) September 27 and Strike 330 pence April (39) June (50) September (60) b, The time value = option premium intrinsic value (where intrinsic value exist) From the Call option: Because the cash price is low than strike price so there is no intrinsic value in Call option Therefore time value = option premium, hence, the minimum of time value in Call premium is the April 20 pence strike at 330 pence and the biggest of time value in Call premium is the September 60 pence at 300 pence From put premium The intrinsic value for 300 pence is 10 pence The intrinsic value for 330 pence is 40 pence So the lowest time value for put option is the April 45 pence at 330 which the time value is 5 pence ((45-40) Therefore, the lowest time value is the April 330 pence put premium d, There is no intrinsic value in call premium However, from put premium pence the intrinsic value is 10 pence at 300 pence and 40 pence at 330 pence. Hence, the highest intrinsic value is the 330 pence at April (45), June (50) and September (60) c, If you expect the share price increases to 450 pence, the strategy is that you should buy the call option at the strike prices 300 pence with price of call premium 30 pence per share. If you are proved correct. You can sell it with price of 450 and make profit of 120 pence per share (450 300 30) or 1200 of the total profit.