Options, Futures, and Other Derivatives

John C. Hull

Chapter 2

Mechanics of Futures Markets - all with Video Answers

Educators

Chapter Questions

Problem 1

Distinguish between the terms open interest and trading volume.

Nick Johnson

Nick Johnson

Numerade Educator

Problem 2

What is the difference between a local and a commission broker?

Kaylee Mcclellan

Kaylee Mcclellan

Numerade Educator

Problem 3

Suppose that you enter into a short futures contract to sell July silver for $$\$ 10.20$$ per ounce on the New York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is $$\$ 4,000,$$ and the maintenance margin is $$\$ 3,000$$. What change in the futures price will lead to a margin call? What happens if you do not meet the margin call?

Jonathan Tapiwa

Jonathan Tapiwa

Numerade Educator

Problem 4

Suppose that in September 2009 a company takes a long position in a contract on May 2010 crude oil futures. It closes out its position in March 2010 . The futures price (per barrel) is $$\$ 68.30$$ when it enters into the contract, $$\$ 70.50$$ when it closes out its position, and $\$ 69.10$ at the end of December 2009 , One contract is for the delivery of 1,000 barrels. What is the company's total profit? When is it realized? How is it taxed if it is (a) a hedger and (b) a speculator? Assume that the company has a December 31 year-end.

Amit Srivastava

Amit Srivastava

Numerade Educator

Problem 5

What does a stop order to sell at $$\$ 2$$ mean? When might it be used? What does a limit order to sell at $$\$ 2$$ mean? When might it be used?

Vikash Ranjan

Numerade Educator

Problem 6

What is the difference between the operation of the margin accounts administered by a clearinghouse and those administered by a broker?

KM

Kanishk Mishra

Numerade Educator

Problem 7

What differences exist in the way prices are quoted in the foreign exchange futures market, the foreign exchange spot market, and the foreign exchange forward market?

Kaylee Mcclellan

Kaylee Mcclellan

Numerade Educator

Problem 8

The party with a short position in a futures contract sometimes has options as to the precise asset that will be delivered, where delivery will take place, when delivery will take place, and so on. Do these options increase or decrease the futures price? Explain your reasoning.

Jonathan Tapiwa

Jonathan Tapiwa

Numerade Educator

Problem 9

What are the most important aspects of the design of a new futures contract?

Kaylee Mcclellan

Kaylee Mcclellan

Numerade Educator

Problem 10

Explain how margins protect investors against the possibility of default.

Shivani Sharma

Numerade Educator

Problem 11

A trader buys two July futures contracts on orange juice. Each contract is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the initial margin is $\$ 6,000$ per contract, and the maintenance margin is $\$ 4,500$ per contract. What price change would lead to a margin call? Under what circumstances could $\$ 2,000$ be withdrawn from the margin account?

Carson Merrill

Numerade Educator

Problem 12

Show that, if the futures price of a commodity is greater than the spot price during the delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity exist if the futures price is less than the spot price? Explain your answer.

Niamat Khuda

Numerade Educator

Problem 13

Explain the difference between a market-if-touched order and a stop order.

Tommy Nguyen

Numerade Educator

Problem 14

Explain what a stop-limit order to sell at 20.30 with a limit of 20.10 means.

Cinsy Krehbiel

Numerade Educator

Problem 15

At the end of one day a clearinghouse member is long 100 contracts, and the settlement price is $\$ 50,000$ per contract. The original margin is $\$ 2,000$ per contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered into at a price of $\$ 51,000$ per contract. The settlement price at the end of this day is $\$ 50,200 .$ How much does the member have to add to its margin account with the exchange clearinghouse?

Rachel Lepak

Numerade Educator

Problem 16

On July $1,2009,$ a Japanese company enters into a forward contract to buy $\$ 1$ million on January 1, 2010. On September 1, 2009, it enters into a forward contract to sell \$1 million on January 1,2010 . Describe the profit or loss the company will make in yen as a function of the forward exchange rates on July $1,2009,$ and September 1,2009.

EA

Erwin Antoni

Numerade Educator

Problem 17

The forward price of the Swiss franc for delivery in 45 days is quoted as 1.2500 . The futures price for a contract that will be delivered in 45 days is $0.7980 .$ Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss francs?

Md.Daniyal Arshad

Md.Daniyal Arshad

Numerade Educator

Problem 18

Suppose you call your broker and issue instructions to sell one July hogs contract. Describe what happens.

Zach Steedman

Numerade Educator

Problem 19

"Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to trade on a futures exchange." Discuss this viewpoint.

Norman Atentar

Numerade Educator

Problem 20

Identify the commodities whose futures contracts have the highest open interest in Table 2.2.

Monica Miller

Numerade Educator

Problem 21

What do you think would happen if an exchange started trading a contract in which the quality of the underlying asset was incompletely specified?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 22

"When a futures contract is traded on the floor of the exchange, it may be the case that the open interest increases by one, stays the same, or decreases by one." Explain this statement.

Jennifer Stoner

Jennifer Stoner

Numerade Educator

Problem 23

Suppose that, on October $24,2009,$ a company sells one April 2010 live cattle futures contract. It closes out its position on January 21,2010 . The futures price (per pound) is 91.20 cents when it enters into the contract, 88.30 cents when it closes out its position, and 88.80 cents at the end of December $2009 .$ One contract is for the delivery of 40,000 pounds of cattle. What is the total profit? How is it taxed if the company is ( $a$ ) a hedger and (b) a speculator? Assume that the company has a December 31 year-end.

Nick Johnson

Numerade Educator

Problem 24

A cattle farmer expects to have 120,000 pounds of live cattle to sell in 3 months. The live cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer's viewpoint, what are the pros and cons of hedging?

Jennifer Stoner

Jennifer Stoner

Numerade Educator

Problem 25

It is July 2008 . A mining company has just discovered a small deposit of gold, It will take 6 months to construct the mine. The gold will then be extracted on a more or less continuous basis for 1 year. Futures contracts on gold are available on the New York Commodity Exchange. There are detivery months every 2 months from August 2008 to December $2009 .$ Each contract is for the delivery of 100 ounces. Discuss how the mining company might use futures markets for hedging.

Reed Mckee

Numerade Educator

Problem 26

A company enters into a short futures contract to sell 5,000 bushels of wheat for 450 cents per bushel. The initial margin is $\$ 3,000$ and the maintenance margin is $\$ 2,000$. What price change would lead to a margin call? Under what circumstances could $\$ 1,500$ be withdrawn from the margin account?

Kaylee Mcclellan

Kaylee Mcclellan

Numerade Educator

Problem 27

Suppose that there are no storage costs for crude oil and the interest rate for borrowing or lending is $5 \%$ per annum. How could you make money on January $8,2007,$ by trading June 2007 and December 2007 contracts? Use Table 2.2.

Breanna Ollech

Numerade Educator

Problem 28

What position is equivalent to a long forward contract to buy an asset at $K$ on a certain date and a put option to sell it for $K$ on that date.

Sarah Wharton

Numerade Educator

Problem 29

The author's Web page (www.rotman.utoronto.ca/ null/data) contains daily closing prices for crude oil and gold futures contracts. (Both contracts are traded on NYMEX.) You are required to download the data and answer the following:
(a) How high do the maintenance margin levels for oil and gold have to be set so that there is a $1 \%$ chance that an investor with a balance slightly above the maintenance margin level on a particular day has a negative balance 2 days later? How high do they have to be for a $0.1 \%$ chance? Assume daily price changes are normally distributed with mean zero. Explain why NYMEX might be interested in this calculation.
(b) Imagine an investor who starts with a long position in the oil contract at the beginning of the period covered by the data and keeps the contract for the whole of the period of time covered by the data. Margin balances in excess of the initial margin are withdrawn. Use the maintenance margin you calculated in part (a) for a $1 \%$ risk level and assume that the maintenance margin is $75 \%$ of the initial margin. Calculate the number of margin calls and the number of times the investor has a negative margin balance. Assume that all margin calls are met in your calculations. Repeat the calculations for an investor who starts with a short position in the gold contract.

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator