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Options, futures and risk management
Supplementary Questions
Most of these “Supplementary Questions” were written by Professor Phil Gray for the benefit of students wishing
to do extra practice on the unit material. There is nothing particularly special about them. In many cases, the level
of difficulty is similar to workshop questions. In some cases, they explore issues more deeply.
It is not necessary that you work through these questions. The material from the seminars and workshops is
sufficient. However, it makes sense to make them available to you for you to use them to further test yourself.
Derivatives concepts can be challenging – you can get on top of the concepts by challenging yourself to solve
these problems.
The smart way to use these Supplementary Questions:
When students are given questions and answers, there is a natural tendency to not do the necessary work. Some
students will read Question 1, look over the answer and then say “yes, that’s how I would have done it if I had
bothered to do the question”. They then read Question 2, look over the answer and then say “yes, that’s how I
would have done it if I had bothered to do the question”. And so on. They are fooling themselves into thinking
they actually understand the material. Not surprisingly, when they get into the exam and are given something very
similar, guess what – they can’t do it!
Therefore, in a perfect world, I would not provide answers at all. Alas, students who do the questions inevitably
want to know “if I got it correct?” For this reason, at the back of this document, I provide “Key Figure” answers.
This allows a student who has done the work to quickly check their answer to the Key Figure. And it stops students
who are too lazy to do the work from reading over the answers and fooling themselves that they really understand
it.
I recommend that you work at these questions until you get the answer provided in the KeyFigures at the back.
Full answers will be made available in due course. However, you will learn very little by simply looking at the
questions and answers without making a serious attempt to work on them.
Ultimately, it’s your choice how you utilise this material. My philosophy is to challenge my students. Provide
them with extensive material which gives them the opportunity to learn a lot. Some students embrace the
challenge, work hard and do very well. Others don’t have the same attitude and do poorly. Each student will
decide which case they fall into.
The questions are ordered/numbered roughly as follows.
Lecture Numbers
Lecture 1 100-199
Lecture 2 200-299
Lecture 3 300-399
Lecture 4 400-499
Lecture 5 500-599
Lecture 6 600-699
Please keep in mind that there are a lot of questions here. Wait for the solutions or post on the assignment
discussion forum to get help from other students.
Some of these Q&As are newly written by Christine. Inevitably, there will be some mistakes in the answers. If
you discover any issues/errors/problems, please let me know and I will fix it up.
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Question 101
Today is 1 May and the spot exchange rate AUD 1.00 = NZD 1.22. That is, one AUD buys NZD 1.22. You have
no underlying position/commitments/exposure in NZD but will merely speculate on exchange rate movements.
The six-month forward rate for AUD 1.00 = NZD 1.18.
a) If I talk about the NZD ‘strengthening’ relative to the AUD, what does this mean? To demonstrate that
you truly understand this concept, give an example of an exchange rate quote after the NZD has
strengthened.
b) If you want to speculate on the NZD strengthening relative to the AUD, will you take a long or short
forward position in NZD?
Given your answer to b), enter a forward contract on (say) NZD 100,000 at the six-month forward rate quoted
above.
c) On maturity of this forward contract in six-months’ time, the spot exchange rate is 1.3000 (i.e., AUD
1.00 buys NZD 1.30). You close out the forward position with a new transaction equal in magnitude and
opposite in sign to your original transaction in part b). Have you made a gain or loss on the forward
position? How much?
d) Ignore c). On maturity of this forward contract in six-months’ time, the spot exchange rate is 1.0500 (i.e.,
AUD 1.00 buys NZD 1.05). You close out the forward position with a new transaction equal in magnitude
and opposite in sign to your original transaction in part b). Have you made a gain or loss on the forward
position? How much?
Question 102
For each of the following scenarios, determine whether the trading behaviour is indicative of hedging or
speculation.
a) A major part of the operating expense for Virgin Blue is fuel cost. Due to the high and rising oil price,
management have decided to enter long forward contracts for oil.
b) You have a portfolio of Australian stocks. Although the Australian stock market has been doing well in
the past few years, you have heard a rumour that there will be a major correction soon. Based on this,
you have decided to short some SPI200 futures contracts.
c) The information is the same as that in part b, except that you have also heard some analysts say that the
Australian stock market is going to stand strong due to extremely good economic outlooks. After doing
some additional research and consulting your financial advisor, you think that the best move is to take
some long SPI200 futures contracts.
d) ABC Company exports a lot of goods to the United States. The payments are usually made in US dollars.
As there are signs that the American economy is slowing down, ABC management have decided not to
take any action.
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Question 103
Speculation and hedging are not restricted to the realm of derivatives trading. Ordinary trading decisions made
when buying and selling ordinary assets, such as shares, can be categorised as hedging and speculating.
In each of the following cases, determine whether the behaviour is speculation or hedging.
1a. A equities trader generates profit by buying and selling shares. Having years of experience in share trading,
the trader forecasts that the price of Virgin Blue shares will increase over the next three months. Despite already
owning 1000 VBA shares, the trader subsequently buys a further 500 more shares today. Contrary to her
predictions, the price of VBA shares actually decreases. Nonetheless, the trader decides to retain the shares with
the hope that the price will eventually correct.
2a. Following the initial decrease in the price of VBA shares, the trader feels confident that the price will not fall
any further. The trader buys a further 500 VBA shares bringing the total number of shares up to 2000. This time,
the trader predicts correctly. The price of VBA shares increases over the next 3 months, and the trader sells off
her stake in VBA, recouping the initial loss and actually generating a modest profit.
2b. Following the initial decrease in the price of VBA shares, the trader is concerned that the original purchase of
500 more shares will be viewed as a poor decision. Concerned that prices will decrease further, the trader decides
to wear the capital loss by selling 500 VBA shares at a price lower than that at which she purchased. The trader
retains 1000 VBA shares however, feeling confident that the price will not fall any further. This is her opportunity
to claw back some of the value lost and breakeven on the initial purchase. The price of VBA shares does actually
increase over the next 3 months, and the trader sells off the remaining VBA shares, recouping the initial loss and
actually generating a modest profit.
3. A commodities trader generates profit by buying and selling gold forward contracts. Having years of experience
in the commodities market, the trader forecasts that the price of gold will increase over the next three months due
to geopolitical trouble in the Middle East. With no current exposure in gold bullion, the trader enters into a long
forward contract, effectively locking in the price of gold.
4. As it turned out, the price of gold did increase with heightened tensions in the Middle East. However, it proved
to be a volatile market, with gold price bouncing up and down as the peace process played out. The trader is now
concerned she will lose any unrealised gains made on the original long forward contract. As a result, the trader
closes the original position by going short gold.
