Homework 6

Due before December 08, 2017

Total Points 100

Chapter 20
Question 1: Explain why the difference between put and call prices depends on whether or
not the underlying security pays a dividend during the life of the contracts.

Dividend payment is an activity carried out by the company when it has earned good profits and
wanted to distribute the profits to its shareholders. The immediate effect of declaring dividends is
that the company will face a fall in the share price. The direct effect of declaring dividends is that
the company will meet a drop in the share price. Because the payment of dividends will be done
from the cash held by the company. When the payment is made, then the cash balance will fall
and so will the value of the share in the market. Call option is a right, but not an obligation to the
investor to buy the stock at a specific price and on a particular date. Put option is a right but not
an obligation to the investor to sell the stock at a specific price and on a specific date. When a
dividend is declared, then the value of the stock falls, and a call option on this kind of stock will
also have a decrease in value. This is because; the call option holders will not receive the
dividends. The dividends are only provided to the investors who hold the stock on the date the
dividends are declared and not to the investors who will hold the stock in future. The value of the
put option increases when a dividend is declared. The investor who wants to sell the stock using
a put option will have to pay the amount of the dividend as well. They receive the dividend like
the other shareholders as they were holding the stock on the dividend declaration date. This
dividend received but the put option holder has to be transferred on to the buyers of the put
option. Thus, it increases the value of the put option. So, the difference between the put and call
prices depends on whether the security pays dividend or not. If the put option pays dividend, then
the value of the option will increase, and if the call option pays dividend then the value of the
option will decrease.

Question 2: Compare and contrast the gain and loss potential for investors holding the
following positions: long forward, short forward, long call, short call, long put, and short
put. Indicate what the terms symmetric and asymmetric mean in this context.

Forward contracts: Forward contracts are the most basic derivative product available. A
forward contract gives its holder both the right and the full obligation to conduct a transaction
involving another security or commodity – the underlying asset – at a predetermined future date
and at a predetermined price. The future date on which the transaction is to be consummated is
called the maturity of the contract, while the predetermined price at which the trade takes place is
the forward contract price.
Long forward: Long forward means that the holder of the forward contract is in buying position
and now wants to sell the contract.

Short forward: Short forward means that the investor has already sold the contact without
actually owning the contract which is known as short selling as well. Now an investor is buying a
contract in order to settle his account.

Call option: Call options are a right, but not an obligation to an investor buying an underlying
security at a specific price and on a specific date. An investor can also enter call options through
long and short.

Long Call: Long call means that the holder of the call option has a right but no commitment to
buy the stock at a specific price and on a particular date. The maximum loss is limited to the
amount of premium paid as when the holder of the contract understands that they’re at a loss and
they will not exercise the contract. However, the maximum gain is unlimited, but it depends on
the market price of the contract.

Short call: Short call means that the holder of the call option has a right but no commitment to
buy the stock at a specific price and on a particular date. The maximum loss is unlimited as the
market price of the contract rises. The higher price is the market price compared to the specified
price in the contract, the higher will be the loss. The maximum gain is the premium amount that
is received from the contract.

Put option: A put option is a right but not an obligation to the investor to sell the security at a
specific price and on a specific date. A put option can also be entered in at two positions of long
and a short, where the long position means a buying position and short position means a selling
position.

Long put: The term long put means that the holder of the put option has a right but not the
obligation to sell the stock at a specific price and on a particular date. The maximum loss is the
premium amount paid for entering into the contract, because once the investors understand that
their position is a loss then they will not exercise their right. The maximum gain is unlimited
since it depends on the market price of the contract. The higher of the two is the price of the
contract as compared to the specified price of the contract.

Short put: the term short put means that the holder of the put option has a right but not the
obligation to sell the stock at a specific price and on a particular date. The maximum loss is
unlimited. It depends on the level to which the price of the contract falls in the market. The
maximum gain is limited to the premium received for sell the contract.

Symmetric and asymmetric: symmetric refers to those financial instruments that do not take up
any premiums from an investor and still manage to protect the investor from the unpredictable
movements of the market, the best example for that is a forward contract.
Asymmetric refers to those financial instruments that charge premium from the investors and
still there is no guarantee that the investor will not have to face an unfavorable price movement
in the market. The best example for that is an option contract.
Question 3: Describe two major factors that a portfolio manager should consider before
designing an investment strategy. What types of decisions can a manager make to achieve
these goals?

The two major factors that the portfolio managers should consider are that a return can be earned
from the portfolio and the risk that is involved all the assets of the portfolio. The decision that a
portfolio manager needs to consider before designing an investment strategy is that the portfolio
manager should be able to achieve an above average rate of return to make an investment
strategy successful. Therefore, the investment manager must design a plan that earns returns
which are higher than average returns that the investor would have earned if they invested in the
market. Additionally, the portfolio manager should be able to diversify the portfolio and
eliminate unsystematic risk. The portfolio should contain several assets, and each asset will have
its risk characteristics. The investment manager should try to remove all the unsystematic, which
will make the portfolio more attractive to investors. Investors would rather have a portfolio with
high returns and less uncertainty.

Question 4: The information ratio (IR) has been described as a benefit-cost ratio. Explain
how the IR measures portfolio performance and whether this analogy is appropriate.

Information ratio is calculated as follows, IR = return of investment – average return of

benchmark portfolio / standard deviation of excess return

The numerator, the expected return, is the benefit that the investor will earn from the investment.
It is wholly based on the investor's ability to analyze the information available in the market and
also in the public domain to decide the stock that they would want to invest in. The decision-
making skills of the investor regarding the investment to be made are tested on this. The profit
that the investor will earn is due to the decision-making ability of the investor. The denominator
computes the standard deviation of the excess return during the period. It measures the
unsystematic risk that an investor has to undertake. Therefore, the information ratio is a benefit-
cost ratio since it considers the profit earned from the investment to the amount of risk that the
investor makes. The benefit earned from the investment is compared to the unsystematic risk or
the risk that cannot be avoided or diversified.

The analogy that the information ratio is a benefit-cost ratio is correct. It is clear from the way in
which the calculation of portfolio performance is done. The benefit that has been earned by
investing in the security is considered as the numerator, and the standard deviation is regarded as
the denominator. The average of the numerator is calculated, and then it is divided but the
standard deviation. The standard deviation depicts the risk or the cost and the average that is the
numerator represents the return or the benefit.
 Example: Exhibit 20.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)

December futures on the S&P 500 stock index trade at 250 times the index value of 1187.70.
Your broker requires an initial margin of 10% percent on futures contracts. The current value of
the S&P 500 stock index is 1178.

A. Refer to Exhibit 20.1. How much must you deposit in a margin account if you wish to purchase
one contract?

Margin = 0.10  250  1187.70 = $29,692.50

B. Refer to Exhibit 20.1. Suppose at expiration the futures contract price is 250 times the index
value of 1170. Disregarding transaction costs, what is your percentage return?

Purchase December contract

250  1187.7 = $296,925

Sell December contract

250  1170 = $292,500

Loss in futures = $292,500  $296,925 = $4425

Rate of return = $4425/29,692.50 = .1490 or 14.9%

C. Refer to Exhibit 20.1. Calculate the return on a cash investment in the S&P 500 stock index if the
ending index value is 1170 over the same time period.

Return on cash investment in the index = (1170  1178)/1178 = 0.0068 or 0.68%

Question 5: Use above Exhibit 20.1 to answer the followings:

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)

December futures on the S&P 500 stock index trade at 200 times the index value of 1180.
Your broker requires an initial margin of 10% percent on futures contracts. The current
value of the S&P 500 stock index is 1160.

A. Refer to above. How much must you deposit in a margin account if you wish to purchase
one contract?
B. Refer to above. Suppose at expiration the futures contract price is 200 times the index value
of 1150. Disregarding transaction costs, what is your percentage return?

C. Refer to above. Calculate the return on a cash investment in the S&P 500 stock index if the
ending index value is 1150 over the same time period.

Example: Exhibit 20.2

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)

A futures contract on Treasury bond futures with a December expiration date currently trade at
103:06. The face value of a Treasury bond futures contract is $100,000. Your broker requires an
initial margin of 10%.

A. Refer to Exhibit 20.2. Calculate the current value of one contract.

Current price is 103 6/32 percent of face value of $100,000

= 1.031875  100,000 = $103,187.50

B. Refer to Exhibit 20.2. Calculate the initial margin deposit.

Margin deposit = 0.10  103,187.5 = $10,318.75

C. Refer to Exhibit 20.2. If the futures contract is quoted at 105:08 at expiration calculate the
percentage return.

Purchase December contract

103 6/32 percent of 100,000 = $103,187.50

Sell December contract

105 8/32 percent of $100,000 = $105,250

Gain in futures = $105,250  $103,187.50 = $2,062.50

Rate of return = 2062.5/10318.75 = 0.1999 or 19.9%

 Question 6: Use above Exhibit 20.2 to answer the followings:
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)

A futures contract on Treasury bond futures with a December expiration date currently
trade at 102.40. The face value of a Treasury bond futures contract is $100,000. Your
broker requires an initial margin of 10%.

A. Refer to above. Calculate the current value of one contract.

Current price is 102.40 percent of face value of $100,000

= 1.0240 x 100,000 = 102,400

B. Refer to above. Calculate the initial margin deposit.

Margin deposit = .10 = 102,400 = $10,240

C. Refer to above. If the futures contract is quoted at 104:18 at expiration calculate the
percentage return.

Purchase December contract:

102.40 percent of 100,000 = $102,400

Sell December contract:

104:18 percent of 100,000 = $104,562.5

Gain in futures = 104,562.5 – 102,400 = $2,162.5

Rate of return = 2,162.5 / 102,400 = .0211 or 2.11%