Chapter 1 Assignment questions 1.1. What is a derivative? A derivative is an agreement to enter into a future transaction. Its value depends on (or derives from) other more basic variables. 1.2. Explain the two main ways that derivatives trade? Derivatives trade on exchanges and in the over-the-counter (OTC) market) 1.4. Which is bigger, the exchange-traded market or the OTC market? The OTC market is much bigger. 1.5. What is the difference between a long forward position and a short forward position? In a long forward, the trader is agreeing to buy an asset for a certain price at a certain future time. In a short forward, contract the trader is agreeing to sell an asset for a certain price at a certain future time. 1.7. What is the difference between a forward contract to buy an asset at $30 and a call option to buy the same asset for $30? In the forward contract, the trader is committing to a future trade. In an option, the trader has the right but not the obligation to carry out the future trade. 1.8. Explain carefully the difference between hedging, speculation, and arbitrage. Hedging involves reducing an existing risk. Speculation involves having a view on the market and taking a risk. Arbitrage involves locking in a profit by trading in two different markets. 1.9. Explain the meaning of bid and ask quotes. Bid is the price at which a market maker is prepared to buy. Ask is the price at which the market maker is prepared to sell. 1.12. An investor enters into a short forward contract to sell 100,000 British pounds for U.S. dollars at an exchange rate of 1.3000 USD per pound. How much does the investor gain or lose if the exchange rate at the end of the contract is (a) 1.2900 and (b) 1.3200? (a)The investor is obligated to sell pounds for 1.3000 when they are worth 1.2900. The gain is (1.3000−1.2900) ×100,000 = $1,000. (b)The investor is obligated to sell pounds for 1.3000 when they are worth 1.3200. The loss is (1.3200−1.3000)×100,000 = $2,000
