FINM3405Answers Tutorial 3

FINM3405Answers Tutorial 3 - FINM3405 Derivatives &...

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FINM3405 Tutorial 3 © Philip Gray 2009 1 FINM3405 Derivatives & Risk Management Tutorial 3 Question 1 a) The usual approach … What is the risk we face? Spot gold price is $926 per ounce. In three month's time, we will purchase gold. Danger is that gold price will rise before we make our purchase. What derivative position will make money in this event? You make money when prices rise with a long position. Hence, we will enter a long forward contract for the delivery of one ounce of gold in three month's time at the quoted delivery price of $936. b) With many commodities, physical delivery is possible. That is, a long forward contract on gold is a commitment to buy one ounce of gold at the $936 delivery price. In most cases, however, derivative traders close-out just prior to maturity (this is mainly for convenience). The forward contract has served its hedging purpose, and the gold is purchased on the spot market. (time 0) Enter long forward contract to purchase one ounce gold $936 (3 mths) Close-out by selling forward contract for one ounce gold $896 Loss on forward contract $ 40 Purchase one ounce gold on spot market $896 Total cost of one ounce gold $936 c) Your partner is correct … had we not locked-in a $936 price for gold, we could have purchased gold on the spot market for $896. If, however, we had remained unhedged, and gold price had in fact risen, the gold would have cost us more than $936. It is important to realise that not hedging amounts to speculating prices will move favourably. And this is a risk many businesses are not prepared to take. d) (time 0) Enter long forward contract to purchase one ounce gold $ 936 (3 mths) Close-out by selling forward contract for one ounce gold $966 Gain on forward contract $ 30 Purchase one ounce gold on spot market $966 Total cost of one ounce gold $936
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FINM3405 Tutorial 3 © Philip Gray 2009 2 Question 2 We price forward contracts using the cost-of-carry formula: ( ) T u r e S F + = 0 r is the interest cost of borrowed money u is the cost of storing/securing/etc the physical asset. These cost are expressed as %pa. a) () . 000 , 131 , 1 $ ounces 000 , 1 131 , 1 $ 926 $ 2 04 . 0 06 . 0 = × = = + e F b) Same answer as part a. In theory, it doesn't matter whether we are talking long or short, there is one and only one correct price. Note that, in practice, there is almost always a bid/ask spread around prices. That is, there is a slightly different price for buyers and sellers (anyone who has traded shares online will be accustomed to seeing bid/ask spreads. Similarly, when we exchange currency at the airport, we see slightly different prices depending on whether we are buying or selling the currency in question. These spreads allow the market maker to make a small profit on the transaction). c) 16 . 453 , 447 , 1 $ tonnes 000 , 10 75 . 144 $ 140 $ 12 / 5 02 . 0 06 . 0 = × = = + e F d) 53 . 2050 2020 12 / 9 04 . 0 06 . 0 = = e F e) ( ) share. per 54 . 9 $ 90 . 0 10 12 / 9 06 . 0 12 / 5 06 . 0 0 = = = × × e e e I S F rT
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FINM3405 Tutorial 3 © Philip Gray 2009 3 Question 3 In our previous examples, we have used SPI futures to hedge against a falling market. You could also use futures to speculate on a movement in a particular direction. This is a risky strategy, since a wrong prediction will generate a loss.
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This note was uploaded on 08/27/2009 for the course FINM 3405 taught by Professor Philipgray during the Three '09 term at Queensland.

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FINM3405Answers Tutorial 3 - FINM3405 Derivatives &...

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