sm21 - CHAPTER 21 AN INTRODUCTION TO DERIVATIVE MARKETS AND...

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Unformatted text preview: CHAPTER 21 AN INTRODUCTION TO DERIVATIVE MARKETS AND SECURITIES Answers to Questions 1. Since call values are positively related to stock prices while put values are negatively related, any action that causes a decline in stock price (e.g., a dividend) will have a differential impact on calls and puts. Specifically, an impending dividend will boost put values and depress call values. Another way to consider the situation is to represent the difference between the theoretical price of a call option (C) and the theoretical price of a put option (P) as C-P. This is the same as a portfolio that is long a call option and short a put option. For a firm that pays dividends, we expect that the price of its stock will decline by the amount of the dividend on the last day before the stock goes ex-dividend. A decline in stock price makes a call less valuable and a put more valuable, so C-P will decrease. This portfolio has the same payoff as being long a forward contract with a contract price equal to the strike price. Since there is no guarantee that the strike price is the forward price, this forward contract will typically have a non-zero value (i.e. the call and put will have different prices). A dividend will decrease the up-front premium for a long position in a forward contract because the expected stock price at expiration decreases. Consequently, C-P is decreased by dividends. 2. It is generally true that futures contracts are traded on exchanges whereas forward contracts are done directly with a financial institution. Consequently, there is a liquid market for most exchange traded futures whereas there is no guarantee of closing out a forward position quickly or cheaply. The liquidity of futures comes at a price, though. Because the futures contracts are exchange traded, they are standardized with set delivery dates and contract sizes. If having a delivery date or contract size that is not easily accommodated by exchange traded contracts is important to a future/forward end user then the forward may be more appealing. If liquidity is an important factor then the user may prefer the futures contract. Another consideration is the mark-to-market property of futures. If a firm is hedging an exposure that is not marked-to-market, it may prefer to not have any intervening cash flows, hence it will prefer forwards. 3. For forwards, calls and puts, what the long position gains, the short position loses, and vice versa. However, while payoffs to forward positions are symmetric, payoffs to call and put positions are asymmetric. That is to say, long and short forwards can gain as much as they can lose, whereas long calls and puts have a gain potential dramatically greater than their loss potential. Conversely, short calls and puts have gains limited to the option premium but have unlimited liability....
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This note was uploaded on 05/20/2010 for the course FIN 5DLS taught by Professor Leejohn during the One '10 term at La Trobe University.

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sm21 - CHAPTER 21 AN INTRODUCTION TO DERIVATIVE MARKETS AND...

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