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Chapter One Introduction

1.1 Explain why the following businesses might be interested in heating degreeday and cooling degree-day futures contracts:
a. Soft-drink manufacturers.
The sale volume of soft-drink will rise when its hot so manufacturers dont like
cool day. They are interested in cooling degree-day contract to hedge their
business risk since people drink less soft drink when its cool.
b. Ski-resort operators.
People love skiing when its cool. Ski operators will suffer large losses when its
extremely hot. They are interested in heating degree-day contracts since it result
payment when their businesses suffer.
c. Electric utilities.
Electric companies in warm area such as Georgia have huge profits when its hot,
so they are interested in cooling degree-day contracts that can compensate their
loss in winter. Meanwhile, other electric companies in cool area such as New
York gain more profits during winter months, so they are interested in heating
degree-day contracts.
d. Amusement park operators.
Park operators dislike bad weather and cool days, because people wont go to
park during these days. Operators should buy cooling degree-days to offset their
loss.
1.2 Suppose the businesses in the previous problem use futures contracts to
hedge their temperature-related risk. Who do you think might accept the opposite
risk?
As to a and b, they are opposite. Soft-drink manufacturers should invest in
cooling contracts while ski-resort operators can buy heating contracts.
Not only the opposite side will take opposite risk but also those who have
different opinion.
E.g: Those who dont believe that we will have excessive temperature variations
in the future will invest in the contracts about stable weather.
1.3 ABC stock has a bid price of $40.95 and an ask price of $41.05. Assume
there is a $20 brokerage commission.
What amount will you pay to buy 100 shares?
$41.05*100+$20=$4125
What amount will you receive for selling 100 shares?
$40.95*100-$20=$4075
Suppose you buy 100 shares, then immediately sell 100 shares with the bid and
ask prices being the same in both cases. What is your round-trip transaction
cost?
$4125-$4075+$20*2=90
Round-trip transaction cost doesnt count on changes in the bid-ask prices.
$4125-$4075=$50

1.4 Repeat the previous problem supposing that the brokerage fee is quoted as
0.3% of the bid or ask price.
$41.05*100*1.003=4117.32
$40.95*100*(1-0.3%)=4082.72
$4117.32-$4082.72=34.6
1.5 Suppose a security has a bid price of $100 and an ask price of $100.12. At
what price can the market-maker purchase a security? At what price can a
market-maker sell a security? What is the spread in dollar terms when 100
shares are traded?
(1) $100
(2) $100.12
(3) ($100.12-$100)*100=12
1.6 Suppose you short-sell 300 shares of XYZ stock at $30.19 with a commission
charge of 0.5%. Supposing you pay commission charges for purchasing the
security to cover the short-sale, how much profit have you made if you close the
short-sale at a price of $29.87?
$30.19*300*(1-0.5%)-[$29.87*300*(1+0.5%)]=$9011.72-$9005.81=$5.91
1.7 Suppose you desire to short-sell 400 shares of JKI stock, which has a bid
price of $25.12 and an ask price of $25.31. You cover the short position 180 days
later when the bid price is $22.87 and the ask price is $23.06.
a. Taking into account only the bid and ask prices (ignoring commissions and
interest), what profit did you earn?
$22.87*400-$25.31*400=-$976
The sale of a stock you do not already own is called a short-sale which involves
borrowing shares of JKI stock and then selling them. Some time later, buy stock
back paying cash for it, and return it to the lender.
($25.12-23.06)*400=$824
b. Suppose that there is a 0.3% commission to engage in the short-sale (this is
the commission to sell the stock) and a 0.3% commission to close the short-sale
(this is the commission to buy the stock back). How do these commissions
change the profit in the previous answer?
Sell stock at price $25.12 and buy stock back at price $23.06.
$25.12*400*(1-0.3%)-$23.06*400*(1+0.3%)=$10017.86-$9251.67=$766.19
c. Suppose the 6-month interest rate is 3% and that you are paid nothing on the
short-sale proceeds. How much interest do you lose during the 6 months in which
you have the short position?
$25.12*400*(1-0.3%)*3%=$300.54
1.8 When you open a brokerage account, you typically sign an agreement giving
the broker the right to lend your shares without notifying or compensating you.
Why do brokers want you to sign this agreement?
In short selling, a short seller will have to deposit some profits to the lender as
collateral, so lenders gain interest proceeds on those collaterals. The reason that
brokers want you to sign the agreement is to have additional profit.

1.9 Suppose a stock pays a quarterly dividend of $3. You plan to hold a short
position in the stock across the dividend ex-date. What is your obligation on that
date? If you were a taxable investor, what would you guess is the tax
consequence of the payment? (In particular, would you expect the dividend to be
tax deductible?) Suppose the company announces instead that the dividend is
$5. Should you care that the dividend is different from what you expected?
(1) My obligation is to pay dividend whose volume is my shares * 3.
(2) The payment can result deductible amount of my duty tax.
(3) In a perfect capital market, we would expect the stock price falls exactly by
the amount of dividend on ex-date, so we dont care. However, two complications
may arise: 1 , we may not have enough money to pay dividend. 2 , an
unexpected increased dividend is a strong signal that a company is doing very
well. We will observation a sharp increase in stock price after dividend
announcement. As we are a short position, we make profit if stock price falls.
Therefore, we should really care an unexpected dividend.
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1.10 Short interest is a measure of the aggregate short positions on a stock.


Check an online brokerage or other financial service for the short interest on
several stocks of your choice. Can you guess which stocks have high short
interest and which have low? Is it theoretically possible for short interest to
exceed 100% of shares outstanding?
(1) I can follow the website of www.cboe.com/ and http://www.cmegroup.com/
to see trends of a particular stock to guess if it has high interest or not.
http://www.marketdata.nasdaq.com
(2) Its theoretically possible for short interest to exceed 100% of shares
outstanding since some intermediaries have ability to short sell a stock
without having someone who wants to lend it.
1.11 Suppose that you go to a bank and borrow $100. You promise to repay the
loan in 90 days for $102. Explain this transaction using the terminology of shortsales.
In a long position of short-selling, we can buy forward contract with $100 and sell
it some time later with a higher price (>$102). So we can make profits.
In a short position, we are interested in borrowing asset money. Bank is our
lender. We sell the asset by going to ATM and withdrawing it. After some time, we
buy the asset back by depositing $102 to our bank account. Therefore, Bank
(lender) is repaid and we covered our short-selling position.
1.12 Suppose your banks loan officer tells you that if you take out a mortgage
(i.e., you borrow money to buy a house), you will be permitted to borrow no more
than 80% of the value of the house. Describe this transaction using the
terminology of short-sales.
The same as 1.11
1.13 Pick a derivatives exchange such as CME Group, Eurex, or the Chicago
Board Options Exchange. Go to that exchanges website and try to determine the
following:
a. What products the exchange trades.
CME Group has contracts about agriculture, weather and energy, etc.
b. The trading volume in the various products.
c. The notional value traded.
H2G4 Chicago HDD Monthly Futures
FUT CME $1205

What do you predict would happen to these measures if the notional value of a
popular contract were cut in half? (For example, instead of an option being based
on 100 shares of stock, suppose it were based on 50 shares of stock.)
Exchange volume will rise sharply.
1.14 Consider the widget exchange. Suppose that each widget contract has a
market value of $0 and a notional value of $100. There are three traders, A, B,
and C. Over one day, the following trades occur:
A long, B short, 5 contracts. A long, C short, 15 contract. B long, C short, 10
contracts. C long, A short, 20 contracts.
What is each traders net position in the contract at the end of the day? (Calculate
long positions minus short positions.)
A: 5+15-20=0
B: 10-5=5
C: 10+20-15=15
What are trading volume, open interest, and the notional values of trading volume
and open interest? (Calculate open interest as the sum of the net long positions,
from your previous answer.)
Trading volume = 5+15+10+20=50
Open interest = 10
Notional value = $100*50=$5000
How would your answers have been different if there were an additional trade: C
long, B short, 5 contracts?
Trading volume = 50+5=55
Open interest = 5
Notional value = $100*55=$5500
How would you expect the measures in part (b) to be different if each contract
had a notional value of $20?
Notional value = 55*$20=$1100.