BFF3751 Derivatives 1

Tutorial 1

Required Reading

Lecture 1 (class notes)

Hull Chapter 1 Hull Chapter 2

Section 1.1 Section 2.1
Section 1.2 Section 2.2
Section 1.3 Section 2.3
Section 1.4 Section 2.4 (skim)
skip 1.5 Section 2.5
Section 1.6 Section 2.6
skip 1.7 Section 2.11
Section 1.8 (skip: speculation with options)
Section 1.9
Section 1.10

Instructions for the Semester Regarding Tutorial Material

A lot of thought and effort has gone into preparing the tutorial questions for BFF3751. I am
confident that, if you work diligently through all of the tute questions, you will learn a lot. And
if you don’t, you won’t ...

Some questions will re-visit and build upon examples given in lectures. Some questions will
take counter examples to those given in lectures. Other questions will present entirely new
issues and challenges.

Students are required to complete all questions on the tutorial sheet. To re-iterate, in order
to gain the level of understanding and competency required for success in BFF3751, you must
complete all questions.

However, the one-hour tutorials will not allow the tutors to work through all questions in detail.
The questions labelled with an asterisk (*) are the ones that tutors will focus most time on in
class. This does not mean that other questions can be ignored. The questions without an
asterisk tend to be easier and I hope you can solve them even before attending the tutorial. The
knowledge/issues covered in these easier questions will then form a base from which the more
challenging (*) questions will build. This is why you must complete all questions on each
tutorial.

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Tutorial Questions

Question 1

Some people use derivative markets to hedge, while others use them to speculate. Explain the
difference between hedging and speculation.

For each of the following scenarios, determine whether the trading action is indicative of
hedging or speculation:

a) Jet fuel is a major operating expense for Qantas. Qantas enters long forward contracts for
oil.

b) A cattle farmer anticipates having 50,000 kgs of cattle ready to take to auction in 6 weeks.
The price for live cattle at auction is highly volatile, but the farmer decides against using
cattle futures to lock in a sale price.

c) An electricity wholesaler buys electricity from generators and sells to retailers. While the
price at which electricity sold to retailers is very stable, the purchase price of electricity
from generators is extremely volatile. For example, on a 40 degree day in summer, air
conditioning demand is high and the spot price of electricity might be 1000 times the typical
price. An electricity wholesaler enters long futures positions to buy electricity.

d) The price of cocoa has been rising for some times and recently hit an all-time high.
Chocolate-maker Cadbury has had long futures contracts in place to lock-in the price at
which they can cocoa and therefore protect themselves against further price rises. However,
at a recent meeting senior executives reached a consensus that prices won’t go any higher
and are likely to fall. Hence, they decide to close-out their long cocoa futures positions.

e) Fund Manager X has an uncanny knack of correctly forecasting market movements. Based
on her latest research, she predicts the market is due for a correction. Accordingly, she
enters a bunch of short SPI200 futures positions. As often happens, Ms X is right – the
market falls 15% in August and she closes out to realise a handsome profit.

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Question 2

One of our lecture examples demonstrates a speculative trade based on a prediction that gold
price would fall. The spot price of gold is about USD 1803 per ounce. A forward contract for
Dec-2021 delivery of gold is quoted at USD 1780 per ounce. We speculated on a falling gold
price by entering a short forward contract for the delivery of 1,000 ounces of gold in December
2021.

In the lecture example, we saw that:

• If the spot price of gold does fall to (say) USD 1620, we close our short position by
entering a long forward contract for the delivery of 1,000 ounces of gold in Dec-2021.
This correct prediction/guess generated a profit of USD 160,000.

• However, if our prediction/guess of falling gold price is wrong, we lose money with a
short forward position. For example, if the spot price of gold rose to (say) USD 2200,
we suffer a loss of USD 420,000.

Assuming our initial trade is a short forward contract for the delivery of 1,000 ounces of gold
in Dec-2021 at a contract price (F) of USD 1780, calculate the profit or loss for each of the
following scenarios.

Calculate profit or loss if Dec-2021 gold price is:

1400 1500 1620 1700 1800 2000 2200 2300 2400
Profit or loss on
+160k -420k
short gold forward

In completing this table, you are essentially constructing the “payoff diagram” for a short
forward contract. Plot the Dec-21 gold price on the horizontal axis and the profit from the short
forward position on the vertical axis.

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Question 3 (*)

After completing BFF3751 with a high distinction, you decided to drop out of university and
become a trader. In fact, you have shown quite a knack for successfully predicting price
movements in a variety of markets and are making a very handsome living. You still keep in
touch with some of your old BFF3751 classmates, despite the fact that they are complete losers.
They never really took their study seriously. Didn’t work very hard. Tended to focus only on
what they needed to know to pass the exam rather than grabbing the opportunity to learn as
much as they could. Most of them are working nine-to-five jobs for modest graduate salaries.

Anyway, you have just been reading about a severe drought in Brazil, which is the world’s
largest orange juice producer. You are also aware of a deadly citrus virus that is decimating
orange crops in the US. Putting two and two together, you realise that, if the supply of oranges
is adversely affected by these factors, this is likely to squeeze orange juice prices higher.
Another profit opportunity for you!

In your home office, you have a wall of LED monitors in front of you, with one dedicated to
commodity futures. It is showing that frozen concentrated orange juice (FCOJ) futures trade
on the Intercontinental Exchange (ICE). One FCOJ contract covers 15,000 pounds of orange
juice solids. Standard delivery months are Jan, Mar, May, July, Sep and Nov.

You think the impact of the drought and virus on orange price is likely to happen over the next
few months, so select the near-dated Sep-2021 expiry FCOJ contract which has a quoted future
price (F) of 200 cents per pound. You hit <enter> on your keyboard and get an instant
confirmation that you have successfully traded 10 long Sep-21 FCOJ futures contracts.

a) Having entered 10 long FCOJ contracts, what are your obligations? What is the risk you
face that might keep you awake at night?

b) As a star trader, you have an enormous following on twitter. You send out a few tweets
noting how terrible the Brazilian drought is. And another tweet expressing your sympathy
for the American farmers whose orange crops are being destroyed by the citrus virus. Your
prayers are with them. Within a couple of days, the futures price for Sep-21 FCOJ has risen
sharply to 230 cents per pound. Although there is still time remaining before the September
2021 expiry, you jump on the computer and close out by shorting 10 Sep-21 FCOJ futures.
Calculate your profit from trading these orange juice futures.

c) To understand the possible payoffs from long futures (and forward) positions, complete the
table below. Plot you answer to see the payoff diagram.

Calculate profit or loss if Sep-21 FCOJ futures price is:

100 125 150 175 200 225 250 275 300
Profit or loss on ten
long FCOJ futures

https://www.ft.com/content/b012e240-ed4e-11e6-ba01-119a44939bb6?mhq5j=e1
http://www.marketwatch.com/story/heres-why-orange-juice-futures-just-closed-at-an-all-time-high-2016-11-01

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Question 4 (*)

Today is 1 July and the spot exchange rate between Australian dollars and Swiss francs is AUD
1.00 = CHF 0.74. That is, one AUD buys you 0.74 Swiss francs. You have no underlying
position/commitments in Swiss francs and will merely speculate on exchange rate movements.
Your local bank quotes a six-month forward rate at AUD 1.00 = CHF 0.7450.

a) If I talk about the CHF ‘strengthening’ relative to the AUD, what does this mean? That
is, give me an example of an exchange rate quote after the CHF has strengthened.

b) If you want to speculate on the CHF strengthening relative to the AUD, will you take a
long or short forward position in CHF?

Given your answer to b), enter a forward contract on CHF 60,000 at the six-month forward rate
quoted above.

c) Six months later when this forward contract expires, the spot exchange rate is 0.80 (i.e.,
AUD 1.00 buys CHF 0.80). You close out the forward position with a new transaction
equal in magnitude and opposite in sign to your original transaction in part b). Have
you made a gain or loss on the forward position?

d) Ignore c). When this forward contract expires in six-month's time, the spot exchange
rate is 0.70 (i.e., AUD 1.00 buys CHF 0.70). You close out the forward position with a
new transaction equal in magnitude and opposite in sign to your original transaction in
part b). Have you made a gain or loss on the forward position?

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Question 5 (*)

You are planning an overseas trip departing 1st December to celebrate completion of semester
2 – assuming of course that you pass your university exams and don’t have to spend summer
studying for a Supplementary Exam. Today is 1 August and a quick check of the newspaper
shows that the relevant exchange rate is AUD 1.00 = EUR 0.6800.

Your budget suggests that EUR10,000 will be required to guarantee an awesome vacation.
Naturally, you fear that the Australian Dollar might weaken between now and December, thus
impacting on the quality of your vacation.

There are a number of courses of action available to you and we will explore the outcomes of
each.

a) Assume that you decide to do nothing about your exposure to exchange rate risk. In
December, the day before your departure, you visit the bank and ask to buy EUR10,000 for
your holiday. Assume that the spot exchange rate in December is AUD 1.00 = EUR 0.5000.
How much will the EUR10,000 cost you?

b) Not wanting to risk the consequences of the AUD weakening, you go to the bank today (1st
August) and buy EUR10,000 at the spot rate of 0.6800. You put these Euros under your
mattress and leave them there until December. How much does your vacation cost?

c) The Commonwealth Bank in Melbourne CBD has a large foreign exchange desk and they
offer a forward contract on Euros for delivery in December at a quoted price of 0.6823.
You enter a long forward contract to buy Euros at the quoted price. In December, you
honour your obligation under the long forward contract to buy EUR10,000. How much
does your vacation cost you?

d) Assume that forward contracts are too confusing for you. You like the idea from part b of
buying Euros now, but you don’t exactly have the spare cash to be buying them so far in
advance of your trip. Instead, you do the following: (i) calculate how much it will cost you
to buy EUR 10,000 now at the spot rate, (ii) arrange a loan from the local bank at 2% p.a.
continuously-compounded interest so that you can buy the Euros now, (iii) in December,
you repay the balance of that loan in full. The effective cost of your vacation is the payout
figure on the loan. How much is it?

e) The approach in part d is clever but nonetheless suboptimal in that, after you arrange the
loan and buy EUR 10,000, you merely put those Euros under the mattress until December.
Obviously, you are missing out on potential interest! Here’s a better plan. Go to a local
bank today and borrow AUD14,560. With this money, you convert them into Euros at the
spot exchange rate (0.6800). Next, you open a bank account somewhere in Europe and
deposit the Euros for a 4-month period from 1st August through 1st December. The foreign
bank account pays you 3% p.a. continuously compounded on the deposit.

How much money is in that European bank account in December? What is the balance
owing on your Australian bank loan? What is the effective cost of your vacation now?

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Question 6

At any given time during the life of a forward or futures contract, there is likely to be a
difference between the quoted futures price (F) and the spot price of the underlying asset (S0).
For example:

• In the lecture example, in July the spot price of gold was USD 1803 per ounce, but the
forward price for Dec-2021 delivery of gold was USD 1780.
• In Question 4, the spot exchange rate was AUD 1.00 = CHF 0.74, but the forward rate
for delivery in 6 months was AUD 1.00 = CHF 0.7450.

However, as a forward/futures contract approaches the delivery date, the quoted delivery price
for the contract converges to the spot price of the underlying asset. When we get to the point
where the forward/futures contract is just about to expire, the quoted delivery price must equal
the spot price of the underlying asset.

For example, consider a forward contract to deliver 100 ounces of gold on 31 October. The
quoted delivery price is $1795/ounce. The current (spot) price of gold is probably something
different to $1795 (it was USD 1803 in our lecture example). As time passes between now and
October, the quoted forward price for the delivery of gold at the end of October will change. 1
However, by the expiry day, the quoted forward price for October delivery of gold must equal
the spot price of the underlying gold.

Why does this happen? To answer the question, consider the following scenario. Assume that
just one hour before the expiry of the October forward contract, the spot price of gold is
$1900/ounce. However, assume that the quoted delivery price on the forward contract is $1910.
What would an arbitrageur do in these circumstances?

What would the arbitrageur do if the October-delivery gold forward contract was quoted at
$1895 just hours before expiry?

1
As we will see in Lecture 3, the quoted forward/futures price moves to reflect changes in the price of underlying
asset, as well as time to delivery.

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