Question 1

a. Sand is an important raw material used in the construction of buildings, roads, and the manufacture of glass. Despite its importance in the economy, there are no futures contracts for Appraise the issue and briefly offer two (2) possible explanations. (12 marks)

b. Rossi is the CFO of Starlight Corporation which manufactures light fittings. Its main market is the US. Mr. Rossi wanted to hedge his US dollar receipts.

Discuss two (2) reasons why Rossi chose to use forward contracts instead of futures contracts. (12 marks)
Discuss one (1) reason why Rossi did not consider using swaps instead of futures contracts. (6 marks)

c. (i) Discuss what the term “open interest” (3 marks)

Appraise the use of open interest by traders in the futures (6 marks)
Explain how the open interest for a futures contract can remain the same even though there are transactions for the (6 marks)

d. (i) John Tan is a commodity trader. He observed the following prices in the commodity Appraise whether there is an arbitrage opportunity, how he can execute it, and the profit that can be made.

Spot price of commodity = $50

Futures price of commodity = $52

1-year risk-free interest rate = 4%

1-year storage cost = 1% (9 marks)

(ii) Discuss two (2) obstacles in the market that prevents Mr. Tan from realizing the profit. (6 marks)

Question 2

a. Discuss whether the following options will be exercised

Dividend-paying call
Non-dividend paying put (10 marks)

b. You are an options trader for a hedge Your assistant prepared the following sheet containing the prices of various options on January 31. Assume the options expire at the end of the expiration month. The risk-free interest rate is 8% per annum.

Expiration Months

Stock
Stock Price
Std. Dev.
Exercise Price
March
June
September

DDE call
50
20%
50
4.00
4.50
5.00

DDE put
50
20%
50
3.50
4.50
—

DDE call
50
20%
55
2.00
3.80
5.20

HJK call
50
30%
50
4.00
4.70
4.40

Appraise the options and identify three (3) pricing discrepancies. You may use the Excel program to help you uncover the pricing discrepancies. Show how you would profit from them.

Use the following format to answer this question.

Pricing Discrepancy:

 Strategy to profit from pricing discrepancy: (24 marks)
List two (2) limitations of using the Black-Scholes model for valuing (6 marks)

Answer to Above Questions on Derivative Securities

Answer 1 a. A commodity future contract is defined as an agreement to buy or sell a predetermined amount of commodity at a specific price on a specific date in the future. As sand is considered as an important raw material in the construction of buildings, roads and in the manufacturing of glass, still there are no future contracts for sand. The main reason for which sand does not have a future contract is because of its high weight as compared to its cost, and because of that it is difficult to move it from one place to another and it therefore becomes expensive. Another possible explanation for not recognising sand in the future contract