EIFM Seminar 11 – week commencing Jan 10^th 2022

Question 1: Suppose trader X bought one December gold futures contracts on COMEX division of the New York Mercantile Exchange on June 5. The gold futures price is $600 per ounce on that day. The contract size is 100 ounces. The initial margin is $2,000 per contract. The maintenance margin is $1,500 per contract. Suppose the settlement price of Dec gold futures from June 5th to June 7th is shown in the table. Trader X closes out the position on June 7th at $597. Between the opening and closing day, he keeps the position by meeting margin calls. Compute the daily gain (loss), cumulative gain (loss), margin account balance of and variation margin of trader X each day. Calculate his total return.

Answer:

Total return = -300/(2,000+600+700) = -9.09% in 3 days!

2. Explain the role of a clearing house in a futures market.

Answer:

The principal role of the clearing house is to reduce default risk in futures markets. It does this in a variety of ways. First, all contracts entered into are contracts between a client and the clearing house. Thus, although there is in any deal with both a buyer and a seller, the buyer buys from the clearing house; the seller sells to the clearing house. The clearing house has the obligation to meet any default. The clearing house, then, acts to try to ensure that both parties to the deal can meet their obligations under the contracts. The major way of achieving this is through the system of margin payments, which requires the contracting parties to pay into accounts with the clearing house, sufficient funds to cover potential losses. The sums held in these accounts are adjusted daily to reflect price changes in the underlying asset market. In the jargon, the margins are ‘marked to market’.

Other actions are taken by the exchange to reduce default risk. For example, it is possible for large changes in price to take place in a single day’s trading and this cannot be covered by the system of daily margin payments. Therefore, in turbulent market conditions, the exchange can set price limits. Reaching these limits triggers the closure of the exchange for the day.

3. Given the information in the table below answer the following two question

(a) What will be the proceeds and net profit to an investor who purchases the April expiration Intel calls with exercise price $20 if the stock price at maturity is $23? What if the stock price at maturity is $17?

(b) Answer part (a) for an investor who purchases an April expiration Intel put option with exercise price $22.5

Answer:

(a) Denote the stock price at option expiration by ST, and the strike price by X.

Value at expiration = ST – X = ST – 20 if this value is positive; otherwise the call expires worthlessly

Profit = Proceeds – call premium = Proceeds – $1.650

When ST = $23, Proceeds = 23 – 20 = $3 and profits = 3 – 1.65 = $1.35

When ST = $17, Proceeds = $0 and profits = -$1.65

(b) Value at expiration = X – ST = 22.5 – ST, if this value is positive; otherwise the put expires worthlessly.

Profit = Proceeds – put premium = Proceeds – 3.3

When S = $23, Proceeds = 0 and profits = -$3.3

When S = $17, Proceeds = 22.5 – 17 = $5.5 and profits = 5.5 – 3.3 = $2.2

4. Explain the statement made by the Chairman of CBoT in the following extract:

‘The Chicago Board of Trade will launch an oats futures options contract on May 1. Options on oats will provide a variety of hedging possibilities. The American Oats Association in Minneapolis said that producers were more likely to use options than futures. According to the CBoT chairman, by purchasing options, a hedger can establish price ceilings and floors, and still benefit if cash prices change in his favour’.

Answer:

Options are more flexible than futures because options allow hedging without loss of the opportunity to make a profit.

Consider a call option. A hedger is short in the cash market and runs the risk that the instrument in which he is short (say, oats) will rise in price. On the other hand, he will profit if the price of the instrument falls. Therefore, he wishes to hedge by going long in the options market – buying a call option that allows him to buy US oats at the agreed strike price. The option establishes a ceiling – the trader knows that even if the price of oats does rise sharply, the maximum price he will have to pay is the strike price agreed in the options contract. If the price of the instrument does rise, he buys the oats he needs at the strike price and the option is successful in providing the hedge. However, if the price of oats falls, the trader will gain in the underlying market (the amount he has to pay for the oats he needs costs him less than expected) and he simply abandons the option. Thus, he makes the same gain as he would have made without the hedge, except for the premium paid for the option.

Equally, a put option provides a floor to prices. A second trader who is long in oats knows that should the price of oats fall, the lowest price he can obtain will be the price agreed in the put option contract. However, should the price of oats rise, this second trader would gain fully apart from the premium paid for the option. Futures could establish a hedge in both of these cases but would not preserve the profit possibilities outlined above.