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Homework 1 FINA338 Individual and Corporate Risk Management Please answer the questions below on separate sheets and show your steps (no step, no score). In addition, please write down your seat number beside your name in the answer sheets. 1. Now is January 2016. Sophie will buy 50,000 pounds of lean hog in March 2016. To hedge the hog price, she buys a March 2016 maturity lean hog contract at the future price of $1.20 per pound. Suppose that when the contract matures in March 2016, the market price of hog turns out to be $1 per pound. This future contract calls for purchase of 50,000 pounds. a) Calculate Sophie's payoff from purchasing 50,000 pounds of hogs in the spot market in March 2016 (note: a payment for purchase is a negative payoff); b) Calculate Sophie's payoff from the future market in March 2016; c) Calculate Sophie's total payoff from both the spot and future markets in March 2016; d) If the market price of hog goes up to $1.50 per pound in March 2016, what's Sophie's total payoff? e) Draw the future contract payoff graph for Sophie. 2. There are traded options with XYZ stocks as their underlying assets. a) The following table lists prices of various XYZ options. Use the data in this table to calculate the payoffs and the profits for the position in each of the following June maturity options, assuming that the stock price on the maturity date is $102. Strike Price (X) Option Premium Short put option, X = $96 2.30 Short call option, X = $103 3.10 Long put option, X = $104 4.80 Long call option, X = $98 6.00 Payoff Profit b) Draw the payoff graphs for a long XYZ call with strike price $98 and a long XYZ put with strike price $104 respectively. In addition, draw the payoff graph for the combined position of a long XYZ call with strike price $98 and a long XYZ put with strike price $104. (Draw these three graphs separately and label them clearly with values of important points on the x- and y-axes.) 1 3. Tony Smith believes that the price of a particular underlying, currently selling at $93, will increase substantially in the next six months, so he purchases a European call option expiring in six months on this underlying. The call option has an exercise price of $95 and sells for $1.50. a) How much is the current credit risk, if any? (Hint: European option can be exercised only at the expiration date of the option.) b) How much is the current value of the potential credit risk, if any? c) Which party bears the credit risk(s), Tony Smith or the seller? 4. Consider a 9-month forward contract established at rate of $28. The contract is 3 months into its life. The spot price is $30, the annual risk-free rate is 4 percent, and the underlying makes no cash payments. At month 3, determine: a) the amount at risk of a credit loss; b) which party bears credit risk right before marking to market, long or short? 2