Financial Management Tutorial Solutions

Problem 1.1: Long vs. Short Forward Position

A long forward position means an investor agrees to buy an asset at a future date for a
predetermined price. A short forward position means an investor agrees to sell an asset at a
future date for a predetermined price.

Key Differences:

 A long position benefits if the price increases because the investor can buy the asset at
a lower agreed price and sell it at a higher market price.

 A short position benefits if the price decreases because the investor can sell the asset at
a higher agreed price and buy it at a lower market price.

 Both parties are obligated to execute the contract at the expiration date, unlike options
where the holder has the right but not the obligation.

Problem 1.2: Hedging, Speculation, and Arbitrage

 Hedging: This strategy is used to reduce or eliminate risk associated with price
movements. For example, an airline company may buy fuel futures to protect itself from
rising fuel costs.

 Speculation: This strategy involves taking on risk to potentially earn a profit. A trader
buying stock options in anticipation of a price increase is engaging in speculation.

 Arbitrage: This involves taking advantage of price differences between two or more
markets to earn a risk-free profit. For example, if a stock trades at different prices on two
exchanges, a trader can buy low and sell high simultaneously.

Problem 1.3: Forward Contract vs. Call Option

Feature Long Forward Contract Long Call Option

Obligation Must buy at $50 Can choose to buy at $50

Upfront Cost None Pays premium upfront

Risk Unlimited loss if price drops Limited loss (only premium paid)
Feature Long Forward Contract Long Call Option

Profit Potential Unlimited if price rises High, but reduced by premium

A long forward contract requires the investor to buy the asset at $50 at expiration, regardless of
its market price. If the price drops, the investor incurs losses. A call option, on the other hand,
gives the investor the right but not the obligation to buy at $50. If the price is below $50, the
investor simply lets the option expire, losing only the premium.

Problem 1.4: Selling Call Option vs. Buying Put Option

Feature Selling a Call Option Buying a Put Option

Right or Obligation Obligation to sell if exercised Right to sell

Profit Potential Limited to premium received High if price drops significantly

Risk Unlimited (if price rises significantly) Limited to premium paid

A call option seller (writer) receives a premium but has the obligation to sell the asset at the
strike price if the option is exercised. If the stock price rises significantly, the seller faces
unlimited losses. A put option buyer pays a premium to gain the right to sell the asset at the
strike price. This strategy is useful if the investor expects the stock price to drop.

Problem 1.5: Short Forward Contract (Currency Exchange)

 Forward contract rate: 1.5000 USD/GBP

 Contract size: 100,000 GBP

(a) If exchange rate at expiration = 1.4900 USD/GBP

Profit=(1.5000−1.4900)×100,000=$1,000Profit = (1.5000 - 1.4900) \times 100,000 = \$1,000

Since the investor agreed to sell GBP at 1.5000, but the market price is lower, they make a
profit.

(b) If exchange rate at expiration = 1.5200 USD/GBP

Loss=(1.5200−1.5000)×100,000=$2,000Loss = (1.5200 - 1.5000) \times 100,000 = \$2,000

Since the market price is higher, the investor sells at a loss.

 Over-the-Counter (OTC) Market:

o Contracts are customized between two parties.

o Less regulation and greater counterparty risk.

o Used for derivatives like swaps and forward contracts.

 Exchange-Traded Market:

o Standardized contracts traded on formal exchanges.

o More transparency and lower counterparty risk.

o Examples include futures and options.

 Bid Price: The price a market maker is willing to buy an asset.

 Offer Price (Ask Price): The price at which a market maker is willing to sell.

Problem 1.12: Futures for Speculation and Hedging

A futures contract is an agreement to buy or sell an asset at a future date for a predetermined
price.

 Hedging: Companies or investors use futures to reduce exposure to price fluctuations.

 Speculation: Traders use futures to bet on price movements without intending to own
the asset. If they predict the price will rise, they take a long position, and if they predict
a fall, they take a short position.

Problem 1.37: Downside Risk Strategies (Google Shares)

Factor Buying Put Option Stop-Loss Order

Cost $3,810 (100 x $38.10) None

Downside Protection Guarantees sale at $660 No guarantee of execution price

Upside Potential Unlimited (still owns shares) None after sale

Execution Risk No risk Risk of selling below $660 if price gaps down

Analysis:

1. Buying a put option: The investor pays $3,810 for the right to sell at $660, guaranteeing
a minimum sale price. If Google’s stock price remains above $660, the put expires
worthless, and the investor loses the premium.

2. Stop-loss order: If the stock falls to $660, the shares are sold. However, if the price gaps
down significantly below $660, the sale may occur at a much lower price.

Recommendation:

 If the investor wants guaranteed protection, the put option is better.

 If they want to avoid upfront costs, a stop-loss order is a cheaper but riskier alternative.

Comparison of Downside Risk Strategies for Google Shares

An investor holding 100 shares of Google on May 3, 2016, with a stock price of $696 is
evaluating two ways to limit downside risk:

1. Buying a December put option with a $660 strike price at $38.10 per share

2. Using a stop-loss order to sell the shares at $660

1. Buying a December Put Option ($660 Strike)

A put option gives the investor the right, but not the obligation, to sell 100 shares at $660 per
share regardless of the market price. The cost of this insurance (premium) is $3,810 ($38.10 ×
100 shares).

Advantages

✅ Guaranteed Floor Price: The investor is protected against a price drop below $660—they can
sell at $660 no matter how low the market price goes.

✅ Upside Potential is Retained: If the stock rises above $696, the investor still benefits from
price appreciation.

✅ No Immediate Sale: The investor maintains ownership and can defer capital gains taxes if
applicable.

Disadvantages
❌ Premium Cost: The investor pays $3,810 for protection, reducing overall returns. If the stock
stays above $660, the option expires worthless.

❌ Time Decay: If the stock remains stable or rises slightly, the option loses value over time.

2. Stop-Loss Order at $660

A stop-loss order instructs the broker to sell 100 shares once the stock price hits $660,
automatically executing a market sell order.

Advantages

✅ No Upfront Cost: Unlike the put option, the investor does not have to pay a premium, making
this strategy free to implement.

✅ Simple Execution: Once the price hits $660, the broker sells the shares automatically, limiting
potential losses.

Disadvantages

❌ No Price Guarantee: The actual sell price may be lower than $660 if the stock gaps down
suddenly. For example, if the stock plummets overnight to $640, the order executes at $640, not
$660.

❌ Lost Upside Potential: If the stock briefly dips to $660 and then rebounds, the investor loses
out on future gains.

❌ Emotional Impact: If the stop-loss triggers, the investor might regret selling too early,
especially if the stock recovers.

Conclusion: Which Strategy Is Better?

 If the investor wants certainty and retains upside potential, the put option is the better
choice, despite the cost.

 If the investor wants a cost-free strategy and is willing to accept execution risk, the stop-
loss order is a simpler alternative.

A hybrid approach (e.g., a tighter stop-loss combined with a put option for deep downside
protection) could also be considered.