UNIVERSITI TUNKU ABDUL RAHMAN (UTAR)

Financial Markets and Regulations (UKFB 3053)

Tutorial11:Optionmarkets

Questions and answer:

1. Explain the difference in the gain and loss potential of a call option and a long
futures position. Under what circumstances do you think someone would prefer
the option to the future or vice versa?
The loss potential for the writer and the gain potential for the buyer could be
unlimited as the future price of the option could increase infinitely. The gain
for the writer and the loss for the buyer will be the call premium. For someone
in a futures contract they have unlimited potential for a loss or a gain.
Someone who participates in futures contract will be less risk adverse then
someone in option contracts. Someone who is looking for pure hedging
strategy would prefer a futures contract and someone who wishes to maximize
their upside potential and protect themselves from downside swings would
prefer an option.
2.

Explain the difference between a put and a call.

A call is the right to buy an underlying assets at the strike price while a put is
the right to sell an underlying assets at the strike price.

3.

Why do you think exchanges are more concerned with naked option writers
than covered option writers?
Covered option writers have own the security that have agreed to sell or
already sold short the securities they have agreed to buy. Naked options
writers do not own an offsetting security position. Therefore they need to
deposit margin requirements with the exchange to guarantee their promise.

Additional questions:
1. Why does a lower strike price imply that a call option will have a higher premium
and a put option a lower premium?
Because for any given price at expiration, a lower strike price means a higher profit
for a call option and a lower profit for a put option. A lower strike price makes a call
option more desirable and raises its premium and makes a put option less desirable
and lowers its premium.
2. Explain how foreign exchange derivatives could be used by U.S. speculators to
speculate on the expected appreciation of the Japanese yen.
U.S. Speculators could attempt to lock in an exchange rate at which they could
exchange dollars for yen at a future point in time. This could be accomplished by
purchasing forward contracts or future contracts on Japanese yen, negotiating a swap
for swap for yen, or purchasing yen call option. They could also sell yen put options
to capitalize on their expectation.
3. What are some considerations in the decision to use options for hedging?
Gains and losses in futures contracts are virtually without limit. For that reason, some hedgers
prefer options. Options give a one-sided type of price protection that is not available from

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futures. However, premium on options may be high, and the value of options decays over
time . The buyer of protection must decide whether the insurance value provided by the
option is worth the price.
4. If you buy a put option on a $100,000 Treasury bond future contract with an

exercise price of $95 and the price of the Treasury bond is $120 at expiration, is
the contract in the money, out of the money, or at the money? What is your profit
or loss on the contract if the premium was $4,0000?
5. Explain why greater volatility or a longer term to maturity leads to higher
premium on both call and put options.

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