Practice True / False questions for exam 2 – econ 351 – Chuderewicz – spring 2008
Futures / Futures Option Questions
Suppose you are plaster board producer and your main input is gypsum, a commodity that can be bought or
sold in the futures or the futures options market (we are pretending). You just signed a contract, a big
contract with a firm to supply 100,000 ‘plaster boards.’ at some future date. Let us also suppose that
plaster board needs to be produced with fresh gypsum, so that you are going to buy gypsum in the futures
or futures option market. Suppose that each gypsum futures contract represents the purchase or sale of
1000 lbs of gypsum and to make 100,000 ‘plaster boards’ you need 5000 lbs of gypsum. Suppose the
current spot and futures price of gypsum is $ 0.50 per lb. Please answer the following questions:
1. As a user of gypsum, you could lock in a price right now ($ 0.50 per lb.) and hedge against high prices
in the future by buying 5 futures contracts in gypsum.
2. The buyer of the 5 futures contracts will look smart when prices go above $ 0.50 per lb. This notion is
consistent with the fact that buying futures is a bullish position.
3. If the price of gypsum falls to $0.25, then the seller of the 5 futures contracts (assuming he/she is a
speculator) makes a profit of $1250 while the buyer of the 5 futures contracts (a speculator as well) loses
$1250 and thus, this futures market is a zero sum game
Futures Options
We now consider the futures options market for gypsum. Suppose call and put futures options are
available. In particular, a futures options put or a futures options call is available with a strike price of
$0.50, which happens to be the current spot price (as assumed above). Each of these futures options can be
purchased for $100 per contract.
4. Given the fall in the price of gypsum to $ 0.25 lb as assumed above, the seller of the 5 futures contracts
(assumed to be a speculator) would be better off if he / or she would have bought 5 futures options puts
instead, since he/she would have limited their losses to $500, the cost of the 5 futures options puts.
5. The writer of the 5 futures options calls, given the fall in the price of gypsum to $0.25 per lb. gets to
keep the $500 (the premium of the 5 futures options), since the 5 futures options calls expire out of the
money.
6. The break even point (spot at expiration) for the speculator who buys the 5 futures options puts is when
the spot price of gypsum at expiration is $ 0.40 per lb.
7. If the price of gypsum falls to $0.25 per lb at expiration, assuming that the futures options market was
active, then the two biggest winners would be the buyer of the futures options put and the writer of the
futures options call (recall there are four players).
8. If gypsum prices expire at $0.25 per lb, then the futures options call (strike price = $0.50 /lb) is
worthless where the futures options put (strike price = $0.50 /lb) would be worth over $1000!
Another Futures / Futures Options Problem
Suppose you are holding a large sum of cash since you need to pay a huge bill at the end of June, 2008.
You purchase a bunch of US Treasuries with a face value of $1.5 million and you want to protect the value
of those Treasuries until you need the cash in June.
9. To hedge against higher interest rates in the future, you could sell 15 June 08 interest rate (US Treasury)
futures contracts.
1
Suppose you did sell 15 interest rate futures contracts, please answer the following questions.
10. By selling these futures, you are establishing a bullish position since if prices go up, you make a higher
profit since the contract gives you right to sell at this higher price.
11. Suppose you sold your 15 contracts with an agreed upon price of 108. Given this price, these
Treasuries are selling at a discount.
12. By selling 15 interest rate futures contracts for 108, you are obligated to sell your $1.5 million face
value of Treasuries for $1.62 million.
13. Suppose new NEWS hits such that the payroll report was stronger than expected. Given the Fisher
effect, we would expect yields on these Treasuries to go up.
14. Given the NEWS, the futures price of your contracts goes down to 107.5. Excluding transactions
costs, you made a profit of $7500 and the buyer of these (15) futures contracts lost $7500.
Futures Options Questions
Suppose alternatively that you play the futures options market. You, the bear, can buy purchase futures
options puts with a strike price of 108 for $1000. Likewise, the bull can purchase futures options calls with
a strike price of 108 for $1000. Each futures option contract represents one futures contract.
Suppose the same NEWS hits (stronger than expected payroll report) so that the futures price falls to 107.5
as above and the option expires that way. Let’s consider the fortunes or misfortunes of the 4 players
involved. Again, all calculations are excluding transactions costs and recall that we are dealing with 15
futures contracts – that is, the writers write 15 option contracts (call / puts) and the other 2 players buy the
puts and the calls.
15. The writer of the calls is the biggest winner of all the four players involved.
16. The writer of the puts is the biggest loser of all the four players involved.
17. This is a zero sum game since when you add up all the winners winnings and losers losings they sum to
zero.
18. Suppose again that you are hedging your bonds so that you purchase the 15 futures options puts as
above (strike price = 108, premium = $1000). The breakeven point at expiration is a futures price of 109.
19. By writing a futures options call on wheat, you are hoping that the spot price of wheat rises and stays
above the strike price so that you can keep the premium that you received when you wrote the call.
20. If you write a futures options call on crude oil then we say you are ‘bullish’ on crude oil.
21. The term ‘credit crunch’ is consistent with lenders not willing to lend due to risk aversion. If you knew
beforehand that a credit crunch was coming then you should short US Treasuries by either selling futures
contracts or by buying futures options puts.
22. A futures options put gives the owner
A) the right to sell the underlying futures contract.
B) the obligation to sell the underlying futures contract.
C) the right to buy the underlying futures contract.
D) the obligation to buy the underlying futures contract.
2
23. Futures options are more attractive relative to futures for various reasons one of which is that the
amount that you can lose is limited to the premium (excluding other transactions costs) you pay for the
futures option. This is not true for futures.
24.
Parties who have bought an interest rate futures contract are obligated to _____ the bonds at some
future date are said to have taken a ____ position.
A) sell; short
B) buy ; short
C) sell; long
D) buy; long
25. If you owned a gasoline station (a user of gasoline) and wanted to hedge against higher prices in the
future then you could do so by buying a futures contract (in gasoline).
26. All else constant, if the current and expected level(s) of interest rates fall, then stock prices will rise.
This phenomenon can be clearly shown via the stock price determination equation and is why most believe
that looser monetary policy is good for stocks.
27. As we discussed in class, all you need is inside information on news announcements to make money in
the stock market.
28. An argument can be made, according to the efficient market theory, that if the consumer confidence
index comes out exactly as expected, then nothing would happen in terms of bond and stock prices since
these prices would have already reflected this expectation.
29. A technical analyst focuses more on the past behavior of stocks and looks at charts to figure out where
the stock price is headed.
30. When someone says that stocks follow a random walk they are implying that movements (changes) in
stock prices occur randomly – that is, changes in stock prices are unpredictable.
31. Two properties of the forecast error term from predicting tomorrow’s stock price with today’s,
according to rational expectations and efficient markets, is that it better be uncorrelated with itself and all
information that is available today.
32. Technical analysts try to find patterns in stock prices by looking at charts and thus, are often referred to
as chart watchers.
33. The price to earnings ratio is calculated by taking the price of the stock and dividing it by the current
earnings of the firm.
34. In class we argued that the wealth effect on consumption, dollar for dollar, is stronger for changes in
stock market wealth relative to equal changes in real estate wealth, since it is easier to cash in capital gains
from stocks since they are more liquid than capital gains in real estate.
35. According to efficient markets, the best predictor of tomorrow’s stock price is today’s stock price,
since today’s stock price already reflects all relevant and available information regarding the determination
of that stock price.
36. According to our stock price determination formula, if expectations of future interest rates rise, all else
constant, then you should be a bear since stock prices will fall.
37. We argued in class that when we are at full employment, the aggregate supply curve is likely to be very
steep in slope and thus, any discretionary macroeconomic policy will have more influence on the general
price level as compared to real output (GDP).
3
38. Investors tend to prefer liquid assets relative to non-liquid assets. Therefore, there exists a positive
relationship between an asset’s price and its liquidity, all else constant.
39. The efficient market theory implies that there is no information that is available today that will help us
predict the stock price tomorrow.
40. Many are worrying about the moral hazard problem when it comes to recent Fed policy (in particular)
and future housing policy (in general). By moral hazard, we mean that if the Fed or Federal government
bails out people who took on the risk on purpose like speculators, then these speculators will just take that
risk again and again and that’s the problem.
41. Currently, we can think of the discount rate serving as an upper band for the federal funds rate. That is,
if there is an adverse shock in the reserve market so that reserve demand skyrockets, then the most banks
will pay for overnight funds is the discount rate, which is currently set 25 basis points above the target for
the federal funds rate.
42. Given the recent actions taken by the Fed, non-member banks can now borrow from the federal funds
desk in New York, just like member banks.
43. The term ‘helicopter Ben’ originates from the fact that Ben Bernanke used to be a helicopter pilot
during the Vietnam war.
44. In terms of this credit crunch / housing crisis, if we were to pick a starting point in terms of Fed action,
we would probably pick 9/18/2007, since that was the first move the Fed made, in terms any statements,
etc., regarding the credit crunch, when they cut the federal funds rate target by 25 basis points.
45. The term auction facility was established to help get rid of the stigma that is associated with borrowing
at the discount window.
Here is a problem
Before the Fed cut interest rates, the expected earning stream of a firm for the next three years was
$30,000, $25,000, and $30,000 respectively (assume the firm falls off the face of the earth in three years as
we did in class). Meanwhile, interest rates are expected to be 4 % for the next three years. Given 5,000
shares of existing stock, what is inferred (exact) price of the stock (show all work)?
b)What is the price to earnings ratio (use the expected earnings in year 1 to make this calculation)?
c) Now the Fed cuts their target for the federal funds rate and expectations change (they also “jawbone”
down future expectations with their statement). New conditions: expectations of future earnings are
$35,000 for each of the next three years; expected interest rates fall to 3 percent for the next three years.
What is the price of the stock now (again – show all work)?
d) What is the price to earnings ratio?
4