Answer to Chapter 1 Introduction to Derivatives & Risk Management, Chance, Brooks.

CHAPTER 1 INTRODUCTION END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. (Market Efficiency and Theoretical clean-living Value) An efficient commercialise is wizard in which wrongs reflect the true scotch values of the assets trading therein. In efficient markets, no unmatchable loafer earn make its that atomic number 18 more than commensu ordain with the level of try. Efficient markets argon characterized by first-class honours degree transaction costs and by the rapid rate at which new information is incorporated into determines. 2. ( merchandise and the practice of law of One Price) merchandise is a type of investment transaction that seeks to profit when superposable adepts atomic number 18 harmd differently.Buying an item at one price and immediately shoping it at another is a type of arbitrage. Because of the combined activities of arbitrageurs, identical goods, in general financial assets, cannot altogetherot for different prices for long. This is the law of one price. Arbitrage helps function our markets efficient by assuring that prices ar in line with what they are supposed to be. In short, we cannot get roughthing for nothing. A situation involving deuce identical goods or portfolios that are not priced equivalently would be exploited by arbitrageurs until their prices were equal.The one price that an asset must be is called the theoretical fair value. 3. (Arbitrage and the Law of One Price) The law of one price is break if the same good is selling at different prices. On the surface it may await as if that is the case however, it is beta to look beneath the surface to tick if the goods are identical. Part of the cost of the good is convenience and node service. virtually rentrs competency be willing to pay more because the corpus is determined in a more desirable section of town.Also, the higher priced dealer may have a better reputation for service and customer satisfaction. Buyers may be willing to pay more if they fee l that the aid they pay helps assure them that they are getting a fair deal. It is important to note that many goods are indeed identical and, if so, they should sell at the same price, but the Law of One Price is not violated if the price differential accounts for some economic value. 4. (The reposition Mechanism) Storage is just holding the asset.Some assets, exchangeable commodities, require considerable storage blank and entail significant storage costs. Others, like stocks and bonds, do not consume much space but, as we shall see afterward, do incur costs. Storage enables us to more adequately meet our consumption compulsions and, thus, abides for a more efficient alteration of our consumption patterns across sentence. For example, we can barge in grains for the winter. In the case of stocks and bonds, we can store them and sell them later. The proceeds from the cut-rate sale of the securities can be used to meet consumption needs at the later time.Likewise, storage e nables speculators to hold goods and securities in the hope of selling them later at a profit. In addition, storage plays an important role in defining the relationship between spotlight instruments and derived functions. 5. (Delivery and Settlement) In futures markets, delivery rarely occurs. Since delivery is always possible, however, an expiring futures scram will be priced like the spot instrument. The knowledge that futures prices will eventually converge to spot prices is important to the determine of futures use ups. 6. The Role of Derivative Markets) Derivative markets provide a means of adjusting the risk of spot market investments to a more acceptable level and identifying the consensus market beliefs. They suck trading easier and less costly and spot markets more efficient. These markets in addition provide a means of speculating. 7. (Criticisms of Derivatives Markets) On the surface, it may be hard-fought to distinguish speculation from gambling. Both entail hig h risk with the foresight of high gain. The major difference that makes speculation moderately more socially acceptable is that it offers benefits to society not conveyed by gambling.For example, speculators are necessary to absorb the risk not wanted by others. In gambling, there is no risk creation hedged. Gamblers simply accept risk without there creation a concomitant reduction in someone elses risk. 8. (Misuses of Derivatives) Derivatives can be misused by speculating when one should be hedging, by not having acquired the infallible knowledge to use them properly by acting irresponsibly when victimisation derivatives such as by being overly confident of ones ability to forecast the direction of the market. 9. The Role of Derivative Markets) The existence of derivative markets in the United States providence and indeed throughout roughly modern countries of the world undoubtedly leads to a much higher phase of market efficiency. Derivatives facilitate the activities o f individual arbitrageurs so that unequal prices of identical goods are arbitraged until they are equal. Because of the large number of arbitrageurs, this is a quick and efficient process. Arbitrage on this large a scale makes markets less capable of being manipulated, less costly to trade in, and therefore more attractive to investors. The hazard to hedge also makes the markets more attractive to investors in managing risk. ) This is not to give tongue to that an economy without derivative markets would be inefficient, but it would not have the utility of this arbitrage on a large scale. It is important to note that the derivative markets do not necessarily make the U. S. or world economy any larger or wealthier. The basic wealth, expected returns, and risks of the economy would be about the same without these markets.Derivatives simply create dispiriteder cost opportunities for investors to correct their risks at more satisfactory levels. This may not necessarily make them we althier, but to the extent that it makes them more satisfied with their positions, it serves a valuable purpose. 10. ( call back and Risk) Return is the numerical measure of investment executing. There are dickens chief(prenominal) measures of return, dollar return and percentage return. Dollar return measures investment accomplishment as total dollar profit or loss.For example, the dollar return for stocks is the dollar profit from the change in stock price convinced(p) any cash dividends paid. It represents the absolute movement. Percentage return measures investment performance per dollar invested. It represents the percentage increase in the investors wealth that results from make the investment. In the case of stocks, the return is the percentage change in price plus the dividend yield. The concept of return also applies to preferences, but, as we shall see later, the explanation of the return on a futures or forward contract is somewhat unclear. 1. (Repurchase Agreeme nts) A repurchase agreement (known as repos) is a legal contract between a seller and a buyer, the seller agrees to sell a specified asset to the buyer currently as well as buy it back usually at a specified time in the future at an agreed future price. The seller is efficaciously borrowing gold from the buyer at an implied interest rate. Typically, repos involve low risk securities, such as U. S. Treasury bills. Repos are useful because they provide a great deal of flexibility to both the borrower and lender.Derivatives traders often need to be able to borrow and lend money in the most(prenominal) cost-effective manner possible. Repos are often a very low cost way of borrowing money, particularly if the firm holds government securities. Repos are a way to earn interest on short capital with minimal risk (for buyers) and repos are a way to borrow for short-term needs at a relatively low cost (for sellers). 12. (Derivative Markets and Instruments) An cream is a contract between two partiesa buyer and a sellerthat gives the buyer the right, but not the obligation, to purchase or sell something at a later date at a price agreed upon today.The option buyer pays the seller a sum of money called the price or premium. The option seller stands ready to sell or buy according to the contract terms if and when the buyer so desires. An option to buy something is referred to as a call an option to sell something is called a put. A forward contract is a contract between two partiesa buyer and a sellerto purchase or sell something at a later date at a price agreed upon today.A forward contract sounds a lot like an option, but an option carries the right, not the obligation, to go through with the transaction. If the price of the cardinal good changes, the option holder may decide to forgo buying or selling at the fixed price. On the other hand, the two parties in a forward contract incur the obligation to finally buy and sell the good. 13. (The Underlying Asset) Beca use all derivatives are based on the random performance of something, the word derivative is appropriate.The derivative derives its value from the performance of something else. That something else is often referred to as the underlying asset. The term underlying asset, however, is somewhat confuse and misleading. For instance, the underlying asset might be a stock, bond, currency, or commodity, all of which are assets. However, the underlying asset might also be some other random element such as the weather, which is not an asset. It might even be another derivative, such as a futures contract or an option.