Question

(5) Explain the role that arbitrageurs play in keeping the price for the underlying security in the "spot market and the price in the futures market closely aligned. To show it you may want to assume that the two prices are not the same and show that there are profit opportunities to be exploited (so-called arbitrage opportunities“). (6) Explain how a call option works. What are the rights and obligations of each party to a call option contract? Are the rights and obligations symmetric? Provide an example of a call option being used to insure against the risk of price changes in the underlying security

Answer 1

(5) and $5.2 respectively. in Consider the price of security ABC is $5 2 different secondary markets X and Y x + spot maskel et future market The difference in the price of the security opportunity. To illustrate : arises arbitrage from market A, Arbitrageer buys too units of surity ABC - this will lead to the arbitrageur paying $5 XIDO - $ 500 d with respondiente → Arbitrageun, then sells these 100 units of at market B. is this will lead to the arbitraguer receiving $ 5.2 x 100 = $520.- trei suurila ABC at the Cash flow of arbitrageur Details CR DR $ 500 1. Buying ABC 2. Swing A B C from market. A at market B 2. S $ 520 -- - Proft earned + $520 - $ 500 + $ 20. Here $20 is the arbitrage opportunity exploited by the arbitragwer. Thus, the sput price and future prices tend to be closely aligned, to minimize arbitrage opportunities, ( Scanned with CamScanner

(6) Call option is a type of the buyer and seller which from increase in price of time in future. financial contact between protects the buyer the securities in the spuifical buyer It gives the right to, but not obligation underlying suundy at a predetermined a Speu fico time. to buy the price at within It comes with an obligation to exercise the contract if rights to buy ... to the seller of the call option the buyers wishes to use the for buyer and suller Hence, of the the rights call option and are obligations not tric ощas pot Sbot "price of sucurity 4.7 4.8 4.5 5 5.1 $-2 3-2 5-4 maturity consider fig ca). Buyer buys the option contract by paying a premium g $0.10, os at strike price $4.9. 20. premium Afryshe, arth This means that sy bruger, the buyu can buy the secersity at $ 4.g even when the spot price of the scurring at the time of maturing - paid. 2. Sellest's " profit is Scanned with CamScanner

time severity g maturely at $4.9. for instance, consider the spot price at is $5-3, the buyer can still buy the His net profit would be. $ 5.3 - $ 4.9 - $ 0.1 (premiun). $ 0.3 The seller will register $0.3 loss in this scenario. In other maturity buyer instance, if the spot falls below $ 4.9 will not usereise the price at time (say $4.), contract and be y the protected & the loss only . of The buyer premium and $0.1 $01 will be will be considered the net as loss profit to the the seller. to profit Thus, the buyu ( theorctically) amount paid. has and auess to * a maximum unlimited loss of the premium. Scanned with CamScanner