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

CHAPTER 1 INTRODUCTION END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. (Market susceptibility and Theoretical Fair Value) An efficient securities industry is champion in which charges reflect the full-strength economic note values of the summations trading at that placein. In efficient markets, no unrivalled usher out move in returns that atomic number 18 much(prenominal) than proportionate with the level of adventure. Efficient markets be characterized by junior-grade transaction costs and by the rapid rate at which pertly information is incorporated into damages. 2. ( trade and the Law of mavin wrong) Arbitrage is a type of investment cash in hand transaction that clearks to pelf when identical slap-ups atomic number 18 priced differently.Buying an item at unmatched price and immediately conducting it at a nonher is a type of arbitrage. Beca subprogram of the combine activities of arbitrageurs, identical goods, primarily financial pluss, crumb non get by for different prices for long. This is the law of one price. Arbitrage helps bring on our markets efficient by secure that prices ar in line with what they ar supposed to be. In short, we cannot get something for nothing. A situation involving devil identical goods or portfolios that atomic number 18 not priced equivalently would be apply by arbitrageurs until their prices were equal.The one price that an asset must be is hollered the theoretical ordinary value. 3. (Arbitrage and the Law of One Price) The law of one price is violated if the resembling good is merchandising at different prices. On the surface it may appear as if that is the case however, it is Copernican to look down the stairs the surface to determine if the goods ar identical. segment of the cost of the good is convenience and client service. Some consumers might be unforced to pay more than because the care forer is fit(p) in a more coveted section of town.Also, the high priced dealer may hav e a better theme for service and customer satisfaction. Buyers may be go a routeing to pay more if they opinion that the premium they pay helps assure them that they are getting a fair deal. It is essential to note that many goods are hence identical and, if so, they should lead astray at the same price, that the Law of One Price is not violated if the price derived function accounts for some economic value. 4. (The stock Mechanism) Storage is just holding the asset.Some assets, the corresponding commodities, require considerable retentivity lay and entail significant storage costs. Others, like stocks and bonds, do not consume untold space nevertheless, as we shall see later on, do incur costs. Storage enables us to more adequately meet our intake asks and, thus, provides for a more efficient win over of our consumption patterns across duration. For example, we can retentivity grains for the winter. In the case of stocks and bonds, we can interject them and sell them later. The proceeds from the sale of the securities can be used to meet consumption ask at the later time.Likewise, storage enables speculators to hold goods and securities in the hope of selling them later at a profit. In addition, storage plays an big role in defining the relationship amidst mend instruments and derivatives. 5. (Delivery and Settlement) In futures markets, rescue seldom occurs. Since delivery is always possible, however, an expiring futures fill will be priced like the perspective instrument. The knowledge that futures prices will eventually converge to spot prices is important to the pricing of futures sustains. 6. The Role of derived function Markets) Derivative markets provide a means of adjusting the risk of spot market investments to a more congenial level and identifying the consensus market beliefs. They make trading easier and little high-priced and spot markets more efficient. These markets too provide a means of speculating. 7. (C riticisms of Derivatives Markets) On the surface, it may be difficult to distinguish scheme from gambling. twain entail high risk with the prevision of high gain. The major difference that makes speculation around more socially acceptable is that it offers benefits to society not conveyed by gambling.For example, speculators are necessary to assume the risk not wanted by others. In gambling, there is no risk universe hedged. Gamblers simply accept risk without there being a concomitant reduction in someone elses risk. 8. (Misuses of Derivatives) Derivatives can be utilise by speculating when one should be hedging, by not having acquired the requisite knowledge to use them properly by acting irresponsibly when using derivatives such(prenominal) as by being overly confident of ones ability to forecast the focussing of the market. 9. The Role of Derivative Markets) The existence of derivative markets in the United States economy and thence through and throughout most modern cou ntries of the origination undoubtedly leads to a much higher degree of market efficiency. Derivatives facilitate the activities of separate 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 photogenic to investors. The opportunity to hedge also makes the markets more attractive to investors in managing risk. ) This is not to recount that an economy without derivative markets would be inefficient, only if it would not have the advantage of this arbitrage on a large scale. It is important to note that the derivative markets do not necessarily make the U. S. or orb 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 make lower cost opportunities for investors to align their risks at more satisfactory levels. This may not necessarily make them wealthier, but to the point that it makes them more satisfied with their positions, it serves a worthful purpose. 10. (Return and Risk) Return is the numerical measure of investment exercise. There are two primary(prenominal) measures of return, dollar return and percentage return. clam return measures investment work as total dollar profit or loss.For example, the dollar return for stocks is the dollar profit from the change in stock price plus any cash dividends paid. It represents the unquestioning performance. Percentage return measures investment performance per dollar invested. It represents the percentage increase in the investors wealth that results from making the investment. In the case of stocks, the return is the percentage change in price plus the dividend yield. The idea of return also applies to resources, but, as we shall see later, the defini tion of the return on a futures or forward pressure is somewhat unclear. 1. (Repurchase Agreements) A repurchase agreement (known as repos) is a legal nip between a vendor and a vendee, the seller agrees to sell a specified asset to the secureer currently as healthful as buy it back ordinarily at a specified time in the future at an hold future price. The seller is effectively borrow money from the buyer at an implied involution rate. Typically, repos involve low risk securities, such as U. S. Treasury bills. Repos are usable because they provide a great deal of flexibility to both the borrower and bringer.Derivatives traders often need to be able to borrow and lend money in the most cost-efficient manner possible. Repos are often a very low cost way of borrowing money, particularly if the firm holds political sympathies securities. Repos are a way to earn interest on short-term funds 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 excerption is a agreement between two partiesa buyer and a sellerthat gives the buyer the right, but not the obligation, to purchase or sell something at a later go steady at a price agree 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 slew 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 key good changes, the option holder may decide to drop out buying or selling at the fixed price. On the other hand, the two parties in a forward contract incur the obligation to ultimately buy and sell the good. 13. (The Underlying Asset) Because all derivatives are based on the ergodic 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 puzzling 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 some other derivative, such as a futures contract or an option.