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CHAPTER 1
Introduction
Practice Questions
Problem 1.1.
What is the difference between a long forward position and a short forward position?
When a trader enters into a long forward contract, she is agreeing to buy the underlying asset
for a certain price at a certain time in the future. When a trader enters into a short forward
contract, she is agreeing to sell the underlying asset for a certain price at a certain time in
the future.
Problem 1.2.
Explain carefully the difference between hedging, speculation, and arbitrage.
A trader is hedging when she has an exposure to the price of an asset and takes a position in a
derivative to offset the exposure. In a speculation the trader has no exposure to offset. She is
betting on the future movements in the price of the asset. Arbitrage involves taking a position
in two or more different markets to lock in a profit.
Problem 1.3.
What is the difference between entering into a long forward contract when the forward price
is $50 and taking a long position in a call option with a strike price of $50?
In the first case the trader is obligated to buy the asset for $50. (The trader does not have a
choice.) In the second case the trader has an option to buy the asset for $50. (The trader does
not have to exercise the option.)
Problem 1.4.
Explain carefully the difference between selling a call option and buying a put option.
Selling a call option involves giving someone else the right to buy an asset from you. It gives
you a payoff of
max(S K0) min(K S 0)
T T
Buying a put option involves buying an option from someone else. It gives a payoff of
max(K S 0)
T
In both cases the pote
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