NAME: ___________________________________

ACE 428 Commodity Futures & Options

Spring 2013
ANSWER KEY FOR Exam #2, Version A 113 Points Possible
There are 11 (eleven) pages in this exam make sure you have all the pages before you begin.

Write your name at the top of this page

Write your answers in the spaces provided below each question.
If you need additional room for calculations or other work, you can use the back side of these
pages.
Feel free to draw pictures or diagrams to help explain or think about your answers.
If you take apart this exam booklet, be sure to re-assemble and staple it with the pages in the
correct order when you submit your completed exam.

* * * * *
Short Answer Questions (25 points total)
Please answer the following questions clearly and concisely. A word or phrase is OK if that is
all it takes to answer the question. If you provide a longer answer, only the first 2 sentences of
your answer for each part of the question will be graded.
QUESTION 1: The following exchange is from the Trading Places clip we viewed in class
the Wednesday before Spring Break:
President of the Exchange: Margin call, gentlemen. You know the rules, all accounts
must be settled at the end of the day, without exception.
Randolph Duke: You know perfectly well we do not have $394 million in cash!
President of Exchange: Oh, I am sorry. [To his assistant] Put the Dukes' seats on the
Exchange up for sale and seize all holdings and property of Mortimer and Randolph
Duke.
Mortimer Duke: This is an outrage! I demand an investigation! A Duke has been sitting
on this Exchange ever since it was founded!
[Randolph Duke collapses in shock]
A. What direction did the Dukes expect orange juice prices to move following the USDA
report? What was their market position long or short? (2 points)
Higher (up)
Long

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B. What direction did orange juice prices actually move following the USDA report, and
resulted in the margin call? (1 point)
Lower (down)

C. By receiving a margin call, were the Dukes trading futures or options? How do you know
this? (2 points)
Futures
No margins or margin calls with long options

D. When a margin call occurs, can the exchange actually sell a traders seat (exchange
membership) and seize a traders other assets to cover the shortfall, or is this just a case of
Hollywood storytelling? (1 point)
Yes, the exchange can do all these things

QUESTION 2: When an option expires out of the money, what does the option buyer receive?
Does the option buyer have a profit, a loss, or is it unclear? How much is the option buyers
profit or loss? (3 points)
Receives nothing
Loss
Premium paid at the outset
QUESTION 3: When an option expires in the money, what does the option seller receive?
Does the option seller have a profit, a loss, or is it unclear? How much is the option sellers
profit or loss? (3 points)
Receives a losing futures position at the strike price
Unclear (depends on premium received versus loss on futures position)
Difference between the premium received and the loss on the futures position
assigned at exercise

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QUESTION 4: Answer the following questions on option premiums.
A. How would an option premium change (increase or decrease) if there is an increase in
volatility? Explain your answer in terms of the probability that the option will be exercised.
How much would the premium change a lot or a little? Give an example of an option
trading strategy that would profit from an increase in volatility. (4 points)
Increase
More volatility means a greater chance that the option will move (deeper) in the
money and be exercised
A lot
Anything long premium

B. How would an option premium change (increase or decrease) if there is an increase in

interest rates? How much would the premium change a lot or a little? (2 points)
Decreases
A little

C. How would an option premium change (increase or decrease) if there is a decrease in the
number of days to expiration? Explain your answer in terms of the probability that the option
will be exercised. Give an example of an option trading strategy that would profit from a
decrease in the time to expiration. (3 points)
Decrease
Fewer days to expiration means a lesser chance that the option will move
(deeper) in the money and be exercised
Anything short premium

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QUESTION 5: One of our homework assignments used linear regression to find the best way to
hedge a commodity, even when the futures contract is for a different commodity than the
commodity being hedged.
A. What does the Hedge Ratio measure? What statistic from linear regression is used for the
Hedge Ratio? (2 points)
Number of futures contracts Quantity of cash commodity (measured in futures
contracts) OR Percentage of cash commodity covered by futures
Slope term ( coefficient)

B. What does Hedging Effectiveness measure? What statistic from linear regression is used for
Hedging Effectiveness? (2 points)
Percentage of price risk eliminated by the hedge
Coefficient of variation (R-squared)

PROBLEM 1 (14 points)

On Friday, April 12, June crude oil futures settled at $91.61; the June $95 put option settled at
premium of $4.33 with a delta of -0.7201
A. Calculate the time value and intrinsic value. (2 points)
Intrinsic value = $3.39 = $95 - $91.61
Time value = $0.94 = $4.33 - $3.39

B. Is this option in-the-money, at-the-money, or out-of-the-money? Why? (2 points)

In the money
Strike price > Futures price; has intrinsic value

C. If you are long this option, would it make economic sense to exercise it now? Why or why
not? (2 points)
Yes
Has intrinsic value (in of the money)

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D. What is the probability that this option will expire in the money? (1 point)
.7201 or 72.01%

E. If the crude oil futures price goes up 10 cents per barrel, how much would the premium on
the option change? Which way would the premium change (up or down)? (2 points)
-.07201 or -7.2 cents
Goes down

F. What would be the delta of a June $95.00 call option? (1 point)

Delta = +.2799 = 1 ABS (-.7201), using [ABS (put delta) + call delta = 1]

G. How many June $95 put options (rounded to the nearest whole number) would be needed to
obtain similar performance (within a narrow price range and short time frame) as 50 short
June crude oil futures contracts? Should these put options be long or short? (2 points)
69 put options 69.4348 = -50 -.7201 = Number of futures Delta
Long options, because long puts are analogous to short futures

H. Suppose that on May 16 the day when the June options expire the June crude oil futures
price is $93.00. What would be the premium for the June $95 put option at expiration? How
much time value erosion would have occurred since April 12? (2 points)
$2.00 = intrinsic value; time value at expiration = 0
$0.94 = all of the time value on April 12

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PROBLEM 2 (36 points)
Show how you would create a synthetic long call for natural gas, selecting the futures and
options you need from the following list:

Long futures at $4.38

Short futures at $4.38
Long $4.40 call at a premium of $0.12
Short $4.40 call at a premium of $0.12
Long $4.40 put at a premium of $0.15
Short $4.40 put at a premium of $0.15

A. Circle the two items from this list that you will use to create a synthetic long call. (2 points)
B. Complete the payoff table below. (25 points)

Premium for
Option
Position

Profit on
Option
Position

Combined
Profit on
Futures &
Option
Positions

Futures
Price

Profit on
Futures
Position

Value of
Option
Position at
Expiration

$4.20

-$0.18

+$0.20

-$0.15

+$0.05

-$0.13

$4.30

-$0.08

+$0.10

-$0.15

-$0.05

-$0.13

$4.40

+$0.02

$0

-$0.15

-$0.15

-$0.13

$4.50

+$0.12

$0

-$0.15

-$0.15

-$0.03

$4.60

+$0.22

$0

-$0.15

-$0.15

+$0.07

C. Use the data in the payoff table to plot a payoff diagram on the grid on the next page, with 3
separate lines showing the profits at expiration for:

The natural gas futures position

The natural gas option position
The synthetic long call

You will not be graded on your artistic ability, but your payoff diagram should:

Show each line with the proper shape and drawn to scale (6 points)
Be properly labeled to show which axis is the profit and which axis is the underlying
future price (2 points)
Cover the range of future prices from $4.20 to $4.60 (1 point)

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SyntheticLongCall
$0.25
$0.20
$0.15

Profit

$0.10
$0.05
SyntheticLongCall

$0.00

LongCashat$4.28

$0.05

Long$4.40Putat$0.15

$0.10
$0.15
$0.20
$4.60

$4.50

$4.40

$4.30

$4.20

FuturesPrice

PROBLEM 3 (4 points)
Using the put-call parity formula, calculate the missing values in the table below:
Commodity

Futures
149.80

Call Premium
4.42

Strike Price
150.00

Put Premium
4.62

Apr Feeder Cattle

May Rice

1566.00

34.75

1600.00

68.75

Feb Butter

171.00

5.00

176.00

10.00

May Lumber

333.8

37.9

300.1

4.2

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PROBLEM 4 (34 points)
Earlier we looked at a jewelry manufacturer who buys gold and hedged those purchases with
futures. Now we want to compare the results from hedging with futures to the results from
hedging with options.
The jewelry manufacturer knows that it will need to buy a large quantity of gold during the
summer for making holiday gift items. The cash price in February, when it is making its
purchasing plans, is $1,520, and the manufacturer expects the price to move higher between
February and July. However, the jewelry manufacturer does not have the ability to buy the cash
gold in February, so it hedges by buying July futures at a price of $1,520. When July arrives, the
July futures price is $1,585 and the cash price is $1,585.
For simplicity, we will assume the basis is unchanged at zero.
manufacturers results using a futures hedge:
Date

Cash

Here are the jewelry

Futures

Basis

Feb

Short at $1,520

Long July at $1,520

$0

July

Long at $1,585

Short July at $1,585

$0

-$65

+$65

$0

Gain/Loss

Net Price Paid for Gold = $1,520

A. Construct a hedge using a July $1,520 call option. The premium in February is $76 and the
premium in July is $66. (6 points)
Date

Cash
Long or Short? Price?

July $1520 Call

Long or Short?
Premium?

Feb

Short at $1,520

___ Long___ Call at $76

July

Long at $1,585

___ Short___ Call at $66

Gain/Loss

-$65

-$10

Net Price Paid for Gold = $1,595

(show your work)
= $1,585 cash price in July + $10 option loss OR
= $1,520 cash price in Feb + $65 cash price increase from Feb to July + $10 option loss

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For the hedge using the call option:
1) Calculate the difference between the net price paid for gold with the call option hedge to
the price that the manufacturer would have paid in July without hedging. Did the call
option hedge make the manufacturer better off or worse off? (2 points)
$10 = $1,595 with call option hedge - $1,585 cash price in July
Worse off (by $10)

2) Use the steps below to calculate the change in intrinsic value on the call option between
February and July (4 points)
a) Intrinsic value in February: $0
b) Intrinsic value in July: $65 = $1,585 futures price - $1,520 strike price
c) Change in intrinsic value: $65
d) Is this a profit (+) or loss (-) to the hedger? Profit (+)

3) Use the steps below to calculate the change in time value on the call option between
February and July: (4 points)
a) Time value in February: $76 = $76 - $0
b) Time value in July: $1 = $66 - $65
c) Change in time value: $75
d) Is this a profit (+) or loss (-) to the hedger? Loss (-)

4) Use your answers from Part 2 and Part 3 to explain the jewelry manufacturers call option
hedging results. (1 point)
Loss in time value > Gain in intrinsic value, so call option hedge wasnt effective

ACE 428 Exam #2A ANSWER KEY

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B. Next, construct a hedge using a July $1,520 put option. The premium in February is $76 and
the premium in July is $1 (one dollar). (6 points)
Date

Cash
Long or Short? Price?

July $1520 Put

Long or Short?
Premium?

Feb

Short at $1,520

___ Short___ Put at $76

July

Long at $1,585

___ Long___ Put at $1

Gain/Loss

-$65

+$75

Net Price Paid for Gold = $1,510

(show your work)
= $1,585 cash price in July - $75 option gain OR
= $1,520 cash price in Feb + $65 cash price increase from Feb to July - $75 option gain

For the hedge using the put option:

1) Calculate the difference between the net price paid for gold with the put option hedge to
the price that the manufacturer would have paid in July without hedging. Did the put
option hedge make the manufacturer better off or worse off? (2 points)
$75 = $1,510 with put option hedge - $1,585 cash price in July
Better off (by $75)

2) Use the steps below to calculate the change in intrinsic value on the put option between
February and July (4 points)
a) Intrinsic value in February: $0
b) Intrinsic value in July: $0
c) Change in intrinsic value: $0
d) Is this a profit (+) or loss (-) to the hedger? Any answer OK

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3) Use the steps below to calculate the change in time value on the put option between
February and July: (4 points)
a) Time value in February: $76 = $76 - $0
b) Time value in July: $1 = $66 - $65
c) Change in time value: $75
d) Is this a profit (+) or loss (-) to hedger: Profit (+)
5) Use your answers from Part 2 and Part 3 to explain the jewelry manufacturers put option
hedging results. (1 point)
No change in intrinsic value, but time value erosion benefits an option seller, so put
option hedge was effective

END OF EXAM #2