1 A hedger has taken a long position in the wheat futures ma

1. A hedger has taken a long position in the wheat futures market.

a. What does a long position in the above example mean?

b. What is the risk that is hedged in this transaction?

c. What are the risks and rewards of buying versus writing options?

d. Does the existence of derivatives markets enhance an economy’s ability to grow, or not and why?

e. What kind of an option should you purchase if you anticipate selling $1 million of treasury bonds in one year’s time and wish to avoid a capital loss?

f. You are completely convinced that the price of copper is going to rise significantly over the next year and want to take as large a position as you can in the market but have limited funds. How could you use the futures market to leverage your position?

Solution

a. Long position means, the heger has bought an option. He is expecting the price of wheat to rise and hence will take a long position which implies he will buy the wheat at a certain future date for the price which he agred upon now.

b. Risk is that, if the price of wheat happens to decrease, the hedger may not execute the option and hence the option premium which he paid to buy the option will be a loss for him.

c. Buying option limits the loss to only the premium amount paid by the buyer. The profit can be unlimited depending on the strike price.   

Writing an option will limit the profit to only the option premium received by the writer. But the loss can be as much as 100%.

d. The existence of the derivatives market enhance the economy\'s ability togrow because it gives the option of hedging against the unusual losses that might occur in future for the organizations. But sometimes, it might also lead lo huge losses for speculators.

e. If i want to sell 1million $ of treasury bonds in one year, i will buy a put option which gives me the right to sell.

f. If I know that price of copper is going to rise significantly, but have limited funds, i will borrow the copper now, and sell it in the future when price increases, and repay the amount to borrower. I can also use margin call.