Questions on Financial Derivatives and Risk Management

[1] What do you mean by financial derivatives? Explain carefully the difference (10)
between hedging, speculation and arbitrage.

[2] (a) A trader enters into a short cotton futures contract when the futures price is 50 (04)
cents per pound. The contract is for the delivery of 50000 pounds. How much
does the trader gain or lose if the cotton price at the end of the contract is (a)
48.20 cents per pound and (b) 51.30 cents per pound.

(b) Discuss under what circumstances a Short Hedge and a Long Hedge appropriate. (06)
OR
The following table gives data pertaining to monthly changes in the spot and (10)
futures prices for a certain commodity. Use the data to calculate a minimum
variance portfolio.
Spot Price Change +0.50 +0.61 -0.22 -0.35 +0.79
Futures Price Change +0.56 +0.63 -0.12 -0.44 +0.60
Spot Price Change +0.04 +0.15 +0.70 -0.51 -0.41
Futures Price Change -0.06 +0.01 +0.80 -0.56 -0.46

[3] (a) Discuss the operation of margin account administered by the broker of a client (10)
with suitable example of your own.
OR
(a) Suppose that the standard deviation of a quarterly changes in the prices of a (05)
commodity is $0.65, the standard deviation of quarterly changes in a futures price
of the commodity is $0.81 and coefficient of correlation between the two changes
is 0.8. What is the optimal hedge ratio for a 3-month contract? What does it
mean?
(b) What is basis risk? Explain in details with suitable examples. (05)