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(a) Explain briefly the difference between hedging and speculating using financial derivatives.
(b) Suppose that a European put option to sell a share for €50 costs €6 and is held until maturity. Under what circumstances will the seller of the option (the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option.
(c) A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the variation of the trader’s profit with the asset price. What trading strategy is being described here?
(d) Suppose that put options on a commodity with strike prices $30 and $35 cost $4 and $7, respectively. How can the options be used to create (i) a bull spread and (ii) a bear spread? Construct a table that shows the profit and payoff for both spreads.
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