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Derivatives and Option Markets

1. What are the major functions of derivative markets in the economy? What are some ways in which derivatives can be misused?

2. Explain the difference between an American option and a European option. What do they have in common?

Questions 3-5 use the information found in the following table from the CBOE for options on Google's stock selling at the time for $315 per share.

Calls Last Sale Net Bid Ask Vol Open Int Puts Last Sale Net Bid Ask Vol Open Int
09 Jan 310.00 (GGD AB-E) 10.80 -8.00 10.50 11.00 147 2097 09 Jan 310.00 (GGD MB-E) 5.30 +0.90 5.50 5.80 1042 3860
09 Jan 320.00 (GGD AD-E) 5.80 -6.10 5.30 5.70 774 4003 09 Jan 320.00 (GGD MD-E) 10.50 +3.20 10.20 10.70 561 4355
09 Feb 310.00 (GGD BB-E) 26.50 -6.00 25.60 26.10 32 540 09 Feb 310.00 (GGD NB-E) 20.00 +2.15 20.40 20.90 28 911
09 Feb 320.00 (GGD BD-E) 21.35 -5.05 20.30 20.80 133 827 09 Feb 320.00 (GGD ND-E) 24.30 +2.30 25.10 25.70 79 524

3. Which contracts in the table are currently in-the-money? Which are out-of-the-money?

4. For which contract(s) is the bid-ask spread lowest? Why do you think this is so?

5. Suppose an investor buys the Feb 320 call contract on January 1 and holds to expiration when the stock is selling for exactly $360. What is the annualized return on investment for this option position if the contract is until expiration?

Solution Preview

1. What are the major functions of derivative markets in the economy? What are some ways in which derivatives can be misused?

Answer:
The major functions of financial derivatives market in the economy are:
(i) The effectiveness of derivative market and market efficiency increases due to intrinsic links between derivatives and primary securities and this helps the market on price discovery.
(ii) Derivative helps in risk transfer and this risk transfer can be categorized into hedging for value preservation and procurement of a satisfactory risk position. So derivative market has its unique role and significance in risk transfer in the economy.
(iii) Derivative market increase liquidity in the market.

The negative impact of derivative markets:
The derivative market trading primarily covers excess speculation and off-balance trading. Increased leverage effect, and difficulties for financial regulators owing to the complexity and variation of financial derivatives transactions ...

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