Fight Finance

Suppose that the US government recently announced that subsidies for fresh milk producers will be gradually phased out over the next year. Newspapers say that there are expectations of a 40% increase in the spot price of fresh milk over the next year.

Option prices on fresh milk trading on the Chicago Mercantile Exchange (CME) reflect expectations of this 40% increase in spot prices over the next year. Similarly to the rest of the market, you believe that prices will rise by 40% over the next year.

What option trades are likely to be profitable, or to be more specific, result in a positive Net Present Value (NPV)?

Assume that:

• Only the spot price is expected to increase and there is no change in expected volatility or other variables that affect option prices.
• No taxes, transaction costs, information asymmetry, bid-ask spreads or other market frictions.

You believe that the price of a share will fall significantly very soon, but the rest of the market does not. The market thinks that the share price will remain the same. Assuming that your prediction will soon be true, which of the following trades is a bad idea? In other words, which trade will NOT make money or prevent losses?

An equity index fund manager controls a USD500 million diversified equity portfolio with a beta of 0.9. The equity manager expects a significant rally in equity prices next year. The market does not think that this will happen. If the fund manager wishes to increase his portfolio beta to 1.5, how many S&P500 futures should he buy?

The US market equity index is the S&P500. One year CME futures on the S&P500 currently trade at 2,155 points and the spot price is 2,180 points. Each point is worth $250.

The number of one year S&P500 futures contracts that the fund manager should buy is:

Which class of derivatives market trader is NOT principally focused on ‘buying low and selling high’?