Series 65: Unit 4 Quiz 2

The term derivative would apply to all of the following except A. forwards B. hedge funds C. options D. futures

Hedge funds

Which one of the following option positions would generally command the greatest time value? A. Calls B. Straddles C. Puts D. LEAPS

LEAPS LEAPS, the acronym for long-term equity anticipation securities, have expiration dates that can run more than three years compared with the nine months for standard option contracts. Because time value is a direct function of the length of the option, the longer the time until expiry, the greater the potential time value.

Covered call writing is a strategy where an investor A. buys two calls on the same security he owns to leverage the position. B. buys a call on a security he has sold short. C. sells a call on a security he owns to reduce the volatility of the stock's returns and to generate income with the premium. D. sells a call on an index that contains some of the securities that he has in his portfolio.

Sells a call on a security he owns to reduce the volatility of the stock's returns and to generate income w/ the premium A covered call is simply defined as an investor owning 100 shares of the underlying stock for each option written (sold). The premium received is not only a source of income but also serves to provide downside protection to the extent of the amount received.

Standardized equity options are issued by A. the Options Clearing Corporation (OCC). B. all of these. C. the issuer of the underlying security. D. the Chicago Board Options Exchange (CBOE).

The Options Clearing Corporation (OCC) Standardized equity options are issued and guaranteed by the OCC. They are traded on the CBOE and other exchanges. The issuer of the underlying stock is not involved in any way.

An investor would write a call option to A. protect the premium. B. obtain income. C. seek long-term capital gain. D. fix the purchase price to add stock to his portfolio.

Obtain income The writing (selling) of an option always generates premium income to the writer. If the call is exercised, the writer must sell the stock, so this is not a way to add to your portfolio. In general, option writers only realize short-term gains, not long-term gains. If the question had said this was a covered call, then the second best choice would have been to protect the long position (not the premium).

Which of the following is not considered a derivative? A. Unit investment trust B. Call option C. Futures contract D. Warrant

Unit investment trust All of the other choices "derive" their value from some underlying asset. A UIT is an investment company, and its value is based on its own assets.

Kurt expects a certain stock to significantly rise in value in the near future. He is expecting a bond to mature in two months and does not want to miss out on any appreciation on the stock while waiting for the funds to become available. Which of the following would be the best option strategy for Kurt? A. Sell a call option. B. Buy a put option. C. Buy a call option. D. Sell a put option.

Buy a call option Kurt can lock in the price of the stock by purchasing a call option with an expiration date exceeding two months. Remember the phrase call up. If you think the stock's price is going up, buy a call.

Which of the following statements regarding derivative securities is not true? A. An option contract is a derivative security because it has no value independent of the value of an underlying security. B. Derivative securities can be sold on listed exchanges or in the over-the-counter market. C. An owner of a put has the obligation to purchase securities at a designated price (the strike price) before a specified date (the expiration date). D. An option contract's price fluctuates in relationship to the time remaining to expiration as well as with the price movement of the underlying security.

An owner of a put has the obligation to purchase securities at a designated price (the strike price) before a specified date (the expiration date) An owner of a put has the right—not the obligation—to sell, not purchase, a security at a designated price (the strike price) before a specified date (the expiration date). Although this exam deals exclusively with listed equity options, there are options traded in the OTC market. Two of the factors affecting the market price of an option (its premium) are the length of time until expiration (the longer the time, the greater the time value) and whether or not the option has intrinsic value (the difference between the stock price and the market price).

One of your clients purchases a European-style put option on a stock. The premium is $3 and the exercise price is $35. If the price of the underlying asset is $40 on the exercise date, the client has A. made $500. B. lost $300. C. made $200. D. lost $200.

Lost $300 This option is out of the money and is therefore worthless. Remember, European-style options are exercisable only at expiration, and a $35 put is worth nothing unless the market price of the underlying asset is less than $35. As is the case with any long option position, the maximum loss is the premium paid.

Which of the following are characteristics of newly issued warrants? A. Time value but no intrinsic value B. Time value and intrinsic value C. Intrinsic value but no time value D. No intrinsic value and no time value

Time value but no intrinsic value Warrants can be thought of as call options with a long expiration period. They are always issued with a strike price in excess of the current market value, so there is no intrinsic value. One could say that, on issuance, they are always out of the money. The only value is in the time to expiration—usually several years or longer.

An investor buys five put contracts with a strike price of $55 per share. The current price of the underlying stock is $60 and the option premium is $7. The commission schedule is as follows: Trade Amount Commission Rate ≤ $2,500 $35 + 0.9% of trade amount $2,501-$11,999 $35 + 0.7% of trade amount ≥ $12,000 $35 + 0.5% of trade amount Using the information provided, what is the total commission cost for this trade? A. $39.90 B. $199.50 C. $297.50 D. $59.50

$59.50 The cost per contract is $7 × 100 shares, or $700. That makes the total trade amount $700 × 5 contracts, or $3,500, which qualifies for the commission rate of $35 + 0.7% of the trade amount. The math is $35 + (0.7% of $3,500) = $35 + (0.7% × $3,500) = $35 + $24.50 = $59.50 total charge.

A financial instrument whose value depends upon the value of another asset is known as A. a security. B. a derivative. C. a commodity. D. an investment contract.

A derivative The definition of a derivative is that its value is based on some underlying asset. Included in the term are options, forwards, futures, and convertible securities. Some derivatives are securities, such as options on stock, while others such as forwards and futures contracts are specifically excluded from the definition of a security.

Braydon has received preemptive rights from one of the stocks held in his portfolio. Which of the following is not an alternative regarding these stock rights? A. Selling at the market B. Redeeming them from the issuer for cash C. Giving the rights to his son D. Exercising

Redeeming them from the issuer for cash Rights are not redeemable by the issuer. They may be sold in the secondary market or given to someone else to exercise. If exercised, rights are exchanged for an appropriate number of shares of the underlying common stock.

In May, an investor purchased a futures contract to purchase 5,000 bushels of wheat at $4.30 per bushel for December delivery. On settlement date, the spot price of wheat is $4.20 per bushel. For the investor, this A. represents a loss of $500. B. contract should be left to expire. C. represents a loss of $50. D. represents a successful hedge.

Represents a loss of $500 Unlike options, both parties to a futures contract are obligated to perform. That is, the buyer must accept delivery of the contract (in this case, 5,000 bushels of wheat). In practical matters, instead of having a truck show up at the door, the wheat would be sold at its spot price to a user. Therefore, the investor would lose 10 cents per bushel, which on 5,000 bushels is $500. It was the seller of the contract who had a successful hedge because, instead of having to sell at the $4.20 spot price, the wheat is sold at the strike price of $4.30.

An investor who is long a put option for 100 shares of ABC common stock has the right to A. buy 100 shares at the stated exercise price. B. sell 100 shares at the stated exercise price. C. buy 100 shares at the lower of the exercise or market price. D. sell 100 shares at the higher of the exercise or market price.

Sell 100 shares at the stated exercise price

All of the following pay dividends except A. warrants. B. preferred stock. C. convertible preferred stock. D. common stock.

Warrants Warrants do not pay dividends; the other instruments listed pay dividends when declared by the board of directors.

For which of the following is there no active secondary market? A. Futures contracts B. Forward contracts C. ETFs D. Options

Forward contracts One of the disadvantages when investing in forward contracts is that there is no active secondary market. Because each contract is between one buyer and one seller and there is no standardization, no exchange trading is possible.

A farmer who produces soybeans believes that this year's crop will be the biggest ever. The farmer would most likely hedge this risk by A. going short soybean forwards. B. going short soybean futures. C. going long soybean forwards. D. going long soybean futures.

Going short soybean forwards A big crop means more supply and lower prices when the crop is harvested. Hedging involves taking an opposite position (benefiting if prices fall). If the farmer is correct, selling short at today's price will enable delivery in the future at that higher price. Because this is a producer who will have product to deliver, forwards are likely to be more appropriate than futures.

Rank the following securities from the same issuer from most suitable to least suitable for a client whose primary objective is income. 1. Cumulative preferred stock 2. Convertible preferred stock 3. Common stock 4. Warrant

1. Cumulative preferred stock 2. Convertible preferred stock 3. Common stock 4. Warrant For a client seeking income, preferred stock, especially one that is cumulative, would likely be the most suitable of the choices given. Convertible preferred stock generally pays a lower dividend rate than other preferred stocks. This is because of the attractiveness of the convertibility. Although there are some categories of common stock (e.g., utility stocks that pay liberal dividends), unless specifically mentioned, you can assume that preferred stock dividends are higher than those for common stock of the same issuer. Warrants never provide any income.

Which of the following definitions involving derivatives is inaccurate? A. A long straddle consists of a long call and a long put on the same underlying stock with the same strike price and the same expiration date. B. A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period. C. The seller of a put option has a neutral outlook. D. An option writer is the seller of an option.

A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period A call option gives the owner the right to buy the underlying security at a specific price for a specified time period. Writers of put options are neutral to bullish; it is the put buyers who are bearish. A short straddle is the opposite of a long straddle—it is a short call and a short put on the same underlying stock with the same strike price and the same expiration date.

News reports indicate that the wheat crop scheduled to be harvested in three months will be much larger than normal. To hedge, a wheat farmer would most likely A. grow corn instead. B. take a short position in wheat futures. C. sell wheat stock short. D. take a long position in wheat futures.

Take a short position in wheat futures

The long party to a put option contract has A. the obligation to buy the underlying asset. B. the right to buy the underlying asset. C. the right to sell the underlying asset. D. the obligation to sell the underlying asset.

The right to sell the underlying asset Being long a put option means owning the option. Owners have rights, while sellers have obligations. A put option gives the owner the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price if the buyer exercises the option.

The RIF Corporation would not be able to issue A. RIF common stock. B. RIF rights. C. RIF warrants. D. RIF call options.

RIF call options Options contracts are not issued by the underlying asset. Technically, listed options (the only type that will be on the exam) are issued by the Options Clearing Corporation (OCC). A corporation issues common stock and can issue rights (preemptive rights) and/or warrants.

The writer of a call option A. is obligated to buy the underlying asset. B. receives the premium. C. has the right to sell the underlying asset. D. pays the premium.

Receives the premium The option premium is the money paid by the buyer of an option to the writer at the beginning of the options contract. That trade settles in T+1 and the premium paid is not refundable. Hence, the call writer would receive the premium. In turn, the call writer is obligated to sell the underlying at the exercise price to the call buyer.

In contrast with a typical forwards contract, futures contracts have A. less liquidity. B. greater counterparty risk. C. nonstandard terms. D. standardized terms.

Standardized terms Futures are contracts that trade on exchanges and have standardized terms, in contrast with forwards contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Because futures contracts trade on organized exchanges and have standardized terms, they are more liquid than forwards contracts.

A farmer entered into a forward contract to sell his produce at $2.25 per bushel. At the expiration date of the contract, the price was $2.00 per bushel. The farmer would receive A. $2.125 per contract. B. $2.00. C. $2.25. D. a price negotiated between the buyer and the seller.

$2.25 The reason the farmer entered into this contract was to hedge against a drop in price. Because the strike price was higher than the market price at expiration, the farmer made a good deal, while the buyer of the contract lost.

One of the differences between call options, rights, and warrants is that A. rights generally have the longest "life" of these three. B. holders of call options stand to profit if the market price of the underlying stock increases. C. warrants generally have a strike price below the current market value of the underlying stock. D. a corporation can't issue call options on its own stock.

A corporation can't issue call options on its own stock Although a corporation can issue stock rights and warrants, they cannot issue call options. Listed call options (the only type that will be on the exam), are issued by the Options Clearing Corporation (OCC). Although there are call options with weekly expiration, most expire in 9 months and rights rarely have a life longer than 45 days. Warrants, which generally have the longest time until expiration, are always issued with a strike price above the current market value of the underlying stock. At issuance, they only have time value. It is true that holders of call options stand to profit if the market price of the underlying stock increases, but so do the other two—they do not differ in that respect.

You have a client who is bullish on XYZ stock and currently owns 100 shares that last traded at $50. He has a CD coming due in March, six months from now, and is afraid that by the time those funds are available, XYZ will have shot up in price. How can he ensure that he'll be able to pick up the stock at today's price six months from now and not miss out on that market appreciation? A. Sell an XYZ March 50 put option. B. Buy an XYZ March 50 call option. C. Buy an XYZ March 50 put option. D. Buy XYZ stock rights.

Buy an XYZ March 50 call option A call option gives the holder the right, but not the obligation, to purchase shares of the underlying stock at the exercise price until the expiration date. Owning a March 50 call means that any time between now and the expiration date in March, the investor could exercise the option and purchase 100 shares per contract at $50 per share. If the stock doesn't rise in price, the investor can allow the option to expire. Buying a put option would be a good choice if the question asked, "How can the client protect against a market decline?" Selling a put obligates the client to buy the stock at $50, but that would only be exercised if the stock's price fell; this is not something this client would want to do. Stock rights would never run as long as six months.

All of the following statements regarding futures contracts are correct except A. a short position will increase in value if the underlying commodity or asset declines in value. B. completing a futures contract requires the delivery of the commodity. C. purchasing a contract for future delivery is considered taking a long position. D. futures contracts can be written on financial assets or commodities.

Completing a futures contract requires the delivery of the commodity In almost all cases, the holder of the futures contract will purchase an offsetting contract canceling the original position or sell the contract prior to expiration. In isolated cases, delivery of the commodity may be made but is not required. Futures contracts can be written on financial assets such as currencies and stock indexes, as well as on commodities such as agricultural products or precious metals. As with anyone taking a short position, the value goes up when the price of the underlying asset declines. And, just as purchasing a stock or bond, a long position represents one of ownership.

An investor who is long XYZ stock would consider going long an XYZ call to A. hedge the long position. B. protect against an increase in the market price of XYZ stock. C. obtain income from the premium. D. protect against a decrease in the market price of XYZ stock.

Protect against an increase in the market price of XYZ stock Going long a call means that you have bought it. Only sellers of options generate income. If you wish to hedge your long stock position, you buy a put, not a call. That leaves us with two choices that are polar opposites. Good test-taking skills teach us that, in almost all cases, when we see that, one of those must be the right answer. Buying a call is bullish. Forget the first part (you are long the stock). You would buy a call so that, if the price of the stock went up, you could exercise at the lower strike price of your call option.

An investment adviser representative attends a seminar discussing derivative investments. It would be unlikely that there would be any mention of A. futures. B. call options. C. REITs. D. warrants.

REITs REITs are not derivatives, but options (both puts and calls), futures (and forwards), and warrants (and stock rights) are.

When contrasting preemptive rights and warrants, it would be correct to state that, at issuance, A. rights have intrinsic and time value while warrants only have intrinsic value. B. rights have intrinsic and time value while warrants only have time value. C. rights have time value while warrants have intrinsic and time value. D. rights have intrinsic value while warrants have intrinsic and time value.

Rights have intrinsic and time value while warrants only have time value

A speculator, believing that a drought in the Midwest will lead to a weak corn crop, would probably A. take a long position in orange juice futures. B. take a short position in corn futures. C. take a long position in corn forwards. D. take a long position in corn futures.

Take a long position in corn futures A weak corn crop means a shortage in the supply. That will lead to an increase in prices. When one is speculating that prices will go up, the best position is a long one. So, why not the long forwards? Those who purchase forward contracts anticipate accepting delivery of the asset. This individual is merely speculating and has no interest in taking physical possession of the commodity and paying for transportation, silage, and insurance until the commodity is sold. If the person in the question had been a user of corn (a cereal maker, for example), then the forward contract would have been a better choice.

Included in the definition of derivative would be all of the following except A. rights. B. futures. C. options. D. leveraged ETFs.

Leveraged ETFs

An investor purchased a Mosaks, Inc., put option with a strike price of $105. If Mosaks' stock price is $115 at expiration, the value of the put option is A. $105. B. $10. C. -$10. D. $0.

$0 The put has a value of $0 because it will not be exercised. Why would you want to exercise (sell the stock) at $105 per share when the current market value is $115?

An investor purchases two PMJ Dec 16 calls at $0.85. If the commission charge is $8, the total cost is A. $178. B. $93. C. $328. D. $188.

$178 A premium of 85 cents per share means each contract has a cost of $85. There are two of them, making that $170. Adding the $8 commission brings the total to $178.

If a call option with an exercise price of $50 is purchased for $300, the maximum amount the investor can lose is A. $4,700. B. $5,000. C. unlimited. D. $300.

$300 Think about it—you bought something for $300 (the premium on an option is per 100 shares). What is the most you can ever lose with anything of any type that you pay $300 for? Your purchase price!

A European-style option differs from an American-style option primarily in that it A. can only be exercised on its expiration date. B. is primarily used for options on foreign securities. C. derives its value from some underlying asset. D. is generally offered with a limited number of expiration dates.

Can only be exercised on its expiration date

A commodities speculator purchases a 1,000-bushel wheat futures contract at 50 cents per bushel. At expiration, the settlement price is 45 cents per bushel. This individual A. has a $50 gain. B. has a $50 loss. C. must make delivery of the wheat. D. effectively hedged the long wheat position.

Has a $50 loss

Nonsecurities derivatives would include which of these? 1. Forward contracts 2. Futures contracts 3. Hedge funds 4. REITs

Forward and futures contracts Forward contracts and futures contracts are known as nonsecurities derivatives because they derive their value from something that is not a security. REITs and hedge funds are securities, not derivatives.

A purchaser of which of the following investments has an obligation? A. Options B. Stock rights C. Warrants D. Forwards

Forwards It is only in the case of forward contracts that the buyer (and seller) are both obligated to complete the contract. Holders of options have the right to exercise but are not obligated to do so. The same is true of stock rights and warrants.

An option that may be exercised before its expiration date is said to be A. European style. B. American style. C. Premature style. D. Flexible style.

American style There are two forms of option exercise—American and European. American style can be operationally exercised any day that the market is open before the expiration date. With European style, the only time you can operationally exercise your contract is the last trading day before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

One way in which futures contracts differ from options contracts is that A. both parties are obligated on futures contracts whereas only the buyer is obligated on an options contract. B. only the seller is obligated on a futures contract whereas both parties are obligated on options contracts. C. both parties are obligated on futures contracts whereas only the seller is obligated on an options contract. D. only the buyer is obligated on a futures contract whereas only the seller is obligated on an options contract.

Both parties are obligated on futures contracts whereas only the seller is obligated on an options contract Unlike options contracts, where only the seller of the option is obligated to perform (if the option is exercised), both parties to a futures contract are obligated to fulfill the terms.

An investor has been following the price movements of ABC common stock and believes that the stock is positioned for a significant upward move in the very near term. If the investor's goal is capital gains, which of the following would be the most appropriate position for this investor to take? A. Sell ABC put options. B. Buy ABC put options. C. Sell ABC call options. D. Buy ABC call options.

Buy ABC call options When an investor is expecting the price of a security to rise, we say that investor has a bullish outlook. Bulls buy call options, especially when the expected market move is anticipated shortly. Put options are purchased by investors who are of the belief that a stock's price will decline in the near term. Selling options is done for income (the premium), not for capital gains.

All of the following are exchange traded EXCEPT: A. futures contract. B. index options. C. ETFs. D. forward contracts.

Forward contracts Forward contracts are a one-to-one investment where the buyer and seller set the terms of the deal. Lack of standardization makes exchange trading an impossibility.

Which of the following would not be considered derivatives? A. Warrants B. Forwards C. Options D. ETFs

ETFs ETFs are investment companies (exchange-traded funds) and are not included in the definition of derivative.

An investor would exercise a put option when A. the current premium is higher than the initial cost. B. the market price of the stock is below the strike price. C. the market price of the stock is above the strike price. D. the market price of the stock is equal to the strike price.

The market price of the stock is below the strike price A put option gives its owner the right to sell the underlying security at a specified price (strike price) for a specified time period. When the stock's price is less than the strike price, a put option has value and is said to be in the money.

Which of these would be specified in an exchange-traded futures contract? 1. The quantity of the underlying asset 2. The quality of the underlying asset 3. The time of delivery of the underlying asset 4. The location of delivery of the underlying asset

The quantity of the underlying asset, the quality of the underlying asset, the time of delivery of the underlying asset, and the location of delivery of the underlying asset Typically, there are five standardized parts to an exchange-traded futures contract: - Quantity of the commodity (e.g., 5,000 bushels of corn or 100 oz. of gold) - Quality of the commodity (specific grade or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades) - Delivery price (similar to exercise or strike price with options) - Time for delivery (e.g., December wheat to be delivered) - Location (approved for delivery)