Types & Characteristics of Derivative Securities - Unit 16

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

A) 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

An investor purchases two PMJ Dec 16 calls at $.85. If the commission charge is $8, the total cost is A) $178. B) $93. C) $188. D) $328.

A) $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.

News reports indicate that the wheat crop scheduled to be harvested in 3 months will be much larger than normal. To hedge, a wheat farmer would most likely A) take a long position in wheat futures. B) sell wheat stocks short. C) grow corn instead. D) take a short position in wheat futures

D) take a short position in wheat futures A bumper crop means lower prices for the producers (farmers). The appropriate protection is a short hedge - selling wheat futures. Think of it this way - if you thought a stock's price was going to decline, you would sell that stock short. Here, believing that wheat prices will decline, you take a short position in that commodity futures contract. There is no such thing as wheat stock and the wheat has already been planted; it is too late to switch crops.

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

D) 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.

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

B) LEAPS LEAPS, the acronym for long-term equity anticipation securities, have expiration dates that can run more than 3 years compared with the 9 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.

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

C) Time value, but no intrinsic value Warrants could 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.

Traders in stock index options are exposed to A) credit risk B) systematic risk C) redemption risk D) call risk

B) systematic risk Systematic risk is the possibility that an overall decline in the market will cause a loss in an investment. Index options investors are exposed to the risk that market movement will cause the option positions to move adversely.

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

B) 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.

All of the following pay dividends EXCEPT A) convertible preferred stock B) warrants C) common stock D) preferred stock

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

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

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

An investor owns five DEF call options with a strike price of $40. The options are European style. If the holder exercises, the cost will be A) $20,000. B) zero because European options are exercisable only at expiration. C) $2,000. D) $4,000.

A) $20,000 Each option contract represents 100 shares. Exercising five call options means buying 500 shares at a price of $40 each, which equals $20,000. Although it is true that European-style options are exercisable only at expiration, nothing in the question indicates the investor tried to exercise before then.

Nonsecurities derivatives include futures and forwards. Among the differences between futures and forwards is that futures contracts A) are not regulated by the CFTC while forwards are. B) are rarely exercised while forwards generally are. C) are nonstandardized while forwards are. D) are preferred to forwards by producers.

B) are rarely exercised while forwards generally are In the vast majority of the cases, futures contracts are closed out prior to expiration. That is one reason they are more popular with speculators than forwards. Because forwards are generally delivered, they are the preferred tool by producers and it is futures which are standardized and CFTC regulates, not forwards.

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

D) 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.

Which of the following statements is most accurate when describing equity straddle options? I. The option buyer is looking for market volatility. II. The option buyer is looking for market stability. III. The option seller is looking for market volatility. IV. The option seller is looking for market stability. A) II and IV B) I and III C) II and III D) I and IV

D) I and IV A straddle is the combination of a put and a call on the same stock with the same strike prices and expiration dates. The solution to the question is the same for any option position in that option buyers need price movement and option sellers make money from stability. In the case of a straddle, a buyer is expecting sharp movement but does not know the direction of the move. The seller of the straddle will benefit if there is no significant price movement.

An investor will likely exercise a put option when the price of the stock is A) above the strike price. B) at the strike price. C) above the strike price plus the premium. D) below the strike price.

D) below the strike price. First of all, we know this investor is long the put. How? Because only those who own options (are long) can decide to exercise. The owner of a put (long put) profits when the stock falls. The put would be exercised when the price of the stock is below the strike price. For example, if this is a 50 put, the investor has the right to exercise and sell the stock at $50 per share. That is a benefit when the market price of the stock is below 50 and the lower the better. Remember the phrase "put down" because a put option becomes valuable to the holder when the market price goes below the exercise (strike) price.

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 call options B) Buy ABC call options C) Sell ABC put options D) Buy ABC put options

B) 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.

Mark's company, which is located in Oregon, makes unfinished wood furniture. His company sells this furniture directly to the public from a large warehouse. Theresa's company, which is located in southern Georgia, grows cotton for t- shirts manufacturers. Which of the following statements correctly identifies hedging strategies for Mark and Theresa? I. Mark should buy lumber futures. II. Theresa should sell cotton futures. III. Mark should sell lumber futures. IV. Theresa should buy cotton futures. A) I and II B) I and IV C) III and IV D) II and III

A) I and II Mark is "short" lumber because he needs lumber to produce his products. A hedge position for Mark would be to go long lumber futures, that is, to purchase lumber futures. Theresa is "long" cotton because she owns cotton for manufacturing purposes. A hedge position for Theresa is to go short, that is, to sell cotton futures.

All of the following positions expose a customer to unlimited risk EXCEPT A) Short 2 XYZ uncovered calls B) Short 2 XYZ uncovered puts C) Short 200 shares of XYZ D) Short 200 shares of XYZ and short 2 XYZ puts

B) Short 2 XYZ uncovered puts A put writer will lose money if the stock goes down, but the furthest it can drop is to zero. Therefore, the potential loss is not unlimited. All of the other positions expose the client to unlimited risk because a loss will occur if the stock price rises.

Which of the following statements regarding derivative securities is NOT true? A) Derivative securities can be sold on listed exchanges or in the over-the-counter market. B) 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. 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 is a derivative security because it has no value independent of the value of an underlying security.

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). 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).

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

A) 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.

An investor wishes to be able to obtain the right, but not the obligation, to purchase 100 shares of KAPCO common stock at $50 per share for the next 6 months. KAPCO is currently selling for $52 per share. This investor's wishes could be met by A) the purchase of a forward contract B) the purchase of a call option C) the purchase of a pre-emptive right D) the sale of a put option

B) the purchase of a call option A call option gives the holder the right, but not the obligation, to buy an asset at a specific price during a specific period. Although it would be possible to purchase a stock right in the open market, it is unlikely to ever find one with an expiration date more than 45 days from issuance. Selling a put creates an obligation on the seller to buy the stock if the option is exercised and there are no forward contracts on stock.

A commodities speculator purchases a 1,000-bushel wheat futures contract for 75 cents per bushel. At expiration, the settlement price is 85 cents per bushel. This individual A) must make delivery of the wheat B) has a $100 loss C) effectively hedged the long wheat position D) has a $100 gain

D) has a $100 gain The simple math is this: The individual bought at 75 cents and sold at 85 cents, making 10 cents per bushel. Multiply 10 cents ($.10) by 1,000 bushels and the gain is $100. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of) the wheat.

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

A) 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

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

A) 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 forwards 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.

A client calls to say he has just read about a European option and doesn't know what it is. You would explain that it is a derivative because A) its value is based on some underlying asset B) intrinsic value does not affect the premium C) the currency used is generally something other than the U.S. dollar D) it can only be exercised on the expiration date

A) its value is based on some underlying asset Although the unique characteristic of a European option is that it can only be exercised on its expiration date, that doesn't answer this question. It is a derivative like any other option because its value is based on the underlying asset.

A member of the investment banking department of ABC Securities is explaining some of the advantages and disadvantages of rights and warrants to the board of directors of XYZ Corporation. Which of the following statements could he make? I. The exercise prices of stock rights are usually below the current market price of the underlying security at time of issue. II. The exercise prices of warrants are usually above the current market price of the underlying security at time of issue. III. Both rights and warrants may trade in the secondary market and may have prices that include a speculative (time) value. IV. Warrants are often issued attached to a bond issue to reduce the interest costs to the issuer. A) I only B) I, II, III, and IV C) I and II D) I, II, and III

B) I, II, III, and IV All are true statements. The exercise prices of stock rights are usually below the current market price of the underlying security at time of issue. The exercise prices of warrants are usually above the current market price of the underlying security at time of issue. Both rights and warrants may trade in the secondary market and may have prices that include a speculative (time) value. Warrants are often issued attached to a bond issue to reduce the interest costs to the issuer.

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

D) 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

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

B) $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!

One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing the following risks: I. Liquidity II. Creditworthiness of the buyer III. Lack of assurance that the delivery price will remain stable IV. The location for the delivery may change A) II and III B) I and IV C) I and II D) III and IV

C) I and II Because there is no standardization for forward contracts, they are considered to be illiquid. Because there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract, as is the method, location, and time of delivery.

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) must make delivery of the wheat C) has a $50 loss D) effectively hedged the long wheat position

C) has a $50 loss The simple math is, the individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($.05) by 1,000 bushels and the loss is $50. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of) the wheat.

When contrasting call options, preemptive rights, and warrants, it would be correct to state A) only call options are traded on listed exchanges. B) only call options and warrants have time value. C) only preemptive rights and warrants are issued by the underlying corporation. D) all of these are issued by the underlying corporation.

C) only preemptive rights and warrants are issued by the underlying corporation. Corporations issue preemptive rights (if called for in the corporate charter) when issuing additional shares. Warrants are issued by corporations usually as a sweetener to make a bond issue more attractive. Call options are issued by the options exchanges, not the underlying corporation. All three of these products trade on listed exchanges and all of them have time value with warrants generally having the longest expiration date.

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

A) both parties are obligated on futures contracts where 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.

Which of the following definitions involving derivatives is inaccurate? A) An option writer is the seller of an option. 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) 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. 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.

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

B) leveraged ETFs ETFs, whether leveraged or not, are investment companies and are not included in the definition of derivative.

Which of the following financial instruments is NOT a derivative? A) LEAPS B) A put option C) A call option D) A share of stock

D) A share of stock A derivative is a type of financial instrument that derives its value from another asset or combination of assets. The best known examples of derivatives are options, of which puts, calls, and LEAPS are examples.

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, 6 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 6 months from now and not miss out on that market appreciation? A) Buy an XYZ March 50 put option B) Sell an XYZ March 50 put option C) Buy XYZ stock rights D) Buy an XYZ March 50 call option

D) 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 6 months.

Which of the following investments would NOT be considered an exchange-traded derivative? A) Warrants B) Options C) Futures D) Forwards

D) Forwards Forwards are never traded on an exchange; the other 3 choices can be traded OTC or on an exchange

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

D) 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.

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

D) 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.

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