Unit 4
If a call option with an exercise price of $50 is purchased for $300, the maximum amount the investor can lose is: A) $300 B) $4,700 C) $5,000 D) unlimited
A) $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!
In general, the value of a derivative is primarily determined by which of the following? (2 answers) A) The price volatility of the underlying asset B) The exchange on which it is traded C) The length of time until the contract expires D) Whether it is purchased from a broker or a dealer
A) The price volatility of the underlying asset C) The length of time until the contract expires The two most important factors influencing the price of a derivative are the price movement (volatility) of the underlying asset and the length of time until the contract expires (the longer the time, the greater the time value).
The term derivative would apply to all of the following except: A) hedge funds B) forwards C) futures D) options
A) hedge funds Hedge funds are pooled investments, a form of investment company, and are not derivatives as are the other three choices. This is an example of a question where you get the correct answer by knowing the other three choices are not the exception.
All of the following are characteristics of a rights offering except: A) the subscription period is up to two years B) it is issued to current stockholders C) the subscription price is below the current market value D) the rights are marketable
A) the subscription period is up to two years Rights offerings are usually very short-lived (30 to 45 days).
Which of the following are characteristics of newly issued warrants? A) Intrinsic value but no time value B) Time value but no intrinsic value C) No intrinsic value and no time value D) Time value and intrinsic value
B) 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.
With respect to the specific commodity that is the subject of the contract, all of the following are standardized parts to an exchange-traded futures contract except: A) the quality B) the market price C) the quantity D) the time for delivery
B) the market price It is the delivery price that is standardized, not the market price (which is continuously fluctuating). Exchange-traded futures contracts offer standardized quantities and qualities (grade of the commodity), as well as a standardized time for delivery.
A client is long 400 shares of ABC common stock. The current market price of ABC is $150 per share. The client is of the opinion that the market is going to be moving sideways for a while and would like to generate additional income from the ABC stock. What strategy might you recommend? A) Write four ABC 150 put options B) Write an ABC 150 call option C) Write four ABC 150 call options D) Buy two ABC 150 put options and write two ABC 150 call options
C) Write four ABC 150 call options Writing call options on a long stock position (a covered call) is a common strategy for generating additional income from a stock holding. If the market moves sideways (neither up nor down), the option will likely expire unexercised and the client will earn the premium and still have the stock. Being long 400 shares would mean writing four contracts. Writing put options would generate premium income, but if the stock price falls, the writer could be exercised requiring the purchase of an additional 400 shares at $150 per share (the client really doesn't want to own 800 shares). If the client buys two options and sells two options, the premiums will likely offset each other and not help the client reach the objective of generating additional income.
The writer of a call option: A) pays the premium B) is obligated to buy the underlying asset C) receives the premium D) has the right to sell the underlying asset
C) 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.
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 forwards B) take a long position in orange juice futures C) take a long position in corn futures D) take a short position in corn futures
C) 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.
Which of the following investments would not be considered exchange-traded derivatives? A) Futures B) Warrants C) Options D) Forwards
D) Forwards Forwards are never traded on an exchange; the other choices can be traded OTC or on an exchange.
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) intrinsic value does not affect the premium B) it can only be exercised on the expiration date C) the currency used is generally something other than the U.S. dollar D) its value is based on some underlying asset
D) 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.
Rank the following securities from the same issuer from most suitable to least suitable for a client whose primary objective is income: Cumulative preferred stock Convertible preferred stock Common stock 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.
All of the following pay dividends except: A) preferred stock B) common stock C) warrants D) convertible preferred stock
C) warrants Warrants do not pay dividends; the other instruments listed pay dividends when declared by the board of directors.
An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to: A) buy a call B) sell a put C) buy a put D) sell a call
D) sell a call Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not staying steady in price.
Exercise of which of the following would not result in a change on the issuer's balance sheet? A) A call option B) Rights C) Convertible preferred stock D) Warrants
A) A call option When a call option is exercised, the strike price is paid to the seller of the option, not the issuer. The issuer is not involved in any way, so there is no effect on the company's financial statements. When the holder of a convertible preferred stock exercises the conversion privilege, the equity portion of the balance sheet shows a reduction in the preferred stock outstanding and an increase to the common stock outstanding. When rights or options are exercised, assets increase due to the cash paid for the stock and the equity portion of the balance sheet reflects an increase to the number of shares of common stock outstanding.
Which one of the following option positions would generally command the greatest time value? A) LEAPS B) Straddles C) Calls D) Puts
A) 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.
Options positions can create either rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Selling a put B) Purchasing a call C) Selling a call D) Purchasing a put
A) Selling a put When you sell (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is put to you. In the case of a call, you are obligated to sell stock that is called away from you. Options buyers have rights. They can choose what they wish to do; there are no obligations.
Which of the following statements is most accurate when describing equity straddle options? (2 answers) A) The option buyer is looking for market volatility B) The option buyer is looking for market stability C) The option seller is looking for market volatility D) The option seller is looking for market stability
A) The option buyer is looking for market volatility D) The option seller is looking for market stability 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.
Many investors with a long position in common stock employ the technique of writing call options on the underlying stock for the purpose of: A) generating income B) participating in the growth of the company C) protecting the premium D) increasing the dividend return
A) generating income A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. This action has no impact on the amount of the dividends received. It is the uncovered (or naked) call option that has unlimited risk.
A commodities speculator purchases a 1,000-bushel wheat futures contract at $0.50 per bushel. At expiration, the settlement price is $0.45 per bushel. This individual: A) has a $50 loss B) must make delivery of the wheat C) has a $50 gain D) effectively hedged the long wheat position
A) has a $50 loss The simple math is the individual bought at $0.50 and sold at $0.45, losing $0.05 per bushel. Multiplying $0.05 times 1,000 bushels shows 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.
An investor will likely exercise a put option when the price of the stock is: A) above the strike price B) below the strike price C) above the strike price plus the premium D) at the strike price
B) 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.
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) futures contracts can be written on financial assets or commodities D) purchasing a contract for future delivery is considered taking a long position
B) 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 was sure that a stock's price was going to move substantially but wasn't sure in which direction would be able to benefit by: A) purchasing the stock and a put on the stock B) purchasing a straddle on that stock C) selling the stock short and purchasing a call on the stock D) writing a straddle on that stock
B) purchasing a straddle on that stock Purchasing a straddle on a stock means going long a put and a call at the same strike price with the same exercise date. If the stock goes up, the investor profits on the call; if the stock goes down, the investor profits on the put. When an investor writes a straddle, a put and a call are sold at the same exercise price and expiration date. Short straddles profit when the stock price remains stable (the opposite of what is presented in this question). Taking a long position in a stock with a long put offers protection to the downside but no profit. Likewise, shorting a stock and taking a long position in a call offers protection to the upside but no profit.
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 successful hedge B) represents a loss of $500 C) represents a loss of $50 D) contract should be left to expire
B) 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.
All of the following positions expose a customer to unlimited risk except: A) short 200 shares of XYZ B) short 2 XYZ uncovered puts C) short 2 XYZ uncovered calls 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.
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
C) $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.
Which of the following definitions involving derivatives is inaccurate? A) An option writer is the seller of an option B) 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 C) A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period D) The seller of a put option has a neutral outlook
C) 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.
Which of the following statements is true? A) A futures contract does not involve obligations to buy or sell an asset B) Unlike forwards, futures are not traded on an exchange C) A futures contract has standardized terms D) A futures contract always requires delivery of an asset
C) A futures contract has standardized terms Futures contracts are traded on exchanges and, therefore, have standardized terms. In forwards, the terms of each contract are separately negotiated.
An option that may be exercised before its expiration date is said to be: A) European style B) Premature style C) American style D) Flexible style
C) 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.
Nonsecurities derivatives include futures and forwards. Among the differences between futures and forwards is that futures contracts: A) are nonstandardized, while forwards are B) are preferred to forwards by producers C) are rarely exercised, while forwards generally are D) are not regulated by the CFTC, while forwards are
C) 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 that are standardized and CFTC regulates, not forwards.
An investor goes short five soybean futures contracts on the Chicago Mercantile Exchange (CME). When the contract expires: A) only the buyer is obligated to perform B) only the exchange is obligated to perform C) both the buyer and the seller are obligated to perform D) only the seller is obligated to perform
C) both the buyer and the seller are obligated to perform Among the ways in which futures differ from options is that both parties, long and short, are obligated to execute the contract. At expiration date, if not exercised before, the buyer must purchase at the contract price and the seller must deliver at the contract price. In the case of options, the buyer (long position) is the one who chooses to exercise or not, and it is the seller (short position) who becomes obligated to perform.
You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wishes to use options to protect against unlimited loss, you would suggest the client: A) buy 1 RIF put B) sell 1 RIF call C) buy 1 RIF call D) sell 1 RIF put
C) buy 1 RIF call Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.
When contrasting call options, preemptive rights, and warrants, it would be correct to state: A) only call options are traded on listed exchanges B) all of these are issued by the underlying corporation C) only preemptive rights and warrants are issued by the underlying corporation D) only call options and warrants have time value
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 Clearing Corporation (OCC), 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.
Buying a put option on a security one currently owns allows an investor to: A) increase his profit if the security declines in price B) receive the premium for the purchase of the put C) participate in additional gains if the security continues to increase in price D) buy more stock if he exercises the put
C) participate in additional gains if the security continues to increase in price This is an example of a protective put, that is, purchasing a put option on a stock the investor already owns. This allows the stockholder to lock in a sale price (the strike price of the put). If the market price of the stock continues to rise, the investor would not exercise the put. The put would expire, and the long stock would remain in the account at the higher market price. The investor could hold the stock or sell it at the higher market price.In either case, the investor would continue to participate in the additional gains. The protection (the hedge) occurs if the price of the stock falls. Then the investor would be able to exercise the right to sell the stock at the strike price. That would offset the loss on the long position, not generate additional profit. Remember that options buyerspay the premium; they do not receive it. Exercising a put gives the holder the right to sell the stock, not buy it.
When contrasting preemptive rights and warrants, it would be correct to state that, at issuance: A) rights have time value while warrants have intrinsic and time value B) rights have intrinsic value while warrants have intrinsic and time value C) rights have intrinsic and time value while warrants only have time value D) rights have intrinsic and time value while warrants only have intrinsic value
C) rights have intrinsic and time value while warrants only have time value At the time of issuance, preemptive rights always offer the stock at a price below the current market, thus creating intrinsic value. Although rights rarely are effective for longer than 45-60 days, that does represent time value. On the other hand, warrants are always issued with an exercise price above the current market (no intrinsic value) but do have time value.
The term sweetener would most often apply to: A) rights B) convertibles C) warrants D) derivatives
C) warrants A warrant is a derivative that gives the holder the ability to acquire shares of common stock at a fixed price. At issuance, that price is always higher than the current market value of the stock, but warrants generally have a long expiration date that gives them great time value. When an issuer attaches warrants to a bond or preferred stock issue, they serve to sweeten the offering resulting in lower interest rates or dividends.
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) sell wheat stock short B) take a long position in wheat futures 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.
