Series 65: Unit 4 Quiz 1

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

Can only be exercised on its expiration date

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

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.

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-shirt manufacturers. Which of the following statements correctly identify hedging strategies for Mark and Theresa? 1. Mark should buy lumber futures. 2. Theresa should sell cotton futures. 3. Mark should sell lumber futures. 4. Theresa should buy cotton futures.

Mark should buy lumber futures and Theresa should sell cotton futures 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.

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

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).

George owns XYZ stock. Based on recent analyst projections and George's own research, he believes XYZ's price will remain flat over the next few months. Accordingly, which strategy would George most likely employ? A. Sell a call option. B. Sell a put option. C. Buy a warrant. D. Buy a call option.

Sell a call option When the price is expected to stay flat, selling an option is a way to profit with little risk of the option being exercised. Why sell the call instead of the put? Because George owns the XYZ stock, this is a covered call and entails no downside risk. Selling the put would expose George to potentially significant loss if the price of XYZ should suffer a large decline.

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

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

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. Buy a put option. B. Sell a call option. C. Buy a call option. D. Sell a put option.

Buy a call option

The term derivative would not apply to which of the following? A. Forwards B. Warrants C. REITs D. Futures

REITs REITs are not based on the value of something other than their own assets. Warrants (and rights) derive their value from the underlying security. Futures and forwards are contracts whose value is based on some underlying asset.

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

Has a $50 loss The simple math is as follows: The individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($0.05) 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 contact, not long (the owner of) the wheat.

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. contract should be left to expire. B. represents a loss of $500. 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.

One of the differences between call options, rights, and warrants is that A. rights generally have the longest "life" of these three. B. warrants generally have a strike price below the current market value of the underlying stock. C. holders of call options stand to profit if the market price of the underlying stock increases. 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.

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 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). 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).

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. Buy XYZ stock rights. B. Buy an XYZ March 50 put option. C. Sell an XYZ March 50 put option. D. Buy an XYZ March 50 call option.

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.

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

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.

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 six months. KAPCO is currently selling for $52 per share. This investor's wishes could be met by A. the purchase of a call option. B. the purchase of a preemptive right. C. the purchase of a forward contract. D. the sale of a put option.

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.

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)

Which of the following investments would not be considered exchange-traded derivatives? A. Futures B. Options C. Forwards D. Warrants

Forwards Forwards are never traded on an exchange; the other choices can be traded OTC or on an exchange.

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

$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.

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. The seller of a put option has a neutral outlook. C. An option writer is the seller of an option. D. 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 sell the underlying asset a specific price for a specified time period

Bail Bonds, Inc., might issue warrants in connection with a bond issue for which of the following reasons? 1. As an inducement to make the bonds more marketable 2. To lower their interest cost on the issue 3. To increase the marketability of their common stock 4. To increase the number of common shares outstanding

As an inducement to make the bonds more marketable and to lower their interest cost on the issue Warrants permit the purchase of common stock of the issuer at a fixed price. A bond with warrants attached has more value than a straight bond and is more attractive (marketable) to investors. Attaching warrants to a bond issue usually permits the bonds to be issued with a lower interest rate.

If your customer owns 100 shares of a volatile stock and wants to limit downside risk, you may recommend A. buying puts B. shorting the same stock C. writing calls and selling puts D. buying calls

Buying puts Downside risk is reduced by purchasing a put with a strike price at or close to the stock's purchase price. Should the stock decline below the strike price, the investor can exercise the put at the strike price. Selling put options will increase the downside risk. Buying calls is a bullish strategy that increases downside risk. Shorting stock will lock in the current price but will limit upside potential.

An investor goes long one ABC May 45 Put @ 3 and short one ABC May 50 Put @ 6. This would be known as A. a combination B. a straddle C. a debit spread D. a credit spread

A credit spread A spread option position is a long and short position of the same type of option on the same stock with different strike prices or different expiration dates. In this case, the proceeds of $600 from the short position exceed the $300 cost of the long, giving the investor a credit of $300.

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

Which of the following would not be considered derivatives? A. Forward contracts B. An ETF tracking the Bloomberg Commodity Index C. Equity options D. Futures contracts

An ETF tracking the Bloomberg Commodity Index

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

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 goes short five soybean futures contracts on the Chicago Mercantile Exchange (CME). When the contract expires, A. only the seller is obligated to perform. B. only the buyer is obligated to perform. C. both the buyer and the seller are obligated to perform. D. only the exchange is obligated to perform.

Both the buyer and the seller are obligated to perform

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

The Options Clearing Corporation (OCC)

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

Completing a futures contract requires the delivery of the commodity

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. has a $100 loss. B. must make delivery of the wheat. C. has a $100 gain. D. effectively hedged the long wheat position.

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 ($0.10) 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.

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. the currency used is generally something other than the U.S. dollar. C. intrinsic value does not affect the premium. D. it can only be exercised on the expiration date.

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.

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

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

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 $200. B. lost $300. C. made $500. D. lost $200.

Lost $300

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

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 for 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.

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 and time value while warrants only have time value. C. rights have intrinsic and time value while warrants only have intrinsic 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

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. sell a put. B. buy a put. C. buy a call. D. sell a call.

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.

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

Which of the following is a multi-option strategy? A. Straddle B. Long call C. Short call D. Protective put

Straddle A straddle consists of a put and a call on the same stock with the same strike price and the same expiration date. If the investor has purchased both options, it is known as a long straddle; if they've both been sold (written), it is known as a short straddle. Therefore, with two option positions, it is a multi-option strategy.

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

Systematic risk Systematic risk is the possibility that an overall decline in the market will cause a loss in an investment. With index options, investors are exposed to the risk that market movement will cause the option positions to move adversely.

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

Take a long position in corn futures

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. take a long position in wheat futures. B. take a short position in wheat futures. C. sell wheat stock short. D. grow corn instead.

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.

Standardized equity options are issued and guaranteed by A. the Options Clearing Corporation (OCC). B. the Chicago Board Options Exchange (CBOE). C. the Commodities Futures Trading Commission (CFTC). D. the National Futures Association (NFA).

The Options Clearing Corporation (OCC) The OCC has the role of issuer and guarantor of all standardized equity options. That means if one party to an options contract fails to perform, the OCC steps in and takes that role (and then goes after the recalcitrant party).

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.

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.

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

The market price of the stock is below the strike price

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.

The term derivative would apply to which of the following? A. Warrants B. REITs C. UITs D. DPPs

Warrants A derivative has its value based upon some underlying asset. The value of a warrant is based on the value of the security into which it is exchangeable.