Series 65, Unit 4: Derivatives

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

A & B.

What is the difference between American and European exercises?

American exercises can be exercised at any time before the expiration date. European exercises can only be exercised on the expiration date.

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. Buy 1 RIF call C. Sell 1 RIF put D. Sell 1 RIF call

B. Buy 1 RIF call

Among the purposes of purchasing derivatives would be all of the following except: A. hedging. B. income. C. profits. D. speculation.

B. Purchase of a derivative, whether an option, a forward, or a futures contract, never generates income. Selling one does, but the question refers to a purchaser, and that is why the correct answer is choice B.

Long =

Buyer, holder, owner

GEMCO Manufacturing Company, traded on the NYSE, has announced that it will be issuing 10 million new shares of common stock to raise new capital for the purchase of new equipment. Your client, owning 1,000 shares of GEMCO common stock, would probably receive: A. an advance invitation to purchase some of the new shares. B. options to purchase some of the new shares. C. preemptive rights to purchase some of the new shares. D. warrants to purchase some of the new shares.

C.

Exercise of which of the following would not result in a change on the issuer's balance sheet? A. Rights B. Warrants C. A call option D. Convertible preferred stock

C. A call option

Which of the following strategies would be considered most risky in a bull market? A. Writing naked puts B. Buying calls C. Writing naked calls d. Buying a put

C. Writing naked calls Writing naked calls provides unlimited liability and the most risk. Buying a call would be an attractive strategy in a bull market with risk limited to calls paid. Writing naked puts risks only the difference between the strike price and zero, less any premium received. Buying a put is a bearish strategy with risk limited to the amount paid for the put.

A ____________ option gives its holder the right to buy a stock for a specific price within a specified time frame. A call buyer buys the right to buy a specific stock, and a call seller takes on the obligation to sell the stock.

Call

Forwards & futures have the same characteristics are essentially regulated completed opposite of each other. "buyers take & sellers make"

Futures are standardized - forwards are unique Futures are liquid - forwards are illiquid Futures have 3rd party negotiators - forwards don't Futures are graded & uniform - forwards are custom Futures are speculatory - forwards are used by producers to hedge

Options are a popular tool for reducing investment risk. Which risk is hedged when a corporation buys call options on its own common stock?

Market Risk

Standardized equity options are issued and guaranteed by

Options Clearing Corporation (OCC)

What is the major difference between rights & warrants?

Options originate on the exchange on which they are traded whereas rights and warrants originate with the issuer of the stock.

Buying a put option on a security one currently owns allows an investor to

Participate in additional gains if the security continues to increase in price.

A ____________ option gives its holder the right to sell a stock for a specific price within a specified time frame. A put buyer buys the right to sell a specific stock, and a put seller takes on the obligation to buy the stock.

Put

Short =

Seller, Writer, Grantor

Why do investors buy puts?

The investor believes that a stock will decline in price

Why do investors write puts?

The investor believes that a stock will rise in price or remain stable

What is an option's cost?

The premium (plus any commissions from the brokerage)

Why do investors buy calls?

They expect a stock to increase in value

Why do investors write calls?

They expect the stock's price will stay the same or decline

One of the differences between call options, rights, and warrants is that

a corporation can't issues call options on its own stock.

Options strategies are either

bullish or bearish **call up, put down**

A clearing firm is the counterparty and guarantor of exchange-traded activity, acting as the buyer to all sellers and seller to all buyers. This eliminates _______________ risk when investing in futures contracts.

counterparty risk

A derivative's value is dependent on ...

the underlying asset

Each option has three standardized terms. What are they?

1. Underlying asset 2. Expiration Date 3. Exercise or Strike Price

(T/F) Futures & Forwards are regulated by the SEC

False The SRO (self regulatory organization) & CFTC (commodity futures trading commission) is in charge of regulation

What does "call up, put down" mean?

You would buy a call because you are hoping (or are afraid) the price of the stock will go up, and you would buy a put because you are hoping (or are afraid) the price of the stock will go down.

Many investors with a long position in common stock employ the technique of writing call options on the underlying stock for the purpose of

generating income

Option contracts offer investors a means ___________________ an investment's value or speculate on the price movement of individual securities, markets, foreign currencies, and other instruments

to hedge, or protect

What are some benefits to options?

- Leverage - Less Risk - Alternative to selling short - Hedging

What are some risks to options?

- Time decay - Taxation (taxed as ordinary income which is higher than short term cap gains)

What are some key points about warrants?

- exercisable at a price above market - life is considerably longer than rights/calls - can be detached and traded like a security - can be viewed as "call options with a long expiry" - do not have voting rights or dividends

What are some key points about rights?

- given (not sold) to existing shareholders - exercisable at a price below market - short lifespan, generally 45-60 days - can be sold & buyer can exercise them - can be left to expire, but that is unwise

What are the 2 most important factors affected the price of a derivative?

- price movement of the underlying asset - length of time until the contract expires

5 components of futures & forwards:

- quantity & quality of the commodity - time & place of delivery - price to be paid

How many shares does each stock option contract cover?

100 shares

How long is an option contract generally?

9 months

Which of the following statements regarding derivative securities is not true? A. Derivatives can be sold on securities and nonsecurities. B. An option contract is a derivative security because it has no value independent of the value of an underlying security. C. 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. D. 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.

What is the purpose of a straddle?

Those who buy a straddle will profit from volatility, while those who sell a straddle will profit if the market is stable because the options will expire unexercised.

(T/F) Futures are most commonly used by speculators, while forwards are used by producers. That explains why such a small percentage of futures contracts ever end with delivery.

True

(T/F) Opening option buyers are long the positions; opening option sellers are short the positions.

True

(T/F) You must remember that all options, regardless of their length, are derivative securities.

True