Unit 4: Types and Characteristics of Derivative Securities

Which of the following statements is true? A) A futures contract has standardized terms. B) Unlike forwards, futures are not traded on an exchange. C) A futures contract always requires delivery of an asset. D) A futures contract does not involve obligations to buy or sell an asset.

A) 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.

Which of the following are characteristics of newly issued warrants?

A) 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.

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 rights are marketable. D) the subscription price is below the current market value.

A) the subscription period is up to two years. Rights offerings are usually very short-lived (30 to 45 days).

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.

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.

The term sweetener would most often apply to A) derivatives. B) rights. C) warrants. D) convertibles.

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 expiry date which 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.

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

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

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

In general, the value of a derivative is primarily determined by 1. the price volatility of the underlying asset. 2. the exchange on which it is traded. 3. the length of time until the contract expires. 4. whether it is purchased from a broker or a dealer

I and III 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).

Which of the following statements is most accurate when describing equity straddle options? 1. The option buyer is looking for market volatility. 2. The option buyer is looking for market stability. 3. The option seller is looking for market volatility. 4. The option seller is looking for market stability.

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.

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

Buying a put option on a security one currently owns allows an investor to A) participate in additional gains if the security continues to increase in price. B) increase his profit if the security declines in price. C) buy more stock if he exercises the put. D) receive the premium for the purchase of the put.

A) 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 remains in the account at the higher market price. The investor could hold the stock or sell it at the higher market price and in either case, the investor continues 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 buyers pay the premium; they do not receive it. And exercising a put gives the holder the right to sell the stock not buy it. Perhaps viewing an example will help. The investor owns 100 shares of ABC stock currently trading at $50 per share. Wanting to protect against a drop in price, the investor purchases an ABC put option with a strike price of 50 and pays a premium of 3. If the stock's price rises to $60 per share by the expiration date, the put option will expire worthless (who wants to put [sell] stock at $50 when it is selling for $60?). In this case, the investor has paid a premium of 3 points to ensure that the stock can always be sold (during the life of the option) for a price of $50 while still having the opportunity to participate in future price increases of the stock. In our example, the investor has gained $7 per share (the difference between the increase from $50 to $60 less the premium paid for the option).