FINC 4450 Final Exam Review

What is the effect of an unexpected cash dividend on (a) a call option price and (b) a put optionprice?

An unexpected cash dividend would reduce the stock price on the ex-dividend date. This stock price reduction would not be anticipated by option holders. As a result there would be a reduction in the value of a call option and an increase the value of a put option. (Note that the terms of an option are adjusted or cash dividends only in exceptional circumstances.)

For equities it is usually assumed that the number of trading days in the year is: 365 252 262 272

252

______ option can only be exercised on the expiration date. A European A Mexican An Asian An American

A European

Which statement is true? The delta of a put option is positive Delta is a measure of the volatility of an option Rho of put option is positive Lamda of an option measures the percentage change in the option value for a one percentage point increase in the underlying asset.

Lamda of an option measures the percentage change in the option value for a one percentage point increase in the underlying asset.

A collar gives downside protection, leaving the upside open. True False

False

The market value of a swap is zero between settlement dates. True False

False

There are three breakeven stock prices in a butterfly spread. True False

False

The Black-Scholes-Merton model assumes stock returns following lognormal distribution T/F

False The Black-Scholes-Merton model assumes stock prices following lognormal distribution

In theory, it's possible that implied volatilities vary for options on the same stock with the same expiration and different exercise prices T/F

False - In theory implied volatilities should not vary for options on the same stock with the same expirationand different exercise prices

Please briefly explain the approach of Black's approximation for dealing with dividends inAmerican Call options

Find the 1st European price is for an option maturing at the same time as the American option; Find the 2nd European price is for an option maturing just before the final ex-dividend date; andSet the American price equal to the maximum of the above two European prices

Find the upcoming net payment in a plain vanilla interest rate swap in which the fixed party pays 10 percent and the floating rate for the upcoming payment is 9.5 percent. The notional amount is $20 million and payments are based on the assumption of 180 days in the payment period and 360 days in a year. floating payer pays $1 million fixed payer pays $1,950,000 floating payer pays $50,000 fixed payer pays $50,000 fixed payer pays $950,000

Fixed payment = $20,000,000 × 10% × (180/360) = $1,000,000 Floating payment = $20,000,000 × 9.5% × (180/360) = $950,000 Net payment = Fixed payment - Floating payment Net payment = $1,000,000 - $950,000 = $50,000 fixed payer

Which of the following are always positively related to the price of a European call option on astock (there are more than one choices) (a) The stock price (b) The strike price (c) The time to expiration (d) The volatility (e) The risk-free rate (f) The magnitude of dividends anticipated during the life of the option

a d e

Which of the following strategies has essentially the same shape of profit diagram as a covered call? a protective put a long put a long call a short put

a short put

Interest rate swap payments are made: on the first day of each month on the last day of the quarter at whatever dates are agreed upon by the counterparties on the 15th of the agreed-upon months on the last day of the month

at whatever dates are agreed upon by the counterparties

Which two statements are true (circle two) (a) Delta is a measure of the volatility of an option (b) Delta is a measure of the position in the underlying stock that should be taken to hedge an option (c) Delta is estimated by considering two adjacent nodes on a tree at a certain time and calculating the difference in option prices divided by the difference in the stock prices (d) The delta of a put option is positive

b c

The value of a pay-fixed, receive floating interest rate swap is found as the value of a None of all is correct floating-rate bond minus the value of a fixed-rate bond. floating-rate bond plus the value of a fixed-rate bond floating-rate bond times the value of a fixed-rate bond.

floating-rate bond minus the value of a fixed-rate bond.

Assume that current stock price=$28. An American put P (X=30) will expire in 6 months. The no-arbitrage price of this American put should be ____________$2. equal to lower than or equal to cannot be determined higher than or equal to

higher than or equal to

Assume that current stock price=$28. An out-of-money European call c (X=30) will expire in 6 months. The no-arbitrage price of this European call should be___________$0. cannot be determined lower than or equal to higher than or equal to equal to

higher than or equal to

Assume that current stock price=$28. An American Call C (X=20) will expire in 6 months. The no-arbitrage price of this American call should be_____________$28. lower than or equal to cannot be determined equal to higher than or equal to

lower than or equal to

Assume that current stock price=$28. An American put P (X=30) will expire in 6 months. The no-arbitrage price of this American put should be ___________$30. equal to higher than or equal to lower than or equal to cannot be determined

lower than or equal to

Which of the following transactions does not profit in a strong bull market. a short put a covered call a protective put none of these

none of these

Interest rate swaps can be used for all of the following purposes except: to hedge interest rate risk to borrow at the prime rate to convert a fixed-rate loan into a floating-rate loan to convert a floating-rate loan into a fixed-rate loan to speculate on interest rates

to borrow at the prime rate

If a trader buys a call and a put with same exercise prices, the trader believes that the market willbecome volatile T/F

True

The notional amount is never exchanged in an interest rate swap. True False

True

Which statement is true? Black-Scholes-Merton option pricing model assumes that the return on options trading is risk free. All are correct. Black-Scholes-Merton option pricing model is never useful for American options. Black-Scholes-Merton option pricing model is less useful for American put options than for American call options. None is correct.

Black-Scholes-Merton option pricing model is less useful for American put options than for American call options.

A stock price is currently 23 dollars. A reverse (i.e short) butterfly spread is created from options with strike prices of $20, 25, and 30. The gain when the stock price becomes 34 dollars is the same as the gain when the stock price is at 16 dollars. True False

True

An American call is exercised early only to capture a dividend T/F

True

The VIX index measures: Implied volatilities for stock options trading on the CBOE Historical volatilities for stock options trading on CBOE Implied volatilities for options trading on the S&P 500 index Historical volatilities for options trading on the S&P 500 index

Implied volatilities for options trading on the S&P 500 index

Why is the expected loss to a bank from a default on a swap less than the expected loss from thedefault on a loan to the counterparty with the same principal? Assume no other transactionsbetween the bank and the counterparty, that the swap is cleared bilaterally, and that no collateralis provided by the counterparty in the case of either the swap or the loan.

In an interest-rate swap a financial institution's exposure depends on the difference between a fixed-rate of interest and a floating-rate of interest. It has no exposure to the notional principal. Ina loan the whole principal can be lost.

An American put option is as value as or more valuable than an European put option. True False

True

When there are dividends: It is never optimal to exercise a call option early It can be optimal to exercise a call option at any time It is only ever optimal to exercise a call option immediately after an ex-dividend date None of the above

None of the above

When there are two dividends on a stock, Black's approximation sets the value of anAmerican call option equal to: The value of a European option maturing just before the first dividend The value of a European option maturing just before the second dividend The greater of the values in (a) and (b) None of the above

None of the above

Which of the following is true? A long call is the same as a short put A short call is the same as a long put None of the above A call on a stock plus a stock the same as a put

None of the above

n the Black-Scholes-Merton option pricing formula N(d1) denotes: The area under a normal distribution from zero to d1 The area under a normal distribution up to d1 The area under a normal distribution beyond d1 The area under the normal distribution between -d1 and d1

The area under a normal distribution up to d1

A bank finds that its assets are not matched with its liabilities. It is taking floating-rate deposits and making fixed-rate loans. How can swaps be used to offset the risk?

The bank is paying a floating-rate on the deposits and receiving a fixed-rate on the loans. It canoffset its risk by entering into interest rate swaps (with other financial institutions orcorporations) in which it contracts to pay fixed and receive floating.

A plain vanilla interest rate swap is equivalent to issuing a fixed-rate bond and using the proceeds to buy a floating-rate bond or vice versa. True False

True

Volatility can be defined as: The standard deviation of the return, measured with continuous compounding, in one year The variance of the return, measured with continuous compounding, in one year The standard deviation of the stock price in one year The variance of the stock price in one year

The standard deviation of the return, measured with continuous compounding, in one year

The Black-Scholes-Merton model assumes: The return from the stock in a short period of time is lognormal The stock price at a future time is lognormal The stock price at a future time is normal None of the above

The stock price at a future time is lognormal

An interest rate swap has two primary risks associated with it. Identify and explain each risk.

The two primary risks associated with interest rate swaps are market risk andcredit risk. For a receive fixed swap, market risk is encountered when interest rates rise, resulting in aloss of swap market value. For a receive fixed swap, credit risk is encountered when interest rates fall,resulting in a gain of swap market value and hence a potential credit loss if the counterparty fails. For areceive floating swap, market risk is encountered when interest rates fall, resulting in a loss of swapmarket value. For a receive floating swap, credit risk is encountered when interest rates rise, resulting ina gain of swap market value and hence a potential credit loss if the counterparty fails.

The underlying amount of money on which the swap payments are made is called: settlement value market value equity value notional amount base value

notional amount

Which of the following is not a type of swap? commodity swaps currency swaps equity swaps settlement swaps interest rate swaps

settlement swaps