Lesson 9: Futures and Derivatives
Which of the following types of contracts are traded on organized exchanges? 1.) Futures contracts 2.) Forward contracts
1.) Futures contracts Futures contracts are traded on an organized exchange. Forward contracts are not traded on an organized exchange.
A put option is available on the stock of Rally Corporation. The exercise price is $65. The put-option price is $1. Rally stock is currently selling for $70 per share. What is the "intrinsic value" of the put option? A) $0 B) $4 C) $5 D) $9
A) $0 The intrinsic value is the minimum value for which an option will trade and equals the strike price minus the FMV of the stock for a put option. It is also how much an option is "in the money." In this case, the intrinsic value equals $0 ($65 − $70). It cannot be less than zero. The intrinsic value is not influenced or impacted by the option price.
According to the Black-Scholes option-pricing model, which of the following will decrease the price of a call option? A) A decrease in volatility B) An increase in price of the stock C) An increase in the time to expiration D) An increase in the risk-free rate
A) A decrease in volatility A decrease in the expected volatility of a stock will reduce the likelihood that the option will provide a payout above the exercise price, resulting in a decrease in the value of the option.
According to the Black-Scholes option-pricing model, which of the following will decrease the price of a call option? A) a decrease in volatility. B) an increase in price of the stock. C) an increase in time to expiration. D) an increase in the risk-free rate.
A) a decrease in volatility. A decrease in the expected volatility of a stock will reduce the likelihood that the option will provide a payout above the exercise price, resulting in a decrease in the value of the option.
When the value of a stock was $100, a put option with a strike price of $95 was sold for $3. On the date of the option's expiration, the stock's value was $90. Who made money in this scenario? A) The put writer B) The put buyer C) The call buyer D) None of the above
B) The put buyer A put buyer will profit when the strike price is greater than the stock's value.
Which of the following is correct regarding convertible bonds? A) The yield for a convertible bond will generally be greater than the yield for an equivalent nonconvertible bond. B) The value of a convertible bond is generally greater than the value of an equivalent bond with no conversion feature. C) The value of a convertible bond will always be greater than its conversion value. D) The conversion value of a convertible bond is specified in the bond indenture.
B) The value of a convertible bond is generally greater than the value of an equivalent bond with no conversion feature. Statement (A) is not correct, because convertible bonds generally will be issued with lower yields. Statement (C) is incorrect because the convertible bond's value should equal its conversion value on the date of exercise. Statement (D) is incorrect because the conversion value is not specified in the bond indenture; it equals the conversion ratio multiplied by the current stock price.
Ethan owned 100 shares of IBM. He then wrote a call option on IBM. Why did he do that? A) To profit if IBM declines. B) To generate additional income in a relatively stable market. C) To hedge an existing stock position in a declining market. D) To hedge an existing stock position in an advancing market.
B) To generate additional income in a relatively stable market. A covered call strategy is used to generate additional income from an existing stock position in a relatively stable market.
An "out of the money put": A) has an intrinsic value of less than 0. B) is where the stock price is greater than the strike price. C) is where the stock price is less than the strike price. D) has a time value that is greater than 0.
B) is where the stock price is greater than the strike price. The stock price is greater than the strike price.
Futures exchanges require all contracts to be ___________ for the purpose of minimizing default risk. A) standardized B) marked-to-market C) settled in cash D) delivered on time
B) marked-to-market Contracts are marked-to-market daily with gains and losses posted to the accounts of the buyer and seller. This process helps to minimize gain and loss surprises and therefore minimize default risk. While all futures contracts must be standardized, the reason is not to reduce default risk. Rather, standardization increases liquidity and ease of trading.
A futures contract will have its price adjusted each day of the contract's life, either up or down, depending on current market conditions. This is called: A) requirements for futures contracts. B) marking to market. C) initial margin requirements. D) maintenance margin requirements.
B) marking to market. Futures contracts are marked to market daily, which results in gains or losses for buyers and sellers.
Sina has a long position in one coffee contract that expires in June. To close her position, she should: A) buy one coffee contract that expires in June. B) sell one coffee contract that expires in June. C) trade her long position contract. D) buy two coffee contracts that expire in June.
B) sell one coffee contract that expires in June. Buying a futures contract is taking a long position. To close the long position, the investor must sell the contract.
All of the following terms are specified in a futures contract EXCEPT: A) the contract size. B) the maximum acceptable price variation during the term of the contract. C) the acceptable quality grade of the commodity of the contract. D) the settlement price.
B) the maximum acceptable price variation during the term of the contract. Futures contracts specify the contract size, the quality and quantity of the underlying commodity, and the settlement price. The maximum price range and the market price at expiration will be determined by the market rather than specified in the contract.
All of the following terms are specified in a futures contract EXCEPT: A) the delivery date. B) the spot price. C) the quality of the commodity. D) the contract price.
B) the spot price. The contract sets the future price, not the spot price.
Derivatives allow market participants to do which of the following? I. Decrease their risk level by transferring risk away from themselves onto another investor. II. Increasing their risk level (and possible return) by transferring other investors' risks onto themselves.
Both Derivatives allow market participants to transfer risk either away from themselves or onto themselves.
A convertible bond has a par value of $1,000, but its current market price is $750. The current price of the issuing company's stock is $17 and the conversion ratio is 30 shares. The bond's conversion premium is closest to: A) $44.12 B) $25.00 C) $240.00 D) $490.00
C) $240.00 The bond is convertible into 30 shares, which is worth $510 at $17 per share. The bond is trading at $750. Thus the conversion premium equals the difference or $240. $750 - (30 × $17 = $510) = $240.
An investor receives a premium of $6 for writing a put option with a strike price of $120 on a stock currently trading for $125. At the options expiration, the stock trades for $117. What is this investor's profit or loss per share? A) -$6 B) -$3 C) $3 D) $6
C) $3 The option will be exercised, requiring the investor to purchase the stock for $120 even though it is only worth $117. This $3 loss is offset by the $6 premium received, leading to a $3 profit per share.
An investor buys a call option on XYZ stock with an exercise price of $300 for $10 per share. When XYZ increases to $320, the call is exercised, and the stock is immediately sold. What is the result? A) A loss of $20 per share B) A loss of $10 per share C) A profit of $10 per share D) A profit of $20 per share
C) A profit of $10 per share $20 gain from stock price − $10 premium = $10 profit per share
An investor buys a call option to purchase 100 shares of XYZ at $60/share for a $5/share premium. When XYZ increases to $70, the call is exercised and the stock is immediately sold. What is the result? A) A profit of $5 B) A profit of $50 C) A profit of $500 D) A profit of $1,000
C) A profit of $500 Premium: -$5/shareCost to purchase shares: -$60/shareSale: $70/shareTotal: $70 - $60 - $5 = $5/share or $500 total
Parker believes that Ace Stock is poised to increase. With which of the following strategies could he make money if the stock increases? I. Buy a call on Ace. II. Sell a put on Ace. A) I only B) II only C) Both I and II D) Neither I nor II
C) Both I and II Buying a call option would allow Parker to participate in the increase in the stock. Selling a put on Ace would generate premium income if the stock increased in price.
A bank owns a portfolio of Treasury bonds but wants to hedge its position. Which of the following would make the most sense? A) Buy call options on Treasury bonds. B) Buy futures contracts on Treasury bonds. C) Sell futures contracts on Treasury bonds. D) Sell put options on Treasury bonds.
C) Sell futures contracts on Treasury bonds. The bank has a long position in the Treasury bond portfolio. Therefore, the bank will need a short position, which is selling a futures contract.
A futures contract: A) is an agreement to buy or sell a specified amount of an asset at today's price on the expiration date of the contract. B) is a contract for a transaction at a specific date in the future by the buyer and the seller of the asset. C) is an agreement to buy or sell a specified amount of an asset at a predetermined price on the expiration date of the contract. D) gives the buyer the right, but not the obligation, to buy an asset prior to expiration of the contract.
C) is an agreement to buy or sell a specified amount of an asset at a predetermined price on the expiration date of the contract. A futures contract locks in the price of an asset to be bought and sold at some future date. Both the buyer and seller of the contract are committed at the inception of the contract.
Jack owns a convertible bond with a $1,000 face value that can be exchanged for 25 shares of WUF stock, which is trading at $50 per share. The conversion value equals: A) $0. B) $250. C) $1,000. D) $1,250.
D) $1,250. The conversion value equals the conversion ratio (25) multiplied by the current value of the common stock ($50), which equals $1,250.
Long positions and short positions in a futures contract have certain requirements for the investor regarding delivery of the underlying commodity. Which of the following accurately describes the requirement for long positions and short positions? A) Long Position: Make delivery; Short Position: Make delivery B) Long Position: Take delivery; Short Position: Take delivery C) Long Position: Make delivery; Short Position: Take delivery D) Long Position: Take delivery; Short Position: Make delivery
D) Long Position: Take delivery; Short Position: Make delivery The investor taking the long position commits to purchasing the commodity on the delivery date. The investor taking the short position commits to delivering the commodity at contract maturity. The investor in the long position is said to "buy" the contract; the investor in the short position is said to "sell" the contract.
A small public medical device company has applied for FDA permission to sell its product. The FDA's decision will either lead to this company being worth over a billion dollars or going bankrupt. An investor who has been following this situation hopes to profit off the FDA's decision, regardless of whether it is positive or negative for the company. The best option strategy for this investor is a: A) collar. B) protective put. C) covered call. D) long straddle.
D) long straddle. A long straddle allows an investor to profit off high volatility. Because this strategy combines a long put and a long call, the investor will profit whether the company's stock price climbs dramatically or goes to zero.
Which of the following is correct regarding derivative securities? I. They allow investors to use leverage to increase their potential return (but also their risk). II. Most types of derivatives are suitable investments for unsophisticated investors.
I. They allow investors to use leverage to increase their potential return (but also their risk). The use of leverage exponentially increases both potential gains and losses, which can be an advantage or a disadvantage. This exponentiation of gains and losses, along with their relative complexity, makes most types of derivatives unsuitable for small, unsophisticated investors.
