M339D Exam #1

European put option payoff

(K-S(T))+

European Call Option payoff

(S(T)-K)+

Covered Put Option components

1. SHORT the risky asset 2. WRITE a put on the asset

Cap Option components

1. short sale of 1 share of non-dividend-paying stock 2. long call

Covered Option components

1. written call option (no dividends) 2. long/buy the underlying

Short forward payoff

F-S(T)

Derivative securities can only be used for hedging, i.e., they can only be bought and written by agents who already have a position in the underlying asset

False

Writing derivative securities can be a regulatory requirement

False

The pre-paid forward price of a non-dividend-paying stock is strictly decreasing with respect to the delivery date

False- Pre-paid forward = S(0) delivery date has no effect on the price

The position consisting of ONE LONG SYNTHETIC FORWARD CONTRACT benefits from falling prices in the underlying asset

False- A synthetic forward contract has the payoff function which is increasing as a function of the final price of the underlying asset. So it benefits from rising prices and not from falling prices of the underlying asset

A producer of oranges wishes to hedge using put options on oranges. She should WRITE put options

False- Producers should buy put options

Put-call parity applies to both American and European options

False- Put-call parity applies to only European options

Suppose stock XYZ has a current price of 100. The forward price for delivery of this stock in 1 year is 110. Also, assume there are no dividends, and that the annual effective interest rate is 10%, unless otherwise indicated. Which of the following is false? D. If the 10% interest rate were continuously compounded instead of annual effective, then it would be more beneficial to invest in the stock, rather than the forward contract

False- The profit of the stock investor is always 100e^(1.1)-100>0 below the profit of the forward contract investor

A COVERED PUT consists of a written put and a short position in the underlying asset

False- covered put consists of written put option and buying the underlying

Users of forward contracts are more able to minimize credit risk than are users of futures contracts

False- forward contracts do not have margin accounts

In the setting of a futures contract, a margin call is issued if the balance in the margin account drops below the initial margin

False- if falls below the maintenance margin level

The agent is ONLY allowed to write options on an underlying asset if they already own units on the underlying

False- the so-called NAKED writing option is a legal and common practice

A covered call is a portfolio consisting of a written call option and the short underlying

False- write call buy underlying

Reinsurance companies can further share risk by investing in catastrophe bonds

False-- Reinsurance companies ISSUE catastrophe bonds

Long forward payoff

S(T)-F

A (long) put is a SHORT position with respect to the underlying asset

True

An asset-investor with a long/short position in the underlying also hedges using a short/long forward contract

True

Asset call payoffs (both long and short) are LONG with respect to the underlying asset

True

Asset put payoffs (both long and short) are NEITHER LONG NOR SHORT with respect to the underlying

True

Cash call payoff does not have a breakeven point

True

Cash put payoffs (both long and short) are SHORT with respect to the underlying asset

True

Derivative securities are sometimes used as employee compensation

True

Floors commonly arise when the producer of a commodity or the owner of a risky asset (shares of stock, etc.) uses PUTS to hedge their exposure to risk

True

Forward contracts are more customized to suit the buyers needs than futures contracts are

True

Forward contracts can be used to synthetically switch a portfolio invested in stocks into bonds

True

Frequent marking-to-market an settlement of future contracts can lead to pricing differences between a futures contract and an otherwise identical forward contract

True

Futures contracts are more liquid, as one can offset an obligation by taking the opposite position

True

Futures contracts are settled daily, and marked-to-market

True

Futures contracts are structured to minimize the effects of credit risk

True

Futures contracts have price limits, beyond which trading may be temporarily halted

True

Ideally, an risk-sharing mechanism should benefit all parties sharing the risk

True

If Kp=Kc then it is a zero-width collar

True

In an insurance market, individuals that do not want to incur losses have shared risk with individuals that do incur losses

True

In the case of a fully-leveraged portfolio, the payoff and the profit are always equal

True

Insurance companies can share risk by ceding some of the excess risk from large claims to reinsurers

True

Naked writing is the practice of writing options without taking an offsetting position in the underlying asset

True

On the expiration date of your American call option, you look back and you realize that you exercised the option at the optimal time. This means that the time of early exercise was when the price of the underlying asset achieved its maximum during the life of the option

True

Over-the-counter forward contracts can be customized to suit the buyer or seller, whereas futures contracts are standardized

True

Reinsurance companies endeavor to share risk by issuing catastrophe bonds

True

Risk sharing reduces diversifiable risk, more so than reducing non-diversifiable risk

True

The PURCHASED call is the opposite of the WRITTEN call

True

The PURCHASED put option is the opposite of the WRITTEN put

True

The holder of a long futures contract must place a fraction of the cost with an intermediary and provide assurances on the remaining purchase price

True

The long call payoff curve has an unlimited growth potential

True

The position consisting of ONE LONG HOMEOWNERS INSURANCE CONTRACT benefits from falling prices in the underlying asset

True

The pre-paid forward price of a non-dividend-paying stock does not depend on the delivery date

True

Derivative securities can reduce the risk of both the buyer and writer of the security

True - Future contracts are an example of this situation

The European call option is LONG with respect to the underlying

True - the payoff and profit curves are both increasing functions

It is possible for the buyer and the write of the same option to end up having the same profit on the exercise date

True - this happens if they both break even , i.e., if both of their profits equals 0

Producers have an inherent LONG position in their product

True- Producers or manufacturers of goods and services (commodities) are going to be profitable if the revenue from the sale of produced goods in the market exceeds the manufacturing costs

The profit diagram and the payoff diagram for long positions in a forward contract are identical

True- Profit=Payoff

Suppose stock XYZ has a current price of 100. The forward price for delivery of this stock in 1 year is 110. Also, assume there are no dividends, and that the annual effective interest rate is 10%, unless otherwise indicated. Which of the following is false? C. There is no comparative advantage to investing in the stock versus investing in the forward contract

True- The profits are equal

Suppose stock XYZ has a current price of 100. The forward price for delivery of this stock in 1 year is 110. Also, assume there are no dividends, and that the annual effective interest rate is 10%, unless otherwise indicated. Which of the following is false? A. the time-1 profit diagram and the time-1 payoff diagram for long positions in this forward contract are identical

True- There is no initial cost to entering a forward contract, so its payoff and profit are always equal

Suppose stock XYZ has a current price of 100. The forward price for delivery of this stock in 1 year is 110. Also, assume there are no dividends, and that the annual effective interest rate is 10%, unless otherwise indicated. Which of the following is false? B. The time-1 profit for a long position in this forward contract is exactly opposite to the time-1 profit for the corresponding short forward position

True- This statement is ALWAYS true for long and shirt positions in the same contract

Suppose stock XYZ has a current price of 100. The forward price for delivery of this stock in 1 year is 110. Also, assume there are no dividends, and that the annual effective interest rate is 10%, unless otherwise indicated. Which of the following is false? E. If there was a dividend of 3.00 paid 6 months from now, then it would be more beneficial to invest in the stock, rather than the forward contract

True- Without any dividend payments, the two positions are equivalent. The dividend payment is given to the stock investor and not to the forward investor, so the stock investor is certainly better off

The users or buyers of commodities have an inherent short position with respect to that commodity

True- the users or buyers of commodities benefit from a decrease in the price of the good

Arbitrage portfolio

a portfolio whose PROFIT is: 1. NON-NEGATIVE in ALL STATES OF THE WORLD and 2. STRICTLY POSITIVE in AT LEAST ONE state of the world

Collar equation

collar= long put(strike Kp)+short call (strike Kc)

Which of the following option positions is the investor exposed to an unlimited loss? a. Long put option b. Short put option c. Long call option d. Short call option e. None of the above

d. Short call option

Short with respect to a certain asset

if its payoff function is DECREASING as a function of the asset's final price

Long with respect to a certain asset

if its payoff function is INCREASING as a function of the asset's final price

Profit

the difference between the payoff and the future value at time-T of the initial cost

Covered Option

the option's WRITER takes an appropriate position in the underlying asset

in-the-money

the owner of the option would receive a STRICTLY POSITIVE cashflow were the option exercised immediately S(T)<K

at-the-money

the owner of the option would receive a ZERO cashflow were the option exercised immediately S(T)=K

out-of-the-money

the owner would receive a STRICTLY NEGATIVE cashflow were the option exercised immediately S(T)<K

Naked Option

the writer does not take a position on the option, just writes it