Series 65 Unit 4
A farmer who produces soybeans believes that this year's crop will be the biggest ever. The farmer would most likely hedge this risk by A) going long soybean forwards. B) going long soybean futures. C) going short soybean forwards. D) going short soybean futures.
C)going short soybean forwards. A big crop means more supply and lower prices when the crop is harvested. Hedging involves taking an opposite position (benefiting if prices fall). If the farmer is correct, selling short at today's price will enable delivery in the future at that higher price. Because this is a producer who will have product to deliver, forwards are likely to be more appropriate than futures. LO 4.d
The long party in a futures contract has entered the contract as A) a seller. B) a liquidity provider. C) a market maker. D) a buyer.
D) a buyer. Long is the industry term describing the buyer of a futures contract. The long is committed to buying the underlying asset at the pre-agreed-upon price on the specified future date. Short is the industry term describing the seller of the futures contract. The short is committed to delivering the underlying asset in exchange for the pre-agreed-upon price on the specified future date. Market maker is a term used for securities, not futures, and liquidity provider is a concept that is not tested (as is the case with many incorrect answer choices). LO 4.d
A commodities speculator purchases a 1,000-bushel wheat futures contract at 50 cents per bushel. At expiration, the settlement price is 45 cents per bushel. This individual A) must make delivery of the wheat. B) effectively hedged the long wheat position. C) has a $50 gain. D) has a $50 loss.
D) has a $50 loss. The simple math is as follows: The individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($0.05) by 1,000 bushels and the loss is $50. 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 contact, not long (the owner of) the wheat. LO 4.d
Which of the following strategies would be considered most risky in a bull market? A) Writing naked calls B) Writing naked puts C) Buying calls D) Buying a put
A) 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. LO 4.e
An investor purchased a Mosaks, Inc., put option with a strike price of $105. If Mosaks' stock price is $115 at expiration, the value of the put option is A) $10. B) $105. C) -$10. D) $0.
D) $0. The put has a value of $0 because it will not be exercised. Why would you want to exercise (sell the stock) at $105 per share when the current market value is $115? LO 4.b
When contrasting preemptive rights and warrants, it would be correct to state that, at issuance, A) rights have intrinsic and time value while warrants only have time value. B) rights have time value while warrants have intrinsic and time value. C) rights have intrinsic and time value while warrants only have intrinsic value. D) rights have intrinsic value while warrants have intrinsic and time value.
A) rights have intrinsic and time value while warrants only have time value. At the time of issuance, preemptive rights always offer the stock at a price below the current market, thus creating intrinsic value. Although rights rarely are effective for longer than 45-60 days, that does represent time value. On the other hand, warrants are always issued with an exercise price above the current market (no intrinsic value) but do have time value. LO 4.c
An investor would exercise a put option when A) the market price of the stock is below the strike price. B) the market price of the stock is above the strike price. C) the market price of the stock is equal to the strike price. D) the current premium is higher than the initial cost.
A) the market price of the stock is below the strike price. A put option gives its owner the right to sell the underlying security at a specified price (strike price) for a specified time period. When the stock's price is less than the strike price, a put option has value and is said to be in the money. LO 4.b
Which of the following are characteristics of newly issued warrants? A) No intrinsic value and no time value B) Time value but no intrinsic value C) Intrinsic value but no time value D) Time value and intrinsic value
B) 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. LO 4.c
Which of the following statements regarding warrants is true? A) Warrants' terms are generally shorter than rights' terms. B) Warrants are often issued with other securities to make the offering more attractive. C) Warrants are safer than corporate bonds. D) Warrants give the holder a perpetual interest in the issuer's stock.
B) Warrants are often issued with other securities to make the offering more attractive. Warrants are generally issued with bond offerings to make the bonds more attractive. Warrants are long-term options to buy stock, and because they are equity securities, warrants, as investments, are considered less safe than bonds. LO 4.c
A speculator, believing that a drought in the Midwest will lead to a weak corn crop, would probably A) take a short position in corn futures. B) take a long position in corn futures. C) take a long position in corn forwards. D) take a long position in orange juice futures.
B) take a long position in corn futures. A weak corn crop means a shortage in the supply. That will lead to an increase in prices. When one is speculating that prices will go up, the best position is a long one. So, why not the long forwards? Those who purchase forward contracts anticipate accepting delivery of the asset. This individual is merely speculating and has no interest in taking physical possession of the commodity and paying for transportation, silage, and insurance until the commodity is sold. If the person in the question had been a user of corn (a cereal maker, for example), then the forward contract would have been a better choice. LO 4.d
Which of the following statements best describes a preemptive right? A) A privilege extended to existing holders of a company's common stock enabling them to sell their shares when additional shares are issued B) The right given to existing holders of a company's stock enabling them to vote ahead of preferred stockholders C) A privilege extended to existing holders of a company's common stock enabling them to maintain their proportionate interest in the company when additional shares are issued D) The right given to existing holders of a company's stock enabling them to receive dividends in proportion to their equity in the company
C) A privilege extended to existing holders of a company's common stock enabling them to maintain their proportionate interest in the company when additional shares are issued The preemptive right is an equity security representing a common stockholder's entitlement to the first opportunity to purchase new shares issued by the corporation at a predetermined price (normally less than the current market price) in proportion to the number of shares already owned. LO 4.c
Rank the following securities from the same issuer from most suitable to least suitable for a client whose primary objective is income. I. Cumulative preferred stock II. Convertible preferred stock III. Common stock IV. Warrant A) I, III, II, IV B) II, III, IV, I C) I, II, III, IV D) III, I, IV, II
C) I, II, III, IV For a client seeking income, preferred stock, especially one that is cumulative, would likely be the most suitable of the choices given. Convertible preferred stock generally pays a lower dividend rate than other preferred stocks. This is because of the attractiveness of the convertibility. Although there are some categories of common stock (e.g., utility stocks that pay liberal dividends), unless specifically mentioned, you can assume that preferred stock dividends are higher than those for common stock of the same issuer. Warrants never provide any income. LO 4.c
Purchasers of options can have a number of different objectives. One of your clients who is a soft-drink fan already has a long position in KO. What would be a possible reason for this client to go long a KO call option? A) Owning a long call on stock you already own offers a hedge against a market decline. B) It completes the other side of a spread. C) It fixes the cost of acquiring additional stock for the portfolio. D) This would generate additional income.
C) It fixes the cost of acquiring additional stock for the portfolio. Those who are bullish on a stock but don't have sufficient funds at this time to purchase the stock can lock in their future cost by going long a call. Income is generated only through selling options. Because a long call is on the same side of the market as long stock, there is no hedge. A spread involves a long and short option. LO 4.b
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) has a $100 loss. B) effectively hedged the long wheat position. C) has a $100 gain. D) must make delivery of the wheat.
C) 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. LO 4.d
A client is long 400 shares of ABC common stock. The current market price of ABC is $150 per share. The client is of the opinion that the market is going to be moving sideways for a while and would like to generate additional income from the ABC stock. What strategy might you recommend? A) Write an ABC 150 call option B) Buy two ABC 150 put options and write two ABC 150 call options C) Write four ABC 150 put options D) Write four ABC 150 call options
D) Write four ABC 150 call options Writing call options on a long stock position (a covered call) is a common strategy for generating additional income from a stock holding. If the market moves sideways (neither up nor down), the option will likely expire unexercised and the client will earn the premium and still have the stock. Being long 400 shares would mean writing four contracts. Writing put options would generate premium income, but if the stock price falls, the writer could be exercised requiring the purchase of an additional 400 shares at $150 per share (the client really doesn't want to own 800 shares). If the client buys two options and sells two options, the premiums will likely offset each other and not help the client reach the objective of generating additional income. LO 4.b
