Chapter 9

The main difference between European and American options is:

American option holders have more options than European option holders.

With a futures contract:

no payment is made until the settlement date.

The option holder is:

the buyer of an option.

The purpose of derivatives is to

transfer the risk from one person to another.

Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $20 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option?

$10

Assume we have a stock currently worth $50. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $50. If the stock can rise or fall by $10 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option?

$5

What is a credit-default swap?

Ans: A CDS is a credit derivative that allows lenders to insure themselves against the risk that a borrower will default. The buyer of a CDS makes payments to the seller, and the seller agrees to pay the buyer if an underlying loan or security defaults.

Describe the condition that would have a call option in the money. Now describe the condition that has a put option out of the money.

Ans: A call option will be in the money when the strike price is below the spot or current market price. The option holder has the right to call the asset away from the option writer at a price below what the asset could be sold for on the spot market. A put option is out of the money when the strike price is below the spot or market price. Here the option holder has the right to put (sell) the asset to the option writer at a predetermined (strike) price. If the strike price is below the market price the option holder would be better off selling the asset on the spot market versus selling it to the option writer.

Explain why a forward contract may actually carry more risk than a futures contract.

Ans: A forward contract is a private agreement between two parties that is customized for the two parties. As a result, the high degree of customization makes them very difficult if not impossible to resell. Futures contracts on the other hand are highly standardized. The high level of standardization allows them to be bought and sold on organized exchanges, which increases their liquidity and reduces risk. In addition, forward contracts are private agreements and thus carry greater default risk. Futures contracts are usually settled through clearing corporations where procedures such as mark to market greatly reduce default risk.

Explain the difference between American and European options.

Ans: American options can be exercised on any date from the time they are written until the date they expire. As a result, the holder of an American option has three choices; (1) continue to hold the option; (2) sell the option to someone else; (3) exercise the option immediately. The holder of a European option has only two options on a date prior to expiration, hold or sell.

Explain how an interest rate futures contract differs from an outright purchase of a bond.

Ans: An investor who purchases a bond does so with the thought that the price of a bond is going to rise. There really is no way to profit from a price decline when you actually purchase the bond. On the other hand, an investor can profit from price declines in bonds by using an interest rate futures contract. With such a contract, two individuals agree that they will make payments to the counterparty based on interest rate movements over some specified time period. Another key difference is that with the futures contract (derivative) one person's loss is the counterparty's gain. The amount on the table never changes, it just moves between the counterparties. Yet another difference is that a futures contract is equivalent to a low-cost, leveraged exposure to fluctuations in the bond price.

Identify four factors that will cause the value of call options to increase.

Ans: Call options will increase in value if there is a decrease in the strike price; if there is an increase in the market price of the underlying asset, if there is an increase in the time to expiration, or if there is an increase in the volatility in the price of the underlying asset.

Consider a call option; in terms of the option writer and option holder, who is the buyer? Who is the seller? Finally, who has the option? Explain.

Ans: In the case of a call option, the option writer is the seller. Here the option writer is stating the underlying asset, strike price, and expiration or delivery date. The option holder is the buyer of the option. The option holder buys the right to have the option of actually purchasing the underlying asset on or before the expiration date for the strike price. The option holder has the option, because she could let the option expire and not "call away" the underlying asset, just foregoing the price paid for the option.

How did CDS' contribute to the financial crisis of 2007-2009?

Ans: In three important ways: (1) fostering uncertainty about who bears the credit risk on a given loan or security, (2) making the leading CDS sellers mutually vulnerable, and (3) making it easier for sellers of insurance to assume and conceal risk.

Explain why for speculation, the purchase of an option may be more attractive than a futures contract or the outright purchase of the underlying asset.

Ans: Let's say an investor believes that interest rates are going to fall over the next few months. There are three ways to bet on this possibility. One is to purchase a bond and if the investor guesses correctly, the bond price will rise as the interest rate falls. This is expensive since it requires the purchase of the bond. Another strategy is to purchase a futures contract, meaning take the long position. If the market price of the bond increases with falling interest rates, the investor will reap the profits. This approach requires a small investment, but this approach is also very risky since the investment is highly leveraged since the market price can move against the investor. A third strategy involves the use of an option. The investor could purchase a call option on a Treasury bond. If he or she is right and interest rates fall, the value of the call option will rise, which is the upside. On the other hand, if the investor bets wrong and interest rates rise, the option will expire worthless and the investor just loses the fee paid for the option. The bet is both highly leveraged and limited in its potential losses.

We have a futures contract for the purchase of 10,000 bushels of wheat at $3.00 per bushel. If the price of wheat were to increase to $3.50, explain what happens to the parties involved in the contract in terms of marking to market. Be sure to identify who is long and short and specifically how much is transferred.

Ans: The buyer of the contract, the long position, will pay $30,000 for 10,000 bushels of wheat. The seller of the contract, the short position, delivers 10,000 bushels of wheat and receives $30,000. If before expiration the market price of wheat increases to $3.50 the seller, (short) will have to give the buyer, (long) $5000 so that the buyer will still only have to pay $30,000 for the wheat. So the buyer's margin account will be marked to market (credited) with $5,000, which comes from the seller's margin account which is marked to market (debited) for the $5,000.

. If the current closing price in the stock of XYZ, Inc. is $87.50 and the July expiration put options with a strike price of $80 are selling for $1.05, what is the intrinsic value of the option? What is the option premium?

Ans: The intrinsic value of a put option is the strike price less the market price, which in this case is a negative $7.50. An option cannot have an intrinsic value less than zero, however, since the option does not have to be exercised. So in this case the intrinsic value is zero. The option premium is the option price less the intrinsic value, so the option premium is $1.05.

Suppose you purchase a call option to purchase General Motors common stock at $80 per share in March. The current price of GM stock is $83 and the time value of the option is $5. What is the intrinsic value of the option? As the expiration date approaches, what will happen to the size of the time value of the option?

Ans: The intrinsic value of an option is equal to the difference between the current market price and the strike price, which in this case is $83 - $80, or $3. The time value of the option at expiration is zero since the option value equals the intrinsic value.

Which of the following statements is true?

Both American and European options can be sold prior to expiration.

Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $5 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option?

None of the answers is correct.

The key difference between a forward and a futures contract is:

a forward contract is customized where a futures contract is not.

The clearing corporation's main role in the futures market is to:

act as the counterparty to both sides of the transaction, thereby guaranteeing payment.

Interest-rate swaps are:

agreements between two parties to exchange periodic interest-rate payments over some future period.

A call option is:

an option giving the holder the right to buy a given quantity of an asset at a specific price on or before a specified date.

The long position in a futures contract is the party that will

benefit from increases in the price of the underlying asset

Users of commodities are:

buyers of futures.

The right to buy a given quantity of an underlying asset at a predetermined price on or before a specific date is called a(n):

call option.

Forward contracts are

contracts usually involving the exchange of a commodity or financial instrument.

Marking to market is a process that:

ensures that the buyers and sellers receive what the contract promises.

Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is lower than Tom expected. Tom will have:

gained money on his long position.

With a call option, the option holder:

has the right to buy the asset.

With a put option, the option holder:

has the right to sell the asset.

Speculators differ from hedgers in the sense that:

hedgers seek to transfer risk.

One key difference between options contracts and futures contracts is:

in an options contract, the rights belong to one party.

As the volatility of the stock price increases, the time value of the option:

increases.

Futures markets and derivatives contribute to economic growth by:

increasing the risk-taking capacity of the economy.

The principal in an interest rate swap is:

is not borrowed, lent, or exchanged. It just serves as the basis for the calculation of cash flows

The intrinsic value of an option:

is the amount the option is worth if it is exercised immediately.

Sue buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is higher than Sue expected. Sue will have:

lost money on her long position.

Sue sells a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is lower than Sue expected. Sue will have:

lost money on her short position.

Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is higher than Tom expected. Tom will have:

lost money on his long position.

The seller of a put option is transferring the risk:

of a price increase of the stock to the buyer of the option.

One key difference between swaps and option contracts is:

options trade on organized exchanges and swaps do not.

One argument why farmers in poor countries remain poor is:

poor farmers in many countries lack access to commodity futures markets.

A key use of interest-rate swaps is to:

provide a hedge against interest-rate risk.

An arbitrageur is someone who:

simultaneously buys and sells financial instruments to benefit from temporary price differences.

An individual who neither uses nor produces a commodity but sells a futures contract for the asset is:

speculating that the price of the commodity is going to fall.

The user of a commodity who is trying to insure against the price of the commodity rising would:

take the long position in a futures contract.

Considering interest-rate swaps, the swap rate is:

the benchmark rate plus a premium.

There is a futures contract for the purchase of 1,000 bushels of corn at $3.00 per bushel. At the end of the day when the market price of corn falls to $2.50:

the buyer (long position) needs to transfer $500 to the seller (short position).

If market participants believe next year's corn crop is likely to be unusually large:

the current spot market price of corn is likely to be above the futures price of corn.

Considering interest-rate swaps, the swap spread is:

the difference between the benchmark rate and the swap rate.

The time value of the option can best be defined as

the fee paid for the potential benefits from buying an option (excluding its intrinsic value).

The two parts that make up an option's price are:

the intrinsic value and the time value of the option.

Considering a call option, if the price of the underlying asset decreases:

the intrinsic value of the option decreases if it is above zero.

If we have a stock selling for $95.00 and a call option for this stock has a strike price of $82.00 and an option price of $13.60:

the intrinsic value of the option is $13.00 and the time value of the option is $0.60.

We have a stock selling for $90.00. There is a put option for this stock with a strike price of $85 and an option price of $1.20:

the intrinsic value of this option is $0.00 and the time value of the option is $1.20.

As an option approaches its expiration date, the value of the option approaches:

the intrinsic value.

With a call option that is described as in the money:

the market price of the stock is above the strike price.

The strike price of an option is:

the price at which the option holder has the right to buy or sell.

As the time of settlement gets closer:

the price of the futures contract will move in lockstep with the price of the underlying asset.

Someone who purchases a call option is really buying insurance to protect against:

the price of the stock rising.

There is a futures contract for the purchase of 100 bushels of wheat at $2.50 per bushel. At the end of the day when the market price of wheat increases to $3.00 per bushel:

the seller (short position) needs to transfer $50 to the buyer (long position).

The option writer is:

the seller of an option.

A put option that is described as in the money would find:

the strike price is above the market price of the stock.

Considering a put option; if the price of the underlying asset increases:

the value of the option decreases.

In a derivative transaction

what one person gains is what the other person loses.

A pension fund manager who plans on purchasing bonds in the future:

will take the long position in a futures contract.