Unit 4
Which of the following financial instruments is not a derivative? A) A share of stock B) A put option C) LEAPS D) A call option
Answer: A) A derivative is a type of financial instrument that derives its value from another asset or combination of assets. The best known examples of derivatives are options, of which puts, calls, and LEAPS are examples. LO 4.a
Which of the following is not traded on any exchange? A) Forward contracts B) ETFs C) Futures contracts D) Closed-end funds
Answer: A) Forward contracts are nonstandardized and, as such, do not trade on any exchange. LO 4.d
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 short soybean futures. B) going short soybean forwards. C) going long soybean forwards. D) going long soybean futures.
Answer: B) 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
Nonsecurities derivatives would include which of these? I. Forward contracts II. Futures contracts III. Hedge funds IV. REITs A) I, II, and III B) I and IV C) I and II D) I, II, and IV
Answer: C) Forward contracts and futures contracts are known as nonsecurities derivatives because they derive their value from something that is not a security. REITs and hedge funds are securities, not derivatives. LO 4.d
The long party in a futures contract has entered the contract as A) a seller. B) a market maker. C) a buyer. D) a liquidity provider.
Answer: C) 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
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) $0. D) $10.
Answer: C) 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
The term used to describe investment vehicles whose value is based on an underlying asset is A) parity. B) separate account. C) funded debt. D) derivative.
Answer: D) Derivatives are referred to as such because they derive their value from some underlying asset, whether it be a stock or a commodity. LO 4.a
An investor would exercise a put option when A) the current premium is higher than the initial cost. B) the market price of the stock is below the strike price. C) the market price of the stock is above the strike price. D) the market price of the stock is equal to the strike price.
Answer: B) 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
Derivatives can serve many purposes. However, investors should be aware that there are positions which can result in A) potential gains. B) asset protection. C) unlimited loss. D) generation of income.
Answer: C) Although all of these are true, the focus of the regulators is on clients being aware of the risks before they learn the benefits. There are some derivative positions, such as an uncovered call, where the potential for loss is unlimited. LO 4.e
A commodities speculator purchases a 1,000-bushel wheat futures contract at $0.50 per bushel. At expiration, the settlement price is $0.45 per bushel. This individual A) has a $50 gain. B) effectively hedged the long wheat position. C) has a $50 loss. D) must make delivery of the wheat.
Answer: C) The simple math is the individual bought at $0.50 and sold at $0.45, losing $0.05 per bushel. Multiplying $0.05 times 1,000 bushels shows 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 contract, not long (the owner of) the wheat. LO 4.d
Among the purposes of purchasing derivatives would be all of the following except A. hedging B. income C. profits D. speculation
Answer: B Purchase of a derivative, whether an option, a forward, or a futures contract, never generates income. Selling one does, but the question refers to a purchaser, and that is why the correct choice is B.
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
Answer: A) 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
A European-style option differs from an American-style option primarily in that it A) can only be exercised on its expiration date. B) is primarily used for options on foreign securities. C) derives its value from some underlying asset. D) is generally offered with a limited number of expiration dates.
Answer: A) The most significant (and tested) difference between these two styles is that an American-style option can be exercised anytime, while a European-style option can only be exercised at expiration. They both derive their value from some underlying asset, which is why they are derivative securities. European style has nothing to do with the domicile of the underlying asset behind the option, and these are offered with a similar range of expiration dates, as are American-style options. LO 4.b
Writing options can be a useful method of generating a stream of income for your customers' portfolio. One issue to be considered is that A. the income isgenerally tax-freee. B. the income is generally taxed as a short-term gain C. the income is generally taxed as long-term gain D. the writer of the option controls whether or not the option is exercised.
Answer: B) The nature of selling options is such that the IRS generally considers the income generated to be taxable as a short-term gain. Currently, the rate of tax on those gains is significantly higher than on long-term gains. It is the owner (holder) of the option, not the writer, who has control over the decision to exercise. Note that for testing purposes, invariably when there ae two choices that are mutually exclusive (taxed short term, or taxed long term), one of those will be the correct answer.
The writer of a call option A) has the right to sell the underlying asset. B) receives the premium. C) pays the premium. D) is obligated to buy the underlying asset.
Answer: B) The option premium is the money paid by the buyer of an option to the writer at the beginning of the options contract. That trade settles in T+1 and the premium paid is not refundable. Hence, the call writer would receive the premium. In turn, the call writer is obligated to sell the underlying at the exercise price to the call buyer. LO 4.b
If a call option with an exercise price of $50 is purchased for $300, the maximum amount the investor can lose is A) unlimited. B) $300. C) $5,000. D) $4,700.
Answer: B) Think about it—you bought something for $300 (the premium on an option is per 100 shares). What is the most you can ever lose with anything of any type that you pay $300 for? Your purchase price! LO 4.b
An investor wishes to be able to obtain the right, but not the obligation, to purchase 100 shares of KAPCO common stock at $50 per share for the next six months. KAPCO is currently selling for $52 per share. This investor's wishes could be met by A) the sale of a put option. B) the purchase of a call option. C) the purchase of a preemptive right. D) the purchase of a forward contract.
Answer: B) A call option gives the holder the right, but not the obligation, to buy an asset at a specific price during a specific period. Although it would be possible to purchase a stock right in the open market, it is unlikely to ever find one with an expiration date more than 45 days from issuance. Selling a put creates an obligation on the seller to buy the stock if the option is exercised and there are no forward contracts on stock. LO 4.b
Exercise of which of the following would not result in a change on the issuer's balance sheet? A) Convertible preferred stock B) Warrants C) A call option D) Rights
Answer: C) When a call option is exercised, the strike price is paid to the seller of the option, not the issuer. The issuer is not involved in any way, so there is no effect on the company's financial statements. When the holder of a convertible preferred stock exercises the conversion privilege, the equity portion of the balance sheet shows a reduction in the preferred stock outstanding and an increase to the common stock outstanding. When rights or options are exercised, assets increase due to the cash paid for the stock and the equity portion of the balance sheet reflects an increase to the number of shares of common stock outstanding. LO 4.c
The term derivative would apply to which of the following? A) DPPs B) UITs C) REITs D) Warrants
Answer: D A derivative has its value based upon some underlying asset. The value of a warrant is based on the value of the security into which it is exchangeable. LO 4.c
When contrasting call options, preemptive rights, and warrants, it would be correct to state A) all of these are issued by the underlying corporation. B) only call options are traded on listed exchanges. C) only call options and warrants have time value. D) only preemptive rights and warrants are issued by the underlying corporation.
Answer: D) Corporations issue preemptive rights (if called for in the corporate charter) when issuing additional shares. Warrants are issued by corporations usually as a sweetener to make a bond issue more attractive. Call options are issued by the Options Clearing Corporation (OCC), not the underlying corporation. All three of these products trade on listed exchanges and all of them have time value with warrants generally having the longest expiration date. LO 4.c
All of the following pay dividends except A) preferred stock. B) common stock. C) convertible preferred stock. D) warrants.
Answer: D) Warrants do not pay dividends; the other instruments listed pay dividends when declared by the board of directors. LO 4.c
All of the following are exchange traded EXCEPT: A) index options. B) forward contracts. C) ETFs. D) futures contract.
Answer: B) Forward contracts are a one-to-one investment where the buyer and seller set the terms of the deal. Lack of standardization makes exchange trading an impossibility. LO 4.d
Which type of contract obligates both parties to act? I. Forward contract II. Futures contract III. Options contract IV. Warrant A) I, II, and III B) I and II C) II and III D) I and IV
Answer: B) It is only in the case of forward and futures contracts that both parties are obligated to fulfill the terms of the contract. Only the seller of an options contract is obligated, and in the case of a warrant, it is the issuer of the warrant who is obligated to deliver the underlying shares if the owner exercises. LO 4.d
One of the privileges frequently offered to holders of common stock is A) call options. B) put options. C) preemptive rights. D) warrants.
Answer: C) The preemptive right is the right given to common stockholders to maintain their proportionate interest in a company. Shareholders are sent those rights. All of the other choices are derivatives that must be purchased individually or, as is so often the case with warrants, attached to another security being purchased. LO 4.c
George owns XYZ stock. Based on recent analyst projections and George's own research, he believes XYZ's price will remain flat over the next few months. Accordingly, which strategy would George most likely employ? A) Buy a warrant. B) Buy a call option. C) Sell a put option. D) Sell a call option.
Answer: D) When the price is expected to stay flat, selling an option is a way to profit with little risk of the option being exercised. Why sell the call instead of the put? Because George owns the XYZ stock, this is a covered call and entails no downside risk. Selling the put would expose George to potentially significant loss if the price of XYZ should suffer a large decline. LO 4.b
Covered call writing is a strategy where an investor A) sells a call on a security he owns to reduce the volatility of the stock's returns and to generate income with the premium. B) buys two calls on the same security he owns to leverage the position. C) buys a call on a security he has sold short. D) sells a call on an index that contains some of the securities that he has in his portfolio.
Answer: A) A covered call is simply defined as an investor owning 100 shares of the underlying stock for each option written (sold). The premium received is not only a source of income but also serves to provide downside protection to the extent of the amount received. LO 4.b
The term sweetener would most often apply to A) warrants. B) derivatives. C) convertibles. D) rights.
Answer: A) A warrant is a derivative that gives the holder the ability to acquire shares of common stock at a fixed price. At issuance, that price is always higher than the current market value of the stock, but warrants generally have a long expiration date that gives them great time value. When an issuer attaches warrants to a bond or preferred stock issue, they serve to sweeten the offering resulting in lower interest rates or dividends. LO 4.c
Which of the following are characteristics of newly issued warrants? A) Time value and intrinsic value B) Time value but no intrinsic value C) Intrinsic value but no time value D) No intrinsic value and no time value
Answer: B 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
A farmer entered into a forward contract to sell his produce at $2.25 per bushel. At the expiration date of the contract, the price was $2.00 per bushel. The farmer would receive A) $2.125 per contract. B) a price negotiated between the buyer and the seller. C) $2.25. D) $2.00.
Answer: C) The reason the farmer entered into this contract was to hedge against a drop in price. Because the strike price was higher than the market price at expiration, the farmer made a good deal, while the buyer of the contract lost. LO 4.d
The term derivative would not include A. futures on commodities B. interest rate swaps C. REITs D. LEAPS
Answer: C) A derivative is something that derives its value from something else. REITS represent direct investment into real estate; the asset purchase is the actual asset. LEAPS are the options with long-term expiry. Never heard of interest rate swaps? Well, on the real exam, there will be occasionally be an answer choice that you never heard of, but it should not affect your ability to choose the correct one.
In May, an investor purchased a futures contract to purchase 5,000 bushels of wheat at $4.30 per bushel for December delivery. On settlement date, the spot price of wheat is $4.20 per bushel. For the investor, this A) contract should be left to expire. B) represents a loss of $500. C) represents a loss of $50. D) represents a successful hedge.
Answer: B) Unlike options, both parties to a futures contract are obligated to perform. That is, the buyer must accept delivery of the contract (in this case, 5,000 bushels of wheat). In practical matters, instead of having a truck show up at the door, the wheat would be sold at its spot price to a user. Therefore, the investor would lose 10 cents per bushel, which on 5,000 bushels is $500. It was the seller of the contract who had a successful hedge because, instead of having to sell at the $4.20 spot price, the wheat is sold at the strike price of $4.30. LO 4.d
Standardized equity options are issued by A) the Options Clearing Corporation (OCC). B) all of these. C) the Chicago Board Options Exchange (CBOE). D) the issuer of the underlying security.
Answer: A) Standardized equity options are issued and guaranteed by the OCC. They are traded on the CBOE and other exchanges. The issuer of the underlying stock is not involved in any way. LO 4.a
In contrast with a typical forwards contract, futures contracts have A) nonstandard terms. B) standardized terms. C) greater counterparty risk. D) less liquidity.
Answer: B) Futures are contracts that trade on exchanges and have standardized terms, in contrast with forwards contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Because futures contracts trade on organized exchanges and have standardized terms, they are more liquid than forwards contracts. LO 4.d
Which of the following definitions involving derivatives is inaccurate? A) The seller of a put option has a neutral outlook. B) A long straddle consists of a long call and a long put on the same underlying stock with the same strike price and the same expiration date. C) A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period. D) An option writer is the seller of an option.
Answer: C) A call option gives the owner the right to buy the underlying security at a specific price for a specified time period. Writers of put options are neutral to bullish; it is the put buyers who are bearish. A short straddle is the opposite of a long straddle—it is a short call and a short put on the same underlying stock with the same strike price and the same expiration date. LO 4.b
The RIF Corporation would not be able to issue A) RIF warrants. B) RIF rights. C) RIF common stock. D) RIF call options.
Answer: D) Options contracts are not issued by the underlying asset. Technically, listed options (the only type that will be on the exam) are issued by the Options Clearing Corporation (OCC). A corporation issues common stock and can issue rights (preemptive rights) and/or warrants. LO 4.c
All the following are standardized for equity options except A. the size of the contract B. the expiration date C. the maximum profit D. the exercise or strike price
Answer: C) The three standardized features of listed equity options are: -The size of the contract on the underlying asset- that is, all options on XYZ stock are for 100 shares of the XYZ common stock. -The expiration date: All options that expire in June (or whatever month) have the same date of expiry. -the exercise or strike price- strike prices are set at standardized intervals. The amount of profit or loss is not standardized. As we'll see later in this unit, there is potential for an unlimited profit or an unlimited loss.
An investor goes short five soybean futures contracts on the Chicago Mercantile Exchange (CME). When the contract expires, A) only the buyer is obligated to perform. B) only the exchange is obligated to perform. C) both the buyer and the seller are obligated to perform. D) only the seller is obligated to perform.
Answer: C) Among the ways in which futures differ from options is that both parties, long and short, are obligated to execute the contract. At expiration date, if not exercised before, the buyer must purchase at the contract price and the seller must deliver at the contract price. In the case of options, the buyer (long position) is the one who chooses to exercise or not, and it is the seller (short position) who becomes obligated to perform. LO 4.d
Which of the following statements best describes a preemptive right? A) The right given to existing holders of a company's stock enabling them to receive dividends in proportion to their equity in the company 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 sell their shares when additional shares are issued D) 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
Answer: D) 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
Braydon has received preemptive rights from one of the stocks held in his portfolio. Which of the following is not an alternative regarding these stock rights? A) Selling at the market B) Exercising C) Giving the rights to his son D) Redeeming them from the issuer for cash
Answer: D) Rights are not redeemable by the issuer. They may be sold in the secondary market or given to someone else to exercise. If exercised, rights are exchanged for an appropriate number of shares of the underlying common stock. LO 4.c
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) effectively hedged the long wheat position. B) has a $50 gain. C) must make delivery of the wheat. D) has a $50 loss.
Answer: D) 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
If your customer owns 100 shares of a volatile stock and wants to limit downside risk, you may recommend A) buying puts B) writing calls and selling puts C) shorting the same stock D) buying calls
Answer: A) Downside risk is reduced by purchasing a put with a strike price at or close to the stock's purchase price. Should the stock decline below the strike price, the investor can exercise the put at the strike price. Selling put options will increase the downside risk. Buying calls is a bullish strategy that increases downside risk. Shorting stock will lock in the current price but will limit upside potential. LO 4.b
The long party in a futures contract has entered the contract as A) a buyer. B) a market maker. C) a liquidity provider. D) a seller.
Answer: A) 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
You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wishes to use options to protect against unlimited loss, you would suggest the client A) buy 1 RIF call. B) sell 1 RIF call. C) buy 1 RIF put. D) sell 1 RIF put.
Answer: A) Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position. LO 4.e
One of your clients purchases a European-style put option on a stock. The premium is $3 and the exercise price is $35. If the price of the underlying asset is $40 on the exercise date, the client has A) made $200. B) lost $300. C) lost $200. D) made $500.
Answer: B) This option is out of the money and is therefore worthless. Remember, European-style options are exercisable only at expiration, and a $35 put is worth nothing unless the market price of the underlying asset is less than $35. As is the case with any long option position, the maximum loss is the premium paid. LO 4.e
options positions can create either rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Selling a put B) Purchasing a put C) Selling a call D) Purchasing a call
Answer: A) When you sell (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is put to you. In the case of a call, you are obligated to sell stock that is called away from you. Options buyers have rights. They can choose what they wish to do; there are no obligations.
An investor would exercise a put option when A) the current premium is higher than the initial cost. B) the market price of the stock is below the strike price. C) the market price of the stock is equal to the strike price. D) the market price of the stock is above the strike price.
Answer: B) 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
All of the following statements describe preemptive rights except A. they are most commonly offered with debentures to make the offering more attractive. B. they are short-term instruments that become worthless after the expiration date. C. they are issued by a corporation D. they are traded in the secondary market
Answer: A A corporation issues rights to existing shareholders to allow them to purchase enough stock, within a short period and at less than the current market price, to maintain their proportionate interest in the company. Rights need not be exercised but may be traded in the secondary market. Warrants, not rights are often issues with debentures to sweeten the offering.
Which of the following definitions involving derivatives is inaccurate? A) A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period. B) An option writer is the seller of an option. C) The seller of a put option has a neutral outlook. D) A long straddle consists of a long call and a long put on the same underlying stock with the same strike price and the same expiration date.
Answer: A) A call option gives the owner the right to buy the underlying security at a specific price for a specified time period. Writers of put options are neutral to bullish; it is the put buyers who are bearish. A short straddle is the opposite of a long straddle—it is a short call and a short put on the same underlying stock with the same strike price and the same expiration date. LO 4.b
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) It fixes the cost of acquiring additional stock for the portfolio. B) This would generate additional income. C) It completes the other side of a spread. D) Owning a long call on stock you already own offers a hedge against a market decline.
Answer: A) 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) must make delivery of the wheat. B) has a $100 gain. C) effectively hedged the long wheat position. D) has a $100 loss.
Answer: B) 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
Many investors with a long position in common stock employ the technique of writing call options on the underlying stock for the purpose of A) protecting the premium. B) generating income. C) participating in the growth of the company. D) increasing the dividend return.
Answer: B) A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. This action has no impact on the amount of the dividends received. It is the uncovered (or naked) call option that has unlimited risk. LO 4.e
A financial instrument whose value depends upon the value of another asset is known as A) a commodity. B) a security. C) a derivative. D) an investment contract.
Answer: C) The definition of a derivative is that its value is based on some underlying asset. Included in the term are options, forwards, futures, and convertible securities. Some derivatives are securities, such as options on stock, while others such as forwards and futures contracts are specifically excluded from the definition of a security. LO 4.a
The value of a derivative is based on A. the value of an underlying asset B. the value set by the CBOE C. the face amount of the derivative D. the time until the underlying asset expires
Answer: A) The reason for the term derivative is because these securities derive their value from the underlying asset. In the case of equity options, the subject covered on the exam, it is the value of the stock that the options are based on. The CBOE is a primary regulator of the options market but has nothing to do with determining value. The term face amount is meaningless, and it is the option that expires, not the underlying corporation.
Covered call writing is a strategy where an investor A) buys two calls on the same security he owns to leverage the position. B) sells a call on an index that contains some of the securities that he has in his portfolio. C) buys a call on a security he has sold short. D) sells a call on a security he owns to reduce the volatility of the stock's returns and to generate income with the premium.
Answer: D) A covered call is simply defined as an investor owning 100 shares of the underlying stock for each option written (sold). The premium received is not only a source of income but also serves to provide downside protection to the extent of the amount received. LO 4.b
One way in which futures contracts differ from options contracts is that A) only the seller is obligated on a futures contract whereas both parties are obligated on options contracts. B) both parties are obligated on futures contracts whereas only the seller is obligated on an options contract. C) only the buyer is obligated on a futures contract whereas only the seller is obligated on an options contract. D) both parties are obligated on futures contracts whereas only the buyer is obligated on an options contract.
Answer: B) Unlike options contracts, where only the seller of the option is obligated to perform (if the option is exercised), both parties to a futures contract are obligated to fulfill the terms. LO 4.d
A client calls to say he has just read about a European option and doesn't know what it is. You would explain that it is a derivative because A) it can only be exercised on the expiration date. B) the currency used is generally something other than the U.S. dollar. C) intrinsic value does not affect the premium. D) its value is based on some underlying asset.
Answer: D Although the unique characteristic of a European option is that it can only be exercised on its expiration date, that doesn't answer this question. It is a derivative like any other option because its value is based on the underlying asset. LO 4.b
All of the following statements regarding futures contracts are correct except A) completing a futures contract requires the delivery of the commodity. B) a short position will increase in value if the underlying commodity or asset declines in value. C) purchasing a contract for future delivery is considered taking a long position. D) futures contracts can be written on financial assets or commodities.
Answer: A) In almost all cases, the holder of the futures contract will purchase an offsetting contract canceling the original position or sell the contract prior to expiration. In isolated cases, delivery of the commodity may be made but is not required. Futures contracts can be written on financial assets such as currencies and stock indexes, as well as on commodities such as agricultural products or precious metals. As with anyone taking a short position, the value goes up when the price of the underlying asset declines. And, just as purchasing a stock or bond, a long position represents one of ownership. LO 4.d
Forwards are commonly used by producers (farmers) to hedge the risk of the price of a commodity falling before it is able to be harvested or sold. For example, if a farmer has planted soybeans and wishes to hedge against a possible decline in the spot or cash price at delivery, the farmer could A. buy forward contracts in a size equal to the amount of soybeans expected to be harvested. B. buy future contracts in a size equal to the amount of soybeans expected to be harvested. C. sell forward or future contracts in a size equal to the amount of soybeans to be harvested. D. sell the soybeans for cash today
Answer: C) Hedging a commodity yet to be harvested is done by selling forward or futures contract on that commodity. Invariably, producers will use forward contracts but could also use future contract. In that way, the price is guaranteed in the event of a market decline. However, the producer is giving up any potential gain in the event the prices rise above the futures/forward agreed-upon one.
Kurt expects a certain stock to significantly rise in value in the near future. He is expecting a bond to mature in two months and does not want to miss out on any appreciation on the stock while waiting for the funds to become available. Which of the following would be the best option strategy for Kurt? A) Sell a put option. B) Sell a call option. C) Buy a call option. D) Buy a put option.
Answer: C) Kurt can lock in the price of the stock by purchasing a call option with an expiration date exceeding two months. Remember the phrase call up. If you think the stock's price is going up, buy a call. LO 4.b
News reports indicate that the wheat crop scheduled to be harvested in three months will be much larger than normal. To hedge, a wheat farmer would most likely A) sell wheat stock short. B) take a long position in wheat futures. C) take a short position in wheat futures. D) grow corn instead.
Answer: C) A bumper crop means lower prices for the producers (farmers). The appropriate protection is a short hedge—selling wheat futures. Think of it this way: if you thought a stock's price was going to decline, you would sell that stock short. Here, believing that wheat prices will decline, you take a short position in that commodity futures contract. There is no such thing as wheat stock, and the wheat has already been planted; it is too late to switch crops. LO 4.d
Which of these would be specified in an exchange-traded futures contract? I. The quantity of the underlying asset II. The quality of the underlying asset III. The time of delivery of the underlying asset IV. The location of delivery of the underlying asset A) II and IV B) I, II, III, and IV C) I, II, and III D) I and III
Answer: B Typically, there are five standardized parts to an exchange-traded futures contract: Quantity of the commodity (e.g., 5,000 bushels of corn or 100 oz. of gold) Quality of the commodity (specific grade or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades) Delivery price (similar to exercise or strike price with options) Time for delivery (e.g., December wheat to be delivered) Location (approved for delivery) LO 4.d
An investor takes a long position in a commodity forward contract at a forward price of $105 when the spot price (current market price) is $102. One month later, the spot price has increased at $110. At that time, the forward price of the contract is A. less than $105 B. $105 C. between $105 and $110 D. greater than $110
Answer: B The price of a forward contract is agreed upon between the buyer and seller at initiation. Remember, forward contracts are not standardized like futures contracts. The value of the contract may change during its life, but not the exercise price. Because forwards tend to be confusing, think of this in the manner of an equity call option. The customer buys a 105 call when the stock's price is $102. One month later, the market price of the stock has risen to $110. What is the strike price? It is still 105. Same concept here.
An investor will likely exercise a put option when the price of the stock is A) at the strike price. B) above the strike price. C) below the strike price. D) above the strike price plus the premium.
Answer: C) First of all, we know this investor is long the put. How? Because only those who own options (are long) can decide to exercise. The owner of a put (long put) profits when the stock falls. The put would be exercised when the price of the stock is below the strike price. For example, if this is a 50 put, the investor has the right to exercise and sell the stock at $50 per share. That is a benefit when the market price of the stock is below 50, and the lower the better. Remember the phrase put down because a put option becomes valuable to the holder when the market price goes below the exercise (strike) price. LO 4.b
An investor owns five DEF call options with a strike price of $40. The options are European style. If the holder exercises, the cost will be A) $0 because European options are exercisable only at expiration. B) $2,000. C) $20,000. D) $4,000.
Answer: C) Each option contract represents 100 shares. Exercising five call options means buying 500 shares at a price of $40 each, which equals $20,000. Although it is true that European-style options are exercisable only at expiration, nothing in the question indicates the investor tried to exercise before then. LO 4.b
One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing which of these risks? I. Liquidity II. Creditworthiness of the buyer III. Lack of assurance that the delivery price will remain stable IV. Location for the delivery may change A) II and III B) III and IV C) I and II D) I and IV
Answer: C) Because there is no standardization for forward contracts, they are considered to be illiquid. Because there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract, as is the method, location, and time of delivery. LO 4.e
A commodities speculator purchases a 1,000-bushel wheat futures contract at 80 cents per bushel. At expiration, the settlement price is 70 cents per bushel. This individual A. has a $100 gain B. has a $100 loss C. must make delivery of the wheat D. effectively hedged the long wheat position
Answer: B The simple math is this: The individual bought at 80 cents and sold at 70 cents, losing 10 centers per bushel. Multiply 10 cents ($.10) by 1,000 bushels, and the loss 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 the expiration). This individual was long the futures contract, not long (the owner of) the wheat.
An investor who is long a put option for 100 shares of ABC common stock has the right to A) sell 100 shares at the higher of the exercise or market price. B) buy 100 shares at the stated exercise price. C) sell 100 shares at the stated exercise price. D) buy 100 shares at the lower of the exercise or market price.
Answer: C) One who is long a put is an owner of the option. Owning a put option gives the holder the right to sell the underlying asset (in this case, 100 shares of ABC stock) at the stated exercise (or strike) price. This would be advantageous if the strike price is above the current market price. LO 4.b
Which of the following statements is true? A) A futures contract always requires delivery of an asset. B) Unlike forwards, futures are not traded on an exchange. C) A futures contract does not involve obligations to buy or sell an asset. D) A futures contract has standardized terms.
Answer: D) Futures contracts are traded on exchanges and, therefore, have standardized terms. In forwards, the terms of each contract are separately negotiated.
Which of the following statements is most accurate when describing equity straddle options? I. The option buyer is looking for market volatility. II. The option buyer is looking for market stability. III. The option seller is looking for market volatility. IV. The option seller is looking for market stability. A) I and IV B) I and III C) II and IV D) II and III
Answer: A) A straddle is the combination of a put and a call on the same stock with the same strike prices and expiration dates. The solution to the question is the same for any option position in that option buyers need price movement and option sellers make money from stability. In the case of a straddle, a buyer is expecting sharp movement but does not know the direction of the move. The seller of the straddle will benefit if there is no significant price movement. LO 4.b
Which of the following definitions involving derivatives is inaccurate? A) An option writer is the seller of an option. B) The seller of a put option has a neutral outlook. C) A call option gives the owner the right to sell the underlying asset at a specific price for a specified time period. D) A long straddle consists of a long call and a long put on the same underlying stock with the same strike price and the same expiration date.
Answer: C) A call option gives the owner the right to buy the underlying security at a specific price for a specified time period. Writers of put options are neutral to bullish; it is the put buyers who are bearish. A short straddle is the opposite of a long straddle—it is a short call and a short put on the same underlying stock with the same strike price and the same expiration date. LO 4.b
In general, the value of a derivative is primarily determined by which of the following? I. The price volatility of the underlying asset II. The exchange on which it is traded III. The length of time until the contract expires IV. Whether it is purchased from a broker or a dealer A) II and III B) I and II C) III and IV D) I and III
Answer: D) The two most important factors influencing the price of a derivative are the price movement (volatility) of the underlying asset and the length of time until the contract expires (the longer the time, the greater the time value).
Options are a popular tool for reducing investment risk. Which risk is hedged when a corporation buys call options on its own common stock? A) Market risk B) Currency risk C) Inflation risk D) Business risk
Answer: A) The company is hedging against a future increase in the company's stock. But isn't hedging designed to protect against loss? Yes, and here the loss is the higher price a company will have to pay for its stock in the open market. Many companies engage in stock buy-back programs. If the company knows it will be executing a buy-back in, let's say, six months, it can buy call options with an exercise price close to today's market price. Then, if the price of the stock is higher in six months, the company can exercise the call options to buy at the lower price. Business risk means the company's fortunes will decline because of bad business decisions. The call option won't be of any help there. Unless we're talking about a non-domestic company (and the question would have to state that), there is no currency or exchange rate risk. Inflation risk is tied to fixed income investments, not common stock. LO 4.b
Buying a put option on a security one currently owns allows an investor to A) participate in additional gains if the security continues to increase in price. B) buy more stock if he exercises the put. C) increase his profit if the security declines in price. D) receive the premium for the purchase of the put.
Answer: A) This is an example of a protective put, that is, purchasing a put option on a stock the investor already owns. This allows the stockholder to lock in a sale price (the strike price of the put). If the market price of the stock continues to rise, the investor would not exercise the put. The put would expire, and the long stock would remain in the account at the higher market price. The investor could hold the stock or sell it at the higher market price. In either case, the investor would continue to participate in the additional gains. The protection (the hedge) occurs if the price of the stock falls. Then the investor would be able to exercise the right to sell the stock at the strike price. That would offset the loss on the long position, not generate additional profit. Remember that options buyers pay the premium; they do not receive it. Exercising a put gives the holder the right to sell the stock, not buy it. Perhaps reviewing an example will help. The investor owns 100 shares of ABC stock currently trading at $50 per share. Since he wants to protect against a drop in price, the investor purchases an ABC put option with a strike price of 50 and pays a premium of 3. If the stock's price rises to $60 per share by the expiration date, the put option will expire worthless. (Who wants to put [sell] stock at $50 when it is selling for $60?) In this case, the investor has paid a premium of 3 points to ensure that the stock can always be sold (during the life of the option) for a price of $50 while still having the opportunity to participate in future price increases of the stock. In our example, the investor has gained $7 per share (the difference between the increase from $50 to $60 less the premium paid for the option).
Which of the following statements concerning put and call options is not correct? A. One call option is an option to buy 100 shares of a particular common stock at a specified price. B. A put option permits investors to speculate on a rise in the price of an underlying common stock without buying the stock itself, and a call option allows investors to speculate on a decline in the stock price without short-selling the common stock any time prior to a specified expiration date. C. One put option gives the buyer the right to sell 100 shares of a particular common stock at a specified price prior to a specified expiration date. D. Options may be used as a hedge against a portfolio position by establishing an opposite position in the option contracts.
Answer: B It is the call option that permits investors to speculate on a rise in the price of the underlying common stock without buying the stock itself and the put option that is the alternative to selling stock short.
A member of the investment banking department of ABC Securities is explaining some of the advantages and disadvantages of rights and warrants to the board of directors of XYZ Corporation. Which of the following statements could he make? I. The exercise prices of stock rights are usually below the current market price of the underlying security at time of issue. II. The exercise prices of warrants are usually above the current market price of the underlying security at time of issue. III. Both rights and warrants may trade in the secondary market and may have prices that include a speculative (time) value. IV. Warrants are often issued attached to a bond issue to reduce the interest costs to the issuer. A) I only B) I, II, III, and IV C) I, II, and III D) I and II
Answer: B) All are true statements. The exercise prices of stock rights are usually below the current market price of the underlying security at time of issue. The exercise prices of warrants are usually above the current market price of the underlying security at time of issue. Both rights and warrants may trade in the secondary market and may have prices that include a speculative (time) value. Warrants are often issued attached to a bond issue to reduce the interest costs to the issuer. LO 4.c
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) Write four ABC 150 call options C) Write four ABC 150 put options D) Buy two ABC 150 put options and write two ABC 150 call options
Answer: B) 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
One of the differences between call options, rights, and warrants is that A) warrants generally have a strike price below the current market value of the underlying stock. B) a corporation can't issue call options on its own stock. C) rights generally have the longest "life" of these three. D) holders of call options stand to profit if the market price of the underlying stock increases.
Answer: B) Although a corporation can issue stock rights and warrants, they cannot issue call options. Listed call options (the only type that will be on the exam), are issued by the Options Clearing Corporation (OCC). Although there are call options with weekly expiration, most expire in 9 months and rights rarely have a life longer than 45 days. Warrants, which generally have the longest time until expiration, are always issued with a strike price above the current market value of the underlying stock. At issuance, they only have time value. It is true that holders of call options stand to profit if the market price of the underlying stock increases, but so do the other two—they do not differ in that respect. LO 4.c
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 four ABC 150 put options B) Write four ABC 150 call options C) Buy two ABC 150 put options and write two ABC 150 call options D) Write an ABC 150 call option
Answer: B) 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
GEMCO Manufacturing Company, traded on the NYSE, has announced that it will be issuing 10 million new shares of common stock to raise new capital for the purchase of new equipment. Your client owning 1,000 shares of GEMCO common stock would probably receive A. an advance invitation to purchase some of the new shares B. options to purchase some of the new shares C. preemptive rights to purchase some of the new shares D. warrants to purchase some of the new shares
Answer: C) Commonly, when a publicly traded company issues new shares of common stock, existing shareholders receive rights, sometimes called stock rights, enabling them to purchase shares in proportion to their current ownership, usually at a reduced price. These rights rarely last longer than 45 days and be must be exercised or sold within that time or they'll just expire worthless. Warrants are not sent to shareholders; they are either purchased in the open market or come attached to a new issue of securities as a "sweetener'"
Which of the following statements about preemptive rights are true? I. Preemptive rights give shareholders the right to purchase shares of new stock issues in direct proportion to the number of shares they already own. II. Preemptive rights allow shareholders to buy as many new shares as they want at any time. III. Preemptive rights allow shareholders to maintain their proportionate share of ownership in the corporation. A) I, II, and III B) II and III C) I and III D) I and II
Answer: C) Preemptive rights give shareholders the right to purchase, in direct proportion to the number of shares they already own, shares in new issues of stock before they are offered to the general public. This allows current shareholders to maintain their proportionate share of ownership in the corporation. LO 4.c
An investor who was sure that a stock's price was going to move substantially but wasn't sure in which direction would be able to benefit by A) writing a straddle on that stock. B) purchasing the stock and a put on the stock. C) purchasing a straddle on that stock. D) selling the stock short and purchasing a call on the stock.
Answer: C) Purchasing a straddle on a stock means going long a put and a call at the same strike price with the same exercise date. If the stock goes up, the investor profits on the call; if the stock goes down, the investor profits on the put. When an investor writes a straddle, a put and a call are sold at the same exercise price and expiration date. Short straddles profit when the stock price remains stable (the opposite of what is presented in this question). Taking a long position in a stock with a long put offers protection to the downside but no profit. Likewise, shorting a stock and taking a long position in a call offers protection to the upside but no profit. LO 4.e
You have a client who is bullish on XYZ stock and currently owns 100 shares that last traded at $50. He has a CD coming due in March, six months from now, and is afraid that by the time those funds are available, XYZ will have shot up in price. How can he ensure that he'll be able to pick up the stock at today's price six months from now and not miss out on that market appreciation? A) Buy an XYZ March 50 put option. B) Sell an XYZ March 50 put option. C) Buy XYZ stock rights. D) Buy an XYZ March 50 call option. Explanation
Answer: D) A call option gives the holder the right, but not the obligation, to purchase shares of the underlying stock at the exercise price until the expiration date. Owning a March 50 call means that any time between now and the expiration date in March, the investor could exercise the option and purchase 100 shares per contract at $50 per share. If the stock doesn't rise in price, the investor can allow the option to expire. Buying a put option would be a good choice if the question asked, "How can the client protect against a market decline?" Selling a put obligates the client to buy the stock at $50, but that would only be exercised if the stock's price fell; this is not something this client would want to do. Stock rights would never run as long as six months. LO 4.b
Which of the following statements regarding derivative securities is not true? A) An option contract is a derivative security because it has no value independent of the value of an underlying security. B) Derivative securities can be sold on listed exchanges or in the over-the-counter market. C) An option contract's price fluctuates in relationship to the time remaining to expiration as well as with the price movement of the underlying security. D) An owner of a put has the obligation to purchase securities at a designated price (the strike price) before a specified date (the expiration date).
Answer: D) An owner of a put has the right—not the obligation—to sell, not purchase, a security at a designated price (the strike price) before a specified date (the expiration date). Although this exam deals exclusively with listed equity options, there are options traded in the OTC market. Two of the factors affecting the market price of an option (its premium) are the length of time until expiration (the longer the time, the greater the time value) and whether or not the option has intrinsic value (the difference between the stock price and the market price). LO 4.c
All of the following are characteristics of a rights offering except A) it is issued to current stockholders. B) the subscription period is up to two years. C) the rights are marketable. D) the subscription price is below the current market value.
Answer: B) Rights offerings are usually very short-lived (30 to 45 days). LO 4.c
Included in the definition of derivative would be all of the following except A) futures. B) leveraged ETFs. C) options. D) rights.
Answer: B) ETFs, whether leveraged or not, are investment companies and are not included in the definition of derivative. LO 4.d
The term derivative would apply to all of the following except A) forwards B) futures C) options D) hedge funds
Answer: D) Explanation Hedge funds are pooled investments, a form of investment company, and are not derivatives as are the other three choices. This is an example of a question where you get the correct answer by knowing the other three choices are not the exception. LO 4.a
Which of the following would not be considered derivatives? A) Forward contracts B) Futures contracts C) Equity options D) An ETF tracking the Bloomberg Commodity Index
Answer: D) An exchange-traded fund (ETF) is an investment company, regardless of what is contained in its portfolio. Forwards, futures, and equity options are derivatives. LO 4.a
An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to A) sell a call. B) buy a put. C) sell a put. D) buy a call.
Answer: A) Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not staying steady in price. LO 4.b
An investor purchases two PMJ Dec 16 calls at $0.85. If the commission charge is $8, the total cost is A) $328. B) $178. C) $93. D) $188.
Answer: B) A premium of 85 cents per share means each contract has a cost of $85. There are two of them, making that $170. Adding the $8 commission brings the total to $178. LO 4.e
Which of the following is not considered a derivative? A) Call option B) Futures contract C) Unit investment trust D) Warrant
Answer: C) All of the other choices "derive" their value from some underlying asset. A UIT is an investment company, and its value is based on its own assets. LO 4.a
