Unit 4

Exercise of which of the following would not result in a change on the issuer's balance sheet? A) Rights B) A call option C) Convertible preferred stock D) Warrants

B) A call option 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.

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

C) I and II 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.

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) I and III D) III and IV

C) I and III 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).

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) -$10. C) $105. 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?

An investor buys five put contracts with a strike price of $55 per share. The current price of the underlying stock is $60 and the option premium is $7. The commission schedule is as follows: Trade Amount Commission Rate ≤ $2,500 $35 + 0.9% of trade amount $2,501-$11,999 $35 + 0.7% of trade amount ≥ $12,000 $35 + 0.5% of trade amount Using the information provided, what is the total commission cost for this trade? A) $59.50 B) $39.90 C) $297.50 D) $199.50

A) $59.50 The cost per contract is $7 × 100 shares, or $700. That makes the total trade amount $700 × 5 contracts, or $3,500, which qualifies for the commission rate of $35 + 0.7% of the trade amount. The math is $35 + (0.7% of $3,500) = $35 + (0.7% × $3,500) = $35 + $24.50 = $59.50 total charge.

Which of the following statements regarding derivative securities is not true? A) 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). B) An option contract is a derivative security because it has no value independent of the value of an underlying security. 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) Derivative securities can be sold on listed exchanges or in the over-the-counter market.

A) 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). 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).

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 and III B) II and III C) I, II, and III D) I and II

A) I and III 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.

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) Owning a long call on stock you already own offers a hedge against a market decline. C) It completes the other side of a spread. D) This would generate additional income.

A) 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.

Which of the following are characteristics of newly issued warrants? A) Time value but no intrinsic value B) Intrinsic value but no time value C) Time value and intrinsic value D) No intrinsic value and no time value

A) 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.

The term derivative would apply to which of the following? A) Warrants B) DPPs C) REITs D) UITs

A) Warrants 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.

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) represents a loss of $500. B) represents a loss of $50. C) contract should be left to expire. D) represents a successful hedge.

A) represents a loss of $500. 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.

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) take a short position in wheat futures. B) sell wheat stock short. C) take a long position in wheat futures. D) grow corn instead.

A) take a short position in wheat futures. 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.

Standardized equity options are issued and guaranteed by A) the Options Clearing Corporation (OCC). B) the Chicago Board Options Exchange (CBOE). C) the National Futures Association (NFA). D) the Commodities Futures Trading Commission (CFTC).

A) the Options Clearing Corporation (OCC). The OCC has the role of issuer and guarantor of all standardized equity options. That means if one party to an options contract fails to perform, the OCC steps in and takes that role (and then goes after the recalcitrant party).

Which of the following statements is true? A) A futures contract does not involve obligations to buy or sell an asset. B) A futures contract has standardized terms. C) A futures contract always requires delivery of an asset. D) Unlike forwards, futures are not traded on an exchange.

B) A futures contract has standardized terms. Futures contracts are traded on exchanges and, therefore, have standardized terms. In forwards, the terms of each contract are separately negotiated.

An option that may be exercised before its expiration date is said to be A) Flexible style. B) American style. C) Premature style. D) European style.

B) American style. There are two forms of option exercise—American and European. American style can be operationally exercised any day that the market is open before the expiration date. With European style, the only time you can operationally exercise your contract is the last trading day before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

Which of the following would not be considered derivatives? A) Forward contracts B) An ETF tracking the Bloomberg Commodity Index C) Futures contracts D) Equity options

B) An ETF tracking the Bloomberg Commodity Index An exchange-traded fund (ETF) is an investment company, regardless of what is contained in its portfolio. Forwards, futures, and equity options are derivatives.

Which of the following is not traded on any exchange? A) Closed-end funds B) Forward contracts C) Futures contracts D) ETFs

B) Forward contracts Forward contracts are nonstandardized and, as such, do not trade on any exchange.

The term derivative would apply to which of the following? A) UITs B) Warrants C) REITs D) DPPs

B) Warrants 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.

A manufacturer of soybean oil is concerned that the price of soybeans will increase over the next six months. The best strategy to employ would probably be A) a trimmed hedge. B) a long hedge. C) a neutral hedge. D) a short hedge.

B) a long hedge. The concern is that the price will go up. Just as with options, when we are concerned that the price of something will go up, we go long that item. With options, it would be a long call; with futures, it is simply hedging by going long (buying) the soybean futures. The soybean farmer who would be concerned about a decline in the price would go short soybean futures.

A European-style option differs from an American-style option primarily in that it A) is generally offered with a limited number of expiration dates. B) can only be exercised on its expiration date. C) derives its value from some underlying asset. D) is primarily used for options on foreign securities.

B) can only be exercised on its expiration date. 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.

The term used to describe investment vehicles whose value is based on an underlying asset is A) separate account. B) derivative. C) funded debt. D) parity.

B) derivative. Derivatives are referred to as such because they derive their value from some underlying asset, whether it be a stock or a commodity.

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) made $500. D) lost $200.

B) lost $300. 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.

Buying a put option on a security one currently owns allows an investor to A) receive the premium for the purchase of the put. B) participate in additional gains if the security continues to increase in price. C) buy more stock if he exercises the put. D) increase his profit if the security declines in price.

B) participate in additional gains if the security continues to increase in price. 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).

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) Currency risk B) Business risk C) Market risk D) Inflation risk

C) Market risk 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.

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 call B) Purchasing a put C) Selling a put D) Purchasing a call

C) Selling a put 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.

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) sell 1 RIF call. B) sell 1 RIF put. C) buy 1 RIF call. D) buy 1 RIF put.

C) buy 1 RIF call. 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.

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 preemptive rights and warrants are issued by the underlying corporation. D) only call options and warrants have time value.

C) only preemptive rights and warrants are issued by the underlying corporation. 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.

One of the privileges frequently offered to holders of common stock is A) call options. B) warrants. C) preemptive rights. D) put options.

C) preemptive rights. 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.

An investor who is long XYZ stock would consider going long an XYZ call to A) hedge the long position. B) obtain income from the premium. C) protect against an increase in the market price of XYZ stock. D) protect against a decrease in the market price of XYZ stock.

C) protect against an increase in the market price of XYZ stock. Going long a call means that you have bought it. Only sellers of options generate income. If you wish to hedge your long stock position, you buy a put, not a call. That leaves us with two choices that are polar opposites. Good test-taking skills teach us that, in almost all cases, when we see that, one of those must be the right answer. Buying a call is bullish. Forget the first part (you are long the stock). You would buy a call so that, if the price of the stock went up, you could exercise at the lower strike price of your call option.

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) selling the stock short and purchasing a call on the stock. C) purchasing a straddle on that stock. D) purchasing the stock and a put on the stock.

C) purchasing a straddle on that stock. 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.

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) buy a call. B) sell a call. C) sell a put. D) buy a put.

C) sell a put. 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.

Which of the following financial instruments is not a derivative? A) A call option B) A put option C) LEAPS D) A share of stock

D) A share of stock 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.

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) II and IV B) I and III C) II and III D) I and IV

D) I and IV 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.

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) Sell a put option. B) Buy a warrant. C) Buy a call option. D) Sell a call option.

D) Sell a call option. 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. The risk to a call writer (seller) is that the market price of the XYZ stock will increase significantly. If the call is not covered, then the writer has to buy it at the current market price (and deliver it at the lower strike price). When, as in this case, the seller owns the stock, regardless of how high the market price goes, it is unnecessary to buy the XYZ because George will deliver the shares he already owns. That is why covered call writing is such a relatively low risk strategy. Selling the put would expose George to potentially significant loss if the price of XYZ should suffer a large decline.

If your customer owns 100 shares of a volatile stock and wants to limit downside risk, you may recommend A) shorting the same stock B) writing calls and selling puts C) buying calls D) buying puts

D) buying puts 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.

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) increasing the dividend return. B) protecting the premium. C) participating in the growth of the company. D) generating income.

D) generating income. 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.

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) has a $50 gain. C) effectively hedged the long wheat position. 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.

The writer of a call option A) pays the premium. B) has the right to sell the underlying asset. C) is obligated to buy the underlying asset. D) receives the premium.

D) receives the premium. 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.

The term sweetener would most often apply to A) rights. B) convertibles. C) derivatives. D) warrants. E) Ariana Grande.

D) warrants. 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.