Unit 4 - Types and Characteristics of Derivative Securities
Which of the following financial instruments is not a derivative? A) A share of stock B) A call option C) LEAPS D) A put option
A) 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. LO 4.a
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. LO 4.c
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 long hedge. B) a trimmed hedge. C) a neutral hedge. D) a short hedge.
A) 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. LO 4.d
The term used to describe investment vehicles whose value is based on an underlying asset is A) derivative. B) funded debt. C) parity. D) separate account.
A) derivative. 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
When contrasting call options, preemptive rights, and warrants, it would be correct to state A) only preemptive rights and warrants are issued by the underlying corporation. B) only call options and warrants have time value. C) all of these are issued by the underlying corporation. D) only call options are traded on listed exchanges.
A) 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 exchanges, 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
One of the privileges frequently offered to holders of common stock is A) preemptive rights. B) put options. C) warrants. D) call options.
A) 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. 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) purchasing a straddle on that stock. B) purchasing the stock and a put on the stock. C) selling the stock short and purchasing a call on the stock. D) writing a straddle on that stock.
A) 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. LO 4.e
The term sweetener would most often apply to A) warrants. B) convertibles. C) rights. D) derivatives.
A) 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. LO 4.c
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) I and IV D) II and III
B) I and II 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
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 and II B) I, II, III, and IV C) I only D) I, II, and III
B) I, II, III, and IV 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
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
B) I, II, III, and IV 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
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) Market risk C) Inflation risk D) Business risk
B) 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. LO 4.b
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 short hedge. B) a long hedge. C) a neutral hedge. D) a trimmed 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. LO 4.d
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) buying puts C) writing calls and selling puts D) buying calls
B) 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. LO 4.b
Included in the definition of derivative would be all of the following except A) rights. B) leveraged ETFs. C) futures. D) options.
B) leveraged ETFs. ETFs, whether leveraged or not, are investment companies and are not included in the definition of derivative. LO 4.d
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) increase his profit if the security declines in price. D) buy more stock if he exercises the put.
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). LO 4.b
An investor would exercise a put option when A) the market price of the stock is equal to the strike price. 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 current premium is higher than the initial cost.
B) the market price of the stock is below the strike price. A put option gives its owner the right to sell the underlying security at a specified price (strike price) for a specified time period. When the stock's price is less than the strike price, a put option has value and is said to be in the money. LO 4.b
The long party to a put option contract has A) the right to buy the underlying asset. B) the right to sell the underlying asset. C) the obligation to sell the underlying asset. D) the obligation to buy the underlying asset.
B) the right to sell the underlying asset. Being long a put option means owning the option. Owners have rights, while sellers have obligations. A put option gives the owner the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price if the buyer exercises the option. LO 4.b
Exercise of which of the following would not result in a change on the issuer's balance sheet? A) Rights B) Convertible preferred stock C) A call option D) Warrants
C) 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. LO 4.c
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 has standardized terms. D) A futures contract does not involve obligations to buy or sell an asset.
C) 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. LO 4.d
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) Buy a put option. B) Sell a call option. C) Buy a call option. D) Sell a put option.
C) Buy a call option. 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
Which of the following is not traded on any exchange? A) Futures contracts B) ETFs C) Forward contracts D) Closed-end funds
C) Forward contracts Forward contracts are nonstandardized and, as such, do not trade on any exchange. LO 4.d
A purchaser of which of the following investments has an obligation? A) Warrants B) Stock rights C) Forwards D) Options
C) Forwards It is only in the case of forward contracts that the buyer (and seller) are both obligated to complete the contract. Holders of options have the right to exercise but are not obligated to do so. The same is true of stock rights and warrants. LO 4.d
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). LO 4.a
The term derivative would not apply to which of the following? A) Futures B) Forwards C) REITs D) Warrants
C) REITs REITs are not based on the value of something other than their own assets. Warrants (and rights) derive their value from the underlying security. Futures and forwards are contracts whose value is based on some underlying asset. LO 4.a
Options positions can create either rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Purchasing a put B) Purchasing a call C) Selling a put D) Selling 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. LO 4.b
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) buy 1 RIF put. C) buy 1 RIF call. D) sell 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. LO 4.e
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) generating income. D) participating in the growth of the company.
C) 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. 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) must make delivery of the wheat. B) has a $50 gain. C) has a $50 loss. D) effectively hedged the long wheat position.
C) has a $50 loss. 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
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 put. B) sell a put. C) sell a call. D) buy a call.
C) sell a call. 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
In contrast with a typical forwards contract, futures contracts have A) greater counterparty risk. B) nonstandard terms. C) standardized terms. D) less liquidity.
C) standardized terms. 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
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 long position in wheat futures. B) sell wheat stock short. C) take a short position in wheat futures. D) grow corn instead.
C) 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. LO 4.d
All of the following pay dividends except A) common stock. B) preferred stock. C) warrants. D) convertible preferred stock.
C) warrants. Warrants do not pay dividends; the other instruments listed pay dividends when declared by the board of directors. LO 4.c
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) Buy a put option. B) Sell a call option. C) Sell a put option. D) Buy a call option.
D) Buy a call option. 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
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 III B) II and IV C) I 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. LO 4.b
Which one of the following option positions would generally command the greatest time value? A) Straddles B) Puts C) Calls D) LEAPS
D) LEAPS LEAPS, the acronym for long-term equity anticipation securities, have expiration dates that can run more than three years compared with the nine months for standard option contracts. Because time value is a direct function of the length of the option, the longer the time until expiry, the greater the potential time value. LO 4.b
Nonsecurities derivatives include futures and forwards. Among the differences between futures and forwards is that futures contracts A) are not regulated by the CFTC, while forwards are. B) are nonstandardized, while forwards are. C) are preferred to forwards by producers. D) are rarely exercised, while forwards generally are.
D) are rarely exercised, while forwards generally are. In the vast majority of the cases, futures contracts are closed out prior to expiration. That is one reason they are more popular with speculators than forwards. Because forwards are generally delivered, they are the preferred tool by producers, and it is futures that are standardized and CFTC regulates, not forwards. LO 4.d
An investor will likely exercise a put option when the price of the stock is A) above the strike price. B) at the strike price. C) above the strike price plus the premium. D) below the strike price.
D) below the strike price. 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
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) made $500. C) lost $200. D) lost $300.
D) 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. LO 4.e
An investor who is long XYZ stock would consider going long an XYZ call to A) protect against a decrease in the market price of XYZ stock. B) obtain income from the premium. C) hedge the long position. D) protect against an increase in the market price of XYZ stock.
D) 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. LO 4.b
The writer of a call option A) is obligated to buy the underlying asset. B) has the right to sell the underlying asset. C) pays the premium. 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. LO 4.b
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 lower of the exercise or market price. C) buy 100 shares at the stated exercise price. D) sell 100 shares at the stated exercise price.
D) sell 100 shares at the stated exercise price. 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
An investor would exercise a put option when A) the market price of the stock is equal to the strike price. B) the current premium is higher than the initial cost. C) the market price of the stock is above the strike price. D) the market price of the stock is below the strike price.
D) the market price of the stock is below the strike price. A put option gives its owner the right to sell the underlying security at a specified price (strike price) for a specified time period. When the stock's price is less than the strike price, a put option has value and is said to be in the money. LO 4.b
All of the following are characteristics of a rights offering except A) the rights are marketable. B) the subscription price is below the current market value. C) it is issued to current stockholders. D) the subscription period is up to two years.
D) the subscription period is up to two years. Rights offerings are usually very short-lived (30 to 45 days). LO 4.c
