6.4 Options and Derivatives Flashcards
Buying a wheat futures contract to protect against price fluctuation of wheat would be classified as a
A. Fair value hedge
B. Cash flow hedge
C. Foreign currency hedge
D. Swap
B. Cash flow hedge
A cash flow hedge is an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk.
You are currently holding a call option on a stock with an exercise price of $100. If the current stock price is $90, the intrinsic value of this option is
A. $90
B. $(10)
C. $10
D. $0
D. $0
The intrinsic value of a call option is the price of the underlying asset less the exercise price. If the value of the underlying is less than the exercise price of the option, the option is “out-of-the-money,” or not worth exercising. Intrinsic value cannot be less than zero. The intrinsic value of an out-of-the-money option is zero.
A gold-mining company expects to sell 10,000 ounces of gold 6 months from today. The revenue risk of selling the gold can be hedged by
A. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.
B. Buying a gold futures contract for 5,000 ounces today that expires in 6 months and selling a gold futures contract for 5,000 ounces today that expires in 6 months.
C. Buying a gold future contract for 10,000 ounces today that expires in 6 months.
D. Selling the gold in the spot market 6 months from today.
A. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.
Selling a gold futures contract for 10,000 ounces today that expires in 6 months would allow the gold-mining company to lock in a selling price today for the sale of the 10,000 ounces in 6 months when the contract expires. This will hedge the revenue risk as the company pre-determined what it will get for the contract in 6 months.
When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying
A. A hedging approach
B. Working capital management
C. Return maximization
D. Financial leverage
A. A hedging approach
Maturity matching, or equalizing the life of an asset and the debt instrument used to finance that asset, is a hedging approach. The basic concept is that the company has the entire life of the asset to recover the amount invested before having to pay the lender.
If a corporation’s stock price experiences increased volatility, what would happen to the value of the call options and the put options on the corporation’s stock?
A. The call options would increase in value, and the put options would decrease in value.
B. The call options would decrease in value, and the put options would increase in value.
C. Both the call options and the put options would increase in value.
D. Both the call options and the put options would decrease in value.
C. Both the call options and the put options would increase in value.
Since options protect against volatility in the stock price, the more volatile a stock is, the more owning the options becomes valuable.
The use of derivatives to either hedge or speculate results in
A. Offsetting risk when hedging and increased risk when speculating.
B. Offsetting risk when speculating and increased risk when hedging.
C. Decreased risk regardless of motive.
D. Increased risk regardless of motive.
A. Offsetting risk when hedging and increased risk when speculating.
Derivatives, including options and futures, are contracts between the parties who contract. Unlike stocks and bonds, they are not claims on business assets. A future contract is entered into as either a speculation or a hedge. Speculation involves the assumption of risk in the hope of gaining from price movements. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements.
An investor wrote a $45 call option and bought a $50 put option, both of which had the same time to expiration. On the transaction date, the stock price was $45, and the prices for the call and put options were $8 and $10, respectively. Subsequently, the stock price fell by $10, where it remained through the option expiration date. As of the expiration date, the total profit on the combined option position, ignoring commissions and other transactions, is
A. $3
B. $17
C. $7
D. $13
D. $13
The amount of gain and loss on a call option for the writer is calculated as the option price minus the excess of the market price over the exercise price, if any. Thus, the call option provides the investor a gain of $8 ($8 - $0).
The amount of gain and loss on a put option for the buyer is calculated as the excess of the exercise price over the market price minus the option price. Thus, the put option provides the investor a gain of $5 [($50-$35) - $10)]. The total profit on the combined option position is $13 ($8 gain + $5 gain).
Which one of the following is not a determinant in valuing a call option?
A. Interest rate.
B. Exercise price.
C. Forward contract price.
D. Expiration date.
C. Forward contract price.
The exercise price, the expiration date, and the interest rate are all determinants in valuing a call option.
The owner of a call option wants to know the respective effects on the call’s price of a decrease in stock-return volatility and a decrease in time to expiration. The respective effects on the call’s price are which of the following?
Decrease in stock return volatility: decrease/increase
Decrease in Time to Expiration: decrease/increase
Decrease in stock return volatility: decrease
Decrease in Time to Expiration: decrease
A decrease in stock-return volatility will cause the call’s price to decrease. A decrease in the time to expiration will also cause the call’s price to decrease. Thus, both of these effects will cause a decrease in the call’s price.
Which of the following financial instruments is not considered a derivative financial instrument?
A. Bank certificates of deposit.
B. Stock-index options.
C. Currency futures.
D. Interest-rate swaps.
A. Bank certificates of deposit.
A derivative is a financial instrument or other contract that (1) has (a) one or more underlyings and (b) one or more notional amounts or payment provisions, or both; (2) requires either no initial net investment or an immaterial net investment; and (3) requires or permits net settlement. An underlying may be a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified. Settlement of a derivative is based on the interaction of the notional amount and the underlying. A certificate of deposit is a financial instrument of the issuing bank that is a type of promissory note. It has no underlying and requires a material net investment. Thus, it is not a derivative.
A derivative financial instrument is best described as
A. A contract that conveys to a second entity a right to future collections on accounts receivable from a first entity.
B. A contract that conveys to a second entity a right to receive cash from a first entity.
C. Evidence of an ownership interest in an entity such as shares of common stock.
D. A contract that has its settlement value tied to an underlying notional amount.
D. A contract that has its settlement value tied to an underlying notional amount.
A derivative is a bet on whether the value of something (underlying notional amount) will go up or down. A derivative has at least one underlying (interest rate, currency exchange rate, price of a specific financial instrument, etc.) and at least one notional amount (number of units specified in the contract) or payment provision, or both. No initial net investment, or one smaller than that necessary for contracts with similar responses to the market, is required. Furthermore, a derivative’s terms require or permit net settlement or provide for the equivalent. Net settlement means that the derivative can be readily settled with only a net delivery of assets. Thus, neither party must deliver (1) an asset associated with its underlying or (2) an asset that has a principal, stated amount, etc., equal to the notional amount.
A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by
A. Selling a put option on that stock.
B. Purchasing a put option on that stock.
C. Purchasing a call option on that stock.
D. Obtaining a warrant option on that stock.
B. Purchasing a put option on that stock.
A put option is the right to sell stock at a given price within a certain period. If the market price falls, the put option may allow the sale of stock at a price above market, and the profit of the option holder will be difference between the price stated in the put option and the market price, minus the cost of the option, commissions, and taxes. The company that issues the stock has nothing to do with put (and call) options.
A seasonal business has decided to finance seasonal variations in current assets with short-term debt while financing the permanent component of current assets and all fixed assets with long-term debt or equity. Which one of the following best describes this type of financing?
A. Spontaneous financing.
B. Leveraged financing.
C. Capital rationing.
D. Hedging.
D. Hedging.
The hedging approach to financing involves matching maturities of debt with specific financing needs.
A distinguishing feature of a futures contract is that
A. Performance is delayed.
B. It is a hedge, not a speculation.
C. The price is marked to market each day.
D. Delivery is to be on a specific day.
C. The price is marked to market each day.
A distinguishing feature of futures contracts is that their prices are marked to market every day at the close of the day. Thus, the market price is posted at the close business each day. A mark-to-market provision minimizes a futures contract’s chance of default because profits and losses on the contracts must be received or paid each day through a clearinghouse.
An entity is planning on issuing at par, £5 million of 10-year, non-prepayable debt at 9% interest. The entity wants to convert its fixed-rate interest payments to floating-rate interest payments based on the London interbank offered rate. Which one of the following contracts should the entity consider?
A. Options.
B. Forwards.
C. Futures.
D. Swaps.
D. Swaps.
Swaps are contracts by which the parties exchange cash flows. Interest rate swaps are agreements to exchange interest payments based on one interest structure for payments based on another structure. For example, a company with fixed debt service charges may enter into a swap with a counterparty who agrees to supply the first party with interest payments based on a floating rate that more closely tracks the first party’s revenues.
