C13 - Derivatives (25-30 Qs C11-C14 'Asset Classes') BC Flashcards
Which of the following best defines what variation margin payment covers?
A) Adverse movements expected over the next week
B) Initial payment to cover future movement in price
C) Adverse movements expected in value from the previous day
D) Adverse movments from the previous week
C - Adverse movements expected in value from the previous day
Variation margin can be a receipt or a payment. It represents the profit or loss on open derivative positions, which result from changes in underlying asset values from the previous day.
An open derivative position is a financial contract that a trader holds and is still active. Open derivative positions can be profitable or result in a loss.
Which of the following best defines initial margin?
A) Adverse movements expected over the next week
B) Initial deposit to cover the maximum likely daily loss on a futures contract
C) Adverse movements in value from the previous day
D) Adverse movements from the previous week
B - Initial deposit to cover the maximum likely daily loss on a futures contract
Initial margin is a ‘goodwill deposit’ payable to the clearing house when entering into futures positions.
A futures position is a commitment to buy or sell a financial instrument or commodity at a predetermined price and date in the future. A futures position can be either long or short:
* Long position: A long position is when an investor buys a futures contract. The investor believes the price of the futures will increase.
* Short position: A short position is when an investor sells a futures contract. The investor believes the price of the futures will decrease.
Types of futures
* Commodity futures: An agreement to buy or sell a commodity at a set price and date
* Index futures: An agreement to buy or sell the cash value of an index at a set price and date
* Currency futures: An agreement to exchange one currency for another at a set price and date
**Closing out a futures position **
To close out a futures position, an investor enters into another contract that offsets the initial transaction
Why would a portfolio manager holding equities use futures?
1. Futures are more liquid than the underlying equities
2. Futures transaction costs are cheaper than underlying equities
3. To increase leverage
A) 1 only
B) 2 only
C) All of the above
D) 2 and 3
C - All of the above
Other advantages include the ability to take a short position and execute trades more quickly than in the cash market.
You hold 1 FTSE100 Index call option contract with an exercise price of 6,000. The index currently stands at 6,020 Ignoring premium costs and commissions, which of the following is TRUE? (The Option is priced at £10 an index point)
A) You are ‘in-the-money’ by £20
B) You are ‘out-the-money’ by £20
C) You are ‘in-the-money’ by £200
D) You are ‘out-the-money’ by £200
C - You are ‘in-the-money’ by £200
Exercising the option would lead to a GAIN of 20 points. at £10 per index point, the total gain (intrinsic value) is £200. If an option has intrinsic value it is ‘in-the-money’.
-
“in the money” (ITM) refers to an option that possesses intrinsic value. An option that’s in the money is an option that presents a profit opportunity due to the relationship between the strike price and the prevailing market price of the underlying asset. An in-the-money call option means the option holder can buy the security below its current market price. An in-the-money put option means the option holder can sell the security above its current market price. Due to the expenses (such as commissions) involved with options, an option that is ITM does not necessarily mean a trader will make a profit by exercising it.
* “Out of the money” (OTM) is an expression used to describe an option contract that only contains extrinsic value. These options will have a delta of less than 0.50. An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively, an OTM put option has a strike price that is lower than the market price of the underlying asset.
What happens to the buyer of a long bond future at delivery?
A) Obliged to deliver the bond
B) Obliged to take delivery of a bond
C) Takes any profit or loss in cash
D) Settles into an option position
B - Obliged to take delivery of a bond
The underlying asset of a long bond future is a NOTIONAL bond. However, the exchange produces a list of ‘deliverable bonds’, which are REAL bonds available for delivery. The buyer of a long bond future is consequently obliged to take delivery of a real bond selected by the seller. This bond is defined as the ‘Cheapest to Delivery’ (CTD).
Taking delivery of a bond is the process of transferring a bond from a seller to a buyer in a futures contract. The delivery process is a three-day event that involves an intention day, notice day, and delivery day.
Which is the BEST definition of a future?
A) An obligation to buy a given quantity of an asset on a range of figure dates at a pre-determined price
B) An agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today
C) An agreement to buy or sell a standard quantity of a specified asset on or before a fixed future date at a price agreed today
D) The right to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today
B - An agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today
Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.
Which of the following statements are TRUE of a call option?
1. The purchaser has the right but not the obligation to BUY an underlying asset
2. The purchaser has the right but not the obligation to SELL an underlying asset
3. The option is exercisable at ANY price
4. The option is exercisable at a SPECIFIC price
A) All of the above
B) 1, 2 and 3
C) 2 and 3
D) 1 and 4
D - 1 (The purchaser has the right but not the obligation to BUY an underlying asset) and 4 (The option is exercisable at a SPECIFIC price)
A Call option is the right to BUY the underlying asset at a specific price, as in the Strike or Exercise price.
A call option is a contract that gives the buyer the right to buy an asset at a predetermined price within a certain time frame. The buyer pays a fee, called a premium, to the seller of the option.
Which of the followig could be undertaken by someone who expects share prices to rise sharply in the near future?
A) Buy a FTSE call option
B) Buy a FTSE put option
C) Buy a FTSE Future
D) Buy a Gilt future
A - Buy a FTSE call option
*A call option gives the buyer the right to purchase an asset at a predetermined price, often done when prices rise above the strike price, while a put option gives the buyer the right to sell an asset at a predetermined price, often when prices fall below a strike price. *
Hedging is which of the following?
A) Trading in futures or options
B) Taking an opposite position in the futures market to your position in the underlying asset
C) Taking a matching position in the futures market to your position in the underlying asset
D) Selling futures in anticipation of a fall in the price of the underlying asset
B - Taking an opposite position in the futures market to your position in the underlying asset
At its core, hedging using futures is a strategy used across financial markets to reduce the potential risk of loss from price fluctuations. As a significant player in this domain, the futures market is a key arena for hedging activities.
Which of the following is TRUE?
A) Call options are the right to sell at a future date
B) American-style options can be exercised at any time (in a given period)
C) Intrinsic value is a measure of future likely increase in share price
D) In the money is where an option has just been traded for cash
B - American-style options can be exercised at any time (in a given period)
An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.
A company has a long dated gilt and worries about a fall in value, which of the following are suitable hedging transactions?
1. Buy a long gilt future
2. Sell a long gilt future
3. Buy a gilt put option
4. Write a gilt put option
A) 1 and 3
B) 2 and 4
C) 1 and 4
D) 2 and 3
D - 2 (Sell a long gilt future) and 3 (Buy a gilt put option)
- 1 would be the same position you are already in.
- 2 Selling a long gilt would be mitigate current position of holding a long gily
- 3 a put position is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame. This mitigates the loss of the long gilt should the price fall.
- 4 A put is a strategy traders or investors may use to generate income or buy stocks at a reduced price. When writing a put, the writer agrees to buy the underlying stock at the strike price if the contract is exercised. Writing, in this case, means selling a put contract in order to open a position. If you are agreeing to BUY a gilt, you are not mitigate the risk of the gilt asset class
The maximum potential loss which could be incurred by a writer of a put option is:
A) Unlimited
B) The exercise price plus the premium
C) The Premium for the option
D) The execise price minus the premium
D - The execise price minus the premium
A put option (or “put”) is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame.
You pay a premium for the Put option, therefore the maximum loss is predetermined exercise price of the put option MINUS the premium you paid.
The exercise price of a put option is the price at which the underlying security can be sold. It’s also known as the strike price.
A writer of a put option on an underlying asset:
A) would hope the price will fall
B) May be forced to pay the premium
C) May be forced to SELL the underlying asset
D) May be forced to BUY the underlying asset
D - May be forced to BUY the underlying asset
A put is a strategy traders or investors may use to generate income or buy stocks at a reduced price. When writing a put, the writer agrees to buy the underlying stock at the strike price if the contract is exercised. Writing, in this case, means selling a put contract in order to open a position.
Which index provides the basis for a future and an option traded on ICE Futures Europe?
A) FT-30
B) FTSE 100
C) FTSE All share
D) FTSE 250
B - FTSE 100
ICE Futures Europe provides trading for London’s softs markets, including futures and options contracts on cocoa, Robusta coffee, white sugar, and feed wheat.
Another method of trading the FTSE 100 involves trading futures contracts, which are an agreement to trade at a specific price on a specific date.
What is TRUE of an American Style Option?
1. It can only be traded in the US Market
2. It can be exercised in a flexible manner - in any given time within the option period.
3. It can only be exercised on a fixed date
4. It only includes the right to buy an underlying asset
A) 1, 2 and 4
B) 1 and 3
C) 2 only
D) 2 and 4
C - 2 (It can be exercised in a flexible manner - in any given time within the option period.)
An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.
Most stock and equity options are American options, while indexes are generally represented by European options. Commodity options can be either style.
Why are futures referred to as being geared or leveraged?
A) The intrinsic value varies over their life
B) An investor can borrow money to invest in them
C) The margin paid is in excess of the price of the future or the potential profit
D) The margin paid is BELOW the price of the future or the potential profit
D - The margin paid is BELOW the price of the future or the potential profit
A company has issued convertible loan stock, which can convert at the rate of 50 ordinary shares per £100 nominal. If the convertible is trading at £140 and the ordinary shares at 220 pence each What is the conversion premium?
A) 57%
B) 27%
C) 40%
D) 79%
B - 27%
Conversion premium = [140/(50x2.2)] - 1 = 0.2727 (27.27%)
A vanilla swap is where:
A) Vanilla essence is swapped with vanilla pods
B) Two interest rates are swapped for each other
C) A bank can switch from one currency to anothr and then back again, at any time over a pre-agreed period
D) A back to back loan is used for hedging
B - Two interest rates are swapped for each other
A vanilla swap is a contract between two parties to exchange interest payments at different rates over a set period of time. It’s the most common type of interest rate swap and is a key part of the global derivatives market.
How it works
* In a vanilla swap, one party pays a fixed rate and the other pays a floating rate.
* The floating rate is usually linked to an interest rate index, such as the Secured Overnight Financing Rate (SOFR).
* The swap can be effective on a specified date in the future or on the spot.
Why it’s used
* Companies use vanilla swaps to hedge against interest rate changes.
* They can also use swaps to speculate on future interest rate movements.
* For example, a company might convert variable-rate debt to a fixed rate to lock in a lower interest rate.
Risks
* Vanilla swaps expose traders to market risk, credit risk, and reputation risk.
* The value of a swap can change over time, making it an asset for one party and a liability for the other.
Which of the following best describes variation margin for transactions on ICE Futures Europe?
A) Cash deposited with the clearing house to cover adverse movements in futures positions beyond a pre-specified point
B) Cash deposited with the clearing house to cover the maximum likely daily loss arising from the futures contract
C) Cash deposited with the exchange to cover the maximum likely daily loss arising from the futures contract
D) Cash deposited with the exchange to cover aderverse movement in futures positions beyond a pre-specified point
A - Cash deposited with the clearing house to cover adverse movements in futures positions beyond a pre-specified point
Variation margin is used to cover the daily, unrealised, profit or loss
Variation margin is a payment made between parties in a financial derivatives transaction to account for changes in the value of their positions. It’s a key part of risk management systems used by exchanges. It is made DURING the futures contract.
How it works
* A clearing member pays variation margin to a clearinghouse when the value of their collateral decreases.
* The payment is based on the daily change in the market value of the contracts.
* The payment is usually made in cash from the party that has lost value to the party that has gained value.
* The payment is made on a daily or intraday basis.
Why it’s important
* Variation margin helps to maintain sufficient margin levels for trading.
* It protects against changes in the market value of a trade or portfolio of trades.
* It reduces the risk exposure of high-risk positions.
Given a September ‘short sterling’ future price of £94.55, what is the implied three month interest rate from September?
A) 4.55%
B) 5.45%
C) 94.55%
D) 1.82%
B - 5.45%
An interest rate future, like ‘short sterling’ is quoted on a price basis, as in 100 - implied 3 month interest rate.
A futures price of £94.55 implies a 3 month rate of 100 - 94.55 = 5.45% annualised
Annualised = recalculated as an annual rate.
Which of the following best describes the intrinsic value of a call option?
A) The extent to which an option is out of the money
B) The potential for a price change to increase the value of the option
C) The premium paid for the option
D) The extent which the share price exceeds the exercise price
D - The extent which the share price exceeds the exercise price
The intrinsic value of an option is the value of the option if it were exercised immediately. It’s the difference between the current price of the underlying security and the option’s strike price.
An option strategy that gives the right to buy or sell shares at an agreed price is called:
A) Call
B) Put
C) Straddle
D) Double
C - Straddle
A straddle is the combination of buying a call option (right to buy) and buying a put option (right to sell) at the same strikes.
A straddle option is a trading strategy that involves buying or selling a call and put option with the same strike price and expiration date. Straddles are a popular way to profit from price volatility without having to predict the direction of the market.
Time value for an option equals:
A) Intrinsic value
B) Premium minus intrinsic value
C) Intrinsic value minus premium
D) None of the above
B - Premium minus intrinsic value
The premium one an option = Intrinsic Value + Time Value
Time value is the portion of an option’s premium that’s due to the amount of time remaining until expiration. It’s also known as the option’s extrinsic value.
Out-of-the-money for an equity put option means:
A) The premium is always zero
B) The exercise price equals the share price
C) The exercise price is MORE than the share price
D) The exercise price is LESS than the share price
D - The exercise price is LESS than the share price
An out of the money put option is an option contract where the strike price is lower than the current market price of the underlying asset. An OTM put option lacks intrinsic value because the underlying asset’s price is above the option’s strike price; it only has extrinsic value (also known as time value).
A long call option position for:
A) Unlimited profit and unlimited losss
B) Limited profit and limited loss
C) Unlimited profit and limited loss
D) Limited profit and unlimited loss
C - Unlimited profit and limited loss
A long call option is a contract that gives the buyer the right to buy a stock at a set price within a specific time frame. The buyer profits if the stock price increases above the set price.
If interest rates rise what is the likely effect on equity option premiums?
A) Call prices up, Put prices down
B) Call prices up, Put prices unchanged
C) Put prices up, Call prices unchanges
D) Put prices up, Call prices down
A - Call prices up, Put prices down
An increase in interest rates makes a call option more valuable and a put option less so. And, of course, vice versa.
What is the maximum profit on buying a put with an exercice price of 80p, a premium of 21pm if the share price is 70p?
A) 59p
B) 69p
C) 80p
D) 90p
A - 59p
The breakeven point on a put equals the strike/exercise rpice MINUS the premium.
80p - 21p = 59p
Therefore, the maximum profit in this example woould be the breakeven point down to zero on the underlying asset.
The difference between a futures price and the cash price is known as the:
A) Spread
B) Backwardation price
C) Basis
D) Settlement price
C - Basis
Basis = Cash - Futures prices
You buy a FTSE 100 index future at 5,400. At expiry of the future the index is 5,600 What is your profit (contract size is £10 per index point)?
A) £1,200
B) £2,000
C) £2,500
D) £5,000
B - £2,000
5,600 - 5,400 = 200 index points
200 x £10 = £2,000
The buyer of a bond future at delivery:
A) Is obliged to deliver a bond
B) Is obliged to take delivery of a bond
C) Takes any profit or loss in cash
D) None of the above
B - Is obliged to take delivery of a bond
Taking delivery of a bond is the process of transferring a bond from a seller to a buyer in a futures contract. The delivery process is a three-day event that involves an intention day, notice day, and delivery day.
The price of the short-term interest rate futures is quoted as:
A) A negative interest rate
B) A positive interest rate
C) 100 minus an interest rate
D) 100 plus an interest rate
C - 100 minus an interest rate
This value is calculated as 100 minus the interest rate. Contracts vary, but are often defined upon an interest rate index such as 3-month sterling
The most common swaps are:
A) Interest rate swaps
B) Currency swaps
C) Equity swaps
D) Option swaps
A - Interest rate swaps
* Interest rate swap (IRS) is a contract between two parties to exchange interest payments over a set period of time. The parties involved are known as “counterparties”.
* Currency swap is a financial agreement where two parties exchange cash flows in different currencies at a set rate over a period of time. The goal of a currency swap is to manage currency risk and interest rate risk.
* Equity swap is an exchange of cash flows between two parties that allows each party to diversify its income while still holding its original assets.
* Option Swap (AKA swaption or swap option) is an option contract that grants its holder the right but not the obligation to enter into a predetermined swap contract. In return for the right, the holder of the swaption must pay a premium to the issuer of the contract.
An investor sells 15 FTSE 100 Futures contracts with the index at 5193 and closes out the position with the index at 5228
What is the profit/loss (contract size = £10 per index point)?
A) Loss £5,250
B) Profit £5,250
C) Loss £350
D) Profit £350
A - Loss £5,250
As the investor has sold the index futures they are looking for the index to fall. As the index has risen, they have made a loss:
Loss = (5,228 - 5,193) x £10 x £15 contracts = £5,250
When is a future trading in contango?
A) When the offer price exceeds the bid price
B) When the spot price is greater than the futures price
C) When the futures price is greater than the spot price
D) When the bid price exceeds the offer price
C - When the futures price is greater than the spot price
Contango = Future > Cash
Backwardation = Future < Cash
Contango and backwardation are terms used to describe the relationship between the price of a futures contract and the spot price of the underlying commodity.
* Contango: When the futures price is higher than the spot price, the market is in contango. This indicates that traders expect prices to increase in the future.
* Backwardation: When the futures price is lower than the spot price, the market is in backwardation. This indicates that traders expect prices to decrease in the future
Which of the following is an advantage of futures markets compared to the underlying asset cash market?
A) Transaction costs are considerably higher
B) Futures contracts are generally more illiquid
C) Transaction costs in futures can be executed more rapidly
D) Short positions are not easily possible
C - Transaction costs in futures can be executed more rapidly
A short straddle is formed by:
A) Buying a put and selling a call
B) Buying a call and selling a put
C) Buying a call and put
D) Selling a call and a put
D - Selling a call and put
A short straddle is an options strategy comprised of selling both a call option and a put option with the same strike price and expiration date.
What is the per cent premium on the following warrant:
* Warrant price = £1.35
* Current stock price = £1.80
* Exercise price = £1.40
* The number of new shares created by each warrant = 3
A) 2.78%
B) 8.33%
C) 22.22%
D) 66.67%
A - 2.78%
The warrant per cent premium calculates the cost to obtain the shares via the warrants compared to the cost of the shares in the open market.
[£1.35 + (3 x £1.40)] / (3 x £1.80) - 1 = 0.0278 i.e. 2.78%
Warrants and options are both financial contracts that give investors the right to buy a company’s stock at a specific price before a specific date. However, they differ in a few ways, including who issues them, how they are traded, and how long they last.
Who issues them?
* Warrants: Usually issued directly by the company to investors, banks, or other companies
* Options: Typically traded between investors, but can also be granted to employees
How they are traded?
* Warrants: Often traded over-the-counter, but can also be traded on a stock exchange
* Options: Typically traded between investors on a stock exchange
How long they last?
* Warrants: Typically have longer periods between issue and expiration than options, often measured in years
* Options: Usually have shorter terms than warrants, often measured in months
Other differences
* Warrants are dilutive, meaning when an investor exercises their warrant, they receive newly issued stock
* Warrants do not pay dividends or come with voting rights
* Options can be used to speculate on whether a stock’s price will increase or decrease
Which of the following best defines variation margin?
A) To cover adverse movements expeced over the next week
B) To cover adverse movements from the previous week
C) To cover the adverse movements in value from the previous day
D) Initial payment to cover future movements in price
C - To cover the adverse movements in value from the previous day
Variation margin can be a receipt or a payment. It represents the profit or loss on open derivative positions, which result from changes in underlying asset values from the previous day.
Two put options with identical expiry dates, the option with the lower exercise price:
A) Will have a lower premium
B) WIll have a higher premium
C) Will be at the money
D) Will require higher margin payments
A - Will have a lower premium
The put option with the lower exercise price will have a less intrinsic value
A fund manager wants to hedge an equity fund of £10 million with a beta of 0.5. The FTSE future is currenty quoted at 6,000. The contract size is £10 per index point
How many contracts should be sold to the nearest contact?
A) 166
B) 167
C) 83
D) 90
C - 83
Number of contracts needed to hedge (the hedge ratio) = (Amount you want to hedge / contract size) x Beta
Number of contracts = (£10m / (6,000 x £10)) x 0.5 = 83.3
*Remember you cannot have a partial contract so round to the nearest whole number. *
What is the variation margin on ICE Futures Europe contracts based on?
A) 10% of the contract value
B) 90% of the anticipated daily movement
C) The credit risk of a broker to the clearing house
D) Additional amounts called by the clearing house to covre adverse price movements
D - Additional amounts called by the clearing house to covre adverse price movements
Variation magrin is used to cover the daily, unrealised, profit or loss.
An investor writes a call option contract with a premium of 30p and an exerecise price of 180p on the shares when the underlying position is at 200p. Contract size = 1,000 shares
If the share price at expiry of the option is 205p what is the profit on the position at expiry?
A) £0
B) £50
C) £100
D) £200
B - £50
Profit for the option writer = Premium - Intrinsic Value
Profit = [30p - (205p - 180p)] x 1,00 shares = £50
An option writer is an investor who sells options contracts in the stock market. They are also known as granters or sellers.
On 16 September the three month interest rate is 9%. The implied 3 month forward rate is 10%
What is fair value for the December three month interest rate future, which expiries in 90 days time on 15 December?
A) 91
B) 90
C) 9
D) 10
B - 90
The 3 month interest future is quoted as 100 - implied 3 month forward rate.
Therefore, the 3 month interest rate futures price (Fair Value) = 100 - 10 = 90
When the spot price exceeds the futures price this is called:
A) Contango
B) Backwardation
C) Basis Risk
D) Arbitrage
B - Backwardation
Backwardation = Future < Cash
Contango = Future > Cash
Contango and backwardation are terms used to describe the relationship between the price of a futures contract and the spot price of the underlying commodity.
* Backwardation: When the futures price is lower than the spot price, the market is in backwardation. This indicates that traders expect prices to decrease in the future
* Contango: When the futures price is higher than the spot price, the market is in contango. This indicates that traders expect prices to increase in the future.
Arbitrage is the practice of buying and selling an asset in different markets to profit from price differences. It’s a fundamental concept in finance that can be applied to stocks, currencies, commodities, and more.
Basis risk is the risk that a hedging strategy won’t be effective because the investments don’t change price in opposite directions. It’s a systematic risk that can impact profits and losses.
Which of the MOST risky transaction to undertake in the equity index options markets, if the stock market is expected to increase substantially after the trasnaction is completed?
A) Write an uncovered call option
B) Write an uncovered put option
C) Buy a call option
D) Buy a put option
A - Write an uncovered call option
Writing an uncovered call option has the potential of unlimited losses as the price increases.
An uncovered option, or naked option, is an options position that is not backed by an offsetting position in the underlying asset.
Any trader who sells an option has a potential obligation. That obligation is met, or covered, by having a position in the security that underlies the option. If the trader sells the option but has no position in the underlying security, then the position is said to be uncovered, or naked.
Traders who buy a simple call or put option have no obligation to exercise that option. However, those traders who sell those same options have an obligation to provide a position in the underlying asset if the traders to whom they sold the options do exercise their options. This can be true for put or call options.
Which of the following factors would NOT affect the value of the call option?
A) Strike pricec
B) The number of shares specified in the contract
C) Share prices
D) Interest rates
B - The number of shares specified in the contract
Which of the following futures traded on the ICE Futures Europe have the potential to be physically delivered?
A) A future based on 3 month Euribor
B) FTSE 100 INdex
C) Short-term interest rate future
D) Long gilt future
D - Long gilt future
The long gilt future is the only contract from the available choices that could result in a phsyical delivery. The actual bond delviered is known as the cheapest to deliver (CTD).
The buyer of a straddle:
A) Buys a call and sells a put
B) Buys a put and sells a call
C) Buys a call and a put
D) Sells a call and a put
C - Buys a call and a put
A straddle option is a trading strategy that involves buying or selling a call and put option with the same strike price and expiration date. Straddles are a popular way to profit from price volatility without having to predict the direction of the market.
Types of straddles
* Long straddle: Involves buying both a call and a put option. This strategy is useful when you expect the market to be volatile but are unsure of the direction of the price change.
* Short straddle: Involves selling both a call and a put option. This strategy is useful when you expect the market to be stable or range-bound.
On the morning of 16 March 2016, an investor buys 125 June 2016 FTSE 100 futures contracts at a price of 3,500. At lunch, the investor sells 50 of these contrcts at a contract price of 3,600. The investor then sells the remainder of these contracts near the end of the trading day at a contract price of 3,300. If we ignore transaction costs, including the costs of maintaining the margin account throughout the trading day, what was the profit/loss on these activities over the day?
A) -£40,000
B) -£75,000
C) -£100,000
D) -£115,000
C -£100,000 (LOSS)
Remember that Index based futures are £10 for every basis point
So 125 contracts at 3,500 = £4,375,000 (3,500 x £10 x 125) paid in total
SO
P/L on lunchtime contract sales (50) = (3,600 - 3,500) x £10 x 50 = £50,000 (PROFIT)
P/L on COP contract sales (125-50 = 75) = (3,330 - 3,500) x £10 x 75 = -£150,000 (LOSS)
£50,000 + -£150,000 = -£100,000 (LOSS)
An investor holds one share in Velux plc, which is currently trading at £4.50. The investor also buys a put option on one share of Velux plc for a premium of £0.90 and a strike price of £4.00. What is the breakeven price for the combined position?
A) £2.60
B) £5.40
C) £5.00
D) £4.90
B - £5.40
The breakeven price for the combination of share and put option (protective put) occurs when the price of the share rises by the amount of the option premium.
SO Breakeven = initial price (£4.50) PLUS premium paid for put option (£0.90) = £5.40
A life assurance fund manager is managing a portfolio of UK equities, which on the 10 May 2016 is valued at £80m and which has a Capital Asset Pricing Model (CAPM) beta coefficient of 0.80. The fund manager wants to hedge the downside risk on this portfolio until June 2016 without sacrificing all of their upside potential. They have the following information:
FTSE 100 Index = 3,500
June FTSE 100 3,800 call options = 50
June FTSE 00 3,300 put options = 45
If the fund manager plans to hold all the derivatives until expiry, how many puts/calls should they buy/sell to effect the hedge?
A) 832 contracts
B) 1,232 contracts
C) 1,829 contracts
D) 1,939 contracts
D - 1,939 contracts
To hedge the portfolio against the downside risk, the manager should buy PUT options (selling the right to sell). If they were to sell call options (selling right to buy ), this would cap the upside potential.
Remember each futures contract can hedge £33,000 (3,300 x £10 as each basis point is worth £10).
The number of contracts to effect the hedge is calculated by:
(Face value of cash exposure / Face value of the futures contract) x Beta
SO
(£80m / £33k) x 0.8 = 1,939.39
You can ignore the actual FTSE 100 index and the current premiums (50 and 45) as they are irrelevent for your hedging calc
Portfolio managers lend stock on behalf of clients because:
A) They think the share price will fall
B) They think the share price will rise
C) To enhance their client’s return
D) To provide portfolio insurance for their client
C - To enhance their client’s return
Short sellers pay a fee to borrow stock to sell in the market. Portfolio managers are prepared to lend stock on this basis to earn these fees and enhance their clients’ returns.
A company issues a convertible debt at a par value of £100, which each bond converted into ten ordinary shares, and the current share price is £5. The conversion value of the bond is:
A) £50
B) £10
C) £20
D) £100
A - £50
Conversion value = current share price (£5) x conversion ratio (10 new shares) = £50
