Chap 14

Question 1

Financial assets

Answer 1

An asset that represents a financial claim on an issuing organization.

Stocks, bonds and convertible securities are examples.

Question 2

Option

Answer 2

gives the holder the right to buy or sell an underlying asset (such as common stock) at a fixed price over a limited period of time.

Question 3

Call

Answer 3

enables the holder to buy the underlying stock at the strike price over a set period of time.

Question 4

Put

Answer 4

gives the holder the right to sell the stock at the strike price within a set period of time.

Question 5

Derivative securities

Answer 5

Options, as well as Futures, are derivative securities because they derive their value from the price behavior of the underlying asset.

Question 6

Option premium:

Answer 6

the price an investor pays to buy an option.

Question 7

Option Seller (Option Writer):

Answer 7

Receives the option premium from the buyer up front.

Has the obligation to sell (in the case of a call option) or buy (in the case of a put option) the underlying asset according to the terms of the option contract.

This obligation is legally binding; option seller cannot walk away from the deal if it turns out to be a money loser for them.

Question 8

Option Buyer:

Answer 8

Has the right to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a fixed price (called the exercise price or strike price) for a given period of time.

To acquire this right, the option buyer must pay the option seller a fee known as the option premium (or option price).

Buyers do not have to exercise their options; they can walk away if exercising the option isn’t profitable.

Question 9

Strike Price

Answer 9

the fixed contract price at which an option holder has the right to buy (for a call) or sell (for a put) the underlying stock.

Conventional (OTC) options may have any strike price (no constraints; mutually agreed upon by the two parties).

Listed options have standardized (by the exchange) prices with price increments determined by the price of the stock.

Question 10

Expiration Date

Answer 10

Stated date when the option expires and becomes worthless if not exercised

Question 11

American Options

Answer 11

allow investors to exercise their right to buy or sell the underlying asset at any time up to the expiration date.

Question 12

European Options

Answer 12

only permit investors to exercise on the expiration date.

Question 13

Intrinsic Value (options)

Answer 13

determined by the relationship between an option’s strike price and the underlying stock’s market price.

Question 14

In-the-Money:

Answer 14

Call option: when the strike price is less than the market price of the underlying security.

Put option: when the strike price is greater than the market price of the underlying security.

When an option is in the money, its intrinsic value is greater than zero.

Question 15

Out-of-the-Money:

Answer 15

Call option: when the strike price is greater than the market price of the underlying security.

Put option: when the strike price is less than the market price of the underlying security.

Question 16

At-the-Money

Answer 16

strike price = market price for a call or put option

Question 17

Put-Call Parity:

Answer 17

future payoffs of a portfolio containing a put option and a share of underlying stock are the same as payoffs of a portfolio containing a call option and a risk-free bond.

Price of a put option + price of stock = price of a call options + price of a risk-free bond

Question 18

major forces that influence the price of an option:

Answer 18

The price of the underlying financial asset

The option’s strike price

The amount of time remaining to expiration

The underlying asset’s volatility

The risk-free interest rate

Question 19

Hedge

Answer 19

a combination of two or more securities into a single investment position for the purpose of reducing risk.

Question 20

Naked options:

Answer 20

writer does not own the optioned securities and has to buy them. No limit on loss exposure

Question 21

Covered options

Answer 21

writer owns the optioned securities. Loss exposure is limited to the price originally paid for the securities.

Question 22

Option spreading:

Answer 22

combination of two or more options into a single transaction.

Options differ in strike price and/or expiration date.

Bull spreads, bear spreads, money spreads, vertical spreads, butterfly spreads and more.

Purpose is to take advantage of differences in prevailing options prices and premiums.

Question 23

Option Straddle

Answer 23

Simultaneous purchase (or sale) of both a put and a call on the same underlying common stock.

Straddles normally involve the same strike price and expiration date.

Object is to earn a profit from either a big or a small swing in the price of the underlying stock.

Question 24

Long straddle

Answer 24

buy an equal number of puts and calls. As long as you make more money on one side than the cost of the options for the other side, you earn a profit.

Question 25

Short straddle

Answer 25

you sell/write an equal number of puts and calls with the same underlying stock, same strike price and same expiration date. You make money when the price of the underlying stock goes nowhere.

Question 26

Currency Options

Answer 26

put and call options written on foreign currencies.

Question 27

LEAPS

Answer 27

puts and calls with lengthy expiration dates; long-term options.

Question 28

Intrinsic value of a call (formula)

Answer 28

(stoke price - exercise price) x 100

or zero

whichever is greater