Chapter 10 Derivatives RQ Flashcards
Determine the investor who is speculating in the futures market.
A. A large coffee chain buys sugar futures for August delivery.
B. A wheat farmer sells 10 wheat futures contracts for January delivery.
C. A doctor buys oil futures because she expects global oil shortages.
D. A Canadian exporter to the U.S. buys a Canadian dollar futures contract.
C. A doctor buys oil futures because she expects global oil shortages.
The doctor is acting as a speculator, as his business does not move large amounts of oil. Speculators use commodities to profit from fluctuating prices. Hedgers are corporations or individuals who deal in actual commodities or financial instruments. They buy or sell futures contracts to limit their financial losses or to protect their position. Hedgers either produce or use the commodity or financial instrument that they are hedging.
Identify a major objective of hedgers in the futures market.
A. Limit financial risk and losses.
B. Make a profit.
C. Increase their rate of return.
D. Increase the leverage of portfolio.
A. Limit financial risk and losses.
Hedgers are corporations and individuals who deal in commodities or financial instruments and buy or sell futures contracts to protect their holdings or expected holdings in the cash market. Futures are used to provide a form of insurance and to limit financial losses.
Praachi deposits initial margin of $10,000 to her futures account to establish her long position. At the end of the first trading day, her contract gains $500 and her account is credited by that amount. Select the term that is used to refer to this activity.
A. Hedging.
B. Valuation.
C. Marking-to-market.
D. Open interest.
C. Marking-to-market.
One of the important features of futures trading is the daily settlement of gains and losses. This process is known as marking-to-market. At the end of each trading day, those who are long a contract make a payment to those who are short, or vice versa, depending on the change in the price of the contract from the previous day.
An investor writes one XYZ Apr. 40 naked call for $3.40. At expiry the stock price is $50 and the writer is assigned. Calculate the gain or loss for the writer.
A. Loss $340.
B. Loss $660.
C. Gain $340.
D. Gain $660.
B. Loss $660.
The call writer is exposed to the risk that the stock price will increase and he/she will be obligated to sell at the then lower strike price. In this example, the writer earned income of $3.40 × 100 shares = $340 from the call premium. At expiry, he/she will lose $10 × 100 shares = $1,000 due to the stock price increase. The call writer will have to buy 100 shares @ $50 ($5,000) and will receive only 100 × $40 ($4,000) from the call buyer. The net loss is $660 ($1,000 - $340).
Khartick purchases an ABC Nov. 50 call for $5.75 when the market price of the stock is $55. The market price of the stock increases to $58 during the trading day. Determine the approximate option premium Khartick would receive if he then immediately sold his calls.
A. $3.00
B. $5.75
C. $8.00
D. $8.75
D. $8.75
The premium will be at least equal to the $8.00 ($58 - $50) intrinsic value. And in addition, it will have time value of approximately $0.75. The time value was $0.75 on the purchase date and since only one day has passed, the time value should be at least $0.75. Keep in mind the following relationships:
Option Price = Intrinsic Value + Time Value
Call Option Intrinsic Value = Current Market Price – Exercise Price
Put Option Intrinsic Value = Exercise Price – Current Market Price
Before the price change occurred, the Call Option Intrinsic Value = $55 - $50 = $5. Since the price of the option was $5.75, we can determine the time value using the Option Price formula noted above:
$5.75 = $5 + Time Value
Time Value = $5.75 - $5
Time Value = $0.75
When the price changes the next day to $58 per share, there is very little change to the time value. Assuming the time value remains $0.75:
Call Option Intrinsic Value = $58 - $50 = $8
The new Call Option Price = $8.00 + $0.75 = $8.75.
Select the primary reason for an investor to write a covered call option.
A. Fix a future price.
B. Earn additional income.
C. Acquire the underlying security.
D. Alternative to selling the underlying security.
B. Earn additional income.
Investors write call options primarily for the income they provide. The income, in the form of the premium, is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does.
Identify a characteristic of an exchange-traded option contracts.
A. Equity put and call option contracts represent 100 shares.
B. Expiration dates can be customized.
C. European-style options can be exercised prior to the expiration date.
D. An opening transaction to buy an option results in a short position in the option.
A. Equity put and call option contracts represent 100 shares.
An option is a contract or agreement between a buyer and seller, based on a particular asset or security, called the underlying security, and expire at specific and pre-established dates. The contract is based on a particular number of shares or units of the underlying security. In the case of an equity option listed on an exchange, the underlying contract size is 100 shares. An opening transaction to buy represents a long position in the option, while an opening transaction to sell represents a short position. American-style options can be exercised at any time up to expiry, while European-style options can only be exercised on expiry.
Using the information in the table below calculate the time value and intrinsic value of WSX warrants.
WSX shares are trading at $35 per share
WSX warrants are trading at $14 per warrant
WSX warrants allow you to buy 1 common share at $25 per share
A. Intrinsic value is $0, time value is $14.
B. Intrinsic value is $10, time value is $4.
C. Intrinsic value is $14, time value is $10.
D. Intrinsic value is $25, time value is $0.
B. Intrinsic value is $10, time value is $4.
Like options, warrants may have both intrinsic value and time value. Intrinsic value is the amount by which the market price of the underlying common stock exceeds the exercise price of the warrant. A warrant has no intrinsic value if the market price of the common stock is less than the exercise price. Time value is the amount by which the market price of the warrant exceeds the intrinsic value.
Nuniq believes that the price of a specific stock is going to continue to fall for another 6 months. Determine an option strategy that will be profitable if her expectations are correct.
A. Buy a call.
B. Buy a future.
C. Write a call.
D. Write a put.
C. Write a call.
If she writes a call, and the stock price declines she will not be assigned and will be able to keep the premium without any further obligation. If she writes a put, and the stock price declines, she will be assigned and have to pay the higher exercise price for the stock. Investors buy futures or forwards to profit from an expected increase in the price of the underlying asset. Nuniq thinks the price will fall.
TMN is trading at $32, and Shania buys one TMN Jan. 25 call at a premium of $10 per share. Calculate the correct time value for the option.
A. $0.00
B. $3.00
C. $7.00
D. $10.00
B. $3.00
A call option’s time value is calculated by subtracting the intrinsic value from the option premium. The call has an intrinsic value of $7 as the strike (exercise) price is $7 less than the current market price of TMN, and the remainder of the premium is the $3 time value.
A client has sold an option that requires her to pay $5,000 for 100 shares of POL Inc. if she is assigned. She has set aside $5,000 in case this happens. Identify the option strategy she is using.
A. Naked put option.
B. Naked call option.
C. Cash-secured put write.
D. Covered call option.
C. Cash-secured put write.
If the put writer had set aside an amount of cash equal to the purchase value of the stock if assigned, the strategy is known as a cash-secured put write.
Analyn enters into a forward contract and makes a deposit intended on assuring the other party to the transaction that she will honour her side of the contract. Identify the type of deposit Analyn has made.
A. Performance bond.
B. Margin call.
C. Mark-to-market.
D. Subscription price.
A. Performance bond.
With forwards, no up-front purchase is required. Sometimes one or both parties provide a performance bond or good-faith deposit, which gives the party on the other side of the transaction a higher level of assurance that the terms of the forward will be honoured.
Ky’s client has purchased 25 ABC May 25 call options. Determine the offsetting transaction for this position.
A. Purchase 25 ABC May 25 put options.
B. Purchase 25 ABC May 25 call options.
C. Sell 25 ABC May 25 call options.
D. Sell 25 ABC August 25 call options.
C. Sell 25 ABC May 25 call options.
A position may be liquidated prior to expiration by way of an offsetting transaction, which, in effect, cancels the position. Offsetting a long position involves selling the same type and number of contracts; offsetting a short position involves buying the same type and number of contracts. In this example, Ky’s client would sell 25 ABC May 25 call options to offset the transaction.
XYZ is currently trading at $60. Determine the option that is out of the money.
A. XYZ May 65 puts.
B. XYZ May 65 calls.
C. XYZ August 60 puts.
D. XYZ August 60 calls.
B. XYZ May 65 calls.
The May 65 calls are out of the money, as the strike price is higher than the current market price. The August 60 calls and August 60 puts are at the money, while the 65 puts are in the money as they would give the owner the right to sell the shares at a price higher than the current market price.
Bruno’s Investment Advisor carefully researches the financial position and history of the other party before entering into forward contracts. Identify the disadvantage of OTC derivatives the IA is attempting to reduce for Bruno.
A. Liquidity risk.
B. Regulatory restrictions.
C. Default risk.
D. Lack of standardization.
C. Default risk.
A downside to the private nature of OTC derivatives is that default risk (also called credit risk) is a major concern. Default risk is the risk that one of the parties to a derivative contract will not be able to meet its obligations to the other party. The IA is carefully determining if the counterparty to the forward contract is creditworthy.
