Lesson 4.2: Equity Derivatives Flashcards
Braydon has received preemptive rights from one of the stocks held in his portfolio. What is not an alternative regarding these stock rights?
Redeeming them from the issuer for cash
Rights are not redeemable by the issuer. They may be sold in the secondary market or given to someone else to exercise. If exercised, rights are exchanged for an appropriate number of shares of the underlying common stock.
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.
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.
What statement best describes a preemptive right?
A privilege extended to existing holders of a company’s common stock enabling them to maintain their proportionate interest in the company when additional shares are issued
The preemptive right is an equity security representing a common stockholder’s entitlement to the first opportunity to purchase new shares issued by the corporation at a predetermined price (normally less than the current market price) in proportion to the number of shares already owned.
A client calls to say he has just read about a European option and doesn’t know what it is. You would explain that it is a derivative because:
its value is based on some underlying asset.
Although the unique characteristic of a European option is that it can only be exercised on its expiration date, that doesn’t answer this question. It is a derivative like any other option because its value is based on the underlying asset.
Covered call writing is a strategy where an investor:
sells a call on a security he owns to reduce the volatility of the stock’s returns and to generate income with the premium.
A covered call is simply defined as an investor owning 100 shares of the underlying stock for each option written (sold). The premium received is not only a source of income but also serves to provide downside protection to the extent of the amount received.
Statement regarding warrants:
Warrants are often issued with other securities to make the offering more attractive.
Warrants are generally issued with bond offerings to make the bonds more attractive. Warrants are long-term options to buy stock, and because they are equity securities, warrants, as investments, are considered less safe than bonds.
Purchasers of options can have a number of different objectives. One of your clients who is a soft-drink fan already has a long position in KO. What would be a possible reason for this client to go long a KO call option?
It fixes the cost of acquiring additional stock for the portfolio.
Those who are bullish on a stock but don’t have sufficient funds at this time to purchase the stock can lock in their future cost by going long a call. Income is generated only through selling options. Because a long call is on the same side of the market as long stock, there is no hedge. A spread involves a long and short option.
An investor who is long a put option for 100 shares of ABC common stock has the right to:
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.
The writer of a call option:
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.
An investor will likely exercise a put option when the price of the stock is:
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.
The RIF Corporation would not be able to issue:
RIF call options.
Options contracts are not issued by the underlying asset. Technically, listed options (the only type that will be on the exam) are issued by the Options Clearing Corporation (OCC). A corporation issues common stock and can issue rights (preemptive rights) and/or warrants.
What is a characteristic of newly issued warrants?
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.
When contrasting preemptive rights and warrants, it would be correct to state that, at issuance,
rights have intrinsic and time value while warrants only have time value.
At the time of issuance, preemptive rights always offer the stock at a price below the current market, thus creating intrinsic value. Although rights rarely are effective for longer than 45–60 days, that does represent time value. On the other hand, warrants are always issued with an exercise price above the current market (no intrinsic value) but do have time value.
George owns XYZ stock. Based on recent analyst projections and George’s own research, he believes XYZ’s price will remain flat over the next few months. Accordingly, which strategy would George most likely employ?
Sell a call option.
When the price is expected to stay flat, selling an option is a way to profit with little risk of the option being exercised. Why sell the call instead of the put? Because George owns the XYZ stock, this is a covered call and entails no downside risk. Selling the put would expose George to potentially significant loss if the price of XYZ should suffer a large decline.
When contrasting call options, preemptive rights, and warrants, it would be correct to state:
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 Clearing Corporation (OCC), 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.
