Options, Futures, & Other Derivatives

Question 1

call

Answer 1

right to buy
call value decrease as strike price increase

Question 2

put

Answer 2

right to sell
put value increase as strike price increase

Question 3

put/call parity

Answer 3

defines relationship between calls, puts, and the underlying futures contract. Requires that the puts & calls are the same strike, expiration, and underlying futures contract. on formula sheet.

Question 4

protective put

Answer 4

buys put option as “insurance” on a stock you already own. “married put”

Question 5

covered calls

Answer 5

buys stock and sells a call option against those shares in exchange for income
used when investor is bullish LT but ST feels it may trade flat.
can impose “sell discipline” if you already planned to sell the stock at “x” price

Question 6

straddles

Answer 6

buy both put and call with the same strike/exp
investor thinks stock will move significantly but unsure which way

Question 7

spreads (horizontal/vertival/diagonal)

Answer 7

combo of 2+ calls (or 2+ puts) on the same stock but with different maturity or exercise price

horizontal: different exp date
vertical: different strike prices
diagonal: combo of horizontal & vertical

Question 8

collar

Answer 8

an options-based hedge that involves selling
(writing) an out of the money call and buying an
out of the money put on an underlying asset that
has imbedded gains

this strategy is intended to lock in profits by buying
downside protection while calls are sold to
generate income to help pay for this downside
protection

Question 9

forward

Answer 9

a deferred-delivery sale of an asset w/ the sale price agreed on now

Question 10

futures

Answer 10

similar to a forward but formalized and standardized contracts.
- creates liquidity - marked to market - exchange mitigates risk

Question 11

Marking to Market

Answer 11

each day the profits or losses from new futures price are paid over or subtracted from the account. “FMV”, not historical pricing

Question 12

Speculators v. Hedgers

Answer 12

Speculators
seek to profit from price
movement
– short - believe price will fall
– long - believe price will rise

Hedgers
* seek protection from
price movement
– long hedge - protecting
against a rise in purchase
price
– short hedge - protecting
against a fall in selling
price

Question 13

What is the futures price of an asset if its current market
price is 75, the discount rate is 8%, there is no cash flow or holding
costs, and the maturity is 6 months?

Answer 13

Calculate Spot – Futures Parity

Answer: $77.94
Solution: F = $75 (1 + .08).5
75 (1.0392) = $77.94
on formula sheet

Question 14

Contango & Backwardation

Answer 14

Application:
- backwardation is desirable for investors who are “net
long”
- backwardation occurs when futures prices are lower
than spot prices
- backwardation indicates short supply

• contango occurs when futures prices are higher than spot prices
• contango indicates immediate supply

Question 15

Swaps

Answer 15

Swaps are multi-
period extensions of
forward contracts.

ex. credit default swaps

has credit risk

Question 16

CDOs

Answer 16

Collateralized Debt Obligations

Mortgage pools in tranches

Question 17

margin call price =

Answer 17

initial purchase price x (1-initial margin / 1- maintenance margin)

Question 18

An investor is looking to purchase a security for $100 with an initial margin of 50% (meaning the investor is using $50 of his money to purchase the security and borrowing the remaining $50 from a broker). In addition, the maintenance margin is 25%. At what price of the security will the investor receive a margin call?

Answer 18

The investor will receive a margin call if the price of the security drops below $66.67.

=(100X ( 1-.50/1-.25))

Question 19

Taxation of futures trading gains and losses …

is based on the contract holding period.
is based on cumulative year-end profits or losses.
can be timed to offset stock portfolio gains and losses.
occurs based on the date contracts are sold or closed.

Answer 19

is based on cumulative year-end profits or losses

Futures profits and losses are taxed based on cumulative year-end value due to marking-to-market procedures.

Question 20

If a stock index futures contract is overpriced, you would exploit this situation by:

selling both the stock index futures and the stocks in the index.
buying both the stock index futures and the stocks in the index.
buying the stock index futures and selling the stocks in the index.
selling the stock index futures and simultaneously buying the stocks in the index.

Answer 20

selling the stock index futures and simultaneously buying the stocks in the index.

If one perceives one asset to be overpriced relative to another asset, one sells the overpriced asset and buys the other one.