Unit 3

Question 1

Derivatives

Answer 1

A contract that derives its value form an underlying asset. A buyer has the right to buy or sell the underlying asset from the seller. Often used for commodities (oil, gas, currencies)

Question 2

Futures

Answer 2

A derivative where the buyer is obligated to buy the underlying asset on a specific date (Oil, gas, gold). Not classified as securities.

Question 3

Options

Answer 3

Derivative securities. They derive their value form underlying stock, stock index, interest rate or foreign currency. Offer investors a mean to hedge investment value or speculate on the price movement of securities.
Amount paid for options contract or received when sold is the contract premium.
The buyer of the contract is the owner and the seller of the contract is called the writer or party.
The writer is obligated to perform if the owner decides to exercise (buy back or sell back) the contract.

Question 4

Equity Options

Answer 4

Options can be created for any item with a fluctuating market value, however the most familiar are equity options which are issued on common stocks.

Question 5

Four basic transactions for an option investor

Answer 5

Buy calls
Sell calls
Buy puts
Sell puts

Question 6

Long Call

Answer 6

A call buyer owns the right to buy x shares of a specific stock at the strike price before the expiration date if they choose. Anticipating the price of the stock to rise.

Question 7

Short Call

Answer 7

A call writer (seller) has the obligation to sell x shares of a specific stock at the strike price if the buyer exercises the contract. Anticipates the price of the stock to fall. If this is the case, the option goes unexercised and the seller keeps the premium of the contract.

Question 8

Long Put

Answer 8

Put buyer owns the right to sell x shares of a specific stock at the strike price before the expiration. Bearish investor, wants prices to fall.

Question 9

Short Put

Answer 9

A put writer (seller) is obligated to buy x shares of a specific stock at the strike price if the buyer exercises the contract. They are a bullish investor who wants the prices to rise or not change.

Question 10

In the money

Answer 10

A call is “in the money” when the price of the stock exceeds the strike price.

A put is “in the money” when the price of the stock is below the strike price.

Question 11

At the money

Answer 11

A call is “at the money” when the price of the stock equals the strike price. Contract will not be exercised.

A put is “at the money” when the price of the stock is below the strike price. Contract will not be exercised.

Question 12

Out of the money

Answer 12

A call is “Out of the money” when the price of the stock is below the strike price. Contract will not be exercised.

A put is “Out of the money” when the price of the stock is higher than the strike price. Contract will not be exercised.

Question 13

Intrinsic Value

Answer 13

Intrinsic value of a contract is the amount of money the contract is worth. A call has intrinsic value if the market price is below the strike price. A put has intrinsic value if the market price is above the strike price. A call’s intrinsic value is zero if the market price is at or above the strike price and a put has zero intrinsic value if it is at or below the strike price.

Question 14

Parity

Answer 14

A put or call option is at parity when the premium equals the intrinsic value.

Question 15

Intrinsic value and premium

Answer 15

Intrinsic value + time value = Premium

Question 16

Index options

Answer 16

Allow investors to profit from market or market segment movements and hedge against market swings. Use multipliers of $100, Settle on the next business day, settles in cash, based on closing value of index on day of exercise.

Both index and equity options expire on the third friday of the expiration month.

Question 17

Broad-based indexes

Answer 17

Reflect the movement of the entire market

Question 18

Narrow-based Indexes

Answer 18

Track the movement of market segments in a specific industry (tech or pharma for example)

Question 19

Interest Rate Options

Answer 19

Directly related to movement of interest rate, based on yields of T-bill, T-notes, and T-bonds. Call or put depending on if you think interest rates will rise or fall and collect cash equal to intrinsic value of option.

Question 20

Currency Options

Answer 20

Options against the performance of foreign currencies. Remember EPIC. Exporters are concerned about the foreign currency dropping so buy puts, if importer you are worried about foreign currency rising so buy calls.

Question 21

American and European style exercise rules

Answer 21

American style option allows the owner to exercise anytime before expiration. A European style option can only be exercised on the expiration day.

Question 22

Break Even (BE) Max gain (MG) Max Loss (ML)

Answer 22

Long call: BE = At or above Strike + premium, MG = Unlimited, ML = Premium
Short call: BE is opposite but MG and ML are swapped

Long Put: BE = below Strike - Premium, MG = Strike - Premium, ML = Premium
Short Put: BE is opposite and MG and ML swap.

Question 23

Protective Puts

Answer 23

A type of insurance policy for investors. If an investor is long stock (bullish) they could but put options in case the value drops. This locks in losses and ensure they will sell stocks for no less than strike price. This can be called a “married put”

Breakeven stock price must rise to stock price paid - premium

Question 24

Protective Calls

Answer 24

A type of insurance policy for an investor who is short stock (bearish). A protective call would allow the investor to buy back the stock at no more than the strike price if shares rise in value. A short stock has unlimited risk, so this controls that risk.

Breakeven stock price must fall to stock price paid - premium