Unit 4 - Types and Characteristics of Derivative Securities (Testing) Flashcards
A commodities speculator purchases a 1,000-bushel wheat futures contract at $0.50 per bushel. At expiration, the settlement price is $0.45 per bushel. This individual
A) has a $50 loss
B) has a $50 gain
C) must make delivery of the wheat
D) effectively hedged the long wheat position
A
Explanation: The simple math is the individual bought at $0.50 and sold at $0.45, losing $0.05 per bushel. Multiplying $0.05 times 1,000 bushels shows the loss is $50. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of) the wheat.
You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wishes to use options to protect against unlimited loss, you would suggest the client
A) sell 1 RIF put.
B) buy 1 RIF call.
C) buy 1 RIF put.
D) sell 1 RIF call.
B
Explanation: Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.
Buying a put option on a security one currently owns allows an investor to
A) buy more stock if he exercises the put.
B) increase his profit if the security declines in price.
C) participate in additional gains if the security continues to increase in price.
D) receive the premium for the purchase of the put.
C
Explanation: This is an example of a protective put, that is, purchasing a put option on a stock the investor already owns. This allows the stockholder to lock in a sale price (the strike price of the put). If the market price of the stock continues to rise, the investor would not exercise the put. The put would expire, and the long stock would remain in the account at the higher market price. The investor could hold the stock or sell it at the higher market price. In either case, the investor would continue to participate in the additional gains. The protection (the hedge) occurs if the price of the stock falls. Then the investor would be able to exercise the right to sell the stock at the strike price. That would offset the loss on the long position, not generate additional profit. Remember that options buyers pay the premium; they do not receive it. Exercising a put gives the holder the right to sell the stock, not buy it. Perhaps reviewing an example will help.
The investor owns 100 shares of ABC stock currently trading at $50 per share. Since he wants to protect against a drop in price, the investor purchases an ABC put option with a strike price of 50 and pays a premium of 3. If the stock’s price rises to $60 per share by the expiration date, the put option will expire worthless. (Who wants to put [sell] stock at $50 when it is selling for $60?) In this case, the investor has paid a premium of 3 points to ensure that the stock can always be sold (during the life of the option) for a price of $50 while still having the opportunity to participate in future price increases of the stock. In our example, the investor has gained $7 per share (the difference between the increase from $50 to $60 less the premium paid for the option).
An investor who was sure that a stock’s price was going to move substantially but wasn’t sure in which direction would be able to benefit by
A) selling the stock short and purchasing a call on the stock.
B) purchasing a straddle on that stock.
C) writing a straddle on that stock.
D) purchasing the stock and a put on the stock.
B
Explanation: Purchasing a straddle on a stock means going long a put and a call at the same strike price with the same exercise date. If the stock goes up, the investor profits on the call; if the stock goes down, the investor profits on the put. When an investor writes a straddle, a put and a call are sold at the same exercise price and expiration date. Short straddles profit when the stock price remains stable (the opposite of what is presented in this question). Taking a long position in a stock with a long put offers protection to the downside but no profit. Likewise, shorting a stock and taking a long position in a call offers protection to the upside but no profit.
In general, the value of a derivative is primarily determined by which of the following?
I. The price volatility of the underlying asset
II. The exchange on which it is traded
III. The length of time until the contract expires
IV. Whether it is purchased from a broker or a dealer
A) II and III
B) I and III
C) I and II
D) III and IV
B
Explanation: The two most important factors influencing the price of a derivative are the price movement (volatility) of the underlying asset and the length of time until the contract expires (the longer the time, the greater the time value).
Options positions can create either rights or obligations. In which option position has the investor created the possible obligation to purchase stock?
A) Purchasing a call
B) Purchasing a put
C) Selling a call
D) Selling a put
D
Explanation: When you sell (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is put to you. In the case of a call, you are obligated to sell stock that is called away from you. Options buyers have rights. They can choose what they wish to do; there are no obligations.
Which of the following is not traded on any exchange?
A) Closed-end funds
B) ETFs
C) Forward contracts
D) Futures contracts
C
Explanation: Forward contracts are non-standardized and, as such, do not trade on any exchange.
The term used to describe investment vehicles whose value is based on an underlying asset is
A) parity.
B) derivative.
C) funded debt.
D) separate account.
B
Explanation: Derivatives are referred to as such because they derive their value from some underlying asset, whether it be a stock or a commodity.
The term sweetener would most often apply to
A) derivatives.
B) rights.
C) convertibles.
D) warrants.
D
Explanation: A warrant is a derivative that gives the holder the ability to acquire shares of common stock at a fixed price. At issuance, that price is always higher than the current market value of the stock, but warrants generally have a long expiration date that gives them great time value. When an issuer attaches warrants to a bond or preferred stock issue, they serve to sweeten the offering resulting in lower interest rates or dividends.
Exercise of which of the following would not result in a change on the issuer’s balance sheet?
A) A call option
B) Convertible preferred stock
C) Rights
D) Warrants
A
Explanation: When a call option is exercised, the strike price is paid to the seller of the option, not the issuer. The issuer is not involved in any way, so there is no effect on the company’s financial statements. When the holder of a convertible preferred stock exercises the conversion privilege, the equity portion of the balance sheet shows a reduction in the preferred stock outstanding and an increase to the common stock outstanding. When rights or options are exercised, assets increase due to the cash paid for the stock and the equity portion of the balance sheet reflects an increase to the number of shares of common stock outstanding.
Which of the following statements is true?
A) Unlike forwards, futures are not traded on an exchange.
B) A futures contract always requires delivery of an asset.
C) A futures contract has standardized terms.
D) A futures contract does not involve obligations to buy or sell an asset.
C
Explanation: Futures contracts are traded on exchanges and, therefore, have standardized terms. In forwards, the terms of each contract are separately negotiated.
One of the privileges frequently offered to holders of common stock is
A) warrants.
B) preemptive rights.
C) call options.
D) put options.
B
Explanation: The preemptive right is the right given to common stockholders to maintain their proportionate interest in a company. Shareholders are sent those rights. All of the other choices are derivatives that must be purchased individually or, as is so often the case with warrants, attached to another security being purchased.
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.
A) II and III
B) I and IV
C) I and III
D) II and IV
B
Explanation: 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.
Many investors with a long position in common stock employ the technique of writing call options on the underlying stock for the purpose of
A) generating income.
B) increasing the dividend return.
C) participating in the growth of the company.
D) protecting the premium.
A
Explanation: A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. This action has no impact on the amount of the dividends received. It is the uncovered (or naked) call option that has unlimited risk.
