Volume 1- Chapter 10 Flashcards
What is a derivative?
A financial contract whose value is derived from an underlying asset.
What are the two basic types of derivatives?
- Options
- Forwards
What rights does the buyer have in an option contract?
The right, but not the obligation, to buy or sell a specified quantity of the underlying asset.
What is the difference between a call option and a put option?
- Call option: right to buy the underlying asset
- Put option: right to sell the underlying asset
What is a forward contract?
A contract where both parties are obliged to trade the underlying asset in the future at a price agreed upon today.
List the common features of all derivatives.
- Contractual agreements between two parties
- Agreed-upon price
- Expiration date
- No up-front payment for forwards
- Premium payment for options
- Zero-sum game
What is the OTC derivatives market?
A loosely connected and lightly regulated network of dealers negotiating transactions directly.
What is one advantage of OTC derivatives?
Contracts can be custom designed to meet specific needs.
What is a derivative exchange?
A legal corporate entity organized for the trading of derivative contracts.
Identify one major difference between exchange-traded derivatives and OTC derivatives.
Exchange-traded derivatives have standardized contracts, whereas OTC derivatives can be tailored.
What is default risk in derivatives?
The risk that one party will not be able to meet its obligations under a contract.
True or False: Exchange-traded derivatives are heavily regulated.
True
Fill in the blank: The two general categories of underlying assets for derivative contracts are _______ and financial assets.
[commodities]
List some types of commodities that underlie derivative contracts.
- Grains and oilseeds
- Livestock and meat
- Precious and industrial metals
- Energy products
What are the predominant equity derivatives?
Equity options (options on individual stocks).
What are the most commonly used underlying assets in currency derivatives?
- U.S. dollar
- British pound
- Japanese yen
- Swiss franc
- European euro
Who are the primary users of derivatives?
- Individual investors
- Institutional investors
- Businesses and corporations
- Derivative dealers
What is hedging in the context of derivatives?
Using derivatives to protect the value of an anticipated or existing position in the underlying asset.
What role do derivative dealers play in the market?
They act as intermediaries, buying and selling to meet the demands of end users.
What is the purpose of hedging in derivatives trading?
Risk management to eliminate or reduce the risk of holding an asset or anticipating a future purchase.
Who are derivative dealers?
Intermediaries in the markets who buy and sell to meet the demands of end users and do not normally take large positions.
What types of derivatives can individual investors typically trade?
Exchange-traded derivatives, including options and futures.
What should individual investors consider before trading derivatives?
They should fully understand all risks and potential rewards and have a high degree of risk tolerance and risk capacity.
Name some types of institutional investors that use derivatives.
- Mutual fund managers
- Hedge fund managers
- Pension fund managers
- Insurance companies
What is speculation in the context of derivatives?
Taking positions to profit from expected market movements, which increases risk instead of reducing it.
Fill in the blank: A method of quickly entering and exiting a market using derivatives is called _______.
Market entry and exit
What is an arbitrage opportunity?
A scenario where the same asset is traded at different prices in separate markets, allowing for risk-free profit.
What does yield enhancement involve?
Boosting returns on an investment portfolio by taking speculative positions based on future market expectations.
How do corporations typically use derivatives?
Primarily for hedging purposes related to interest rate, currency, and commodity price risk.
What is a call option?
A contract that gives the holder the right to buy an underlying asset at a specified price.
What is a put option?
A contract that gives the holder the right to sell an underlying asset at a specified price.
Describe the rights and obligations of a call option holder.
Has the right to buy the underlying asset; pays a premium to the writer.
Describe the rights and obligations of a put option holder.
Has the right to sell the underlying asset; pays a premium to the writer.
What is the strike price in options trading?
The price at which the underlying asset can be purchased or sold in the future.
What is an option premium?
The fee paid by option buyers to sellers to obtain the right to buy or sell the underlying asset.
When do exchange-traded options typically expire?
On the third Friday of the expiration month.
What is the trading unit for exchange-traded stock options in North America?
100 shares.
What are American-style options?
Options that can be exercised any time up to and including the expiration date.
What are European-style options?
Options that can be exercised only on the expiration date.
Define an opening transaction in options trading.
Establishing a new position in an option contract.
What happens when a long position in an option is exercised?
The holder buys the underlying asset from the assigned writer at the strike price.
What occurs if an option expires worthless?
The option buyer loses the premium paid, and the option writer makes money with the premium received.
True or False: Speculation is consistent with the objective of risk management.
False.
What does exercising an option involve?
Selling the underlying asset to the assigned put writer at the strike price.
What happens if the party holding the long position lets the option expire worthless?
The option buyer loses the premium paid, and the option writer makes money with the premium received.
What does it mean for an option to be in-the-money?
It means exercising the option is in the holder’s best financial interest.
When is a call option considered in-the-money?
When the price of the underlying asset is higher than the strike price.
When is a put option considered in-the-money?
When the price of the underlying asset is lower than the strike price.
What defines an out-of-the-money call option?
When the price of the underlying asset is lower than the strike price.
What defines an out-of-the-money put option?
When the price of the underlying asset is higher than the strike price.
What does at-the-money mean for options?
When the price of the underlying asset equals the strike price.
What is intrinsic value in the context of options?
The value of certainty; the in-the-money portion of a call or put option.
How is intrinsic value of an in-the-money call option calculated?
Price of Underlying − Strike Price.
How is intrinsic value of an in-the-money put option calculated?
Strike Price − Price of Underlying.
What is the intrinsic value of a call option on XYZ stock with a strike price of $55 when XYZ is trading at $60?
$5.
What does it mean if an option is not in-the-money?
It has zero intrinsic value.
What is time value in options trading?
The value of uncertainty; the amount an option is trading above its intrinsic value.
How is time value calculated?
Option Price − Option’s Intrinsic Value.
In Canada, where are options traded?
The Montréal Exchange.
What information is typically reported for exchange-traded options?
Prices and trading information on exchanges’ websites, financial data providers, and in the business press.
What are the two primary investment strategies for buying call options?
- Speculate for profit
- Manage risk.
What is a common reason for buying call options?
To profit from an expected increase in the price of the underlying stock.
What are the two ways investors can realize profit on call options?
- Exercise the option
- Sell the option directly into the market.
If an investor buys five XYZ December 55 call options at a premium of $2, what is the total cost?
$1,000.
What is the risk if the stock price falls when holding call options?
The price of the calls will likely fall, leading to potential losses.
What is the return on investment if the price of XYZ stock rises to $60, and the call holder sells for a profit of $4.70?
235%.
What is the return on investment if the stock price declines to $45 and the call buyer sells for a loss of $1.75?
-87.5%.
How does leverage affect profits and losses in options trading?
It increases both profits and losses on a percentage basis.
What is the intrinsic value of a put option with a strike price of $65 when XYZ is trading at $60?
$5.
What happens to at-the-money options at expiration?
They are normally left to expire worthless.
What is the formula to calculate the percentage return on an investment?
$Return ÷ $Investment × 100
What is the percentage return when a stock is bought at $52.50 and sold at $60 for a profit of $7.50?
14.3%
What happens to the rate of return when the stock price falls to $45 after being bought at $52.50?
−14.3%
What is one reason investors buy call options?
To manage risk
What does buying a call option allow a fund manager to do?
Establish a maximum purchase price for shares
If XYZ shares increase to $60 before expiration, what is the intrinsic value of the call option with a strike price of $55?
$5
What is the effective purchase price for a call buyer if the options cost $2 and the strike price is $55?
$57
What is the risk faced by investors who use leverage when buying call options?
Potential loss
What are the two classifications of call option writers?
- Covered call writers
- Naked call writers
What is the main goal of writing call options?
To earn income from the premium
What is the maximum loss a naked call writer can face?
Theoretically unlimited
In a covered call strategy, what does the investor receive when they write call options?
A premium
What is the effective sale price for a covered call writer if they sell stock at $50 and received a premium of $4.55?
$54.55
If a naked call writer writes call options and the stock price rises above the strike price, what must they do?
Buy the stock at market price and sell at the strike price
What is a popular reason for buying put options?
To profit from an expected decline in stock price
What is the intrinsic value of a put option if the stock price is $45 and the strike price is $50?
$5
What does buying a put option provide to an investor who owns the stock?
Insurance against a price decline
What is the effective sale price for a put buyer if they sell at the strike price of $50 but paid $1.50 for the puts?
$48.50
What are the two classifications of put option writers?
- Covered put writers
- Naked put writers
What is a married put?
Buying a put in conjunction with owning the stock
True or False: The income from writing put options is dependent on the price of the underlying asset.
False
Fill in the blank: The maximum profit for a naked call writer is equal to the _______.
initial premium received
What is the primary nature of put-writing strategies?
Speculative in nature but can be used to manage risk.
How can put option writers be classified?
Covered or naked.
What does covered put writing combine?
A short put with a short position in the stock.
Why is covered put writing less common than covered call writing?
There are many more long positions in stocks than short positions.
What is a cash-secured put write?
Writing a put and setting aside cash equal to the strike price.
What should the cash in a cash-secured put write ideally be invested in?
A short-term, liquid money market security such as a Treasury bill.
What is the hope of naked put writers?
To profit from a stock price that stays the same or goes up.
What is the maximum loss a naked put writer may face?
Limited to the price of the underlying stock falling to $0, offset by the premium received.
What is the outcome if a stock price is below the strike price at expiration for a cash-secured put writer?
The put writer will be assigned and must buy the stock at the strike price.
What is the effective purchase price for a cash-secured put write?
Strike price minus the premium received.
In naked put writing, what happens if the price of XYZ stock falls below $50.15 at expiration?
The naked put writer will incur a loss.
What do corporations primarily use options for?
Managing risk related to interest rates, exchange rates, or commodity prices.
What is the purpose of a corporate call option purchase?
To establish a maximum interest rate on floating-rate debt.
What happens if the exchange rate rises above the strike price in a corporate call option?
The corporation will exercise the call and buy U.S. dollars at the strike price.
What is the function of a corporate put option purchase?
To lock in a minimum sale price for an asset.
What distinguishes forwards from futures contracts?
In forwards, both parties are obligated to participate; futures are standardized and exchange-traded.
What are the two main types of futures contracts?
- Financial futures
- Commodity futures
What is the buyer of a futures contract said to hold?
A long position.
What is a cash-settled futures contract?
A contract where delivery involves an exchange of cash based on performance of the underlying asset.
What are margin requirements in futures trading?
Adequate deposits to ensure financial obligations of the contract are met.
What is the initial margin in futures trading?
Required when the contract is entered into.
What is marking to market in futures trading?
Daily settlement of gains and losses based on price changes.
What happens if an account balance falls below the maintenance margin level?
Additional margin must be deposited into the futures account.
What is the initial margin required for futures trading?
The initial margin required is a percentage of the contract’s value, typically 3% to 10%.
How does marking to market work in futures trading?
Accounts are debited and credited daily based on the gain or loss on the futures contract.
What happens when an account falls below the maintenance margin?
A margin call is issued, requiring the trader to deposit funds to restore the account to the initial margin.
What is leverage in the context of futures trading?
Leverage allows investors to control a large position with a small deposit, potentially leading to losses greater than the initial investment.
True or False: Futures contracts inherently include leverage.
False.
What are the two basic positions in futures contracts?
Long and short.
What is a speculative strategy in futures trading?
Buying futures to profit from an expected increase in the price of the underlying asset.
What is the purpose of buying futures to manage risk?
To lock in a purchase price for the underlying asset on a future date.
What is a risk management strategy when selling futures?
Selling a futures contract to lock in a selling price for the underlying asset.
How do corporations use futures contracts?
To manage risk by locking in purchase or sale prices for assets.
What is a right in the context of securities?
A privilege granted to existing shareholders to acquire additional shares from the issuing company.
What is the typical expiration period for rights?
Rights usually have a very short term, often four to six weeks.
What is the subscription price of a right?
The price shareholders pay to purchase additional shares.
What does it mean for shares to trade ex-rights?
Shares are traded without the entitlement to receive rights from the company.
What are the possible actions for a rights holder?
- Exercise some or all of the rights and acquire shares
- Sell some or all of the rights
- Buy additional rights to trade or exercise later
- Do nothing and let the rights expire worthless
How is the intrinsic value of a right calculated during the ex-rights period?
Intrinsic Value of Rights = (S - X) / n, where S is the market price of the stock, X is the exercise price, and n is the number of rights needed to buy one share.
What happens to the intrinsic value of rights if the stock price is below the subscription price?
The intrinsic value will be zero.
What is the main difference between rights and warrants?
Rights are short-term and usually issued to existing shareholders, while warrants tend to have longer expirations.
Fill in the blank: A company may give shareholders rights that allow them to buy additional shares in direct proportion to the number of shares they already own, typically issuing one right for each _______.
[share they own]
What is the net effect of using futures for price protection in a business scenario?
It allows the business to pay a price lower than the market price increase, providing price protection.
What happens on the first day of the ex-rights period?
The rights begin to trade as a separate security.
How is the intrinsic value of each right calculated when ABC shares open at $25?
$0.40
Calculated as follows: (Market Price - Subscription Price) / Number of Rights = ($25 - $23) / 5 = $0.40.
What is the formula for calculating the intrinsic value of rights during the cum rights period?
Intrinsic Value of Rights = (S - X) / (n + 1)
S = market price of the stock, X = subscription price, n = number of rights required.
What happens on June 1 in relation to ABC Co.’s rights offering?
Shareholders of record on June 10 will be granted one right for each common share held.
What is the intrinsic value of each right on June 3 when ABC shares open at $25.60?
$0.43
Calculated as follows: (Market Price - Subscription Price) / Number of Rights = ($25.60 - $23) / 6 = $0.43.
When do trading rights expire for a rights offering?
At the close of business on the expiry day.
What is required by Canadian trading practice for a rights transaction?
The transaction must be settled by the first business day after it takes place.
True or False: Warrants are issued by the company itself.
True.
What is a warrant?
A security that gives its holder the right to buy shares at a set price for a set period of time.
What distinguishes warrants from call options?
Warrants are issued by the company itself, while call options are issued by other investors.
What is the purpose of warrants when issued with new debt or preferred shares?
To make these issues more attractive to buyers by allowing participation in stock appreciation.
What are the two types of value a warrant may have?
- Intrinsic value
- Time value
Define intrinsic value in the context of warrants.
The amount by which the market price of the underlying common stock exceeds the exercise price of the warrant.
What happens to a warrant when the market price of the common stock is less than the exercise price?
It has no intrinsic value.
How does time value affect the value of a warrant?
It is the amount by which the market price of the warrant exceeds the intrinsic value, influenced by time remaining until expiration.
Why do investors buy warrants?
For their leverage potential.
What is the typical relationship between the market price of a warrant and the underlying security?
The market price of a warrant is usually much lower than the price of the underlying security and generally moves in the same direction.
