Deck 19: Understanding Derivative Securities: Options

Question 1

To maximize his/her expected returns, ceteris paribus, an investor who was bearish on a particular stock would execute which of the following options strategies:

A) buy calls
B) write calls
C) buy puts
D) write puts

Answer 1

D

Question 2

The exercise price on an option is also known as the:

A) premium.
B) strike price.
C) theoretical value.
D) spot price.

Answer 2

B

Question 3

A writer of a call can terminate the contract before expiration by:

A) writing a second call.
B) buying a put.
C) buying a comparable call.
D) writing a put.

Answer 3

C

Question 4

Which of the following statements about portfolio insurance is FALSE?

A) There are several methods of insuring a portfolio.
B) It seeks to provide a minimum return while offering the opportunity to participate in rising prices.
C) Futures are typically not used to hedge stock portfolios.
D) Puts and calls typically are not used to insure portfolios.

Question 5

The __________ is NOT a determinant of the value of a call option in the Black-Scholes model?

A) interest rate
B) exercise price of the stock
C) price of the underlying stock
D) expected beta of the underlying stock

Question 6

The writer of a naked call faces

A) an unlimited potential loss.
B) a specified potential loss.
C) no chance of loss because this is a conservative strategy.
D) an unlimited potential gain.

Question 7

Which of the following statements is true regarding American and European options?

A) American options can be exercised only at expiration.
B) American options can be exercised only in the last week prior to expiration.
C) European options can be exercised only at expiration.
D) European options can be exercised any time prior to expiration.

Question 8

Which of the following is not a reason for investors to participate in options?

A) Options eliminate leverage.
B) Options are a smaller investment than stock investments.
C) Options allow investors to trade on the overall market movements.
D) Options can reduce risk.

Question 9

To maximize his/her potential upside returns, ceteris paribus, an investor who was bullish on a particular stock would execute which of the following options strategies:

A) buy calls
B) write calls
C) buy puts
D) write puts

Question 10

To hedge a short sale, an investor could

A) buy a call.
B) write a call.
C) buy a put.
D) write a put.

Question 11

To provide insurance against declining prices on previously purchased stock, an investor could

A) buy a call.
B) write a put.
C) buy a stock index option.
D) buy a put.

Question 12

Put and call options on gold are considered:

A) Commodity derivatives
B) Financial derivatives
C) Forward contracts
D) Futures contracts

Question 13

A major difference between new shares sold by a corporation and shares sold under a call option is that:

A) there is no profit or loss under the shares sold under the call.
B) there is no risk to the investor with the call.
C) there is no increase in the shares outstanding with the call.
D) there is no commission to the investor with the call.

Question 14

Other things equal, after an option first becomes available in the market,

A) its time value approaches zero.
B) its time value increases into maturity.
C) the volatility of the stock is negatively related to the value of the call.
D) if it is out of the money, it will have no time value.

Question 15

Which of the following statements is true regarding the writer of a call contract?

A) The call writer expects the stock to move upward.
B) The call writer expects the stock to remain the same or move down.
C) The call writer expects the stock to split.
D) The call writer expects to sell the stock prior to expiration of the option.

Question 16

The standard option contract is for:

A) 10 shares of stock
B) 50 shares of stock
C) 100 shares of stock
D) 1 share of stock

Question 17

LEAPS are typically:

A) more expensive than short-term options.
B) cheaper than short-term options.
C) only available for major indexes, not individual stocks.
D) long-term options, with maturities often between 5 and 10 years.

Question 18

One important reason for the existence of derivatives is that they:

A) help lower transactions costs.
B) have valuable tax benefits.
C) contribute to market completeness.
D) are risk-free.

Question 19

A call option written against stock owned by the writer is said to be

A) naked. b. in the money.
C) out of the money.
D) covered.

Question 20

Options sold on exchanges are protected against

A) stock dividends and splits.
B) cash dividends.
C) interest rate movements.
D) inflation.

Question 21

Which of the following statements is FALSE?

A) An in-the-money call occurs if the stock price exceeds the exercise price.
B) An out-of -the money call occurs if the stock price is less than the exercise price.
C) If a call is out of the money, the intrinsic value is zero.
D) If a call is in the money, the intrinsic value is zero.

Question 22

Which of the following statements is TRUE?

A) An American option's premium almost never declines below its intrinsic value.
B) If a call is in the money, its intrinsic value equals zero.
C) The speculative premium reflects the option's immediate value.
D) If the exercise price of an put is less than the stock price, the put is "out of the money."

Question 23

Which of the following statements is true regarding equity options contracts?

A) The majority of options contracts are standardized, including strike prices and time to maturity.
B) Investors typically create options contracts to trade amongst themselves.
C) Options contracts are typically customized to suit the needs of each investor.
D) Options are available on all publicly traded U.S. stocks

Question 24

Which of the following is true regarding option pricing:

A) the longer the maturity of the option, the higher the premium.
B) the more volatile the underlying stock, the lower the premium.
C) option prices are less volatile than equity prices.
D) the shorter the maturity of the option, the higher the premium.

Question 25

A combination of two calls and one put is called a:

A) strip
B) strap
C) straddle
D) spread

Question 26

A combination of one put and one call on the same stock with the same exercise price and date is known as a:

A) strip
B) straddle
C) strap
D) spread

Question 27

$---- \text {Call} ---$ $\quad$ $\quad$$-----\text { Put }-----$
$\begin{array}{lllllll}\text { Option/Strike Exp.}&&&\text { Vol. }&\text { Last} &\text {Vol.}&\text { Last.}\\\text { XYZ} \\385 / 8 & 25 & \text { Dec. } & -- & --- & 100 & 1 / 8 \\385 / 8 & 30 & \text { Nov. } & 250 & 8\quad3/4 & 464 & 1 / 16 \\ 385 / 8 & 30 & \text { Dec. } & --- & --- & 572 & 5 / 16 \\385 / 8 & 35 & \text { Nov. } & 154 & 4\quad1 / 2 & 1748 & 5 / 16 \\385 / 8 & 35 & \text { Dec. } & 923 & 5\quad1 / 4 & 580 & 1\quad3 / 16 \\385 / 8 & 35 & \text { Mar. } & -- & --- & 33 & 2\quad5 / 8 \\385 / 8 & 40 & \text { Nov. } & 2023 & 1\quad1 / 8 & 530 & 2\quad3 / 8\end{array}$



-Of the various combinations shown above, how many combinations of put contracts are currently trading "out-of-the-money?"

A) 6
B) 5
C) 4
D) 1

Question 28

$---- \text {Call} ---$ $\quad$ $\quad$$-----\text { Put }-----$
$\begin{array}{lllllll}\text { Option/Strike Exp.}&&&\text { Vol. }&\text { Last} &\text {Vol.}&\text { Last.}\\\text { XYZ} \\385 / 8 & 25 & \text { Dec. } & -- & --- & 100 & 1 / 8 \\385 / 8 & 30 & \text { Nov. } & 250 & 8\quad3/4 & 464 & 1 / 16 \\ 385 / 8 & 30 & \text { Dec. } & --- & --- & 572 & 5 / 16 \\385 / 8 & 35 & \text { Nov. } & 154 & 4\quad1 / 2 & 1748 & 5 / 16 \\385 / 8 & 35 & \text { Dec. } & 923 & 5\quad1 / 4 & 580 & 1\quad3 / 16 \\385 / 8 & 35 & \text { Mar. } & -- & --- & 33 & 2\quad5 / 8 \\385 / 8 & 40 & \text { Nov. } & 2023 & 1\quad1 / 8 & 530 & 2\quad3 / 8\end{array}$



-Which of the following calls is not "in-the-money?"

A) 25 Dec
B) 30 Nov
C) 35 Dec
D) 40 Nov

Question 29

$---- \text {Call} ---$ $\quad$ $\quad$$-----\text { Put }-----$
$\begin{array}{lllllll}\text { Option/Strike Exp.}&&&\text { Vol. }&\text { Last} &\text {Vol.}&\text { Last.}\\\text { XYZ} \\385 / 8 & 25 & \text { Dec. } & -- & --- & 100 & 1 / 8 \\385 / 8 & 30 & \text { Nov. } & 250 & 8\quad3/4 & 464 & 1 / 16 \\ 385 / 8 & 30 & \text { Dec. } & --- & --- & 572 & 5 / 16 \\385 / 8 & 35 & \text { Nov. } & 154 & 4\quad1 / 2 & 1748 & 5 / 16 \\385 / 8 & 35 & \text { Dec. } & 923 & 5\quad1 / 4 & 580 & 1\quad3 / 16 \\385 / 8 & 35 & \text { Mar. } & -- & --- & 33 & 2\quad5 / 8 \\385 / 8 & 40 & \text { Nov. } & 2023 & 1\quad1 / 8 & 530 & 2\quad3 / 8\end{array}$



-The closest quote for the Dec. 25 call, were it to trade, would be

A) 12. Solution: Intrinsic value =38 5/8 - 25
B) 4 7/8. =13 5/8
C) 10 1/2.
D) 13 5/8.

Question 30

The way to protect a stock portfolio most in a bear market is to:

A) Buy stock index calls.
B) Buy stock index puts.
C) Write stock index calls.
D) Write stock index puts.

Question 31

Three types of equity securities derivatives are:

A) puts and calls created by corporations, and warrants created by investors.
B) puts and calls created by investors, and warrants created by corporations.
C) options, preferred stock, and commons stock created by corporations.
D) options, stock, and warrants, created by corporations.

Question 32

An option is a wasting asset because as its expiration date approaches, its

A) intrinsic value approaches zero.
B) time value approaches zero.
C) intrinsic value approaches its time value.
D) price approaches zero.

Question 33

A (an) ---------- seeks to earn a return without assuming risk by constructing riskless hedges.

A) speculator
B) call writer
C) put writer
D) arbitrageur

Question 34

The two basic spreads are the:

A) time spread and price spread
B) put spread and call spread
C) time spread and money spread
D) money spread and rate spread

Question 35

Spreads are used to:

A) increase the return potential
B) circumvent option commissions
C) reduce risk in an option position.
D) all of the above are true.

Question 36

Concerning index options, which of the following statements is FALSE?

A) Index options appeal to speculators due to the leverage they offer.
B) Investors can write index options.
C) If exercised the holder of an index option receives the strike price.
D) Index options are settled in cash.

Question 37

A stock is at $68. A two-month put (strike price = $70) is available at a $6 premium.. The intrinsic value is ___ and the time value is ____.

A) $0 . . . $4.
B) $3 . . . $5.
C) $2 . . . $4.
D) $2 . . . $3.

Question 38

If the price of the common stock exceeds the exercise price of a call for the holder the call is said to be

A) naked.
B) out of the money.
C) in the money.
D) covered.

Question 39

In the Black-Scholes model,

A) all of the inputs except two are observable.
B) all of the inputs except one are observable.
C) the greater the stock price, the lower the price of the call option.
D) there is an inverse relationship between the value of a call and interest rates in the market.

Question 40

Stock market index options are available on all of the following EXCEPT

A) the Standard and Poor's 500 Index.
B) the Major Market Index.
C) the National OTC Index.
D) the Shearson Lehman Hutton Index.

Question 41

What is a hedge ratio?

Question 42

Options can be purchased on margin.

Question 43

If the price of the underlying stock equals the strike price of the call option at maturity, the call buyer has a breakeven transaction.

Question 44

The Options Clearing Corporation does not ensure fulfillment of option obligations.

Question 45

An option buyer has three courses of action available: write a similar option to close the position, exercise the option, or let the option expire unexercised.

Question 46

What is meant by portfolio insurance?

Question 47

What organizational feature of options trading prevents individual traders from having to worry about defaults if options are exercised?

Question 48

According to the Black Scholes (1973) option pricing model, option value is a function of stock price, exercise price, time to maturity, interest rate, and volatility of the underlying asset.

Question 49

If the price of the underlying common stock is less than the exercise price of a call, it is in the money.

Question 50

A stock investor wants to hedge the Dell stock in his portfolio. How can he use a covered call to do this?

Question 51

The writer of a call, like the buyer of a put, is bearish about the stock price.

Question 52

Writing a naked call is potentially riskier than writing a naked put.

Question 53

List five options exchanges.

Question 54

A stock investor wants to hedge the Microsoft stock in his portfolio. How can he use a protective put to do this?

Question 55

What is the put-call parity? How is it related to arbitrage?

Question 56

There is an positive relationship between the price of a put option and the volatility of the underlying common stock.

Question 57

How can the owner of a large stock portfolio use options on individual stocks to enhance the income from the portfolio?

Question 58

What type of equity derivatives are created by corporations?

Question 59

Options traded on organized exchanges are protected against cash dividends.

Question 60

A protective put is a strategy in which an investor with a long position in stock buys one or more puts.

Question 61

An investor has the alternative of buying 100 shares of XYZ at $50 per share or investing the same amount of money in XYZ 6-month calls priced at $5. Calculate the profit or loss from each strategy if the price of XYZ rises to $60 within a week.

Question 62

ABC, which closed at $151, has call options trading in April, July, and October with the following values:
(a) Calculate the intrinsic value of the April 150 call.
(b) Calculate the intrinsic value of the April 140 call.
(c) Should the price of ABC rise to $156, what is the minimum value that the April 150 call should trade at?

Question 63

Listed below are the option quotes on JUP, Inc., in January of this year.
(a) Which calls are in the money?
(b) Which puts are in the money?
(c) Why are investors willing to pay 3 1/2 for the MARCH 35 call but only 1/2 for the March 35 put?
(d) Calculate the intrinsic value of the June 35 call.
(e) Calculate the intrinsic value of the March 40 put.

Question 64

AB Flex Inc. stock is currently trading at $38. The time left until expiration of a call and put trading on AB Flex Inc.'s stock is 6 months and the strike price is $45. If the call is currently trading at $1.96 and the Treasury bill rate is 10 percent per year, what price should the put sell for?

Question 65

Use the Black-Scholes model to calculate the theoretical value of a DBA December 45 call option. Assume that the risk free rate of return is 6 percent, the stock has a variance of 36 percent, there are 91 days until expiration of the contract, and DBA stock is currently selling at $50 in the market.

Question 66

SCORP has puts and calls available for trading for the expiration months of June, September, and December. For the trading day May 2, 199X, SCORP closed at $40 per share. Strike prices for SCORP are $35, $40, and $45. The following prices for the 9 call options (3 expiration dates and 3 strike prices) for this date were (in scrambled order):
A. 5 ½ F. 4 7/8
B. 4 G. 3/4
C. 2 1/16 H. 7 1/4
D. 6 3/8 I. 2 7/16
E. 3 1/8
Fill in the following matrix of prices for these calls, using LETTERS ONLY (i.e., A through I)

Question 67

You buy 1,000 shares of Sunbeam at 11 1/8 and write 10 calls at a premium of 4 3/8 with a strike price of 7 1/2. The stock goes to 20 in 6 months. You receive a 8 cent dividend per share. If the calls are exercised (which is the likely assumption), what is your percentage return?

Question 68

What makes the risk-expected return profile attractive to speculators who purchase put and call options? What is the risk-expected return profile for writers of naked put and call options?

Question 69

How could an investor create 100 shares of artificial stock (i.e., a portfolio with the same payoffs as 100 shares of common stock)?

Question 70

What are the variables in the Black-Scholes option pricing model? How is each related to the price of the call option?