CFA Level 1 - Derivative Investments Session 17 - Reading 63

CFA Level 1 - Derivative Investments Session 17 - Reading 63 (Notes, Practice Questions, Sample Questions) 1. Regarding buyers and sellers of put and call options, which of the following statements concerning the resulting option position is most accurate? The buyer of a: A)call option is taking a long position and the buyer of a put option is taking a short position. B)put option is taking a short position and the seller of a call option is taking a short position. C)call option is taking a long position while the seller of a put is taking a short position. Explanation: The buyers of both puts and calls are taking long positions in the options contracts (but the buyer of a put is establishing a potentially short exposure to the underlying), while writers (sellers) of each are taking short positions in the options contracts. 2. Which of the following represents a long position in an option? A)Writing a call option. B)Buying a put option. C)Writing a put option Explanation: A long position is always the buying position. Remember that the buyer of an option is said to have gone long the position, while the writer (seller) of the option is said to have gone short the position. 3. Which of the following statements about options is most accurate? A)For call options, the lower the strike price relative to the stock's underlying price, the more the call option is worth. B)Most options throughout the world are European options. C)A put writer who deposits shares of the underlying stock has written a covered put. Explanation: The other statements are false. Most options throughout the world are American options. A call writer who deposits shares of the underlying stock has written a covered call. 4. A European option can be exercised by: A)its owner, only at the expiration of the contract. B)its owner, anytime during the term of the contract. C)either party, at contract expiration. Explanation: A European option can be exercised by its owner only at contract expiration 5. Which of the following statements concerning an American-style option is least accurate? A)It allows the holder the right to exercise before maturity of the option. B)The predominant option type is American-style, rather than European-style. C)They are only traded in the U.S. Explanation: American-style options are traded throughout the world. The “American” label simply identifies the option as having the right to be exercised before maturity. American-style options are the predominant type of options contract traded 6. What is the primary difference between an American and a European option? A)The American option can be exercised at anytime on or before its expiration date. B)American and European options are never written on the same underlying asset. C)The European option can only be traded on overseas markets Explanation: American and European options are virtually identical, except exercising the European option is limited to its expiration date only. The American option can be exercised at anytime on or before its expiration date. For the exam, the key concept relating to this difference is the value of the American option must be equal or greater than the value of the corresponding European option, all else being equal 7. For two European put options that differ only in their time to expiration, which of the following is most accurate? The longer-term option: A)can be worth more than the shorter-term option. B)can be worth less than the shorter-term option. C)can be worth at least as much as the shorter-term option Explanation: For European puts, it is possible that the longer term option can be less valuable than a shorter-term option 8. For two American options that differ only in time to expiration, strongest statement we can make is that: A)the longer-term option must be worth less than the shorter-term option. B)the longer-term option must be worth at least as much as the shorter-term option. C)the longer-term option must be worth more than the shorter-term option Explanation: While longer term options generally are worth more, for far in- or out-of-the-money options, the values could be equal 9. Which of the following statements about options is least accurate? A)If an American option is exercised at expiration, its value will be less than that of a European option. B)Option prices are generally higher the longer the time until the option expires. C)For put options, the higher the strike price relative to the stock's underlying price, the more the put is worth Explanation: The American option cannot be worth less than the European option 10. Which of the following statements about long positions in put and call options is most accurate? Profits from a long call: A)are positively correlated with the stock price and the profits from a long put are negatively correlated with the stock price. B)are negatively correlated with the stock price and the profits from a long put are positively correlated with the stock price. C)and a long put are positively correlated with the stock price Explanation: For a call, the buyer's (or the long position's) potential gain is unlimited. The call option is in-the-money when the stock price (S) exceeds the strike price (X). Thus, the buyer's profits are positively correlated with the stock price. For a put, the buyer's (or the long position's) potential gain is equal to the strike price less the premium. A put option is in-the-money when X > S. Thus, a put buyer wants a high exercise price and a low stock price. Thus, the buyer's profits are negatively correlated with the stock price. 11. Which statement best reflects the risk exposure of a put writer? A)Limited risk. B)No risk. C)Unlimited risk. Explanation: Because stock prices cannot fall below $0, a put writer’s risk is limited to the strike price 12. Which statement best reflects the risk exposure of an option buyer? A)Unlimited risk. B)Limited risk. C)No risk. Explanation: The most any option buyer can lose is the amount paid for the option 13. Using put-call parity, it can be shown that a synthetic European call can be created by a portfolio that is: A)long the stock, long the put, and short a pure discount bond that pays the exercise price at option expiration. B)long the stock, long the put, and long a pure discount bond that pays the exercise price at option expiration. C)long the stock, short the put, and short a pure discount bond that pays the exercise price at option expiration Explanation: A stock and a put combined with borrowing the present value of the exercise price will replicate the payoffs on a call at option expiration 14. A fiduciary call is a portfolio that is made up of: A)a call that is synthetically created from other instruments. B)a call option and a bond that pays the exercise price of the call at option expiration. C)a call option and a share of stock. Explanation: A fiduciary call combines a call option and a bond that pays the exercise price of the call at option expiration 15. Assume that the value of a put option with a strike price of $100 and six months remaining to maturity is $5. For a stock price of $110 and an interest rate of 6%, what value is closest to the corresponding call option with the same strike price and same expiration as the put option? A)$11.99. B)$17.87. C)$12.74. Explanation: Call value = $110 + $5 – $100 / 1.060.5 = $17.87 16. The put-call parity relation can be adjusted for dividend payments on a stock by which of the following methods? A)Add the present value of the expected dividend payments to the exercise price. B)Add the present value of the expected dividend payments to the current stock price. C)Subtract the present value of the expected dividend payments from the current stock price Explanation: The correct adjustment is to subtract the present value of the expected dividend payments from the current stock price 17. The lower bound on European call option prices can be adjusted for cash flows of the underlying asset by: A)subtracting the present value of the expected dividend payments from the current asset price. B)adding the present value of the expected dividend payments to the current asset price. C)subtracting the present value of the expected dividend payments from the exercise price Explanation: The correct adjustment is to subtract the present value of the expected dividend payments from the current asset price 18. An increase in the riskless rate of interest, other things equal, will: A)increase call option values and decrease put option values. B)decrease call option values and increase put option values. C)decrease call option values and decrease put option values Explanation: An increase in the risk-free rate of interest will increase call option values and decrease put option values 19. An increase in the riskless rate of interest, other things equal, will: A)increase call option values and decrease put option values. B)decrease call option values and increase put option values. C)decrease call option values and decrease put option values Explanation: An increase in the risk-free rate of interest will increase call option values and decrease put option values 20. For stock options, which of the following will least likely increase put option values and decrease call option values? A)An increase in the riskless rate of interest. B)A decrease in the riskless rate of interest. C)An increase in the exercise price Explanation: An increase in the riskless rate of interest will decrease put option values and increase call option values