CFA Level 1 - Derivative Investments Session 17 - Reading 65

CFA Level 1 - Derivative Investments Session 17 - Reading 65 (Notes, Practice Questions, Sample Questions) 1. A call option has a strike price of $35 and the stock price is $47 at expiration. What is the expiration day value of the call option? A)$0. B)$12. C)$35 Explanation — A call option has an expiration day value of MAX (0, S − X). Here, X is $35 and S is $47 2. A put option has a strike price of $65, and the stock price is $39 at expiration. The expiration day value of the put option is: A)$65. B)$26. C)$0 Explanation — A put option has an expiration day value of MAX (0, X-S). Here, X is $65 and S is $39 3. A call option has a strike price of $120, and the stock price is $105 at expiration. The expiration day value of the call option is: . A)$0. B)$105. C)$15 Explanation — A call option has an expiration day value of MAX (0, S-X). Here, X is $120 and S is $105. Because the call option is out of the money at expiration, its value is zero 4. A put option has a strike price of $80, and the stock price is $75 at expiration. The expiration day value of the put option is: A)$5. B)$0. C)$80 Explanation — A put option has an expiration day value of MAX (0, X-S). Here, X is $80 and S is $75 5. An investor buys 5 calls on Stock XYZ with a strike price of $10 for a price of $1 per call. Three months later, Stock XYZ is trading for $15 per share. Each call entitles the owner to buy 2 shares of Stock XYZ. What is the investor’s net profit? A)$45. B)$20. C)$0 Explanation — ($15 – $10) × (5 × 2) – ($1 × 5 calls). The gross payoff is (15 – 10) × 10 = $50. The net profit is $50 – price of calls ($5) = $45 6. Shigeo Kishiro recently purchased an American put option and Lendon Grey recently wrote an American call option on the same underlying stock, Tackel Sports (currently trading at $40 per share). Kishiro paid $2.75 for an exercise price of $38.00 and Grey received $3.75 for a strike price of $42. Assume that there are no transaction costs to exercise.At a stock price of $43: A)the intrinsic put value is $0 and the put is at-the-money. B)if Grey exercises, he will have gained a total of $4.75. C)the intrinsic call value is $1 Explanation — The intrinsic value of a call is given as: max [0, S − X], where S = stock price and X = strike price. Here, max [0, 43 − 42] = max [0, 1] = 1. The other answers are incorrect. Grey wrote the option and thus cannot exercise. The intrinsic value of the put is correct at $0, or max [0, X − S], but as previously noted, the put is out-of-the money at a stock price of $43. The put is at-the-money when the stock price is equal to the strike price, or $38 7. Which of the following statements about the investors is least accurate? A)Grey's loss is unlimited. B)Kishiro's gain is limited to the strike price minus the premium. C)Grey's maximum gain and Kishiro's maximum loss sum to zero Explanation — Although options are a zero-sum game, it is the counterparty exposures that nets to zero. For example, the put buyer’s maximum loss = put writer’s maximum gain = the premium. The other statements are true. Note that the reason why Grey’s loss is unlimited is that he does not currently own the stock. In other words, he has a naked position. If the stock were to rise, Grey would be forced to buy the stock in the open market to settle the exercise of the option. Because the potential for the stock to rise is unlimited, the potential loss for the naked call writer is also unlimited 8. Mosaks, Inc., has a put option with a strike price of $105. If Mosaks stock price is $115 at expiration, the value of the put option is: A)$10. B)$0. C)$105 Explanation — The put has a value of $0 because it will not be exercised. Put value is MAX (0, X-S) 9. Consider a call option with a strike price of $32. If the stock price at expiration is $41, the value of the call option is: A)$9. B)$0. C)$41 Explanation — The call has a $9 ($41 − $32) value at expiration, because the holder of the call can exercise his right to buy the stock at $32 and then sell the stock on the open market for $41. Remember, the intrinsic value of a call at expiration is MAX (0, S-X) 10. Which of the following statements regarding call options is most accurate? The: A)call holder will exercise (at expiration) whenever the strike price exceeds the stock price. B)breakeven point for the buyer is the strike price plus the option premium. C)breakeven point for the seller is the strike price minus the option premium. Explanation — The breakeven for the buyer and the seller is the strike price plus the premium. The call holder will exercise if the market price exceeds the strike price 11. An investor buys a call option that has an option premium of $5 and a strike price of $22.50. The current market price of the stock is $25.75. At expiration, the value of the stock is $23.00. The net profit/loss of the call position is closest to: A)$4.50. B)-$4.50. C)-$5.00 Explanation — The option is in-the-money by $0.50 ($23.00 – $22.50). The investor paid $5.00 for the call option, thus the net loss is –$4.50 ($0.50 – $5.00) 12. An investor purchases a stock for $40 a share and simultaneously sells a call option on the stock with an exercise price of $42 for a premium of $3/share. Ignoring dividends and transactions cost, what is the maximum profit that the writer of this covered call can earn if the position is held to expiration? A)$3. B)$2. C)$5 Explanation — This is an out of the money covered call. The stock can go up $2 to the strike price and then the writer will get $3 for the premium, total $5 13. Suppose the price of a share of Stock A is $100. A European call option that matures one month from now has a premium of $8, and an exercise price of $100. Ignoring commissions and the time value of money, the holder of the call option will earn a profit if the price of the share one month from now: A)decreases to $90. B)increases to $106. C)increases to $110. Explanation — The breakeven point is the strike price plus the premium, or $100 + $8 = $108. Any price greater than this would result in a profit, and the only choice that exceeds this amount is $110 14. Jimmy Casteel pays a premium of $1.60 to buy a put option with a strike price of $145. If the stock price at expiration is $128, Casteel’s profit or loss from the options position is: A)$18.40. B)$1.60. C)$15.40. Explanation — The put option will be exercised and has a value of $145-$128 = $17 [MAX (0, X-S)]. Therefore, Casteel receives $17 minus the $1.60 paid to buy the option. Therefore, the profit is $15.40 ($17 less $1.60) 15. Al Steadman receives a premium of $3.80 for shorting a put option with a strike price of $64. If the stock price at expiration is $84, Steadman’s profit or loss from the options position is: A)$23.80. B)$16.20. C)$3.80 Explanation — The put option will not be exercised because it is out-of-the-money, MAX (0, X-S). Therefore, Steadman keeps the full amount of the premium, $3.80 16. Linda Reynolds pays $2.45 to buy a call option with a strike price of $42. The stock price at which Reynolds earns $3.00 from her call option position is: A)$2.45. B)$42.00. C)$47.45 Explanation — To earn $3.00, the stock price must be above the strike price by $3.00 plus the premium Reynolds paid to buy the option ($42.00+$3.00+$2.45) 17. A stock is trading at $18 per share. An investor believes that the stock will move either up or down. He buys a call option on the stock with an exercise price of $20. He also buys two put options on the same stock each with an exercise price of $25. The call option costs $2 and the put options cost $9 each. The stock falls to $17 per share at the expiration date and the investor closes his entire position. The investor’s net gain or loss is: A)$4 gain. B)$3 loss. C)$4 loss Explanation — The total cost of the options is $2 + ($9 × 2) = $20. At expiration, the call is worth Max [0, 17-20] = 0. Each put is worth Max [0, 25-17] = $8. The investor made $16 on the puts but spent $20 to buy the three options, for a net loss of $4 18. Which of the following statements about put options is least accurate? The most the: A)writer can gain is the put premium. B)writer can lose is the strike price less the premium. C)buyer can gain is unlimited Explanation — The most the put buyer can gain is the strike price of the stock less the premium 19. In June, Todd Puckett bought stock in SBC Communications for $30 per share. At that time, Puckett sold an equivalent number of call options on SBC with an exercise price of $35 for $2.75. In September, at expiration, the stock is trading at $26. What is Puckett’s profit per share from his covered call strategy? Puckett: A)gained $1.25. B)gained $4.00. C)lost $1.25 Explanation — Since the option is out-of-the-money at expiration (MAX (0, S − X)), the options are worthless. Also, the stock decreased in value from $30 per share to $26 per share, creating a $4 loss. The $4 loss is partially offset by the $2.75 premium Puckett received. Therefore, the loss per share from the covered call position is $1.25 = (–$4 + $2.75) 20. James Jackson currently owns stock in PNG, Inc., valued at $145 per share. Thinking that PNG is overbought and will decrease in price soon, Jackson writes a call option on PNG with an exercise price of $148 for a premium of $2.40. At expiration of the option, PNG stock is valued at $152 per share. What is the profit or loss from Jackson’s covered call strategy? Jackson: A)gained $9.40. B)lost $4.60. C)gained $5.40 Explanation — The option is in-the-money at expiration (MAX (0, S-X) and the PNG stock will be called away from Jackson at $148 per share, limiting Jackson’s gain from owning the stock to $3 ($148-145). However, Jackson also gains the $2.40 from writing the call option. Therefore, Jackson’s gain from the covered call strategy is $5.40 ($3.00+$2.40) 21. George Mote owns stock in IBM currently valued at $112 per share. Mote writes a call option on IBM with an exercise price of $120. The call option is sold for $1.80. At expiration, the price of IBM is $115. What is Mote’s profit (or loss) from his covered call strategy? Mote: A)gained $3.00. B)gained $4.80. C)lost $3.20 Explanation — Since the option is out-of-the-money at expiration (MAX (0, S X)), the option is worthless. Also, the stock increased in value from $112 per share to $115 per share, creating a $3 gain. The $3 gain in the stock price is added to the $1.80 gain from writing the (unexercised) call option. Therefore, the total gain is $4.80 ($3 + $1.80) 22. In October, James Knight owned stock in Valerio, Inc., that was valued at $45 per share. At that time, Knight sold a call option on Valerio with an exercise price of $60 for $1.45. In December, at expiration, the stock is trading at $32. What is Knight’s profit (or loss) from his covered call strategy? Knight: A)gained $11.55. B)lost $11.55. C)gained $1.45 Explanation — Since the option is out-of-the-money at expiration (MAX (0, S-X)), the option is worthless. Also, the stock decreased in value from $45 per share to $32 per share, creating a $13 loss. The $13 loss is partially offset by the $1.45 premium Knight received. Therefore, the total loss from the covered call position is $11.55 (-$13+$1.45) 23. The profit/loss diagram for a covered call strategy looks like what other type of profit/loss diagram? A)Short put. B)Long put. C)Short call. Explanation — The profit/loss diagram for the covered call looks like the profit/loss diagram for a short put position. Both option positions have limited profit potential, with the potential loss equal to the strike price less the premium 24. The potential profits from writing a covered call position on a stock are: A)limited to the premium plus stock appreciation up to the exercise price. B)limited to the premium. C)greater than the potential profits from owning the stock Explanation — The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call. The owner of a stock has the rights to all upside potential. The profits for a short call are limited to the premium. For example, say that a stock owner writes a covered call at a stock price (S) of $50 and an exercise price (X) of $55 for a premium of $4. If at expiration, the price of the stock is more than $50 but less than $55, the buyer will not exercise, and the writer will "gain" the premium plus any stock appreciation between $50 and $55. If at expiration, the price of the stock is more than $55, the buyer will exercise and the writer's gain is limited to the premium 25. A covered call position is equivalent to: A)owning the stock and a long call. B)owning the stock and a long put. C)a short put Explanation — The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call. This is similar reasoning to selling (or going short) a put. A put is in-the-money when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay the premium and never exercise, the seller wants the price of the stock to remain above the exercise price 26. A covered call position is: A)the purchase of a share of stock with a simultaneous sale of a call on that stock. B)the simultaneous purchase of the call and the underlying asset. C)the purchase of a share of stock with a simultaneous sale of a put on that stock. Explanation — The covered call: stock plus a short call. The term covered means that the stock covers the inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will not go up any time soon, and you want to increase your income by collecting some call option premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the money calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call to enhance income depends upon the chance that the stock price will exceed the exercise price at which the trader writes the call 27. The shape of a protective put payoff diagram is most similar to a: A)long call. B)short call. C)covered call Explanation — The payoff diagram for a protective put is like that of a call option but shifted upward by the exercise price of the put 28. An investor buys a 30 put on a share of stock for a premium of $7 and simultaneously buys a share of stock for $26. The breakeven price on the position and the maximum gain on the position are: Breakeven price Maximum gain A)$33 unlimited B)$21 $11 C)$37 $11 Explanation — To break even, the stock price should rise as high as the amount invested, $33 ($26 + $7). The maximum gain is unlimited, as the gain will be as high as the increase in the stock price