Exam (30 MCQ and 2 Problems):

1. What is the maximum loss the writer of an equity put option can suffer?
a. The strike price minus the premium of the put option.
b. The share price minus the premium of the put option.
c. The share price.
d. The put option premium.
e. Unlimited loss potential.

2. What is the maximum profit the writer of an equity call option can gain?
a. The strike price minus the share price.
b. The share price minus the premium of the call option.
c. The share price.
d. The call option premium.
e. Unlimited profit potential

3. What is the maximum profit the holder of an equity call option can gain?
a. The strike price minus the share price.
b. The share price minus the premium of the call option.
c. The share price.
d. The call option premium.
e. Unlimited profit potential.

4. What is the maximum profit the holder of an equity put option can gain?
a. The strike price minus the premium of the put option.
b. The share price minus the premium of the put option.
c. The share price.
d. The put option premium.
e. Unlimited profit potential.

5. The intrinsic value of an out-of-the-money put option is equal to:

a. the put option premium.
b. zero.
c. the share price minus the exercise price.
d. the strike price.
e. time value.

6. The time value of an out-of-the-money call option is equal to:

a. the call option premium.
b. zero.
c. the share price minus the exercise price.
d. the strike price.
e. intrinsic value.

7. According to the put-call parity theorem, the value of a European call option on a non-dividend
paying stock is equal to:
a. the put option premium minus the present value of the strike price plus the share
price.
b. the present value of the share price minus the strike price minus the put option premium.
c. the put option premium plus the present value of the strike price minus the share price.
d. the present value of the share price plus the strike price minus the call option premium.
e. None of the above.

8. The term open interest refers to:

a. the interest payable to the margin account.
b. the number of futures contracts opened today.
c. the interest rate that is open to negotiation before a contract is closed.
d. the number of futures contracts closed.
e. the number of futures contracts outstanding.
9. Which of the following strategy speculates on the appreciation of the underlying asset price?
a. Long call.
b. Long put.
c. Long straddle.
d. Short strangle.
e. Short call.

10. Which of the following strategy speculates on the stability of the underlying asset price?
a. Long call.
b. Long put.
c. Long straddle.
d. Short strangle.
e. Short call.

11. The holder of an European call option:

a. has the right but not the obligation to sell the underlying asset at predetermined price on or
before the expiration.
b. has the right but not the obligation to buy the underlying asset at predetermined price on or
before the expiration.
c. has the obligation to sell the underlying asset at predetermined price on the expiration.
d. has the obligation to buy the underlying asset at predetermined price on the
expiration.
e. None of the above.

12. Which of the following statement is incorrect?

a. The premium for the American option more costly than that of an otherwise identical
European option.
b. The put option writer receives upfront premium for the obligation to buy the underlying
asset at predetermined price from the put option holder.
c. The call option writer receives upfront premium for the obligation to sell the underlying
asset at predetermined price from the call option holder.
d The call option writer receives upfront premium for the obligation to sell the underlying
asset at predetermined price to the call option holder.
e. The payoffs to the long call position are equal but opposite to the payoffs to the short
put position.

13. Currency-translated options have:

a. only underlying asset prices denoted in a foreign currency.
b. only exercise prices denoted in a foreign currency.
c. payoffs that only depend on the maximum price of the underlying asset during the life of
the option.
d. either asset or exercise prices denoted in a foreign currency.
e. None of the above.

14. Buyers of put options anticipate the value of the underlying asset will _________ and sellers of
call options anticipate the value of the underlying asset will _________.
a. increase; increase
b. decrease; increase
c. increase; decrease
d. decrease; decrease
e. Cannot be determined without further information.

15. Asian options differ from American and European options in that:
a. they are only sold in Asian financial markets.
b. they never expire.
c. their payoff is based on the average price of the underlying asset.
d. Both (a) and (b).
e. Both (a) and (c).
16. The value of a stock put option is positively related to the following factors except:
a. the time to expiration.
b. the strike price.
c. the share price.
d. All of the above.
e. None of the above.

17. Derivative securities are also called contingent claims because:

a. their holders may choose whether or not to exercise them.
b. a large contingent of investors holds them.
c. the writers may choose whether or not to exercise them.
d. their payoffs depend on the prices of other assets.
e. contingency management is used in adding them to portfolios.

18. The profit/loss breakeven for a long put position (strike price = R60; premium = R8) is equal to:
a. R48.
b. R0.
c. R52.
d. R2.
e. None of the above.

19. What is the profit/loss for a short call position (strike price =R80; premium = R5) when the price
of the underlying asset at expiration is equal to R82?
a. R7.
b. -R7.
c. R2
d. -R2.
e. R3.

20. What is the return on a long put position (strike price = R60; premium = R5) when the price of
the underlying asset at expiration is equal to R50?
a. 100%.
b. -100%.
c. 8.33%.
d. -8.33%.
e. 10%.

21. What is the return on a long call position (strike price = R80; premium = R8) when the price of
the underlying asset at expiration in equal to R75?
a. 100%.
b. -100%.
c. 62.5%.
d. -62.5%.
e. 0%.

22. What is the maximum (limited) profit of the synthetic option strategy if one combines a long call
(strike price = R50; premium =R5) and a short call (strike price = R60; premium = R2)?
a. R3.
b. R5.
c. R58.
d. R7.
e. Unlimited profit potential.

23. As the underlying asset price increases, the call option valuation function’s slope approaches:
a. zero.
b. one.
c. two times the value of the underlying asset.
d. one-half times the value of the underlying asset.
e. infinity.
24. If the company unexpectedly announces it will pay its first-ever dividend 3 months from today,
you would expect:
a. the call option premium to increase.
b. the call option premium to decrease.
c. the call option premium to remain constant.
d. the put option premium to decrease.
e. the put option premium to remain constant.

25. A portfolio consists of 400 shares and 200 call options on the same share. If the call option delta
is 0.6, what would be the change in the value of the portfolio in response to a one rand decline in
the share price?
a. +R700.
b. +R500.
c. -R580.
d. -R520.
e. None of the above.

26. If the call option delta is 0.50, the put option delta with the same expiration date and exercise
price as the call would be:
a. 0.30.
b. 0.50.
c. -0.60.
d. -0.50.
e. -0.17.

27. Which of the following statements is true?

a. Forward contracts are standardized futures contracts.
b. Futures contracts trade on formal exchange.
c. Futures contracts are illiquid.
d. Forward contracts are inflexible and cannot be tailor-made.
e. Hedging using futures retains upside profit potential and eliminates downside risk.

28. A futures contract is contango when:

a. the futures price is higher than the spot price of the underlying asset.
b. the futures price is lower than the spot price of the underlying asset.
c. the return on the futures contract is volatile.
d. the return on the underlying asset of the futures contract is volatile.
e. the exercise of the futures contract is not profitable.

29. Which “Greek”, as used in analyzing options, measures the sensitivity of the delta of the option
to changes in the price of the underlying asset?
a. Gamma.
b. Vega.
c. Theta.
d. Rho.
e. Delta.

30. Which “Greek”, as used in analyzing options, measures the sensitivity of the value of the option
to changes in the interest rate?
a. Gamma.
b. Vega.
c. Theta.
d. Rho.
e. Delta.
Question 1 (20 Marks)

Mr. Dickson would like to bet on the share price appreciation of Cox Ltd. His brother advises him that
a protective put strategy will allow him to achieve his objective while limiting the downside risk if the
share price of Cox Ltd depreciates. .

Use the information in the table below to answer this question, and demonstrate your answer by
including relevant option algebras and fully-labeled profit/loss diagrams.

Cox Ltd Call Put

Spot Expiry Strike Premium (Contract) Premium (Contract)
70 December 65 580 118
70 December 72 114 180

(a) Construct a protective put strategy (strike price = 65) on Cox Ltd that expires in December.

(b) Mr. Dickson’s financial adviser suggests that a bull spread strategy can also achieve the same
objective. Construct a bull spread strategy (strike prices = 65; 72) on Cox Ltd by adding one
more option to the protective put strategy above.

(c) Evaluate the pros and cons for the bull spread strategy against the protective put strategy.

Question 2 (6 Marks)

It is 15 Sep 2008. I have an equity portfolio worth R20 million with volatility of 40% to be hedged for
3 months. The JSE/FTSI All Share Index is currently 28 000 points with weighted-average dividend
yield of 5% and volatility of 20%. The short-term treasury bill rate is currently at 8%.

(a) Compute the cost of carry for the ALSI futures contracts that close out on 15 December 2008.

(b) Assume that the ALSI futures contracts close out on 15 Dec 2008 is trading at its fair value based
on the spot-futures parity. Calculate the number of short futures contracts on ALSI that are
required to hedge the equity portfolio if the correlation between the return on the equity portfolio
and that of the ALSI futures is equal to 0.8.

Question 3 (4 Marks)

Brendan Ryan owns 20 000 shares of Evelyn Ltd. The September call option delta of Evelyn Ltd is
currently 0.38.

(a) Calculate the number of call option contracts Robyn should go short for her portfolio to be delta
neutral.

(b) Calculate the number of put option contracts Robyn should go long for her portfolio to be delta
neutral.
Suggested Solutions

Question 1

(a) 65
65 70 LA ( +1 ; +1)
Profit/Loss

ST

-70

Profit/Loss

63.82

63.82 ST
LP 65 (-1 ; 0)
-1.18

Profit/Loss Overall:
LC 65 (0 ; +1)

71.18 ST
-6.18

(b and c) Advantage of Bull Spread:

* Reduce the premium paid for LP 65 (P0 = 1.18) by including SC 72 (C0 = 1.14).
 Y-intercept (i.e. Limited Loss) for Bull 65; 72 = -70 +63.82 + 1.14 = -5.04.
This is lower than the limited loss for Protective Put of -6.18.

* The resulting profit/loss breakeven for Bull 65; 72 is lower (i.e. easier to be
profitable) = 5.04 + 65 = 70.04, while the profit/loss breakeven for Protective Put is
higher at 71.18 (i.e. harder to be profitable)!

Disadvantage of Bull Spread: There is a cap/limited profit for the bull spread = 1.96!

65 72
65 70 72 LA ( +1 ; +1 ; +1)
Profit/Loss

ST

-70

Profit/Loss

63.82

63.8 2 ST
LP 65 (-1 ; 0 ; 0)
-1.18

Profit/Loss
1.14 ST

SC 72 (0 ; 0 ; -1)

1.96 Bull 65 72 ( 0 ; +1 ; 0)

-5.04

70.04

Question 2

(a)
Annual cost of carry = 8% - 5% = 3%

Cost of carry for 3 month = (1 + 8% - 5%)0.25 - 1 = 0.74%

(b)
F0 = 28 000 * (1 + 8% - 5%)0.25 = 28 208 (Contract size = R 282 080)

Beta of the portfolio = (0.4 / 0.2) * 0.8 = 1.6

No. of SF contracts required = (20 000 000 * 1.6%) / (282 080 * 1%) = 113 contracts.

Question 3

(a) HR for SC = 1 / 0.38 (b) HR for LP = 1 / (0.38 -1)

= 2.63 = -1.61

To hedge 20 000 shares, Brendan needs to To hedge 20 000 shares, Brendan needs to
short 526 Sep call option contracts long 322 Sep put option contracts
………2.63 * 20 000 ………1.61 * 20 000
Supp (30 MCQ and 2 Problems):
1. An option on a security with a market value of R60 has an exercise price of R70. The option is:
a. in-the-money.
b. out-of-the-money.
c. at-the-money.
d. in-the-money if it is a put option and out-of-the-money if it is a call option.
e. None of the above.

2. A long straddle strategy consist of _________ of the same underlying asset and the same expiry
date.
a. buying at-the-money call and put options
b. writing at-the-money call and put options
c. buying an at-the-money call option and writing an at-the-money put option
d. writing an at-the-money call option and buying an at-the-money put option
e. buying out-of-the-money call and put options

3. The payoff of Asian put option is based on the:

a. price of the underlying at expiration.
b. Maximum price of the underlying at expiration.
c. Minimum price of the underlying at expiration.
d. Average price of the underlying at expiration.
e. Condition that price of the underlying has reach at least certain level.

4. To determine the delta of a put option using Black-Scholes option pricing model we would use
the:
a. implied volatility.
b. N(d1) – 1.
c. N(d1).
d. 1 – N(d1).
e. N(d – 1).
5. A put option gives the holder:
a. the obligation to buy the underlying asset at the exercise price.
b. the right but not the obligation to buy the underlying asset at the exercise price.
c. the obligation to sell the underlying asset at the exercise price.
d. the right but not the obligation to sell the underlying asset at the exercise price.
e. the right to buy or sell the security at the exercise price.

6. If I am convinced that the share price is unlikely to change significantly in the near future, I will
employ:
a. a bull spread strategy.
b. a bear spread strategy.
c. a protective put strategy.
d. a long straddle strategy.
e. a short strangle stratety.

7. Which of the following factors negatively affects the value of a call option?
a. the volatility of the underlying asset returns.
b. the risk-free rate.
c. the underlying share price.
d. the exercise price of the option.
e. None of the above.

8. The payoff of a look-back call option is based on the:

a. minimum price of the underlying asset during the life of the option.
b. maximium price of the underlying asset during the life of the option.
c. average price of the underlying during the life of the option.
d. price of the underlying asset at expiration.
e. price of the underlying asset at the commencement of the contract.
9. A financial futures normally trade above spot price because of the:
a. cost of carry.
b. transaction costs.
c. backwardation.
d. storage cost.
e. lease rates.

10. The standard size of a SAFEX index futures contract is:

a. $10 000.
b. R100 000.
c. index value / 10.
d. Index value * 10.
e. based on private negotiation.

11. When the futures price is below the spot price, the futures transaction is termed:
a. contango.
b. backwardation.
c. basis.
d. spread.
e. margin.

12. The safety deposit required by futures transactions is termed:

a. basis.
b. premium.
c. open interest.
d. inventory.
e. margin.

13. The process that profit and loss are calculated on daily basis in the futures transactions is termed:
a. marketing to mark.
b. marking to spot.
 c. marketing to spot.
d. margin.
e. marking to market.

14. The counterparty risk and credit risk in the futures transactions are absorbed by:
a. the clearinghouse.
b. SARB.
c. counterparties of the futures contract.
d. FSB.
e. SEC.

15. Which of the following variables has negative effect on put option value?
a. Dividend payout.
b. Time to expiration.
c. Volatility of the underlying asset returns.
d. Exercise price of the option.
e. Underlying asset price.

16. Which of the following statements is true?

a. Futures contracts are more flexible than forward contracts.
b. Futures contracts are over-the-counter contracts.
c. Forward contracts are standardized.
d. The credit risk and counterparty risk is lower for the futures contracts compared to
that of the forward contracts.
e. None of the above.

17. Which of the following Greek measures can only be used to hedge against the exposure of very
small movements in the price of the underlying asset?
a. Delta.
b. Gamma.
c. Vega.
d. Rho.
e. Theta.

18. Futures contracts differ from forward contracts in that:

a. forward contracts are more flexible.
b. futures contracts are standardized.
c. futures traded on exchange.
d. marking-to-market applies to futures contracts.
e. All of the above.

19. What is the maximum (limited) loss for the synthetic option strategy if one combines a long call
(strike price = R45; premium = R7) and a long put (strike price = R50 ; premium = R5)?
a. R7 loss.
b. R10 loss.
c. R15 loss.
d. R38 loss.
e. Unlimited loss.

20. What is the maximum profit for the synthetic option strategy if one combines a long call (X =
R50; premium = R10) and a short call (X = R70; premium = R5)?
a. R5 profit.
b. R15 profit.
c. R20 profit.
d. R25 profit.
e. Unlimited profit potential.

21. What is the maximum loss for the synthetic option strategy if one combines a long asset (S 0 =
 R100) and a long put (X = R100; premium = R4)
a. R16 loss.
b. R6 loss.
c. R4 loss.
d. R12 loss.
e. Unlimited loss.

22. What is the time value of a call option (strike price = R190; premium = R20) when the
underlying asset price is R200?
a. R10.
b. R-20.
c. R0.
d. R40.
e. -R40.

23. Which of the following factors positively influences both call and put option prices?
a. The price of the underlying asset.
b. The strike price of the option.
c. The volatility of the underlying asset return.
d. The dividend payout of the underlying equity.
e. None of the above.

24. The party who buys a forward contract:

a. has the right but not the obligation to sell the underlying asset at the predetermined futures
price.
b. has the right but not the obligation to buy the underlying asset at the predetermined futures
price.
c. has the obligation to buy or sell the underlying asset at the predetermined futures price.
d. has the obligation to buy the underlying asset at the predetermined futures price.
e. has the obligation to sell the underlying asset at the predetermined futures price.

25. Which of the following positions describes the situation when a trader writes a call option
without holding the underlying asset?
a. A bull spread position.
b. A bear spread position.
c. A short straddle position.
d. A short strangle position.
e. A naked call position.

26. 14. The risk-free rates in the United States and Australia are 3% and 4% respectively. If the
spot exchange rate is 1.67 Australian Dollar for 1 U.S. Dollar, the non-arbitrage one-year forward
exchange rate should be:
a. 1.703 Australian Dollar / U.S. Dollar.
b. 1.654 Australian Dollar / U.S. Dollar.
c. 1.638 Australian Dollar / U.S. Dollar.
d. 1.778 Australian Dollar / U.S. Dollar.
e. 1.686 Australian Dollar / U.S. Dollar.

27. A portfolio consists of 100 shares and 500 calls on that stock. If the call option delta is 0.70, what
would be the change in the value of the portfolio in response to a one rand decline in the share
price?
a. R700.
b. -R450.
 c. -R1 150.
d. -R950.
e. -R520

28. A portfolio consists of 200 shares and 100 calls on the stock. If the put option delta is -0.3, what
would be the change in the value of the portfolio in response to a one rand decline in the share
price?
a. -R270.
b. R500.
c. -R580.
d. -R520.
e. None of the above.

29. A call option on a stock is said to be in-the-money if:

a. the exercise price is higher than the share price.
b. the exercise price is less than the share price.
c. the exercise price is equal to the share price.
d. the price of the put option is higher than the price of the call option.
e. the price of the call option is higher than the price of the put option.

30. What is the synthetic option strategy if one combines a long call and a short put on the same
exercise price of the underlying asset?
a. A long call.
b. A short strangle.
c. A long asset.
d. A bear spread strategy.
e. A short butterfly strategy.