Module 4.2

Question 1

Background on Options (1 of 5)

Answer 1

Call Option: Right to buy underlying financial instrument at exercise price (or strike price) within a specified period of time.

In the money when market price > exercise price At the money when market price = exercise price

Out of the money when market price < exercise price

Put Option: Right to sell underlying financial instrument at exercise price (or strike price) within a specified period of time.

In the money when market price < exercise price At the money when market price = exercise price

Out of the money when market price > exercise price

Question 2

Comparison of Options and Futures

Answer 2

To obtain an option, a premium must be paid in addition to the price of the financial instrument. The owner of an option can choose to let the option expire on the expiration date without exercising it

Question 3

Markets Used to Trade Options

Answer 3

The Chicago Board Options Exchange (CBOE), created in 1973, is the most important exchange for trading options. Options are also traded at the CME Group. As the popularity of stock options increased, various stock exchanges began to list options. Listing Requirements — One key requirement is a minimum trading volume of the underlying stock. Role of the Options Clearing Corporation — Serves as a guarantor on option contracts traded in the United States. Regulation of Options Trading — SEC and others.

Question 4

How Option Trades Are Executed

Answer 4

Computer technology allows investors to have trades executed electronically. Market-makers can execute stock option transactions for customers. Types of Orders An investor can use either a market order or a limit order for an option transaction. Online Trading — Option contracts can also be purchased or sold online.

Question 5

Stock Option Quotations (Exhibit 14.1) Institutional Use of Options

Answer 5

Although options positions are sometimes taken by financial institutions for speculative purposes, they are more commonly used for hedging. (Exhibit 14.2)

Question 6

Viperon Company Stock Option Quotations

Answer 6

Question 7

Institutional Use of Options Markets

Answer 7

Question 8

Determinants of Call Option Premiums

Answer 8

§Influence of the Market Price — The higher the existing market price of the underlying financial instrument relative to the exercise price, the higher the call option premium, other things being equal. (Exhibit 14.3)

§Influence of the Stock’s Volatility — The greater the volatility of the underlying stock, the higher the call option premium, other things being equal.

§Influence of the Call Option’s Time to Maturity — The longer the call option’s time to maturity, the higher the call option premium, other things being equal. (Exhibit 14.4)

Question 9

Relationship between Exercise Price and Call Option Premium on KSR Stock

Answer 9

Question 10

Relationship between Time to Maturity and Call Option Premium on KSR Stock

Answer 10

Question 11

Determinants of Put Option Premiums

Answer 11

§Influence of the Market Price — The higher the existing market price of the underlying stock relative to the exercise price, the lower the put option premium, other things being equal. (Exhibit 14.5)

§Influence of the Stock’s Volatility — The greater the volatility of the underlying stock, the higher the put option premium, other things being equal.

§Influence of the Put Option’s Time to Maturity — The longer the time to maturity, the higher the put option premium, other things being equal (Exhibit 14.6)

Question 12

Relationship between Exercise Price and Put Option Premium on KSR Stock

Answer 12

Question 13

Relationship between Time to Maturity and Put Option Premium on KSR Stock

Answer 13

Question 14

How Option Pricing Can Be Used to Derive a Stock’s Volatility

Answer 14

§Some investors assess a specific stock’s risk by using the option-pricing formula to estimate the stock’s anticipated volatility.

§By using the prevailing option premium and values for the other factors in the option-pricing formula, the implied volatility or implied standard deviation can be estimated.

Question 15

Explaining Changes in Option Premiums

Answer 15

§Economic conditions and market conditions can cause abrupt changes in the stock price or in the anticipated volatility of the stock price over the time until option expirations, leading to changes in the stock option’s premium. (Exhibit 14.7)

§Indicators Monitored by Participants in the Options Market Traders of options tend to monitor economic indicators because economic conditions affect cash flows of firms and thus can affect expected stock valuations and stock option premiums.

Question 16

Framework for Explaining Why a Stock Option’s Premium Changes over Time

Answer 16

Question 17

Speculating with Stock Options

Answer 17

Speculating with Call Options

§Call options can be used to speculate on the expectation of an increase in the price of the underlying stock.

§See Exhibits 14.8 – 14.11.

Speculating with Put Options

§Put options can be used to speculate on the expectation of a decrease in the price of the underlying stock.

§See Exhibits 14.12.

Question 18

Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $4

Answer 18

Question 19

Potential Gains or Losses for Three Call Options (Buyer’s Perspective)

Answer 19

Question 20

Potential Returns on Three Different Call Options

Answer 20

Question 21

Potential Returns for Three Call Options (Buyer’s Perspective)

Answer 21

Question 22

Potential Gains or Losses on a Put Option: Exercise Price = $110, Premium = $2

Answer 22

Question 23

Excessive Risk from Speculation

Answer 23

§Firms should closely monitor the trading of derivative contracts by their employees to ensure that derivatives are being used within the firm’s guidelines.

§Firms should separate the reporting function from the trading function so that traders cannot conceal trading losses.

§When firms receive margin calls on derivative positions, they should recognize that there may be potential losses on their derivative instruments and should closely evaluate those positions.

Question 24

Hedging with Covered Call Options (Exhibit 14.13)

Answer 24

§Call options on a stock can be used to hedge a position in that stock.

§When the stock declines in value, the premium received from selling the call partially offsets the losses incurred on the stock.

§When the stock increases in value, the call will be exercised and the stock will be sold to the purchaser of the call option.

Question 25

Risk-Return Trade-off from Covered Call Writing

Answer 25

Question 26

Risk-Return Trade-off from Covered Call Writing Graph

Answer 26

Question 27

Hedging with Put Options

Answer 27

§Put options are used to hedge when portfolio managers are concerned about a temporary decline in a stock’s value. §Hedging with LEAPs §Long-term equity anticipations (LEAPs) are options that have longer terms to expiration, usually between two and three years from the initial listing date. §These options are available for some large capitalization stocks, and they may be a more effective hedge over a longer term period than using options with shorter terms to expiration.

Question 28

Options on ETFs and Stock Indexes

Answer 28

§Options are also traded on exchange-traded funds (ETFs) and stock indexes. §A stock index option provides the right to trade a specified stock index at a specified price by a specified expiration date. §Call options on stock indexes allow the right to purchase the index, and put options on stock indexes allow the right to sell the index. §Options on indexes have become popular for speculating on general movements in the stock market. (Exhibit 14.14)

Question 29

Sampling of ETFs and Indexes on Which Options Are Traded

Answer 29

Question 30

Hedging with Stock Index Options

Answer 30

Financial institutions and other firms commonly take positions in options on ETFs or indexes to hedge against market or sector conditions that would adversely affect their asset portfolio or cash flows. §Hedging with Long-Term Stock Index Options — LEAPs are used by option market participants who want options with longer terms until expiration. §Dynamic Asset Allocation with Stock Index Options Dynamic asset allocation involves switching between risky and low-risk investment positions in response to changing expectations. Some portfolio managers use stock index options as a tool for dynamic asset allocation.

Question 31

Using Index Options to Measure the Market’s Risk

Answer 31

§A stock index’s implied volatility can be derived from information about options on that stock index. §The same factors that affect the option premium on a stock affect the option premium on an index.

Question 32

Options on Futures Contracts

Answer 32

§In recent years, the concept of options has been applied to futures contracts to create options on futures contracts (sometimes referred to as “futures options”). §An option on a particular futures contract gives its owner the right (but not an obligation) to purchase or sell that futures contract for a specified price within a specified period of time. §Options are available on stock index futures. §Options on indexes have become popular for speculating on general movements in the stock market. Options are also available on interest rate futures, such as Treasury note futures or Treasury bond futures

Question 33

Speculating with Options on Futures

Answer 33

Speculators who anticipate a change in interest rates should also expect a change in bond prices. §Speculation Based on an Expected Decline in Interest Rates If speculators expect a decline in interest rates, they may consider purchasing a call option on Treasury bond futures. §Speculation Based on an Expected Increase in Interest Rates If speculators expect interest rates to increase, they can benefit from purchasing a put option on Treasury bond futures.

Question 34

Hedging with Options on Interest Rate Futures

Answer 34

Financial institutions commonly hedge their bond or mortgage portfolios with options on interest rate futures contracts .(Exhibit 14.15) Hedging with Options on Stock Index Futures §Determining the Degree of the Hedge with Options on Stock Index Futures — A higher premium must be paid to purchase put options with a higher strike price. §Selling Call Options to Cover the Cost of Put Options — Fees can be generated by selling call options to help cover the cost of purchasing put options.

Question 35

Results from Hedging with Put Options on Treasury Bond Futures

Answer 35

Question 36

Options as Executive Compensation

Answer 36

Limitations of Option Compensation §Many option compensation programs do not account for general market conditions. §Executives with substantial options may be tempted to manipulate the stock’s price upward in the short term, even though doing so adversely affects the stock price in the long term. §Backdating Options — In the late 1990s and early 2000s, some firms allowed their CEOs to backdate options they had already been granted to an earlier period when the stock price was lower. In 2006, firms that allowed backdating terminated the practice.

Question 37

Limitations of Option Compensation Programs

Answer 37

§Stock options are not always effective at aligning executives’ incentives with actual firm performance. §Executives with substantial options may be tempted to manipulate the stock’s price upward in the short term, even though doing so adversely affects the stock price in the long term. Firms can prevent the wrongful use of options by requiring that executives hold them for several years before exercising them

Question 38

Globalization of Option Markets

Answer 38

Currency Options Contracts §A currency call option provides the right to purchase a specified currency for a specified price within a specified period of time. §Speculators purchase call options on currencies that they expect to strengthen against the dollar. §A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. §Speculators purchase put options on currencies they expect to weaken against the dollar. §For every buyer of a currency call or put option, there must be a seller (or writer).