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CHAPTER 20 AN INTRODUCTION TO DERIVATIVE MARKETS AND SECURITIES

TRUE/FALSE QUESTIONS (t) 1 (t) 2 (f) 3 (t) 4 (t) 5 (f) 6 (t) 7 (f) 8 (f) 9 (f) 10 (t) 11 (f) 12 (f) 13 (t) 14 (f) 15 (t) 16 A cash or spot contract is an agreement for the immediate delivery of an asset such as the purchase of stock on the NYSE. Forward and future contracts, as well as options, are types of derivative securities. All features of a forward contract are standardized, except for price and number of contracts. Forward contracts are traded over-the-counter and are generally not standardized. The forward market has low liquidity relative to the futures market. A futures contract is an agreement between a trader and the clearinghouse of the exchange for delivery of an asset in the future. A primary function of futures markets is to allow investors to transfer risk. The futures market is a dealer market where all the details of the transactions are negotiated. Futures contracts are slower to absorb new information than forward contracts. The initial value of a future contract is the price agreed upon in the contract. A futures contract eliminates uncertainty about the future spot price that an individual can expect to pay for an asset at the time of delivery. Investment costs are generally higher in the derivative markets than in the corresponding cash markets. An option buyer must exercise the option on or before the expiration date. The minimum value of an option is zero. An option to sell an asset is referred to as a call, whereas an option to buy an asset is called a put. If an investor wants to acquire the right to buy or sell an asset, but not the obligation to do it, the best instrument is an option rather than a futures contract.

(t) 17 (t) 18 (f) 19 (t) 20 (t) 21

Investors buy call options because they expect the price of the underlying stock to increase before the expiration of the option. A call option is in the money if the current market price is above the strike price. A put option is in the money if the current market price is above the strike price. The price at which the stock can be acquired or sold is the exercise price. The minimum amount that must be maintained in an account is called the maintenance margin. MULTIPLE CHOICE QUESTIONS

(d) 1

Which of the following statements is false? a) Derivatives help shift risk from risk-adverse investors to risk-takers. b) Derivatives assist in forming cash prices. c) Derivatives provide additional information to the market. d) In many cases, the investment in derivatives (both commissions and required investment) is more than in the cash market. e) None of the above (that is, all are reasons) Derivative instruments exist because a) They help shift risk from risk-averse investors to risk-takers. b) They help in forming prices. c) They have lower investment costs. d) Choices a and b e) All of the above There are in number of differences between forward and futures contracts. Which of the following statements is false? a) Futures have less liquidity risk than forward contracts. b) Futures have less credit risk than forward contracts. c) Futures have more default risk than forward contracts. d) In futures, the exchange becomes the counterparty to all transactions. e) None of the above (that is, all statements are true)

(e) 2

(c) 3

(d) 4

Futures differ from forward contracts because a) Futures have more liquidity risk. b) Futures have more credit risk. c) Futures have more maturity risk. d) None of the above e) All of the above The price at which a futures contract is set at the end of the day is the a) Stock price. b) Strike price. c) Maintenance price. d) Settlement price. e) Parity price. Which of the following statements is true? a) The buyer of a futures contract is said to be long futures. b) The seller of a futures contract is said to be short futures. c) The seller of a futures contract is said to be long futures. d) The buyer of a futures contract is said to be short futures. e) Choices a and b The CBOE brought numerous innovations to the option market, which of the following is not such an innovation? a) Creation of a central marketplace b) Creation of a non-liquid secondary option market c) Introduction of a Clearing Corporation d) Standardization of all expiration dates e) Standardization of all exercise prices Which of the following factors is not considered in the valuation of call and put options? a) Current stock price b) Exercise price c) Market interest rate d) Volatility of underlying stock price e) none of the above (that is, all are factors which should be considered in the valuation of call and put options) Which of the following statements is a true definition of an in-the-money option? a) A call option in which the stock price exceeds the exercise price. b) A call option in which the exercise price exceeds the stock price. c) A put option in which the stock price exceeds the exercise price. d) An index option in which the exercise price exceeds the stock price. e) A call option in which the call premium exceeds the stock price.

(d) 5

(e) 6

(b) 7

(e) 8

(a) 9

(a) 10

The value of a call option just prior to expiration is (where V is the underlying asset's market price and X is the option's exercise price) a) Max [0, V - X] b) Max [0, X - V] c) Min [0, V - X] d) Min [0, X - V] e) Max [0, V > X] Which of the following is not a factor needed to calculate the value of an American call option? a) The price of the underlying stock. b) The exercise price. c) The price of an equivalent put option. d) The volatility of the underlying stock. e) The interest rate.

(c) 11

(b) 12 In the valuation of an option contract, the following statements apply except a) The value of an option increases with its maturity. b) There is a negative relationship between the market interest rate and the value of a call option. c) The value of a call option is negatively related to its exercise price. d) The value of a call option is positively related to the volatility of the underlying asset. e) The value of a call option is positively related to the price of the underlying stock. (a) 13 You own a stock that has risen from $10 per share to $32 per share. You wish to delay taking the profit but you are troubled about the short run behavior of the stock market. An effective action on your part would be to a) Buy a put option on the stock. b) Write a call option on the stock. c) Purchase an index option. d) Utilize a bearish spread. e) Utilize a bullish spread.

(b) 14 A vertical spread involves buying and selling call options in the same stock with a) The same time period and exercise price. b) The same time period but different exercise price. c) A different time period but same exercise price. d) A different time period and different price. e) Quotes in different options markets.

(b) 15

The value of a put option at expiration is a) Max [0, S(T) X] b) Max [0, X - S(T)] c) Min [0, S(T) X] d) Min [0, X - S(T)] e) X In the two state option pricing model, which of the following does not influence the option price? a) Past stock price b) Up and down factors u and d c) The risk free rate d) The exercise price e) Current stock price The cost of carry includes all of the following except a) Storage costs. b) Insurance. c) Current price. d) Financing costs. e) Risk free rate. A call option in which the stock price is higher than the exercise price is said to be a) At-the-money. b) In-the-money. c) Before-the-money. d) Out-of-the-money. e) Above-the-money. The price paid for the option contract is referred to as the a) Forward price. b) Exercise price. c) Striking price. d) Option premium. a) Call price. A stock currently sells for $75 per share. A call option on the stock with an exercise price $70 currently sells for $5.50. The call option is a) At-the-money. b) In-the-money. c) Out-of-the-money. d) At breakeven. e) None of the above.

(a) 16

(c) 17

(b) 18

(d) 19

(b) 20

(c) 21

A stock currently sells for $150 per share. A call option on the stock with an exercise price $155 currently sells for $2.50. The call option is a) At-the-money. b) In-the-money. c) Out-of-the-money. d) At breakeven. e) None of the above. A stock currently sells for $75 per share. A put option on the stock with an exercise price $70 currently sells for $0.50. The put option is a) At-the-money. b) In-the-money. c) Out-of-the-money. d) At breakeven. e) None of the above. A stock currently sells for $15 per share. A put option on the stock with an exercise price $15 currently sells for $1.50. The put option is a) At-the-money. b) In-the-money. c) Out-of-the-money. d) At breakeven. e) None of the above. A stock currently sells for $15 per share. A put option on the stock with an xercise price $20 currently sells for $6.50. The put option is a) At-the-money. b) In-the-money. c) Out-of-the-money. d) At breakeven. e) None of the above. An equity portfolio manager can neutralize the risk of falling stock prices by entering into a hedge position where the payoffs are a) Not correlated with the existing exposure. b) Positively correlated with the existing exposure. c) Negatively correlated with the existing exposure. d) Any of the above. e) None of the above.

(c) 22

(a) 23

(b) 24

(c) 25

(b) 26

The derivative based strategy known as portfolio insurance involves a) The sale of a put option on the underlying security position.

b) c) d) e) (d) 27

The purchase of a put on the underlying security position. The sale of a call on the underlying security position. The purchase of a call on the underlying security position. b) and d).

A hedge strategy known as a collar agreement involves the simultaneous a) Purchase of an in-the money put and purchase of an out-of-the-money call on the same underlying asset with same expiration date and market price. b) Sale of an out-of-the money put and sale of an out-of-the-money call on the same underlying asset with same expiration date and market price. c) Purchase of an in-the money put and purchase of an in-the-money call on the same underlying asset with same expiration date and market price. d) Purchase of an out-of-the money put and sale of an out-of-the-money call on the same underlying asset with same expiration date and market price. e) Sale of an in-the money put and purchase of an in-the-money call on the same underlying asset with same expiration date and market price. A call option differs from a put option in that a) a call option obliges the investor to purchase a given number of shares in a specific common stock at a set price; a put obliges the investor to sell a certain number of shares in a common stock at a set price. b) both give the investor the opportunity to participate in stock market dealings without the risk of actual stock ownership. c) a call option gives the investor the right to purchase a given number of shares of a specified stock at a set price; a put option gives the investor the right to sell a given number of shares of a stock at a set price. d) a put option has risk, since leverage is not as great as with a call. e) none of the above Which of the following statements is a true definition of an out-of-the-money option? a) A call option in which the stock price exceeds the exercise price. b) A call option in which the exercise price exceeds the stock price. c) A call option in which the exercise price exceeds the stock price. d) A put option in which the exercise price exceeds the stock price. e) A call option in which the call premium exceeds the stock price. According to put/call parity a) Stock price + Call Price = Put Price + Risk Free Bond Price b) Stock price + Put Price = Call Price + Risk Free Bond Price c) Put price + Call Price = Stock Price + Risk Free Bond Price d) Stock price - Put Price = Call Price + Risk Free Bond Price e) Stock price + Call Price = Put Price - Risk Free Bond Price

(c) 28

(b) 29

(b) 30

MULTIPLE CHOICE PROBLEMS

(d) 1

A one year call option has a strike price of 50, expires in 6 months, and has a price of $5.04. If the risk free rate is 5%, and the current stock price is $50, what should the corresponding put be worth? a) $3.04 b) $4.64 c) $6.08 d) $3.83 e) $0 A one year call option has a strike price of 50, expires in 6 months, and has a price of $4.74. If the risk free rate is 3%, and the current stock price is $45, what should the corresponding put be worth? b) $12.74 a) $10.48 c) $5.00 d) $9.00 e) $8.30 A one year call option has a strike price of 60, expires in 6 months, and has a price of $2.5. If the risk free rate is 7%, and the current stock price is $55, what should the corresponding put be worth? a) $5.00 b) $4.56 c) $5.50 d) $7.08 e) $7.54 A one year call option has a strike price of 70, expires in 3 months, and has a price of $7.34. If the risk free rate is 6%, and the current stock price is $62, what should the corresponding put be worth? a) $5.34 b) $8.00 c) $10.68 d) $14.33 e) $13.33

(d) 2

(c) 3

(d) 4

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS December futures on the S&P 500 stock index trade at 250 times the index value of 1187.70. Your broker requires an initial margin of 10% percent on futures contracts. The current value of the S&P 500 stock index is 1178.

(c) 5

How much must you deposit in a margin account if you wish to purchase one contract? a) $267,232.5 b) $29,450 c) $29,692.50 d) $30,000 e) $265,050 Suppose at expiration the futures contract price is 250 times the index value of 1170. Disregarding transaction costs, what is your percentage return? a) 1.87% b) -0.68% c) -14.90% d) 10.36% e) None of the above Calculate the return on a cash investment in the S&P 500 stock index over the same time period a) 1.87% b) -0.68% c) -14.90% d) 10.36% e) None of the above USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

(c) 6

(b) 7

A futures contract on Treasury bond futures with a December expiration date currently trade at 103:06. The face value of a Treasury bond futures contract is $100,000. Your broker requires an initial margin of 10%. (c) 8 Calculate the current value of one contract a) $100,000 b) $103,600.5 c) $103,187.5 d) $102,306.3 e) $104,293.5 Calculate the initial margin deposit a) $10,000 b) $10,360.50 c) $10,318.75 d) $10,230.63 e) $10,429.35

(c) 9

(b) 10

If the futures contract is quoted at 105:08 at expiration calculate the percentage return

a) b) c) d) e)

1.99% 19.99% 20.62% 25.37% -13.65%

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS On the last day of October, Bruce Springsteen is considering the purchase of 100 shares of Olivia Corporation common stock selling at $37 1/2 per share and also considering an Olivia option. Calls Puts Price December March December March 35 3 3/4 5 1 1/4 2 40 2 1/2 3 1/2 4 1/2 4 3/4 (d) 11 If Bruce decides to buy a March call option with an exercise price of 35, what is his dollar gain (loss) if he closes his position when the stock is selling at 43 1/2? a) $225.00 loss b) $350.00 loss c) $225.00 gain d) $350.00 gain $850.00 gain If Bruce buys a March put option with an exercise price of 40, what is his dollar gain (loss) if he closes his position when the stock is selling at 43 1/2? a) $825.00 loss b) $475.00 loss c) $350.00 loss d) $25.00 loss e) He has a gain

e) (b) 12

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS Rick Thompson is considering the following alternatives for investing in Davis Industries which is now selling for $44 per share: 1) Buy 500 shares, and 2) Buy six month call options with an exercise price of 45 for $3.25 premium.

(a) 13

Assuming no commissions or taxes what is the annualized percentage gain if the stock reaches $50 in four months and a call was purchased? a) 161.54% gain b) 53.85% gain c) 161.54% loss d) 11.11% gain e) 53.85% loss Assuming no commissions or taxes, what is the annualized percentage gain if the stock is at $30 in four months and the stock was purchased? 9.54% loss 95.45% loss 0.9545% gain 95.45% gain 9.54% gain Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3month Johnson Walker put option with an exercise price of $105.00 for $20.00. What is his dollar gain if at expiration the stock is selling for $80.00 per share? a) $200 loss b) $700 loss c) $200 gain d) $700 gain e) None of the above Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3month Johnson Walker put option with an exercise price of $105.00 for $20.00. What is Toms dollar gain/loss if at expiration the stock is selling for $105.00 per share? a) $1000 gain b) $200 loss c) $1000 loss d) $200 gain e) None of the above

(b) 14 a) b) c) d) e) (a) 15

(b) 16

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS Sarah Kling bought a 6-month Peppy Cola put option with an exercise price of $55 for a premium of $8.25 when Peppy was selling for $48.00 per share. (d) 17 If at expiration Peppy is selling for $42.00, what is Sarahs dollar gain or loss? a) $420 gain b) $420 loss c) $475 loss

d) e) (b) 18

$475 gain None of the above

What is Sarahs annualized gain/loss? a) 11.51% gain b) 115.15% gain c) 11.51% loss d) 115.15% loss e) None of the above If at expiration Peppy is selling for $47.00, what is Sarahs dollar gain or loss? a) $25 loss b) $250 loss c) $25 gain d) $250 gain e) None of the above What is Sarahs annualized gain/loss? a) 60.60% gain b) 6.06% loss c) 60.60% loss d) 6.06% gain a) None of the above A stock currently trades for $25. January call options with a strike price of $30 sell for $6. The appropriate risk free bond has a price of $30. Calculate the price of the January put option. a) $11 b) $24 c) $19 d) $30 e) $25

(a) 19

(b) 20

(a) 21

(e) 22

A stock currently trades for $115. January call options with a strike price of $100 sell for $16, and January put options a strike price of $100 sell for $5. Estimate the price of a risk free bond. a) $120 b) $15 c) $105 d) $116 e) $104 Assume that you have purchased a call option with a strike price $60 for $5. At the same time you purchase a put option on the same stock with a strike price of $60

(d) 23

for $4. If the stock is currently selling for $75 per share, calculate the dollar return on this option strategy. a) $10 b) -$4 c) $5 d) $6 e) $15 (c) 24 Assume that you purchased shares of a stock at a price of $35 per share. At this time you purchased a put option with a $35 strike price of $3. The stock currently trades at $40. Calculate the dollar return on this option strategy. a) $3 b) -$2 c) $2 d) -$3 e) $0 Assume that you purchased shares of a stock at a price of $35 per share. At this time you wrote a call option with a $35 strike and received a call price of $2. The stock currently trades at $70. Calculate the dollar return on this option strategy. a) $25 b) -$2 c) $2 d) -$25 e) $0 A stock currently trades at $110. June call options on the stock with a strike price of $105 are priced at $4. Calculate the arbitrage profit that you can earn a) $0 b) $1 c) $5 d) $4 e) None of the above Datacorp stock currently trades at $50. August call options on the stock with a strike price of $55 are priced at $5.75. October call options with a strike price of $55 are priced at $6.25. Calculate the value of the time premium between the August and October options. a) -$0.50 b) $0 c) $0.50 d) $5 e) -$5 A stock currently trades at $110. June put options on the stock with a strike price of $100 are priced at $5.25. Calculate the dollar return on one put contract.

(c) 25

(b) 26

(c) 27

(a) 28

a) b) c) d) e) (d) 29

-$525 $1000 $0 -$1000 $525

A stock currently trades at $110. June call options on the stock with a strike price of $120 are priced at $5.75. Calculate the dollar return on one call contract. a) -$1000 b) $1000 c) $575 d) -$575 e) $0 Consider a stock that is currently trading at $65. Calculate the intrinsic value for a put option that has an exercise price of $55. a) $10 b) $50 c) $55 d) -$10 e) $0 Consider a stock that is currently trading at $20. Calculate the intrinsic value for a put option that has an exercise price of $35. a) $15 b) $55 c) $35 d) -$15 e) $0

(e) 30

(a) 31

(e) 32

Consider a stock that is currently trading at $45. Calculate the intrinsic value for a call option that has an exercise price of $35. a) $25 b) $35 c) $0 d) -$10 e) $10 Consider a stock that is currently trading at $10. Calculate the intrinsic value for a call option that has an exercise price of $15. a) $25 b) -$5 c) $0 d) $20

(c) 33

e)

$5

CHAPTER 20
ANSWERS TO PROBLEMS 1 2 3 4 5 6 p(t) = $5.04 - $50+ $50(1 + .05)- = $3.83 p(t) = $4.74 - $45+ $50(1 + .03)- = $9.0 p(t) = $2.5 - $55+ $60(1 + .07) - = $5.50 p(t) = $7.34 - $62+ $70(1 + .06)-1/4 = $14.33 Margin = 0.10 x 250 x 1187.70 = $29,692.50 Purchase December contract 250 x 1187.7 = $296,925 Sell December contract 250 x 1170 = $292,500 Loss in futures = $292,500 - $296,925 = -$4425 Rate of return = -$4425/29,692.50 = -.1490 or -14.9% 7 8 Return on cash investment in the index = (1170 1178)/1178 = -0.0068 or 0.68% Current price is 103 6/32 percent of face value of $100,000 = 1.031875 x 100,000 = $103,187.50 9 10 Margin deposit = 0.10 x 103,187.5 = $10,318.75 Purchase December contract 103 6/32 percent of 100,000 = $103,187.50 Sell December contract 105 8/32 percent of $100,000 = $105,250 Gain in futures = $105,250 - $103,187.50 = $2,062.50 Rate of return = 2062.5/10318.75 = 0.1999 or 19.9%

11 12 13 14 15

43 1/2 - 35 = 8.5 8.5 - 5 = 3.5 $3.5/share x 100 shares/contract = $350.00 The option is worthless so he loses the $475 he paid for the contract. [(50 - 45 - 3.25) 3.25] x 3 = 161.54% gain [(30 - 44) 44] x 3 = 95.45% loss Profit on put = 105 - 80 - 20 = 5 5 x 100 = $500.00 Loss on stock = $700.00 Net loss = $700.00 - 500.00 = $200.00 (loss)

16

Put value = 0, therefore, loss = $2,000.00 Stock (105 - 87)(100) = $1,800.00 Net loss = $2,000 - 1,800 = $200.00 (loss)

17 18 19 20 21 22 23

[(55 - 42 - 8.25) x 100] = $475 gain [(55 - 42 - 8.25) 8.25] x 2 = 115.15% gain [(55 - 47 - 8.25) x 100] = $25 loss [(55 - 47 - 8.25) 8.25] x 2 = 6.06% loss P = 6 + 30 25 = $11 Bond price = 115 + 5 16 = $104 Profit on call = (75 60) 5 = 10 Profit on put = -4 Total = $6 Profit on stock = 40 35 = 5 Profit on put = -3 Total = $2 Profit on stock = 70 35 = 25 Profit on call = 35 70 + 2 = -23 Total = $2 Arbitrage profit = 110 105 4 = $1 Time premium = 6.25 5.75 = $0.50

24

25

26 27

28 29 30 31 32 33

Dollar return = (100 110 5.25)(100) = -$525 Dollar return = (110 120 5.75)(100) = -$575 Put = Max[55 65, 0] = $0 Put = Max[35 20, 0] = $15 Call = Max[45 35, 0] = $10 Call = Max[10 15, 0] = $0

CHAPTER 22 OPTION CONTRACTS


TRUE/FALSE QUESTIONS (t) 1 (f) 2 (t) 3 (f) 4 (t) 5 (f) 6 (f) 7 (t) 8 The Chicago Board Options Exchange has the largest share of stock option trading. Index options are settled by delivery of the stocks that make up the index. In index options, the aggregate market takes the place of the individual stock issues being traded, as in stock options. Risk management is the driving force behind the futures options market. The longer the time to expiration, the greater the value of a call option. There is an inverse relationship between the market interest rate and the value of a call option. Credit risk in the options market is only a concern to the option seller. The standardization of option contracts and the creation of the Options Clearing Corporation are two important results of the opening of the Chicago Board of Options Exchange. Stock options expire on the Sunday following the third Saturday of the designated month. A price spread (or vertical spread) involves buying and selling an option for the same stock and expiration date but with different exercise prices. A portfolio containing a share of stock and a put option will have the same value as a portfolio containing a call option and the risk-free discount bond. A strip is a call option on a stock that is written by someone that owns the stock. The buyer of a straddle expects stock prices to move strongly in either direction. A long strip position indicates that an investor is bullish but conservative. Index options can only be settled in cash. Unlike stock options, futures options require the holder to enter into a utures contract.

(f) 9 (t) 10 (t) 11 (f) 12 (t) 13 (t) 14 (t) 15 (f) 16

(f) 17 (t) 18 (f) 19 (f) 20 (f) 21 (t) 22

It is a violation of the securities laws to combine option contracts to achieve a customized payoff. European options can only be exercised on the expiration date. The owner of a call option on a futures contract has the obligation to buy the futures contract at a predetermined strike price during a specified time period. Options on futures expire at the same time the futures contract expires. The underlying stock price and the value of the put option are factors that impact the value of an American call option. The binomial option pricing model approximates the price of an option obtained using the Black-Scholes option pricing model as the number of subintervals increases. Investors should purchase market index put options if they anticipate an increase in the index value. MULTIPLE CHOICE QUESTIONS

(f) 23

(d) 1

The creation of the CBOE led to all the following innovations in options except a) The creation of a central marketplace. b) The introduction of a clearing corporation. c) The standardization of expiration dates. d) The creation of a primary market. e) The creation of a secondary market. A calendar spread requires the purchase and sale of two calls or two puts in the same stock with a) The same expiration date but different exercise prices. b) The same exercise price but different expiration dates. c) Different exercise prices and different expiration dates. d) The same exercise price and the same expiration month. e) Traded in different markets.

(b) 2

(b) 3

In a money spread, an investor would a) Buy two in-the-money call options on the same stock with different exercise dates.

b) c) d) e) (b) 4

Buy two out-of-the-money call options on the same stock with different exercise dates. Sell two in-the-money call options on the same stock with different exercise dates. Sell an out-of-the-money call and purchase an in-the-money call on the same stock with the same exercise date. Sell two out-of-the-money call options on the same stock with different exercise dates.

A money spread involves buying and selling call options in the same stock with a) The same time period and exercise price. b) The same time period but different exercise price. c) A different time period but same exercise price. d) A different time period and different exercise price. e) Options in different markets. If you were to purchase an October option with an exercise price of 50 for 8 and simultaneously sell an October option with an exercise price of 60 for 2, you would be a) Bullish and taking a high risk. b) Bullish and conservative. c) Bearish and taking a high risk. d) Bearish and conservative. e) Neutral. You own a stock that has risen from $10 per share to $32 per share. You wish to delay taking the profit but you are troubled about the short run behavior of the stock market. An effective action on your part would be to a) Purchase a put. b) Purchase a call. c) Purchase an index option. d) Utilize a bearish spread. e) Utilize a bullish spread. If you were to purchase an October option with an exercise price of 50 for $8 and simultaneously sell an October option with an exercise price of 60 for $2, you would be a) Bullish and taking a high risk. b) Bullish and conservative. c) Bearish and taking a high risk. d) Bearish and conservative. e) Neutral. A vertical spread involves buying and selling call options in the same stock with a) The same time period and price. b) The same time period but different price.

(b) 5

(a) 6

(b) 7

(b) 8

c) d) e) (c) 9

A different time period but same price. A different time period and different price. Options in different markets.

Which of the following is not a factor needed to calculate the value of an American call option? a) The stock price b) The exercise price c) The exchange on which the option is listed d) The volatility of the underlying stock e) The interest rate Buying a bear spread is equivalent to a) Selling a bull spread. b) Buying an out-of-the-money call and selling an in-the-money call on the same stock with the same exercise date. c) Selling an out-of-the-money call and buying an in-the-money call on the same stock with a different exercise price. d) Choices a and b only. e) None of the above A currency call is like being a) Out-of-the-money b) In-the-money c) Long d) Short e) At-the-money in the currency futures.

(a) 10

(c) 11

(a) 12

A straddle is the simultaneous purchase (or sale) of a put and call option with the same underlying asset, a) Same exercise price, and expiration date. b) Same exercise price but different expiration date. c) Same expiration date but different exercise price. d) Either choices b or c. e) None of the above.

(b) 13

In the Black-Scholes option pricing model, an increase in security price (S) will cause a) An increase in call value and an increase in put value b) An increase in call value and a decrease in put value c) An decrease in call value and an increase in put value d) An decrease in call value and a decrease in put value

e) (c) 14

An increase in call value and an increase or decrease in put value

In the Black-Scholes option pricing model, an increase in exercise price (X) will cause a) An increase in call value and an increase in put value b) An increase in call value and a decrease in put value c) An decrease in call value and an increase in put value d) An decrease in call value and a decrease in put value e) An increase in call value and an increase or decrease in put value In the Black-Scholes option pricing model, an increase in time to expiration (T) will cause a) An increase in call value and an increase in put value b) An increase in call value and a decrease in put value c) An decrease in call value and an increase in put value d) An decrease in call value and a decrease in put value e) An increase in call value and an increase or decrease in put value In the Black-Scholes option pricing model, an increase in the risk free rate (RFR) will cause a) An increase in call value and an increase in put value b) An increase in call value and a decrease in put value c) An decrease in call value and an increase in put value d) An decrease in call value and a decrease in put value e) An increase in call value and an increase or decrease in put value In the Black-Scholes option pricing model, an increase in security volatility () will cause a) An increase in call value and an increase in put value b) An increase in call value and a decrease in put value c) An decrease in call value and an increase in put value d) An decrease in call value and a decrease in put value e) An increase in call value and an increase or decrease in put value

(e) 15

(b) 16

(a) 17

(d) 18

The value of a call option is positively related to: a) Underlying stock price. b) Time to expiration c) Exercise price. d) a) and b) e) b) and c) The value of a call option is inversely related to:

(c) 19

a) b) c) d) e) (b) 20

Underlying stock price. Time to expiration Exercise price. a) and b) b) and c)

If the hedge ratio is 0.50, this indicates that the portfolio should hold a) Two shares of stock for every call option written. b) One share of stock for every two call options written. c) Two shares of stock for every call option purchased. d) One share of stock for every two call options purchased. e) Two call options for every put option written. Options can be used to a) Modify an equity portfolio's systematic risk. b) Modify an equity portfolio's unsystematic risk. c) Manage currency exposures in international equity portfolios. d) Change a portfolios exposure to a particular asset e) All of the above MULTIPLE CHOICE PROBLEMS USE THE FOLLOWING INFORMATION FOR THE NEXT SIX PROBLEMS
Option Type Contract Size Expiry Strike $0.815 $0.820 Call $0.0118 Currency 50000 April Put $0.0068 Canadian dollar Canadian dollars

(e) 21

(d) 1

How much must an investor pay for one call option contract? a) $680 b) $815 c) $625 d) $590 e) $340 How much must an investor pay for one put option contract? a) $680 b) $815 c) $340 d) $625 e) $590 If the spot rate at expiration is $0.90 and the call option was purchased, what is the dollar gain or loss?

(c) 2

(c) 3

a) b) c) d) e) (b) 4

$0 $3750 gain $3660 gain $4650 loss $2680 loss

If the spot rate at expiration is $0.80 and the call option was purchased, what is the dollar gain or loss? a) $123 gain b) $590 loss c) $312 gain d) $237 gain e) $0 If the spot rate at expiration is $0.85 and the put option was purchased, what is the dollar gain or loss? a) $340 loss b) $125 gain c) $750 gain d) $750 loss e) $200 loss If the spot rate at expiration is $0.75 and the put option was purchased, what is the dollar gain or loss? a) $0 b) $200 loss c) $200 gain d) $3160 gain e) $1187 loss

(a) 5

(d) 6

USE THE FOLLOWING INFORMATION FOR THE NEXT TEN PROBLEMS

XYZ CORP
EXERCISE DATE PRICE OCT 85 OCT 90 OCT 95 OCT 85 OCT 90 OCT 95 PRICE 16 3/4 12 7 5/8 1/8 3/8 13/16 NYSE CLOSE 101 11/16 101 11/16 101 11/16 101 11/16 101 11/16 101 11/16

CALLS PUTS

(a) 7

If you establish a long straddle using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $18.75 loss b) $18.75 gain c) $1,668.75 gain d) $1,668.75 loss e) $1,687.50 loss If you establish a long strap using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $1,687.50 loss b) $3,362.50 loss c) $3,675.50 gain d) $13.00 gain e) $13.00 loss If you establish a long strip using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $1,668.75 gain b) $1,700.00 gain c) $1,700.00 loss d) $31.25 gain e) $31.25 loss If you establish a long straddle using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $68.75 loss b) $68.75 gain c) $37.50 loss d) $1,200.00 loss e) $1,200.00 gain

(d) 8

(e) 9

(a) 10

(c) 11

If you establish a long strap using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $37.50 loss b) $37.50 gain c) $100.00 loss d) $100.00 gain e) $2,437.50 loss If you establish a long strip using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $106.25 gain b) $106.25 loss c) $1,275.00 loss d) $1,275.00 gain e) $75.00 loss If you establish a long straddle using the options with an 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $668.75 gain b) $668.75 loss c) $94.56 gain d) $94.56 loss e) $81.25 loss If you establish a long strap using the options with an 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $81.25 loss b) $1,606.25 gain c) $1,606.25 loss d) $268.75 loss e) $268.75 gain If you establish a long strip using the options with a 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16? a) $256.25 loss b) $256.25 gain c) $925.00 loss d) $668.75 gain e) $668.75 loss

(b) 12

(d) 13

(d) 14

(a) 15

(b) 16

If XYZ were trading at $90/share and you formed a bull money spread, what is your profit if XYZ is trading at $110 at expiration?

a) b) c) d) e)

$912.50 loss $87.50 gain $87.50 loss $1,000.00 gain $1,000.00 loss

THE FOLLOWING INFORMATION IS FOR THE NEXT TWO PROBLEMS A stock currently trades for $130 per share. Options on the stock are available with a strike price of $125. The options expire in 10 days. The risk free rate is 3% over this time period, and the expected volatility is 0.35.

(d) 17

Use the Black-Scholes option pricing model to calculate the price of a call option. a) $5.19 b) $4.35 c) $3.93 d) $6.19 e) $8.17 Calculate the price of the put option. a) $1.086 b) $0.862 c) $6.234 d) $0.623 e) $2.317 Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $65. $71.75 $76.75 $58.25 $81.75 None of the above

(a) 18

(a) 19

a) b) c) d) e)

(d) 20

a) b) c) d) e) (d) 21

Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $80. $81.75 $73.25 $86.75 $76.75 None of the above Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $70. $77.75 $87.25 $82.25 $72.75 None of the above Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock. Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $85. $77.75 $87.25 $82.25 $72.75 None of the above.

a) b) c) d) e) (a) 22

a) b) c) d) e)

USE THE FOLLOWING INFORMATION FOR THE NEXT 12 QUESTIONS Consider the following information on put and call options for Citigroup Strike Price $32.50 (b) 23 Put Price $2.85 Call Price $1.65

Calculate the net value of a protective put position at a stock price at expiration of $20, and a stock price at expiration of $45. a) $6.35, $18.85 b) $29.65, $42.15 c) $21.65, $34.15 d) $8, $8

e) (b) 24

-$8, -$8

A protective put is an appropriate strategy if a) An investor wishes to generate additional income. b) An investor wished to insure against a decline in share values. c) An investor expected share prices to be volatile. d) An investor expected share prices to remain in a trading range. e) An investor expected share prices to be volatile, but was inclined to be bullish. Calculate the net value of a covered call position at a stock price at expiration of $20, and a stock price at expiration of $45. a) $6.35, $18.85 b) $29.65, $42.15 c) $21.65, $34.15 d) $8, $8 e) -$8, -$8 A covered call is an appropriate strategy if a) An investor wishes to generate additional income. b) An investor wished to insure against a decline in share values. c) An investor expected share prices to be volatile. d) An investor expected share prices to remain in a trading range. e) An investor expected share prices to be volatile, but was inclined to be bullish. Calculate the payoffs of a long straddle at a stock price at expiration of $20 and a stock price at expiration of $45. a) $6.35, $18.85 b) $29.65, $42.15 c) $21.65, $34.15 d) $8, $8 e) -$8, -$8 A long straddle is an appropriate strategy if a) An investor wishes to generate additional income. b) An investor wished to insure against a decline in share values. c) An investor expected share prices to be volatile. d) An investor expected share prices to remain in a trading range. e) An investor expected share prices to be volatile, but was inclined to be bullish.

(c) 25

(a) 26

(d) 27

(c) 28

(e) 29

Calculate the payoffs of a short straddle at a stock price at expiration of $20 and a stock price at expiration of $45. a) $6.35, $18.85 b) $29.65, $42.15 c) $21.65, $34.15 d) $8, $8 e) -$8, -$8 A short straddle is an appropriate strategy if a) An investor wishes to generate additional income. b) An investor wished to insure against a decline in share values. c) An investor expected share prices to be volatile. d) An investor expected share prices to remain in a trading range. e) An investor expected share prices to be volatile, but was inclined to be bullish. Calculate the payoffs of a long strap at a stock price at expiration of $20 and a stock price at expiration of $45. a) $6.35, $18.85 b) $29.65, $42.15 c) $21.65, $34.15 d) $8, $8 e) -$8, -$8 A long strap is an appropriate strategy if a) An investor wishes to generate additional income. b) An investor wished to insure against a decline in share values. c) An investor expected share prices to be volatile. d) An investor expected share prices to remain in a trading range. e) An investor expected share prices to be volatile, but was inclined to be bullish.

(d) 30

(a) 31

(e) 32

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT THREE QUESTIONS The information provided is relevant in the context of a one period (one year) binomial option pricing model. A stock currently trades at $50 per share, a call option on the stock has an exercise price of $45. The stock is equally likely to rise by 25% or fall by 25%. The one-year risk free rate is 2%. (b) 33 Calculate the possible prices of the stock one year from today a) $37.50 or $17.50. b) $62.50 or $37.50. c) $62.50 or $17.50. d) $50 or $45. e) None of the above. Estimate n, the number of call options that must be written

(a) 34

a) b) c) d) e) (c) 35

-1.4286 -2.9286 -2.8571 -2.5714 -1.1111

Calculate the price of the call option today (C0) a) $7.56 b) $17.48 c) $9.26 d) $5.0 e) $17.15

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FOUR QUESTIONS The following information is provided in the context of a two period (two six month periods) binomial option pricing model. A stock currently trades at $60 per share, a call option on the stock has an exercise price of $65. The stock is equally likely to rise by 15% or fall by 15% during each six month period. The one-year risk free rate is 3%. (c) 36 Calculate the possible prices of the stock at the end of one year a) $69, $51, $79.35 b) $51, $79.35, $58.65 c) $79.35, $58.65, $43.35 d) $58.65, $43.35, $14.35 e) None of the above Calculate the price of the call option after the stock price has already moved up in value once (Cu) a) $7.77 b) $14.35 c) $0 d) $4.21 e) $6.44 Calculate the price of the call option after the stock price has already moved down in value once (Cd) a) $7.77 b) $14.35 c) $0 d) $4.21 e) $6.44

(a) 37

(c) 38

(d) 39

Calculate the price of the call option today (C0) a) $7.77

b) c) d) e)

$14.35 $0 $4.21 $6.44

CHAPTER 22 ANSWERS TO PROBLEMS


1 2 3 4 5 6 7 (US$/Can$)(0.0118)(50,000 Can$) = $590 (US$/Can$)(0.0068)(50,000 Can$) = $340 Cost = $590 Net gain = (0.90 - 0.815)(50,000) -590 = $3,660 Cost = $590 Payoff = (0) 590 = -$590 (Option expires worthless) Cost = $340 Payoff = (0) 340 = -$340 (Option expires worthless) Cost = $340 Payoff = (0.82 0.75)(50,000) - $340= $3160 Long straddle: purchase one OCT 85 put and one OCT 85 call Cost of one call = 16 3/4(100) = $1,675.00 Cost of one put = 1/8(100) = $12.50 Total cost = $1,687.50 Payoff on one call = 100(101 11/16 - 85) = $1,668.75 Payoff on one put = 0, expires out of the money Net gain/loss = $1,668.75 - $1,687.50 = $18.75 loss 8 Long strap: purchase two OCT 85 calls and one OCT 85 put Cost of 2 calls = 2(16.75(100) = Cost of one put = 1/8(100) = Total cost = $3,350.00 $12.50 $3,362.50

Payoff on 2 calls = 2(100)(101 11/16 - 85) = $3,375.00 Payoff on one put = 0, expires out of the money Net gain/loss = $3,375.50 - $3,362.50 = $13.00 gain 9 Long strip: purchase one OCT 85 call and two OCT 85 puts Cost of one call = 16 3/4(100) = $1,675.00 Cost of two puts = 2(1/8)(100) = $25.00

Total cost =

$1,700.00

Payoff on one call = 100(101 11/16 - 85) = $1,668.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $1,668.75 - $1,700.00 = $31.25 loss 10 Long straddle: purchase one OCT 90 put and one OCT 90 call Cost of one call = 12(100) = $1,200.00 Cost of one put = 3/8(100) = $37.50 Total cost = $1,237.50 Payoff on one call = 100(101 11/16 - 90) = $1,168.75 Payoff on one put = 0, expires out of the money Net gain/loss = $1,168.75 - $1,237.50 = $68.75 loss 11 Long strap: purchase two OCT 90 calls and one OCT 90 put Cost of 2 calls = 2(12.00(100) = Cost of one put = 3/8(100) = Total cost = $2,400.00 $37.50 $2,437.50

Payoff on 2 calls = 2(100)(101 11/16 - 90) = $2,337.50 Payoff on one put = 0, expires out of the money Net gain/loss = $2,337.50 - $2,437.50 = $100.00 loss 12 Long strip: purchase one 90 call and two OCT 90 puts Cost of one call = 12(100) = $1,200.00 Cost of two puts = 2(3/8)(100) = $75.00 Total cost = $1,275.00 Payoff on one call = 100(101 11/16 - 90) = $1,168.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $1,168.75 - $1,275.00 = $106.25 loss 13 Long straddle: purchase one OCT 95 put and one OCT 95 call Cost of one call = 7 5/8(100) = Cost of one put = 13/16(100) = Total cost = $762.50 $81.25 $763.31

Payoff on one call = 100(101 11/16 - 95) = $668.75 Payoff on one put = 0, expires out of the money Net gain/loss = $668.75 - $763.31 = $94.56 loss 14 Long strap: purchase two OCT 95 calls and one OCT 95 put

Cost of 2 calls = 2(7 5/8)(100) = Cost of one put = 13/16(100) = Total cost =

$1,525.00 $81.25 $1,606.25

Payoff on 2 calls = 2(100)(101 11/16 - 95) = $1,337.50 Payoff on one put = 0, expires out of the money Net gain/loss = $1,337.50 - $1,606.25 = $268.75 loss 15 Long strip: purchase one 95 call and two OCT 95 puts Cost of one call = 7 5/8(100) = Cost of two puts = 2(13/16)(100) = Total cost = $762.50 $162.50 $925.00

Payoff on one call = 100(101 11/16 - 95) = $668.75 Payoff on two puts = 0, expires out of the money Net gain/loss = $668.75 - $925.00 = $256.25 loss 16 Bull money spread = buy the in-the-money call, i.e., OCT 85 and sell the out-ofthe-money call, i.e., OCT 95 Cost of buying OCT 85 call = 100(16 3/4) = Proceeds from selling OCT 95 call = 100(7 5/8) = Net cost Payoff on OCT 85 call = 100(110 - 85) = $2,500.00 Payoff on OCT 95 call = 100(110 - 95) = ($1,500.00) Net payoff = $2,500.00 - 1,500.00 = $1,000.00 Total gain/loss = $1,000.00 - 912.50 = $87.50 gain 17 Price using the B-S option pricing model d1 = ln(130/125) + [(.03 + 5(.352))(.0833)]/(.35(.02778.5)) = 0.715807 d2 = 0.715807 - (.35(.02778.5)) = 0.657474 N(d1) = 0.762945 N(d2) = 0.744562 Call price = Pc = 120[0.762945 125(e-.03(.02778))( 0.744562] = $6.19 18 19 Put price = 6.19 + 125(e-.03(.02778)) 130 = $1.086 The effective price is 65 + 6.75 = $71.75 $1,675.00 $762.50 $912.50

The option expires worthless so your effective price is the current price plus the option premium. 20 The effective price is 70 + 6.75 = $76.75 The option is exercised so your effective price is the strike price plus the option premium. 21 The effective price is 80 7.25 = $72.75 The option is exercised so your effective price is the strike price less the option premium. 22 The effective price is 85 7.25 = $77.75 The option expires worthless so your effective price is the current price less the option premium. 23 At S = 20 Net value of protective put = (32.5 20) 2.85 + 20 = 29.65 At S = 45 Net value of protective put = 2.85 + 45 = 42.15 This strategy is appropriate if an investor wished to insure against a decline in share values. At S = 20 Net value of covered call = 1.65 + 20 = 21.65 At S = 45 Net value of covered call = -(45 32.5) + 1.65 + 45 = 34.15 This strategy is appropriate if an investor wished to generate additional income. At S = 20 Net payoff on a long straddle = (32.5 20) -1.65 2.85 = 8 At S = 45 Net payoff on a long straddle = (45 - 32.5) -1.65 2.85 = 8 This strategy is appropriate if an investor expected share prices to be volatile. At S = 20 Net payoff on a short straddle = -(32.5 20) + 1.65 + 2.85 = -8 At S = 45 Net payoff on a long straddle = -(45 - 32.5) + 1.65 + 2.85 = -8 This strategy is appropriate if an investor expected share prices to remain in a trading range. At S = 20

24 25

26 27

28 29

30 31

Net payoff on a long strap = (32.5 20) (2)(1.65) 2.85 = 6.35 At S = 45 Net payoff on a long straddle = (2)(45 - 32.5) (2)(1.65) 2.85 = 18.85 32 33 This strategy is appropriate if an investor expected share prices to be volatile. If the stock rises the price one year for now will be = 50(1 + 0.25) = $62.50 If the stock falls the price one year for now will be = 50(1 - 0.25) = $37.50 34 Current stock price = $50 Exercise price = $45 Risk free rate = 2% Price in one year if stock rises = 50(1.25) = $62.50 Price in one year if stock declines = 50(1.25) = $37.50 Intrinsic value of call option if stock rises to $62.50 = Max[0, 62.50 45] = $17.50 Intrinsic value of call option if stock falls to $37.50 = Max[0, 37.50 45] = $0 Estimate the number calls needed by setting: The hedge portfolio will consist of one share of stock held long plus some number of call options written. Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 62.50 + (17.5)(n) = 37.50 + (0)(n) n = -1.4286 35 Value of hedge portfolio today = 50 (1.4286)(C0) = 37.5/(1.02) C0 = $9.26 36 Current stock price = $60 Price in one year if stock rises 15% per six month period= 60(1.15)(1.15) = $$79.35 Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65 Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35 Current stock price = $60 Exercise price = $65 Risk free rate = 3% or 1.49% per six month period = (1.03)0.5 1 = 0.0149 Price in six months if stock rises 15% = 60(1.15) = $69 Price in six month if stock falls 15% = 60(0.85) = $51 Price in one year if stock rises 15% per six month period= 60(1.15)(1.15) = $79.35 Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65 Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35 Intrinsic value of call option if stock rises to $79.35 = Max[0, 79.35 65] = $14.35

37

Intrinsic value of call option if stock falls to $58.65= Max[0, 58.65 65] = $0 Intrinsic value of call option if stock falls to $43.35 = Max[0, 43.35 65] = $0 Estimate the number calls needed by constructing a hedge portfolio. The hedge portfolio will consist of one share of stock held long plus some number of call options written. At the end of the first six month period: Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 79.35 + (14.35)(n) = 58.65 + (0)(n) n = -1.44251 Value of hedge portfolio at the end of first six months = 69 (1.44251)(Cu) = 58.65/(1.0149) Cu = $7.7719 38 39 Cd = 0. Since the ending stock prices of $58.65 and $43.35 are both below the exercise price. To solve for the value of the call today (C0), first determine the number of calls by constructing a hedge portfolio where: Right now: Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls 69 + (7.7719)(n) = 51 + (0)(n) n = -2.31603 Value of hedge portfolio now = 60 (2.31603)(C0) = 51/(1.0149) C0 = $4.2092

CHAPTER 24 PROFESSIONAL ASSET MANAGEMENT


TRUE/FALSE QUESTIONS (t) 1 (t) 2 (t) 3 (f) 4 (f) 5 (f) 6 (t) 7 (t) 8 (f) 9 (t) 10 (t) 11 (t) 12 Management and advisory firms can advise clients on how to structure their own portfolios. In an investment company, the invested funds belong to many individuals. The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value. A portfolio is generally managed by the board of directors of an investment company. A closed-end investment company is normally referred to as a mutual fund. The market price of shares of a closed-end fund is typically determined by supply and demand. An open-end investment company differs from a closed-end investment company by the way they operate after the initial public offering. Open-end investment companies continue to sell and repurchase shares after their initial public offering. A no-load fund imposes a substantial sales charge and sells shares at their NAV. All investment firms charge annual management fees to compensate the professional manager of the fund. Hedge funds are far less liquid than mutual fund shares. The primary purpose of government regulations and voluntary standards in the professional asset management industry is to ensure that managers deal with all investors fairly and equitably and that information about investment performance is accurately reported. Hedge funds have no limitations on when and how often capital can be contributed or removed from the partnership.

(f) 13

(f) 14

The returns received by the average individual investor on funds managed by investment companies will probably be superior to the average results for a specific U.S. or international market. An investor should be cautious when selecting a fund based solely on the managers past performance, since past performance may not be repeated in the future. Diversifying a portfolio to eliminate unsystematic risk is one of the major benefits of investing in mutual funds. High Portfolio turnover lowers mutual fund costs. 18 The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value. Income distributions distributions are the only mutual funds. and source capital gains of returns for

(t) 15

(t) 16 (f) 17 (t)

(f)

19

(t) (f) (t)

20 21 22

The market price of shares of a closed-end fund is typically determined by supply and demand. Closed-end investment companies discounts to their NAV. Market index funds attempt composition and performance of a indicator series. never sell at

to match the specified market

(f)

23 Open-end and closed-end investment companies are similar in that both companies will repurchase shares on demand. MULTIPLE CHOICE QUESTIONS

(d) 1

Which of the following is an approach to asset management? a) Management and advisory firms b) Investment companies c) Strategic management d) Choices a and b only e) All of the above An open-end investment company is commonly referred to as a(n) a) Balanced fund. b) Mutual fund. c) Money market fund.

(b) 2

d) e) (a) 3

Accessible fund. Unit trust.

The main difference between a closed-end fund and an open-end fund is a) The way each is traded after the initial public offering. b) There is no significant difference. c) The minimum initial investment. d) The type of allowable investments. e) The way in which each is regulated by the SEC. Net asset value (NAV) is determined by a) The total market value of all its assets multiplied by the number of fund shares outstanding. b) The total market value of all its assets divided by the number of fund shares outstanding. c) The total market value of all its assets divided by the number of shareholders. d) Supply and demand for the investment company stock in the secondary market. e) Supply and demand for the investment company stock in the primary market. The market price of a closed-end investment company has generally been a) 5 to 20 percent below the NAV. b) 25 to 35 percent below the NAV. c) Equal to the NAV (within a 2 percent range). d) 5 to 20 percent above the NAV. e) 25 to 35 percent above the NAV. The closed-end fund index is a) Value weighted and based on market values. b) Value weighted and based on NAVs. c) Price weighted and based on market values. d) Price weighted and based on NAVs. e) Equally weighted and based on market values. Open-end mutual funds that charge a sales fee when the fund is initially offered to the investor are known as a) 12b-1. b) Americus trusts. c) Unit investment trusts. d) Load funds. e) Contingency funds. A 12b-1 plan allows funds to a) Charge a redemption fee. b) Deduct 7 to 8 percent commission at the initial offering. c) Deduct .75 percent of the average net assets per year.

(b) 4

(a) 5

(c) 6

(d) 7

(c) 8

d) e) (d) 9

Charge a contingent deferred sales load. Switch from closed-end to open-end.

When the offer price and the NAV of a mutual fund are equal it is an indication that a) The funds assets are in equilibrium. b) The fund is trading at par. c) It is strictly a coincidence. d) The fund has no initial fee. e) The fund is backloaded. All investment companies charge an annual a) 12b-1 fee. b) Marketing and distribution. c) Management fee. d) Maintenance fee. e) Market adjustment. The offering price of a load fund equals the NAV of the fund a) Less an initial requirement. b) Plus a sales charge. c) Plus a sales charge and an administrative fee. d) Less a negotiated discount. e) At its stated value. Funds that normally contain a combination of common stock and fixed income securities are known as a) Section 401(k) plans. b) Balanced funds. c) Contractual plans. d) Income funds. e) Flexible funds. Funds that attempt to provide current income, safety of principal and liquidity are known as a) Balanced funds. b) Flexible funds. c) Income funds. d) Money market funds. e) Index funds. A money market fund would be likely to invest in a portfolio containing all of the following except a) Commercial paper. b) Banker's acceptances. c) U.S. Treasury bills.

(c) 10

(b) 11

(b) 12

(d) 13

(e) 14

d) e) (d) 15

Bank certificates of deposit. U.S. Treasury notes.

A mutual fund typically performs all of the following functions, except a) Provides alternative risk-return options. b) Eliminates unsystematic risk. c) Provides diversification. d) Derives a risk-adjusted performance that is consistently superior to riskadjusted net return of the aggregate market. e) Administers the account, keeps records and provides timely information. Mutual fund performance studies have shown that most funds a) Have risks and returns that are inconsistent with their stated objectives. b) Have risks and returns that are consistent with their stated objectives. c) Do not have stated objectives. d) Have experienced risk-adjusted returns above the market. e) Have changed their objectives over time. The text offers a number of suggestions for investing in mutual funds. Which of the following is not such a suggestion? a) Choose only those mutual funds which are consistent with your objectives and constraints. b) Invest in no-load funds whenever possible. c) Avoid investing in index funds. d) Use a dollar cost average strategy. e) None of the above (that is, all are valid suggestions for investing in mutual funds) The gross return of closed-end investments companies has typically been a) 10 - 20 percent less than their NAV. b) 10 - 15 percent less than their NAV. c) Less than the net return. d) About the same as the net return. e) None of the above A major question in modern finance regarding closed-end investment companies is a) Why do these funds sell at discounts? b) Why do the discounts differ between funds? c) What are the returns available to investors from funds that sell at a large discount? d) Choices a and b only e) All of the above

(b) 16

(c) 17

(e) 18

(e) 19

(b) 20

A portfolio manager should be able to perform all of the following functions, except a) Determine risk-return preferences. b) Eliminate systematic risk. c) Maintain diversification ensuring a stabilized risk class. d) Attempt to derive a risk-adjusted performance that is superior to the market. e) Administer the account, keep records and provide timely information. An investment company is a) A corporation that handles the administrative functions for a fund. b) A corporation that has its major assets in a portfolio of securities. c) A corporation that invests in financial services firms. d) a) and b). e) a) and c). An investment management company is a) A corporation that handles the administrative functions for a fund. b) A corporation that has its major assets in a portfolio of securities. c) A corporation that invests in financial services firms. d) a) and b). e) a) and c). In the case of private management firms a) Investors deal with a fund company and do not have separate accounts tailored to their specific needs. b) Investors deal with a fund company and have separate accounts tailored to their specific needs. c) Investors deal with an asset manager and do not have separate accounts tailored to their specific needs. d) Investors deal with an asset manager have separate accounts tailored to their specific needs. e) None of the above. In the case of investment companies a) Investors deal with a fund company and do not have separate accounts tailored to their specific needs. b) Investors deal with a fund company and have separate accounts tailored to their specific needs. c) Investors deal with an asset manager and do not have separate accounts tailored to their specific needs. d) Investors deal with an asset manager have separate accounts tailored to their specific needs. e) None of the above.

(b) 21

(a) 22

(d) 23

(a) 24

(e) 25

In the case of open-end investment companies, shares of the company a) Trade on the secondary market. b) Can be bought from or sold to the investment company at the NAV. c) Are determined by supply and demand. d) a) and c). e) b) and c). In the case of closed-end investment companies, shares of the company a) Trade on the secondary market. b) Can be bought from or sold to the investment company at the NAV. c) Are determined by supply and demand. d) a) and c). e) b) and c). The following are examples of mutual fund companies a) Common stock funds. b) Bond funds. c) Hedge funds. d) a) and b). e) a), b) and c) An example of an international fund would be one that consisted of investments in securities from a) The U.S., Germany, and Japan. b) Germany, Italy, and the U.K. c) The U.S., Korea, and Argentina. d) All of the above. e) None of the above. The Investment Company Act of 1940 a) Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b) Regulates broker-dealers. c) Requires federal registration of all public offerings of securities. d) Regulates the structure and operations of mutual funds. e) Contains a code of ethics and standards of professional conduct. The Securities Act of 1933 a) Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b) Regulates broker-dealers. c) Requires federal registration of all public offerings of securities. d) Regulates the structure and operations of mutual funds. e) Contains a code of ethics and standards of professional conduct.

(d) 26

(d) 27

(b) 28

(d) 29

(c) 30

(b) 31

The Securities Exchange Act of 1934 a) Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b) Regulates broker-dealers. c) Requires federal registration of all public offerings of securities. d) Regulates the structure and operations of mutual funds. e) Contains a code of ethics and standards of professional conduct. The Investment Advisors Act of 1940 a) Contains various anti-fraud provisions and record keeping and reporting requirements for fund advisors. b) Regulates broker-dealers. c) Requires federal registration of all public offerings of securities. d) Regulates the structure and operations of mutual funds. e) Contains a code of ethics and standards of professional conduct. Soft dollars are generated when a) A manager commits to paying a higher than normal brokerage fee in exchange for additional bundled services. b) A manager commits to paying a higher than normal brokerage fee in exchange for secretarial services. c) A manager commits to paying a higher than normal brokerage fee in exchange for office equipment. d) All of the above. e) None of the above. Which of the following is a characteristic of hedge funds a) They are generally less restricted in how and where they can make investments. b) They are more liquid than mutual fund shares. c) They have no limitations on when and how often investment capital can be contributed or removed. d) All of the above. e) None of the above. In a long short-short hedge fund strategy a) Managers take long positions in undervalued stocks and short positions in overvalued stocks. b) Managers take short positions in undervalued stocks and long positions in overvalued stocks. c) Managers take offsetting risk positions on the long and short side. d) All of the above. e) None of the above.

(a) 32

(d) 33

(a) 34

(a) 35

(b) 36

In a convertible arbitrage strategy hedge fund managers attempt to a) Generate profits by taking advantage of convertible bond pricing disparities caused by changing market events. b) Generate profits by taking advantage of disparities in the relationship between prices for convertible bonds and the underlying common stock. c) Generate profits by taking advantage of disparities in the relationship between prices for convertible bonds and the underlying common stock option. d) All of the above. e) None of the above. Ethical conflicts may arise as a result of a) Incentive compensation schemes. b) Soft dollar arrangements. c) Marketing investment management services. d) All of the above. e) None of the above. Which of the following are guiding principles for ethical behavior in the asset management industry as put forward by the CFA Center for Financial Market Integrity a) The interests of investment professional come first. b) The preferred method for promoting fair and efficient markets is to set up a central oversight board. c) Financial markets in various countries should develop high-quality standards for reporting financial information that reflect local customs. d) Financial statements should be reported from the perspective of firm shareholders. e) All of the above. Which of the following are functions that a portfolio manager should perform for clients a) Determine investment objectives and constraints, diversify the portfolio, eliminate tax payments. b) Determine investment objectives, diversify the portfolio, maintain ethical standards and eliminate tax payments. c) Determine investment objectives and constraints, diversify the portfolio, and maintain ethical standards. d) Determine constraints, diversify the portfolio, eliminate tax payments. e) Determine investment objectives and constraints, diversify the portfolio, eliminate tax payments, and achieve risk adjusted return superior to the relevant benchmark.

(d) 37

(d) 38

(c) 39

MULTIPLE CHOICE PROBLEMS USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS Suppose ABC Mutual fund owned only 4 stocks as follows: Stock W X Y Z (b) a) b) c) d) e) 1 2500 2100 2700 1900 Shares $11 14 23 15 Price

$ 1.47 $ 14.75 $ 16.03 $ 27.62 $234.12 2

The fund originated by selling $100,000 of stock at $10.00 per share. What is its current NAV?

(d) a) b) c) d) e)

$26.19 $23.74 $25.25 $26.77 $24.13

What is the offering price for the fund if the NAV is $25.25 and a the load is 6 percent?

(d) 3

Suppose Mega Mutual Fund owns only the 4 stocks shown below with no liabilities. Stock Shares Price A 1800 15 B 2200 11 C 2300 9 D 1900 18 The fund originated by selling $300,000 of stock at $30.00 per share. What is its current NAV? a) $106.10 b) $12.94 c) $129.40 d) $10.61 e) None of the above

(a) 4

Suppose Under Mutual Fund owns only the 3 stocks shown below with no liabilities. Stock Shares Price A 2900 15 B 3100 14 C 3200 12 The fund originated by selling $500,000 of stock at $50.00 per share. What is its current NAV? a) $12.53 b) $15.29 c) $152.90 d) $125.30 e) None of the above Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 14% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 9% and charges a 1/2 percent redemption fee. Which is better and by how much? a) Funds are equal b) Load fund by $32.65 c) Load fund by $50.55 d) No-load fund by $64.55 e) No-load fund by $44.30 Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 11% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 7% and charges a 1/2 percent redemption fee. Which is better and by how much? a) Funds are equal b) No-load fund by $36.98 c) Load fund by $45.25 d) Load fund by $23.15 e) No-load fund by $15.52 Suppose you consider investing $15,000 in a load fund from which a fee of 5% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much? a) Load fund by $318.45 b) No load fund by $457.50 c) Funds are equal d) Load fund by $415.10 e) No load fund by $211.51

(b) 5

(d) 6

(b) 7

(b) 8

Suppose you consider investing $10,000 in a load fund from which a fee of 3% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 0 percent redemption fee. Which is better and by how much? a) Load fund by $151 b) No load fund by $136 c) Funds are equal d) No load fund by $421 e) Load fund by $115 Suppose you consider investing $5,000 in a load fund from which a fee of 8% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much? a) Load fund by $57.50 b) Load fund by $575.50 c) Funds are equal d) No load fund by $575.50 e) No load fund by $57.50 On January 2, 2003, you invest $10,000 in Megabucks Mutual Fund, a load fund that charges a fee of 2%. The funds returns were 13% in 2003, 11% in 2004, 8% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a) $13,600.00 b) $13,275.51 c) $13,297.67 d) $13,995.75 e) $10,000.00 On January 2, 2003, you invest $50,000 in the Lizbiz Mutual Fund, a load fund that charges a fee of 5%. The funds returns were 14.6% in 2003, -6.4% in 2004, 15.2% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a) $66,722.27 b) $15,200.00 c) $58,695.74 d) $33,366.25 e) $10,000.00

(b) 9

(b) 10

(c) 11

(b) 12

On January 2, 2003, you invest $100,000 in the Jeffers Mutual Fund, a load fund that charges a fee of 5%. The funds returns were -14.6% in 2003, -6.4% in 2004, 35% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is: a) $95,600.57 b) $102,515.90 c) $83,297.75 d) $133,995.75 e) $100,000.00 On January 2, 2003, you invest $10,000 in the Tiger Fund, a load fund that charges a fee of 6%. The funds returns were 25% in 2003, 35% in 2004, -5% in 2005. On December 31, 2005 you redeem all your shares of Tiger. The dollar value is a) $5,200.89 b) $13,345.89 c) $7,931.25 d) $15,896.34 e) $8,646.91 On January 2, 2003, you invest $10,000 in the W.O.W. Mutual Fund, a load fund that charges a fee of 5%. The funds returns were 13.6% in 2003, 12.2% in 2004, 8.3% in 2005. On December 31, 2005 you redeem all your W.O.W. shares. The dollar value is a) $13,600.00 b) $13,664.13 c) $10,000.00 d) $131,136.40 e) $13,113.64 On January 2, 2003, you invest $10,000 in the Dog Mutual Fund, a load fund that charges a fee of 7%. The funds returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is a) $12,800.00 b) $12,892.50 c) $100,000.00 d) $128,925.00 e) $10,000.00

(c) 13

(e) 14

(b) 15

(a) 16

On January 2, 2003, you invest $50,000 in A Mutual Fund, a load fund that charges a fee of 7%. The funds returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares in A. The dollar value is a) $64,462.57 b) $644,625.70 c) $50,000.00 d) $6,446.25 e) $10,000.00 On January 2, 2003, you invest $100,000 in Righteous, a load fund that charges a fee of 7%. The funds returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your Righteous shares. The dollar value is a) $12,800.00 b) $12,892.50 c) $100,000.00 d) $128,925.00 e) $10,000.00 Consider the Defiance Bond Fund that consists of the 3 bonds shown below and has no liabilities.

(d) 17

(b) 18

Company

Current Bond Value

# Bonds

Komko 980 120 Hijack 1010 150 Mitsue 1200 100 If initially the value of the fund was $250,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a) $25.00 b) $38.91 c) $39.81 d) $31.98 e) $39.91 (d) 19 Consider X Bond Fund which consists of the 5 bonds shown below with no liabilities.

Company

Current Bond Value

# Bonds

Komko 980 120 Hijack 1010 150 Mitsue 1200 100 Smitsu 800 120 Jones 600 150 If initially the value of the fund was $1,000,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a) $25.00 b) $27.68 c) $25.68 d) $28.76

e) (a) 20

$26.78

Consider the Compliance Bond Fund that consists of the 7 bonds shown below and has no liabilities. Company Current Bond Value # Bonds Komko 980 120 Hijack 1010 150 Mitsue 1200 100 Smitsu 800 120 Jones 600 150 GMM 1000 150 ATP 950 150 If initially the value of the fund was $2,500,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund? a) $27.11 b) $25.00 c) $26.11 d) $21.67 e) $26.27 21 Given the following fees and expected returns for fund X, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years. Investment E(Return) Load Rear-end load Years X 10% 2.5% 0% 5 years a) b) c) d) e) $1069.82 $1550.77 $1042.36 $1689.95 $1389.95 12b-1 0.25% fee

(b)

(d)

22

Given the following fees and expected returns for fund Y, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years Investment E(Return) Rear-end load Years Y 8% 0.50% 3% a) b) c) d) e) $1069.82 $1550.77 $1642.36 $1389.95 $1362.59 Load 5 years 12b-1 0% fee

(c)

23

Calculate the annual rate of return for a mutual fund with the following fees and expected returns Investment E(Return) Years Held Mutual Fund 7% 0.50% 7 years a) b) c) d) e) 4.95% 5.0% 5.85% 2.5% 6.55% Load 12b-1 fee 4%

CHAPTER 24 ANSWERS TO PROBLEMS


1 Original number of shares = $100,000/$10 = 10,000 W X Y Z TOTAL Shares Price 2500 $11 2100 14 2700 23 1900 15 MV $27,500 $29,400 $62,100 $28,500 $147,500

NAV = 2

$147,500/10,000 = $14.75

Offering price = NAV + NAV x Load percentage = $25.25 + 25.25(0.06) = $26.77

Original number of shares = $300,000 $30 = 10,000 Stock A B C D Shares 1800 2200 2300 1900 Price Market Price 15 27,000 11 24,200 9 20,700 18 34,200 Total = 106,100

NAV = $106,100 10,000 = $10.61 4 Original number of shares = $500,000 $50 = 10,000 Stock AA BB CC Shares 2900 3100 3200 Price Market Price 15 43,500 14 43,400 12 38,400 Total = 125,300

NAV = $125,300 10,000 = $12.53

Load Fund: $1,000 (1.00 - 0.02) (1.14) = $1117.20 No-Load Fund: $1,000 (1.09)(1.00 - 0.005) = $1084.55 The difference is 1117.20 - 1084.55 = $32.65 Load fund is better.

Load Fund: $1,000 (1.00 - 0.02) (1.11) = $1087.80 No-Load Fund: $1,000 (1.07)(1.00 - 0.005) = $1064.65 The difference is $1087.80 - $1064.65= $23.15 Load fund is better.

Load Fund

$15,000 (1.00 - 0.05) (1.12) = $15960

No-Load Fund $15,000 (1.10) (1.00 - .005) = $16417.50 The difference is $16417.50 - $15960 = $457.50 No-Load fund is better. 8 Load Fund $10,000 (1.00 - 0.03) (1.12) = $10864

No-Load Fund $10,000 (1.10) = $11000 The difference is $11000 - $10864 = $136 No-Load fund is better. 9 Load Fund $5,000 (1.00 - 0.08) (1.12) = $6048.00

No-Load Fund $5,000 (1.10) (1.00 - .005) = $5472.50 The difference is $6048.00 - $5472.50 = $575.50 Load fund is better. 10 11 12 Dollar value = $10,000 (1.13)(1.11)(1.08)(1.00 - 0.02) = $13275.51 Dollar value = $50,000 (1.146)(0.936)(1.152)(1.00 - 0.05) = $58695.74 Dollar value = $100,000 (0.854)(0.936)(1.35)(1.00 - 0.05) = $102515.90

13 14 15 16 17 18

Dollar value = $10,000 (1.25)(1.35)(0.5)(1.00 - 0.06) = $7931.25 Dollar value = $10,000 (1.136)(1.122)(1.083)(1.00 - 0.05) = $13,113.64 Dollar value = $10,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $12,892.50 Dollar value = $50,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $64,462.51 Dollar value = $100,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $128,925.02 Original # of shares = 250,000 25 = 10,000 NAV = 389,000 10,000 = $38.91 Original # of shares = 500,000 25 = 20,000 NAV = 575,100 20,000 = $28.76 Original # of shares = 800,000 25 = 32,000 NAV = 867,600 32,000 = $27.11 $1000(1 - 0.025)(1 + .10)5(1 - 0.0025)5 = $1,550.77 $1000(1 + 0.08)5(1 - 0.005)5(1 - .03) = $1,389.95 $1(1 0.04)(1 + 0.07)7(1 - 0.005)7 = $1.4884 Annual return = 1.48841/7 1 = 0.05845 = 5.85%

19

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