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# Derivatives Markets, 3e (McDonald) Chapter 3 Insurance, Collars, and Other Strategies 3.

1 Multiple Choice 1) A strategy consists of buying a market index product at \$83 and longing a put on the index !ith a strike of \$83 . "f the put premium is \$18. and interest rates are .#\$ per month% !hat is the profit or loss at expiration &in ' months) if the market index is \$81 ( A) \$) . gain *) \$18.'# gain C) \$3'.)+ loss D) \$43.76 loss Ans!er, )) A strategy consists of buying a market index product at \$83 and longing a put on the index !ith a strike of \$83 . "f the put premium is \$18. and interest rates are .#\$ per month% compute the profit or loss from the long index position by itself expiration &in ' months) if the market index is \$81 . ) \$4!."# loss *) \$)1.)) loss C) \$18. gain -) \$)..)# gain Ans!er, A 3) A strategy consists of buying a market index product at \$83 and longing a put on the index !ith a strike of \$83 . "f the put premium is \$18. and interest rates are .#\$ per month% compute the profit or loss from the long put position by itself &in ' months) if the market index is \$81 . A) \$3..# gain \$) \$#.4! gain C) \$).8 loss -) \$1.3' loss Ans!er, * 4) strateg% consists o& 'u%ing a (ar)et inde* product at \$+3, and longing a put on the inde* -ith a stri)e o& \$+3,. I& the put pre(iu( is \$#+.,, and interest rates are ,.!. per (onth, -hat is the esti(ated price o& a call option -ith an e*ercise price o& \$+3,/ ) \$4".47 \$) \$4!."6 C) \$47.67 D) \$40.!! ns-er1 &83 /18)01. #1'283 r3i chia cho 1. #1'

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#) A strategy consists of longing a put on the market index !ith a strike of 83 and shorting a call option on the market index !ith a strike price of 83 . 7he put premium is \$18. and the call premium is \$... . "nterest rates are .#\$ per month. -etermine the net profit or loss if the index price at expiration is \$83 &in ' months). A) \$ *) \$)3.'8 loss C) \$"6.70 gain -) \$)8.# gain Ans!er, C 6) strateg% consists o& longing a put on the (ar)et inde* -ith a stri)e o& +3, and shorting a call option on the (ar)et inde* -ith a stri)e price o& +3,. 2he put pre(iu( is \$#+.,, and the call pre(iu( is \$44.,,. Interest rates are ,.!. per (onth. 3hat is the 'rea)e4en price o& the (ar)et inde* &or this strateg% at e*piration (in 6 (onths)/ ) \$+,".#" \$) \$+3,.,, C) \$+!!."# D) \$+66.3" ns-er1 C sai 56p 6n +!6.70 8) At the '2month point% !hat is the breake9en index price for a strategy of longing the market index at a price of 83 ( "nterest rates are .#\$ per month. A) \$8 ).1) *) \$83 . C) \$+!!."# -) \$8''.3) Ans!er, C 8) 7he \$8# strike put premium is \$)#..# and the \$8# strike call is selling for \$3 .#1. Calculate the breake9en index price for a strategy employing a short call and long put that expires in ' months. "nterest rates are .#\$ per month. A) \$8)).'8 *) \$8)..8+ C) \$83 .8' -) \$88#.8) Ans!er, * +) :hat is the maximum profit that an in9estor can obtain from a strategy employing a long 83 call and a short 8# call o9er ' months( "nterest rates are .#\$ per month. A) \$'.8 *) \$8.'8 C) \$+.). -) \$1).3) Ans!er, *

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1 ) :hat is the maximum loss that an in9estor can obtain o9er ' months from a strategy employing a long 83 call and a short 8# call( "nterest rates are .#\$ per month. A) \$'.8 *) \$8.'8 C) \$+.). -) \$1).3) Ans!er, 11) :hat is the breake9en point that an in9estor can obtain from a '2month strategy employing a long 83 call and a short 8# call( "nterest rates are .#\$ per month. A) \$83).8) *) \$8.).3) C) \$8#).)) -) \$8').+) Ans!er, * 1)) 7he o!ner of a house !orth \$18 % purchases an insurance policy at the beginning of the year for a price of \$1% . 7he deductible on the policy is \$#% . "f after ' months the homeo!ner experiences a casualty loss 9alued at \$.#% % !hat is the homeo!ner;s net gain<loss( Assume an opportunity cost of capital of .. \$ annually. A) \$ *) \$1% C) \$#% -) \$'% ) Ans!er, 13) =sing option strategy concepts% !hat is the 9alue of an insured home% if the 9alue of the uninsured home is \$)) % % the house !as purchased for \$18 % and the house has a casualty policy costing \$# !ith a \$)% deductible( "gnore interest costs. A) \$18 % *) \$)18%# C) \$)) % -) \$)))%# Ans!er, * 1.) An in9estor purchases a call option !ith an exercise price of \$## for \$).' . 7he same in9estor sells a call on the same security !ith an exercise price of \$' for \$1.. . At expiration% 3 months later% the stock price is \$#'.8#. All other things being e>ual and gi9en an annual interest rate of .. \$% !hat is the net profit or loss to the in9estor( A) \$1.)1 loss *) \$1.# loss C) \$ .#. gain -) \$1.'# gain Ans!er, C

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3.) ?hort Ans!er 6ssay @uestions 1) 6xplain ho! a long stock and long put strategy e>uals the cash flo! from a long call strategy. Ans!er, 7he net effect of the long put and long stock creates a cash flo! identical to the long call% pro9ided you include the cost of funds. )) :hy might the manager of a portfolio employ a protecti9e put strategy( Ans!er, "f the manager desires to protect against a price decline% but is restricted from selling assets% a long put creates a floor belo! !hich losses cannot occur. 3) :hat is the difference bet!een naked and co9ered call !riting( Ans!er, A co9ered position is one in !hich the indi9idual also o!ns the underlying asset in addition to the short call. A naked position in9ol9es !riting the call alone. .) :hat are the similarities and differences bet!een bear and bull spreads( Ans!er, *oth ha9e floors and ceilings. 7he bear position has a ceiling !here prices are falling and a floor !here prices rise. A bull spread has the opposite floor and ceiling. #) :hy is a straddle position considered a speculation on the asset;s 9olatility( Ans!er, 7he strategy loses money if prices stay constant% but benefits from large changes in prices% either up or do!n. 3.3 Class -iscussion @uestion 1) Compare the butterfly spread% bear spread% bull spread% co9ered call% straddle% and other strategies. "s any one strategy better than another( Are there trade2offs bet!een each that is almost perfect or do significant ad9antages exist from one strategy to another(