Options Markets Mechanics

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P1.T3. Financial Markets and Products
Chapter 12. Options Markets
Bionic Turtle FRM Practice Questions
By David Harper, CFA FRM CIPM

www.bionicturtle.com
Key Ideas According to David

INTEREST RATES ..................................................................................................................... 3
FUTURES/FORWARDS (COMMODITIES) ...................................................................................... 4
INTEREST RATE FUTURES ......................................................................................................... 5
SWAPS .................................................................................................................................... 5
OPTIONS AND OPTION TRADING STRATEGIES.............................................................................. 6

P1.T3.724. MECHANICS OF OPTIONS MARKETS ......................................................................... 8
P1.T3.606. MECHANICS OF OPTIONS: POSITIONS......................................................................12
P1.T3.607. MECHANICS OF OPTIONS: CONTRACT FEATURES .....................................................15
P1.T3.608. TRADING AND MARGIN REQUIREMENTS FOR EXCHANGE-TRADED OPTIONS ................17
2
Key Ideas According to David

Before 2020, these questions were covered by Hull, Options, Futures & Other Derivatives.
Although GARP has separated the chapters into different readings, we are retaining
these key ideas in each of the corresponding documents.
 Interest rates
 Futures/Forwards (Commodities)
 Interest rate futures
 Corporate Bonds
 Swaps
 Options and option trading strategies
Interest Rates
Three skills will put you in a good position: compound frequencies; present value (bond) pricing
based on discounted cash flow; and implied forward rates given spot rates:
1. You do need to be fluent with compound frequencies. Probably, like the last exam,
the default compound frequency will be annual. However, you still need to be ready to
convert. If a rate is 8.0% per annum with annual compounding, you should easily be able
to convert to its semi-annual and continuous equivalents.
2. Probably the most basic pricing skill is “vanilla” bond pricing; by vanilla, I refer to a basic
coupon-bearing or zero-coupon bond. For example, given a zero rate curve (5% @ 0.5
years, 5.8% at 1.0 year, 6.4% at 1.5 years, and 6.8% at 2.0 years, each continuously
compounding), what is the price of a two-year $100 face bond that pays a semi-annual
coupon at a coupon rate of 6.0%. You should be able to do this.
3. GARP likes to test the implied forward rate given the spot rate curve. You can
almost expect to be asked. For example, if the 2-year spot rate is 1.2% and the 3-year
spot rate is 1.4%, you should be able to infer the one-year forward rate, f(2,3), under
continuous, annual and/or semi-annual compound frequencies.
 Please note that GARP like a price-based variation on the implied forward rate,
which I reviewed here at http://www.bionicturtle.com/forum/threads/shortcut-to-
forward-rates-if-you-have-bond-prices.4927/
3
Futures/Forwards (Commodities)
This is a potentially deep topic. But I think your focus should be on the following:
 Cost of carry; i.e., be facile with computing the implied model forward price. But
please do not only practice solving for F(0). You must be sufficiently comfortable
such that you can, for example, extract the convenience yield if given F(0).
 The minimum variance hedge ratio is extremely likely to be tested; I included two
examples in the FR, given it appears every year
 Please practice the optimal hedge (minimum variance) with both commodities and
equity portfolios (hedged with index futures)
 I think margin accounts are testable (initial and maintenance margins for the futures
positions that are used to hedge)
 With respect to futures contract sizes, I think you should know that T-bond futures
are standardized at $100,000; Eurodollars at $1,000,000; and S&P 500 at a 250
multiple (*250). They are likely to be provided, but are common enough that it helps
to just know them. More detail here at
http://www.bionicturtle.com/forum/threads/futures-contract-sizes.4959/
 Be comfortable with contango/backwardation (observed) and normal
contango/backwardation (unobserved)
Do you need to memorize the size of commodity contracts?

Probably an exam question will provide you with contract size, rather than assume you know.
Although, I do think it is good practice to know the following due to their exam popularity:
 Treasury bonds: $100,000 (GARP may assume you know)
 S&P 500: $250 * index futures price (popularly used for questions)
 Eurodollar: $1,000,000
And the following are not uncommon:

 Gold: 100 troy ounces (I agree with you)
 NASDAQ 100: $100 * index futures price
 S&P & NASDAQ MINI contracts: one-fifth (1/5th); i.e., $50* and $20*
 Crude oil: 1,000 barrels
 Silver: 5,000 ounces (maybe, do most people know this? I don't think so....)
 Corn (= wheat): 5,000 bushels (popular in quizzes)
 Copper: 25,000 pounds
Where can you find these? http://www.cmegroup.com/ e.g.,

http://www.cmegroup.com/trading/metals/base/copper_contract_specifications.html
4
Interest rate futures

I think you should focus on:
 Day count conventions

 Understanding the mechanics of the Eurodollar futures contract and Treasury bond
futures contracts
 GARP likes to test cheapest-to-deliver (CTD); i.e., given three or four eligible bonds,
identify the CTD
 Definitely be ready to compute the number of interest rate futures contracts used to
duration hedge a fixed-income position. If you are given two durations, you do NOT want
to hedge with the current durations, but RATHER the expected forward durations at
maturity.
Swaps
I think the assignment (Hull) divides into three: comparative advantage; swap mechanics; and
swap valuation. We have several practice questions on comparative advantage (it reduces to
the observation that the total net gain equals the difference between fixed and floating rate
differentials), but historically this tricky idea has barely been tested to my knowledge. You
clearly need to be comfortable with swap mechanics so you can answer a very basic, non-
quantitative question like one I included in the Focus Review (FR):
GARP 2010.P1.12. The yield curve is upward sloping, and a portfolio manager has a long
position in 10-year Treasury Notes funded through overnight repurchase agreements. The risk
manager is concerned with the risk that market rates may increase further and reduce the
market value of the position. What hedge could be put on to reduce the position’s exposure to
rising rates?
a) Enter into a 10-year pay fixed and receive floating interest rate swap.
b) Enter into a 10-year receive fixed and pay floating interest rate swap.
c) Establish a long position in 10-year Treasury Note futures.
d) Buy a call option on 10-year Treasury Note futures.
5
Some key (exam) points to keep in mind with respect to swap mechanics:
 The vanilla interest rate swap (IRS) references notional; i.e., the notional is not
exchanged (But the principal is exchanged in a currency swap, hence the maximum
potential future [credit] exposure of a currency swap occurs at maturity)
 By default, the floating rate is determined at the beginning of each period and paid at the
end; e.g., the first fixed-rate settlement is known at swap inception
 The duration of a swap position can be inferred from its valuation treatment as consisting
of two bond legs: just as value[swap, POV of fixed-rate receiver, floating-rate payer] =
value[fixed-rate bond] - value[floating-rate bond], the duration of the IRS from the
perspective of the fixed-rate receiver (who is effectively long the fixed-rate bond-
equivalent and short the floater) is approximately equal to the duration of the fixed-rate
bond-equivalent. For example, the (modified) duration of a swap with a 3-year tenor,
from the perspective of a 4.0% fixed rate payer is about 2.8 years at settlement because
the duration equals 2.8 years (i.e., fixed rate bond) minus about zero (duration of
floating-rate bond is time-to-next-coupon).
In regard to swap valuation, you must practice a few. You'll quickly see that it's just like pricing a
bond but with a tiny additional step, where the key insight is that the floating-rate bond-
equivalent, for valuation purposes, only requires a single cash flow due to the elegant fact that it
prices exactly at par at the next settlement. In the FR, I included the classic sort of swap
valuation that you could see on the exam:
GARP 2011.P1.E1.10. A bank had entered into a 3-year interest rate swap for a notional
amount of USD 300 million, paying a fixed rate of 7.5% per year and receiving LIBOR annually.
Just after the payment was made at the end of the first year, the continuously compounded 1-
year and 2-year annualized LIBOR rates were 7% per year and 8% per year, respectively. The
value of the swap at that time was closest to which of the following choices?
Options and option trading strategies

In collecting the three-year sample of exam-type questions, I was surprised at the high
prevalence of put-call parity in the FRM. Historically, put-call parity questions are very common.
(Please note this is a T3 summary and does not include discussion of option pricing models,
OPM, which are T4 topics). It is essential that you memorize, and are utterly comfortable with,
the put-call parity formula; for example, can you, without any reference, quickly produce the
formula's equivalent of a covered call or protective put?
After you have mastered the usage of the put-call parity, c + K*exp(-rT) = p + S, you might take
a look at my method for dealing with an arbitrage exploitation question, see
http://www.bionicturtle.com/forum/threads/how-to-work-put-call-parity-arbitrage-problems.6167/
Finally, I would be familiar with Hull's rules about the optimality of early exercise under the four
permutations of call/put and European/American.
6
Option Trading Strategies
In my opinion, the section (a single Hull chapter) requires some of your time, if you want to be
fully ready. So far, it's always been included in the exam. And, as i mentioned in the FR audio,
to illustrate how we lack a shortcut here, last year GARP asked a question about box spreads,
which totally surprised me as it's a really minor strategy. With respect to mechanics, Hull parses
them into:
 Asset + option; e.g., protective put, covered call

 Spread strategies
 Combinations
While that is a fine way to grasp them, you are unlikely to encounter an exam question along
these lines. Rather, you want to focus on applications and risk/reward perspective, with
particular emphasis on upside/downside potential. For example,
 Which of the strategies are long volatility?

 Which of the strategies are directional;
i.e., benefit from an increase/decrease in asset price?
 Which have capped or uncapped payouts?
 Which produce an initial cash inflow?
7

P1.T3.724. Mechanics of options markets
P1.T3.606. Mechanics of options: positions
P1.T3.607. Mechanics of options: contract features
P1.T3.608. Trading and margin requirements for exchange-traded options
P1.T3.724. Mechanics of options markets

Learning objectives: Describe the types, position variations, and typical underlying
assets of options. Explain the specification of exchange-traded stock option contracts,
including that of nonstandard products. Describe how trading, commissions, margin
requirements, and exercise typically work for exchange-traded options.
724.1. A stock with a volatility of 31.0% is currently trading at $47.00 while the risk-free rate is
3.0%. An investor purchases a European straddle with a strike price of $45.00: a straddle is a
call and a put on the same stock with identical strike prices and expiration dates. The straddle
expires in nine months (0.75 years). The price of the put is $3.50. Among the following choices,
which best summarizes the final stock price required (in nine months, at expiration) in order for
the trader to realize at least a positive net PROFIT on this trade?
Stock to stay inside the interval {$35.00 to $55.00}; i.e., both above $35.00 and below
$55.00
Stock to stay inside the interval {$37.00 to $57.00}; i.e., both above $37.00 and below
$57.00
Stock to fall outside the interval {$35.00 to $55.00}; i.e., either below $35.00 or above
$55.00
Stock to fall outside the interval {$40.00 to $54.00}; i.e., either below $40.00 or above
$54.00
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724.2. Last week, Peter purchased one contract for 100 call options on StrongDrill Corporation
(ticker: SDC) with a strike price of $15.00. The options on SDC are exchange-traded. Today the
stock price is $18.00 so Peter's options are "in the money." Consider the impact of the following
four corporate actions if they were immediately affected, when the stock price is $18.00:
I. 2-for-1 split
II. 20.0% stock dividend
III. 1-for-5 reverse split
IV. 12.0% one-time cash dividend
Each of the following statements is true EXCEPT which is false?
The (II.) stock dividend will have no impact on the strike price or quantity of Peter's
option position
Peter's intrinsic value in his option position is $300.00 and it will be unchanged by any of
the four scenarios
Among the four corporate actions, the highest adjusted strike price will be realized by
(III.) the 1-for-5 reverse split
Among the four corporate actions, this greatest adjusted number of options will be
realized by (I.) the 2-for-1 split
724.3. Assume a European call option has an exercise (aka, strike) price, K = $95.00, and a
time to expiration of one year. The risk-free rate is 3.0% per annum. The current stock price,
S(0) = $110.00 and the stock pays a 3.0% dividend (the dividend happens to equal to the risk-
free rate!) and this dividend has an equivalent lump sum present value (PV) over the life of the
option equal to $3.35. Consider the following statements about this call option:
I. If the option's value is $20.52, then it's time value is about $5.52
II. If the stock does NOT pay any dividends, the minimum value (lower bound) of this European
option would be about $17.81
III. If the stock pays a 3.0% dividend with a discounted present value (over the life of the option)
equal to $3.35, then the minimum value of this European option is below its intrinsic value
IV. If this were instead an American option, and if the stock pays a dividend, then it might be
optimal to exercise early
Which of the above statements is (are) TRUE?
None are true

Only I. is true
Only II. and IV. are true
All are true
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Answers:
724.1. C. True: Stock to fall outside the interval {$35.00 to $55.00}; i.e., either below
$35.00 or above $55.00. Per put-call parity, the price of call must be c = S + p - K*exp(-rT) =
47.00 + 3.50 - 45*exp(-0.030*0.75) = $6.50. The total cost of the straddle $3.50 + 6.50 =
$10.00, so that the price must drop at least $10 below the strike (in which case, the long put is
profitable) or at least $10.00 above the strike (in which case, the long call is profitable). Here is
a net PROFIT diagram of this straddle purchase:
724.2. A. False. The 20% stock dividend is essentially the same as a 6-for-5 stock split
such that Peter's contract is changed to give him the right to buy (an adjusted number)
100*6/5 = 120 shares at an adjusted strike price of $15.00 * 5/6 = $12.500.
In regard to (B), (C) and (D) each is TRUE.

 In regard to true (B), intrinsic value is preserved under any adjustment scenario.
 In regard to true (C), the 1-for-5 reverse split changes Peter's contract to give him the
buy 100*1/5 = 20 shares at an adjusted strike price of $15.00 * 5/1 = $75.00. Note that
we expect the stock price to increase to $18 * 5 = $90.00 such that Peter's total intrinsic
value is unchanged at ($90.00 - $75.00) * 20 shares = $300.00
 In regard to true (D), the 2-for-1 split changes Peter's contract to give him the buy
100*2/1 = 200 shares at an adjusted strike price of $15.00 * 1/2 = $7.50. Note that we
expect the stock price to drop to $18 * 1/2 = $9.00 such that Peter's total intrinsic value
is unchanged at ($9.00 - $7.50) * 200 shares = $300.00
10
724.3. D. All are true.

 In regard to true (A), time value equals option value minus intrinsic value; in this case,
time value = $20.52 - ($110.00 - 90.00) = $5.52
 In regard to true (B), minimum value = S(0) - K*exp(-rT) = $110.00 - 95.00*exp(-
3.0%*1) = $17.81
 In regard to true (C), minimum value with dividend = S(0) - K*exp(-rT) - D = $110.00 -
95.00*exp(-3.0%*1) - 3.35 = $14.46, which is below $15.00!
 In regard to true (D), while it is never optimal to early exercise an American call option
on a non-dividend-paying stock, it MIGHT be optimal to early exercise if the dividend is
high. Basically, if the dividend earned is greater than interest saved on deferring the
strike, then it is optimal. For example, if we assume the 3.0% dividend yield assumption
in choice (C), then the dividend's present value of $3.35 is greater than the value of
deferring which is given by K - K*exp(-rt) = $2.81. In this case, it would be optimal to
early exercise and the (conditional) minimum value on such an American option is
$15.00 + 3.35 = $18.35.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-724-mechanics-of-

options-markets-hull-chapter-10.10679/
11
P1.T3.606. Mechanics of options: positions

Learning Objectives: Describe the types, position variations, and typical underlying
assets of options.
606.1. Illustrated below is the profit (not payoff) diagram for a bull spread EXCEPT one of the
two option positions is missing:
The long call, which is plotted with a dashed blue line, has a premium of $4.00 and a strike price
of $40.00; i.e., c = $4.00 and K = $40.00. The bull spread profit is simply a plot of the
combination of the displayed long call and the un-displayed option. Which option is not plotted;
ie, which option must contribute to the bull spread profit yet is NOT displayed in the graph?
Long call with a $1.25 premium and strike of $39.00; i.e., c = 1.25, K=39.00
Short call with a $2.65 premium and strike of $43.00; ie, p = 2.65, K=43.00
606.2. A trader buys a call option with a strike price of $33.00 and a put option with a strike price
of $28.00. Both options have the same maturity. The call costs $2.65 and the put costs $1.85.
At what stock prices does the trader break even on profit? Please note: profit = payoff minus the
initial cost without regard to the time value of money. [this is a variation on Hull 10.12]
a) $25.00
b) $39.00
c) $23.50 or $37.50
d) $21.75 or $39.00
606.3. While the stock price is $25.00, a trader buys three at-the-money (ATM) options: two
calls and one put. The calls cost $3.40 and the put costs $2.30. The trader defines return on
investment (ROI) as profit divided by initial cost without regard to the time value of money. The
trader is aiming for an ROI of 30.0%. At what stock price(s) is the trade's ROI equal to 30.0%?
a) $38.00
b) $19.23 or $36.51
c) $13.17 or $30.92
d) This trade cannot achieve an ROI of 30.0%
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Answers:
606.1. B. Short call with a $2.65 premium and strike of $43.00; i.e., p = 2.65, K=43.00
606.2. C. $23.50 or $37.50. This is a strangle and the initial cost = $2.65 + $1.85 = $4.50.
Break-even is achieved if the profit on the call is $4.50 (i.e., $37.50 - 33.00 = 4.50) or if the profit
on the put is $4.50 (i.e., $28.00 - 23.50 = 4.50).
13
606.3. C. $13.17 or $30.92
The initial cost of this trade (which is a "strap") = ($3.40*2) + $2.30 = $9.10. To achieve a 30%
ROI, we must have 30% = profit/$9.10, such that profit = $9.10*0.30 = $2.73. Therefore, the
payoff = $2.73 + 9.10 = $11.830; i.e., $11.830/$9.10 - 1 = 30.0%. On the downside, this is
reached at $25.00 - $11.83 = $13.70; on the upside, this is reached at $25.00 + $11.83/2 =
$30.92.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-606-mechanics-of-

options-positions-hull.9332/
14
P1.T3.607. Mechanics of options: contract features

Learning Objectives: Explain the specification of exchange-traded stock option
contracts, including that of nonstandard products.
607.1. Hull explains that stock options in the United States trade on one of three cycles: the
January, February or March cycle. Specifically, "The January cycle consists of the months of
January, April, July, and October. The February cycle consists of the months of February, May,
August, and November. The March cycle consists of the months of March, June, September,
and December." (Hull 10.4 Specifications of Stock Options)
Assume the stock options on XYZ Corp are on a March cycle and today is August 3rd. The
options of XYZ Corp will trade today with expiration dates in which of the following months?
September, December, March and June
August, September, October, and November
August, September, October, and December
August, September, December, and March
607.2. Robert purchases an equity option on a major trading exchange when the underlying
share price is $96.00. Each of the following specifications is a plausible entry in the option
contract EXCEPT which is not a contract specification or element?
a) Strike prices of $90.00, $95.00 or $100.00
b) Underlying: 100 shares of the equity security
c) Implied volatility: limited to 25.00% or the average of last twenty trading days
d) Exercise style: American; may be exercised on any business day up to and including on
the expiration date
607.3. In regard to option mechanics, each of the following is true EXCEPT which is not?
a) A margin account is required when clients write (i.e., sell) options but not when the buy
options
b) An American option is always worth at least as much as a European option on the same
asset with the same strike price and exercise date.
c) To hedge foreign exchange risk, a long binary option on the currency provides insurance
that is identical to a short foreign exchange futures contract
d) While the exercise of an exchange-traded option typically does not cause dilution of the
underlying company's equity, exercise of an employee stock option (ESO) typically does
cause dilution
15
Answers:
607.1. D. August, September, December, and March
There are three cycles: Jan, Feb, March. This question asks about an option on a March cycle;
the March cycle = Mar, Jun, Sep, Dec. [information that's included in the question]. Given that
the expiration date is the third Friday of the expiration month, as of August 3rd (aka, the
beginning of the month), the option (on a March cycle) trades with expiration dates (i) in the
current month, (ii) the following month, (iii) and the next two months the cycle. So that's August
(ie, current), September (following), December (next in cycle), and March (next-next in cycle).
607.2. C. False: option contract will NOT specify price, valuation (e.g., moneyness) or
market-derived variables such as implied volatility. Implied volatility requires an option
priced model (i.e., Black-Scholes) and a traded option price as an "input" into the model.
In regard to (A), (B) and (D), each is a typical specification or element. Here is an example from
CBOE: http://www.cboe.com/products/equityoptionspecs.aspx
607.3. C. False. A futures (forward) contract provide more complete insurance than an
option, but the hedged outcome can be significantly worse that the un-hedged outcome;
also, an option requires an up-front premium. A binary option provides a fixed payoff is the
strike price is reached, so this answer is doubly false.
In regard to (A), (B) and (D), each is TRUE. In regard to true (A): A margin account is required
when clients write (ie, sell) options but not when they buy options. The purchase of an option
does not create a potential future obligation.
In regard to true (B): An American option is always worth at least as much as a European option
on the same asset with the same strike price and exercise date. This is a true statement
because the American style option gives you everything you get in the equivalent European
(i.e., the option to exercise at maturity) plus you get an early exercise option, so it must be worth
more. We can think of an American option as its European equivalent plus an embedded option
to exercise early, such that its value is greater by the value of this embedded option.
In regard to false (C): A binary option is discontinuous (it pays something or nothing), so does
not match the hedge efficacy of a futures contract (with payoff that it more continuous) but, even
if we ignore this fact, there is the essential difference in insurance terms between an option and
a futures contract: the option requires an up-front premium which may be lost, but that is the
capped profit downside, compared to a futures contract that does not require an up-front
premium, yet has a symmetrical payoff with the possibility of a significant downside loss.
In regard to true (D): An exchange-traded option is a derivative contract. The counterparties and
the exchange can reference the underlying stock involving the reference company. On the other
hand, an ESO is granted by the company and its exercise is dilutive (e.g., a key motivation of
high-tech company buybacks is to mitigate/offset the dilution created by ESO grants).
Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-607-mechanics-of-

options-contract-features-hull.9346/
16
P1.T3.608. Trading and margin requirements for exchange-traded

options
Learning Objectives: Describe how trading, commissions, margin requirements, and
exercise typically work for exchange-traded options.
608.1. A trader has a put option contract to sell 100 shares of a stock for a strike price of
$50.00. Each of the following is true EXCEPT which is not? (note: this question is based
on Hull's Problem 10.24)
If there is a 4-for-1 stock split, the option contract becomes one to sell 400 shares with
an exercise price of $12.50
If there is an 10.0% stock dividend, the option contract becomes one to sell 90.0 shares
with an exercise price of $55.56
If there is $2.00 cash dividend declared, there is no effect on the contract
If there is a reverse 1-for-5 stock split, the option contract becomes one to sell 20 shares
with an exercise price of $250.00
608.2. Hull explains the following margin requirements for a short position in naked options:
"Writing Naked Options

A naked option is an option that is not combined with an offsetting position in the underlying
stock. The initial and maintenance margin required by the CBOE for a written naked call option
is the greater of the following two calculations:
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less
the amount, if any, by which the option is out of the money
2. A total of 100% of the option proceeds plus 10% of the underlying share price
For a written naked put option, it is the greater of
1. A total of 100% of the proceeds of the sale plus 20% of the underlying share price less
the amount, if any, by which the option is out of the money
2. A total of 100% of the option proceeds plus 10% of the exercise price.
The 20% in the preceding calculations is replaced by 15% for options on a broadly based stock
index because a stock index is usually less volatile than the price of an individual stock."
Question: A trader writes ten (10) naked put option contracts, with each contract being on 100
shares. The strike price is $50.00 and the stock price is currently $55.00. The option price is
$3.40. The time to maturity is six months and the implied volatility is 40.0%. What is the margin
requirement?
a) $3,400
b) $5,500
c) $7,300
d) $9,400
17
608.3. In regard to option markets, with which of the following statements would John Hull
most DISAGREE?
a) If an investor sells a stock at a loss then buys a call option within 30 days, the "wash
sale rule" disallows the loss as a tax deduction
b) Convertible bonds (aka, convertibles) are bonds issued by a company that can be
converted into equity at certain times using a predetermined exchange ratio.; therefore,
they are therefore bonds with an embedded call option on the company’s stock.
c) Because vanilla executive stock options (i.e., ESOs with a fixed strike price) profit when
the company's stock increases, ESOs are an optimal tool for aligning a public company's
executive compensation with its shareholders, and for rewarding performance relative to
industry peers
d) Warrants are options issued by a financial institution or nonfinancial corporation. A
common use of warrants by a nonfinancial corporation is at the time of a bond issue; the
corporation issues call warrants on its own stock and then attaches them to the bond
issue to make it more attractive to investors
18
Answers:
608.1. B. False. If there is a 10.0% stock dividend, the option contract becomes one to
sell 100*(1+10%) = 110 shares with an exercise price of $50/(1+10%) = $45.45
In regard to (A), (C) and (D), each is TRUE.

 In the case of true (A), if there is a 4-for-1 stock split, the contract becomes one to sell
4*100 = 400 shares with an exercise price of $50.00/4 = $12.50
 In the case of true (C), exchange-traded options are not usually adjusted for cash
dividends, although an exception is sometimes made for large cash dividends (typically
one that is more than 10% of the stock price)
 In the case of true (D), if there is a reverse 5-for-1 stock split, the contract becomes one
to sell 1/5*100 = 20 shares with an exercise price of $50/(1/5) = $250.
608.2. D. $9,400. The margin requirement is the greater of 1,000*($3.40 + 20%*$55.00 -

MAX[0, 55-50]) and 1,000*$3.40+10%*$50.00; i.e., the greater of $9,400 and $8,400 (time to
maturity and implied volatility are red herrings).
608.3. C. Vanilla ESOs are not well-aligned with relative performance. On the upside, they
can payout generously even if the company under-performs; on the downside, they do
not bear the risk of loss.
In regard to (A), (B) and (D), each is factually true.
Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-608-trading-and-

margin-requirements-for-exchange-traded-options-hull.9357/
19

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P1.T3. Financial Markets and Products

Chapter 12. Options Markets

Bionic Turtle FRM Practice Questions

By David Harper, CFA FRM CIPM

Key Ideas According to David

Chapter 12. Options Markets

Key Ideas According to David

Do you need to memorize the size of commodity contracts?

And the following are not uncommon:

Where can you find these? http://www.cmegroup.com/ e.g.,

Interest rate futures

 Day count conventions

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Option Trading Strategies

 Asset + option; e.g., protective put, covered call

 Which of the strategies are long volatility?

Chapter 12. Options Markets

P1.T3.724. Mechanics of options markets

Each of the following statements is true EXCEPT which is false?

Which of the above statements is (are) TRUE?

None are true

In regard to (B), (C) and (D) each is TRUE.

724.3. D. All are true.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-724-mechanics-of-

P1.T3.606. Mechanics of options: positions

606.3. C. $13.17 or $30.92

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-606-mechanics-of-

P1.T3.607. Mechanics of options: contract features

607.1. D. August, September, December, and March

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-607-mechanics-of-

P1.T3.608. Trading and margin requirements for exchange-traded

"Writing Naked Options

In regard to (A), (C) and (D), each is TRUE.

608.2. D. $9,400. The margin requirement is the greater of 1,000*($3.40 + 20%*$55.00 -

In regard to (A), (B) and (D), each is factually true.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-608-trading-and-

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608.2. D. $9,400. The margin requirement is the greater of 1,000($3.40 + 20%$55.00 -