Derivatives and Risk Management Flashcards
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Read the first 6 Derivatives and Risk Management flashcards as text
An investor purchases a call option on XYZ stock with a strike price of $50 for a premium of $3 per share. At the time of expiry, XYZ stock is trading at $58. What is the intrinsic value of the option per share?
Answer: $8
The intrinsic value of a call option is the amount by which the underlying stock's price is above the strike price. It is calculated as: Market Price - Strike Price. In this case, $58 - $50 = $8. The premium paid ($3) is not part of the intrinsic value calculation, but it does affect the overall profit/loss of the position.
Which of the following BEST describes a key difference between a forward contract and a futures contract?
Answer: Futures contracts have standardized terms and are traded on an exchange, minimizing counterparty risk.
Futures contracts are standardized in terms of quantity, quality, and delivery date, and are traded on formal exchanges with a clearinghouse that guarantees performance, thus minimizing counterparty (default) risk. In contrast, forward contracts are customized, private agreements traded over-the-counter (OTC), which exposes the parties to higher counterparty risk.
A portfolio manager is concerned about rising interest rates negatively impacting the value of a fixed-rate bond portfolio. To hedge this risk, the manager could enter into an interest rate swap. Which position should the manager take in the swap?
Answer: Pay a fixed rate and receive a floating rate.
To hedge against rising interest rates on a fixed-rate asset portfolio, the manager wants to convert the fixed-rate cash flows into floating-rate ones. By entering a swap where they pay a fixed rate and receive a floating rate, the floating payments received will increase as interest rates rise, offsetting the decline in the value of the fixed-rate bonds.
An investor who is bullish on a stock believes its price will rise significantly. Which of the following option strategies offers limited risk and unlimited potential profit?
Answer: Buying a call option
Buying a call option gives the investor the right, but not the obligation, to buy the stock at a predetermined price. If the stock price rises, the potential profit is theoretically unlimited. If the stock price falls, the maximum loss is limited to the premium paid for the option.
Which of the following scenarios describes the primary motivation for a speculator using derivatives?
Answer: An investor buying S&P/TSX 60 Index futures because they believe the overall market is undervalued and will rise.
Speculation involves using derivatives to profit from an anticipated change in the price of an underlying asset, without having a direct offsetting business risk to hedge. Buying index futures based on a belief that the market will rise is a clear example of speculation. The other options describe hedging, which is the practice of using derivatives to reduce or eliminate an existing risk.
The premium of an option is composed of its intrinsic value and its time value. If a put option is 'at-the-money,' what constitutes its entire premium?
Answer: Time value only
An option is 'at-the-money' when its strike price is equal to the current market price of the underlying asset. In this case, the intrinsic value (the value if exercised immediately) is zero. Therefore, the entire premium of an at-the-money option consists of its time value, which reflects the possibility that the option will become in-the-money before it expires.