Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz.com CFA Level III Item-set - Question Study Session 15 June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8851 Questions 1(8852) through 6(8857) relate to Reading 29 Martin Reed Case Scenario Martin Reed is a U.S portfolio manager working for a money management firm Reed owns a bond currently selling for $104.5 per $100 face value A call option on the bond is selling for $12.45 and has an exercise price of $112 A put option on the bond with an exercise of $96 has an option premium of $11.23 Reed is analyzing the consequences of adding either the call option or the put option to his long bond position For an opinion, Reed approached his colleague, Adam Hughes, who also works for the firm as a portfolio manager Hughes made the following comment: Statement 1: “If you add a short call to your bond position, you will limit your upside potential as compared to adding a long put to the bond position However, the former strategy will generate cash up front, whereas the latter will require the payment of cash.” Reed asked Hughes about the value of the position at expiration of the option if he decides to buy a put option on the bond he holds Hughes told him that if the price of the bond exceeds $96, the position will be worth only the value of the bond Reed said that if, however, the price exceeds $96 plus the option premium, the value of the position may be worth more Reed is also concerned with breaking even in case he buys the put He is not sure about the bond price at which he would breakeven Hughes told him that if he bought the put, the bond price will have to increase by almost 10.75% over the life of the option for him to breakeven However, if he sold the call, the breakeven price would equal $115.73 Reed knows that there are certain benefits to buying the put to complement his bond position While talking to Hughes about them, Reed made the following comment: “Buying the put will help provide a limit on the downside with no limit on the upside In my case, the lower limit will equal $19.73.” Reed then posed the following question to Hughes: Statement 2: “If I buy the put and the price of the bond falls to $93.27, what will the value and profit of my position be?” FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8852 With regards to statement 1, Hughes is most likely: A correct B incorrect with respect to the upside potential C incorrect with respect to the initial cash transaction FinQuiz Question ID: 8853 Are Hughes and Reed most likely accurate with respect to the value of the position at expiration of the put option? Hughes A Yes B No C Yes Reed No Yes Yes FinQuiz Question ID: 8854 Is Hughes most likely correct with respect to the breakeven price at expiration, in case of adding a long put or a short call to his long bond position? Long put A No B Yes C No Short Call Yes No No FinQuiz Question ID: 8855 Is Reed most likely accurate with respect to her comment about the benefit of buying a put? A Yes B No, because buying the put will also limit the upside because of the option premium C No, because the lower limit does not equal $19.73 FinQuiz Question ID: 8856 If Reed decides to add the long put to her bond portfolio, the maximum profit that he can earn from the position is closest to: A $115.73 B $93.27 C ∞ FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8857 What is the most appropriate response to statement 2? A The value will equal $93.27 and the profit will equal -$8.5 B The value will equal $96 and the profit will equal $2.73 C The value will equal $96 and the profit will equal -$19.73 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8867 Questions 7(8868) through 12(8873) relate to Reading 29 James Torres Case Scenario James Torres is a U.S portfolio manager who believes that the S&P 500 index would go up in the near future He therefore buys a call on the index with an exercise price of 2500 for $76.05 Torres plans to hold the option till expiration that is six months from now During a discussion with his friend, John Powell, Torres made the following comments about the call he had just purchased: Statement 1: “If the index value is greater than the exercise price, the value of the option will move up one-for one with the index value, but the profit will not.” Statement 2: “When graphed, the breakeven is the price of the index corresponding to the point where the profit line crosses the x-axis.” Statement 3: “The value of this call option at expiration will either be zero or the index value less the exercise price, whichever is greater.” FinQuiz Question ID: 8868 With regards to statement 1, Torres is most likely: A correct B incorrect, because the value of the option may not move one-for-one with the index value C incorrect, because both the value and profit will move up one-for-one with the index value FinQuiz Question ID: 8869 Torres is most accurate with respect to: A Statement only B Statement only C both statements and FinQuiz Question ID: 8870 The breakeven price of the underlying, at expiration of the call option, is closest to: A 2,576.05 B 2,423.95 C 2,500.00 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8871 10 If the price of the underlying at expiration is 2650, the value at expiration and profit for Torres will be closest to: A B C Value 150 2650 Profit –76.05 73.95 150 FinQuiz Question ID: 8872 11 The maximum profit and maximum loss to the seller of the call option is closest to: Maximum profit A ∞ B 76.05 C 2,576.05 Maximum loss 76.05 ∞ 2,423.95 FinQuiz Question ID: 8873 12 What will be the value and profit for the seller of the call option if the price of the underlying is 2010, and 2,550 respectively? Price= 2,010 A Value: 490, Profit: 566.05 B Value: -490, Profit: -413.95 C Value: 0, Profit = 76.05 Price= 2,550 Value: 0, Profit: 76.05 Value: 50, Profit: 126.05 Value:-50, Profit: 26.05 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8884 Questions 13(8885) through 18(8890) relate to Reading 29 Richard Watson Case Scenario Richard Watson, a portfolio manager, is writing a research report on the use of option strategies to alter the risk and return profile of a position In his report, he mentioned the concept of spreads and explained their construction He wrote the following statements: Statement 1: “Option spread strategies can be of two types In one strategy, an investor sells an option and buys another one that is identical to the first in all respects except time to expiration In the other strategy, the second option differs only with respect to the exercise price.” Statement 2: “One option strategy that attempts to gain from movements in the price of the underlying is a bull spread A bull spread has some similarities to another option strategy.” Candia Hamilton is Watson’s close friend and came to him for advice She expects the market to go up and wants to benefit from the increase using derivatives Watson told her that one way she could benefit from the increase in the market is to buy a call with a high exercise price and sell a call with a low exercise price Such a strategy would result in a profit if the value of the underlying increases Although Hamilton expects the overall market to go up, she believes the stock of RoadLand Enterprises, an automobile spare parts manufacturer, to go down Hamilton is not sure which strategy to use to benefit from this decrease in price so she asked Watson for an opinion She specifically mentioned that she does not want to spend any money for implementing the strategy Hamilton recently attended a seminar on money spread strategies by the CEO of a large investment bank in the U.S During his speech, the CEO made the following comments: Statement 3: “A bear put strategy and a bear call strategy have identical payoffs and investments, since they both benefit from a decrease in the price of the underlying, and have identical graphical depictions.” Statement 4: “Both a bull call spread and a bear put spread have limited gains and a limited loss potential.” FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8885 13 What are the option spread strategies, mentioned in statement 1? Former Strategy A Expiration Spread B Time Spread C Maturity Spread Latter Strategy Exercise Spread Money Spread Price Spread FinQuiz Question ID: 8886 14 The former strategy, mentioned by Watson in statement 1, most likely attempts to exploit: A differences in perceptions of volatility of the underlying B perceived mispricing of options with different maturities C time differences in different regions of the world FinQuiz Question ID: 8887 15 The option strategy Watson is most likely referring to in statement is a: A butterfly spread B straddle C covered call FinQuiz Question ID: 8888 16 Watson’s advice to Hamilton for benefiting from an increase in the market is most likely: A correct B incorrect, because Hamilton should buy a call with a low exercise price and sell one with a high exercise price C incorrect, because Hamilton should buy a put with a high exercise price and sell a put with a low exercise price FinQuiz Question ID: 8889 17 The most appropriate strategy for Hamilton to use for the stock of RoadLand Enterprises is a: A bear call spread B bear put spread C protective put FinQuiz Question ID: 8890 18 The CEO is most accurate with respect to: A Statement only B Statement only C both statements and FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8891 Questions 19(8892) through 24(8897) relate to Reading 29 Rosewood Case Scenario Rosewood Investment Company is an asset management firm in Texas Candice Price works as a portfolio manager at the firm and manages portfolios for many of the firm’s clients Price recently implemented a strategy for a client by buying a call on a stock currently selling for $50 She simultaneously sold a call on the same stock with the same time to expiration as the long call The long call has an exercise price of $55 with an option premium of $15 The short call has an exercise price of $65 with an option premium of $7 The options will expire in one month During a meeting with the client, Price made the following comments: Statement 1: “For a bear spread using puts, both puts need to have exercise prices lower than the current price of the underlying.” Statement 2: “For a bull spread using calls, both calls need to have exercise prices lower than the current price of the underlying.” One of Price’s clients has implemented a bear put spread When asked about the outcomes of the strategy, Price mentioned that such a strategy would earn a maximum profit if both puts expire in the money He also said that the breakeven price is such that leaves one put in the money and the other out of money FinQuiz Question ID: 8892 19 Price is most accurate with respect to: A statement only B statement only C neither statement nor statement FinQuiz Question ID: 8893 20 If at expiration of the calls the price of the underlying is $62, the profit to Price’s client will be closest to: A $7 B – $1 C $15 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8894 21 For the position Price took, the maximum profit and maximum loss is closest to: Maximum Profit A $2 B $8 C $28 Maximum Loss $8 – $2 $22 FinQuiz Question ID: 8895 22 For the position Price took, the breakeven stock price at expiration is closest to: A $47 B $77 C $63 FinQuiz Question ID: 8896 23 Is Price most likely accurate about the maximum profit and breakeven price of a bear put spread? A B C Maximum Profit Yes No Yes Breakeven Price No Yes Yes FinQuiz Question ID: 8897 24 Which of the following about option strategies is most accurate? A The payoff and profits for a bear call spread are the exact opposite of the payoff and profits for a bull call spread B The worst outcome for a bear put spread occurs when the stock price is less than the exercise price of the short put C The maximum a bull call spread can gain is the difference between the exercise prices of the short call and the long call FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8901 Questions 25(8902) through 30(8907) relate to Reading 29 Tactical Management Inc (TMI) Case Scenario Tactical Management Inc (TMI) is a firm that specializes in implementing option strategies to benefit from movements in asset prices Recently the firm transacted in two put options on a bond selling for $103 per $100 par One put has an exercise price of $95 and is selling for $12 The other put has an exercise price of $105 and is selling for $17 Both puts expire in three months Cindy Flores works at TMI and is going to hold a seminar to educate freshly graduated finance students about the concept and construction of option spread strategies Flores plans to make the following comments during her speech: Statement 1: “The maximum profit for both a bull call spread and a bear put spread is similar: the difference between the exercise prices of the options less the initial outlay.” Statement 2: “The breakeven price for the underlying in a bull call spread and a bear put spread is also similar: the lower exercise price plus the initial outlay.” FinQuiz Question ID: 8902 25 If TMI implemented a bear spread using the puts mentioned above, the value and profit, assuming the price of the bond is $92 at expiration, are closest to: A B C Value $5 $10 $20 Profit $0 $5 $15 FinQuiz Question ID: 8903 26 Using the scenario in Part 1, which of the following is most accurate? A The profit for the position will be the same for all prices of the bond above $105 B The profit for the position will be the same for all prices of the bond below $103 C The profit for the position will vary as the price of the underlying falls below the exercise price of the short put FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8904 27 If TMI implemented a bear spread using the puts, the breakeven price of the bond will be closest to: A $100 B $66 C $76 FinQuiz Question ID: 8905 28 If TMI implemented a bear spread using the puts, the maximum profit will most likely be: A only $2 greater than the maximum loss B only $12 greater than the maximum loss C equal to the maximum loss FinQuiz Question ID: 8906 29 Flores is least accurate with respect to: A Statement only B Statement only C neither Statement nor Statement FinQuiz Question ID: 8907 30 If TMI implemented a bear put spread, the profit, if the bond’s price stays within the exercise prices of the puts, will vary from: A –$5 to $5 B $0-to $10 C –$5 to $15 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 8908 Questions 31(8909) through 36(8914) relate to Reading 29 Patrick Payne Case Scenario Patrick Payne is using a bull call spread to benefit from an increase in the market The equity market index is currently at 1400 and Payne has bought a call with an exercise price of 1350 and sold a call with an exercise price of 1600 The long call is selling for $18 and the short call is selling for $13 Payne is not sure how much the market should move for him to break even Payne has been considering using a butterfly spread but is uncertain about its construction and outcomes To get an expert opinion, Payne visited Harry Palmer, a portfolio manager and a close friend Palmer told Payne that a butterfly spread is basically a combination of a bull spread and a bear spread He also told him that a butterfly spread with calls constitutes three different exercises prices, and most often the difference between two times the exercise price of the sold options and the sum of the other two exercise prices is zero Payne is not sure how much cash he would need to spend upfront to establish the butterfly spread When he asked Palmer, Palmer made the following comment: “The initial value of the butterfly spread is usually negative This means that there will most likely be a cash inflow at the initiation of the position.” While talking about the profit for a butterfly spread, Palmer made the following comment: “The maximum profit occurs if the price of the underlying is either greater than or less than the exercise price of the sold options.” Payne is going to use the following call options to construct the butterfly spread: Call with an exercise price of $20 selling for $8 Call with an exercise price of $25 selling for $5 Call with an exercise price of $30 selling for $3 FinQuiz Question ID: 8909 31 For Payne to breakeven in his bull call spread, the market must: A move down by 3.21% B move up by 3.57% C move down by 3.93% FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 8910 32 If instead of bull call spread, Payne had implemented a bear call spread, the maximum loss would have been closest to: A $5 B $245 C $255 FinQuiz Question ID: 8911 33 Is Palmer most likely correct with regards to the construction of a butterfly spread and the relationship between the exercise prices of the options? Construction A No B Yes C Yes Exercise prices No No Yes FinQuiz Question ID: 8912 34 Is Payne accurate with respect to his comments about the initial value and profit of a butterfly spread? Initial Value A Yes B Yes C No Maximum Profit No Yes No FinQuiz Question ID: 8913 35 If the price of the underlying is $22 at the expiration of the calls, the value and profit to the butterfly spread will be closest to: Value A $2 B $14 C $2 Profit $1 $11 $3 FinQuiz Question ID: 8914 36 The maximum loss and maximum profit to the butterfly spread implemented by Payne are closest to: Maximum Loss A $1 B $6 C $1 Maximum Profit $1 $4 $4 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 9013 Questions 37(9014) through 42(9019) relate to Reading 29 Russell Ford Case Scenario Russell Ford works at an investment management firm and has just bought a call and a put on a stock currently selling for $75 The call and put have an exercise price of $76 The call has a premium of $7.5 and the put has a premium of $5.8 Jessica Sullivan, a portfolio manager working at the same investment firm as Ford, has also purchased a call and a put on the stock During a discussion about the strategy, Ford made the following comments to Sullivan: Statement 1: “A strategy whose performance is based on similar expectations about the market is the short butterfly spread For the short butterfly spread, the gains are limited, whereas our strategy provides an unlimited upside potential But our strategy can be very costly.” Statement 2: “Just like a long butterfly spread which earns its maximum profit if the price of the underlying ends up precisely at the exercise price of the sold options, the maximum profit for our strategy would occur if the underlying ends up precisely at the exercise price of the options.” Sullivan has been advising a number of clients to implement this strategy to earn extra returns One of his clients asked him when it would be appropriate to use such a strategy Sullivan replied with the following comment: “Following are examples of times when such a strategy would prove to be profitable for a particular stock: Just before an expected earnings announcement Before an unanticipated decrease in volatility in the price of a stock Before a merger between two companies that has largely been kept private.” FinQuiz Question ID: 9014 37 With respect to Statement 1, is Ford most likely correct regarding the benefit and drawbacks of the strategy? Benefit A Yes B No C Yes Drawback No Yes Yes FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 9015 38 If the price of the stock increases to $98 at expiration, the value and profit to Ford will be closest to: Value A $23 B $22 C $22 Profit $9.7 $8.7 $20.3 FinQuiz Question ID: 9016 39 With respect to statement 2, Ford is most likely: A correct B incorrect with respect to the maximum profit of the strategy C incorrect with respect to the maximum profit of the strategy and the long butterfly spread FinQuiz Question ID: 9017 40 The breakeven stock prices at expiration, for the strategy Ford has implemented, are closest to: A $89.3 and $62.7 B $88.3 and $61.7 C $77.7 and $74.3 FinQuiz Question ID: 9018 41 With respect to the times when the strategy would be profitable, Sullivan is most accurate with respect to: A B and C FinQuiz Question ID: 9019 42 The maximum profit and maximum loss to Ford, with respect to his strategy, are closest to: Maximum Profit A ∞ B $1 C ∞ Maximum Loss $12.3 $1.7 $13.3 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 9030 Questions 43(9031) through 48(9036) relate to Reading 29 Arthur Gibson Case Scenario Arthur Gibson is a portfolio manager working for Total Investment Management (TIM), an equity portfolio management firm Gibson has been carrying out a research on the use of options to benefit from the movements in asset prices as well as changes in asset price volatilities While reading an article about butterfly spreads, he came across the following statements: Statement 1: “If an investor expects the market to be volatile, he should buy a butterfly spread using calls If, instead, he expects the market to be less volatile, he should buy a butterfly spread using puts.” Statement 2: “A butterfly spread using puts is, in effect, a long bear put spread and a short bear put spread.” John Webb, Gibson’s colleague, has executed a butterfly spread using puts on a stock currently selling for $70 The exercise prices of the three put options that he used are $60, $70 and $80 respectively The puts are selling for $4.75, 5.89, and 7.89 respectively The puts all expire next month Webb is familiar with executing butterfly spreads using calls but is not sure how using puts could affect the profits and payoffs to the position When he asked Gibson about when to use calls and when to use puts while executing a butterfly spread, Gibson told him that both can be used to benefit from similar expectations about the market, and one would only be preferred over the other in case an extra return can be reaped due to any mispricing Webb then posed the following question to Gibson: “What is a sandwich spread?” FinQuiz Question ID: 9031 43 Are the statements made in the article Gibson read most likely correct? Statement A Yes B No C Yes Statement No Yes Yes FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 9032 44 If the price of the stock is $67 at the expiration of the puts, the value and profit to Webb will be closest to: Value A $7 B $8 C $19 Profit $6.14 $7.86 $18.14 FinQuiz Question ID: 9033 45 Which one of the following represents the range within which the strategy will be profitable? A ±13% from the starting value of the stock B ±7% from the starting value of the stock C ±9% from the starting value of the stock FinQuiz Question ID: 9034 46 If the stock price at expiration is $71, the return to Webb will be closest to: A 746.5% B 846.5% C 946.5% FinQuiz Question ID: 9035 47 With regards to Gibson’s reply to Webb concerning butterfly spreads, Gibson is most likely: A correct B incorrect with respect to their usage C incorrect with respect to the preference of one over the other FinQuiz Question ID: 9036 48 The most appropriate response to Webb’s question is that a sandwich spread is a: A long butterfly spread with puts B short butterfly spread with either calls or puts C long butterfly spread with calls and a short butterfly spread with puts FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 9037 Questions 49(9038) through 54(9043) relate to Reading 29 Shirley Diaz Case Scenario Shirley Diaz manages portfolios for large institutional clients One of her clients has instructed her to combine a covered call with their recently established protective put position The protective put had been executed to protect a position in a stock worth $45.5 The put is currently selling for $0.55 Diaz sold a call for $0.55 The exercise prices for the put and the call are $40 and $47.5, respectively Diaz went to her boss, Pamela Wood, to discuss the outcomes of the position she just executed Wood made the following comments: Statement 1: “This position is called a ‘zero-cost collar’ Since it is ‘zero-cost’ there is absolutely no ‘cost’ to this transaction.” Statement 2: “The profit to this position will be determined by the stock and will move directly with the value of the stock.” Statement 3: “The breakeven price for the stock equals $40.” While talking about the similarities of the position with other derivative positions, Diaz mentioned that collars are very similar to forward contracts She said that other than forwards, the payoffs to a collar are very similar to those of another option strategy FinQuiz Question ID: 9038 49 With regard to Statement 1, Woods is most likely: A incorrect B correct, a zero-cost collar is a combination of a covered call and protective put C correct, a zero-cost collar has no explicit or implicit costs FinQuiz Question ID: 9039 50 Woods is most accurate with respect to: A Statement only B Statements and C Statements and FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 9040 51 What is the value at expiration and profit if the stock’s price is $47? Value A $1.5 B $45.5 C $47 Profit $1.5 $45.5 $1.5 FinQuiz Question ID: 9041 52 The profit for the position will vary from: A – $3 to $5.5 B $0 to $4.5 C – $5.5 to $2 FinQuiz Question ID: 9042 53 With respect to Diaz’s comment about collars’ similarity to forward contracts, collars are most likely similar to a forward contract with respect to the: A initial outlay B payoff profile C initial outlay and payoff profile FinQuiz Question ID: 9043 54 The other option strategy Diaz is most likely referring to is a: A bear put spread B protective put C bull call spread FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 9046 Questions 55(9047) through 60(9052) relate to Reading 29 AAA Bank Case Scenario AAA Bank is a large bank with a number of branches across U.S AAA Bank extends loans to a number of its institutional clients One loan it planned to extend on December was to the Agricultural Group Ltd (AgriGroup), a corporation in the agricultural sector The loan will be taken out on January at a rate of LIBOR plus 275 basis points To protect against falling interest rates AAA Bank bought an interest rate floor with 1-year maturity and quarterly settlement payments on April 1, July 1, October 1, and next year January To finance the purchase of the put, AAA Bank sold an interest rate cap with the same maturity and settlement dates The floor has a strike rate of 4.5% and the cap has a strike rate of 7.8% The loan is worth $40 million and the premiums on the floor and cap exactly offset each other Currently, LIBOR is at 5% Following are the LIBOR rates on the settlement dates: Exhibit Date 90 day LIBOR January 9.01% April 3.50% July 9.00% October 4.75% January (next year) 8.33% FinQuiz Question ID: 9047 55 The effective interest on April will be closest to: A $1,055,000 B $1,176,000 C $1,297,000 FinQuiz Question ID: 9048 56 The effective interest on July will be closest to: A $733,056 B $530,833 C $631,944 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 9049 57 The effective interest on October will be closest to: A $1,323,778 B $1,078,444 C $797,333 FinQuiz Question ID: 9050 58 The lowest payment the bank can expect is closest to: A $725,000 B $741,111 C $1,078,444 FinQuiz Question ID: 9051 59 The long floor and short cap results in AAA Bank receiving interest within the range of: A 4.5% to 7.8% B 7.25% to 10.55% C 1.75% to 5.05% FinQuiz Question ID: 9052 st 60 On October , AAA Bank sells an interest rate call option and buys an interest rate put option with premiums $22,000 and $15,000 respectively for the loan extended on January The effective amount loaned out on January next year will be closest to: A $39,992,866 B $40,007,134 C $40,037,709 FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Item-set ID: 9071 Questions 61(9072) through 66(9077) relate to Reading 29 Martin Green Case Scenario While discussing delta hedging with his colleague Martha Lee, Martin Green, a U.S portfolio manager, made the following comments: Statement 1: “A delta hedged portfolio should also be gamma hedged This ensures that the value of a portfolio consisting of a short option position and a position in the underlying does not change when either delta or volatility changes.” Lee is not sure about the relationship of delta to the price of the underlying relative to a call option’s strike price Green told her that deltas of in the money options move towards one as expiration approaches He also mentioned that deltas of slightly in the money options temporarily move down as expiration approaches Lee just attended a seminar on the functioning of a dynamically managed delta hedged portfolio The speaker was Steve Robinson, a portfolio manager at a large investment bank During the seminar, Robinson made the following comments: Statement 2: “An option dealer who is long an option and short the underlying will suffer large losses in case the volatility of the underlying increases.” Statement 3: “Gamma is largest for at the money options close to expiration In contrast, options are most sensitive to the volatility of the underlying when they are deep in the money.” FinQuiz Question ID: 9072 61 With respect to statement 1, Green is most likely: A correct B incorrect, because gamma hedging does not ensure hedging against changes in delta C incorrect, because gamma hedging does not ensure hedging against volatility changes FinQuiz Question ID: 9073 62 Is Green most likely correct with respect to in-the-money options and slightly in-the-money options? A B C In-the-money Yes No Yes Slightly in-the-money No Yes Yes FinQuiz.com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz.com FinQuiz Question ID: 9074 63 Which of the following is most likely an out of the money option? A A call option with a delta of 0.61 B A call option with a delta of 0.40 C A put option with a delta of – 0.70 FinQuiz Question ID: 9075 64 Robinson is least accurate with respect to: A statement only B statement only C both statements and FinQuiz Question ID: 9076 65 The most appropriate way dealers can hedge an option position against changes in the volatility of the underlying is by: A taking a position in another option whose vega offsets the vega on the original option B forecasting changes in volatility and building in these changes in the option pricing model used C selling another option such that both vega and gamma equal zero FinQuiz Question ID: 9077 66 Which of the following about delta hedging is most accurate? A Delta, gamma and vega need to be managed separately B Delta and gamma should be managed jointly and vega should be managed separately C Delta, gamma and vega should be managed jointly FinQuiz.com © 2018 - All rights reserved ... All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz. com FinQuiz Item- set ID: 9 030 Questions 43( 9 031 ) through 48(9 036 ) relate to Reading 29 Arthur Gibson Case... puts FinQuiz. com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz. com FinQuiz Item- set ID: 9 037 Questions 49(9 038 ) through 54(90 43) relate to Reading. .. will be closest to: A $ 733 ,056 B $ 530 , 833 C $ 631 ,944 FinQuiz. com © 2018 - All rights reserved Reading 29 Risk Management Applications of Option Strategies FinQuiz. com FinQuiz Question ID: 9049