2019 CFA level 3 qbank reading 33 risk management applications of option strategies answers

10/12/2018 Learning Management System Question #1 of 33 All of the following are conditions that make the second-order gamma e ect more important to a manager delta-hedging an option EXCEPT when the: A) delta is near zero B) option is near expiration C) option is at-the-money .in Explanation (Study Session 17, Module 33.6, LOS 33.f) Related Material m Question #2 of 33 bo ok c SchweserNotes - Book en tre All of these conditions make the gamma e ect more important except the delta being near zero If the delta is near zero or one then the option delta will move more slowly towards zero or one and cause less of an a ect on gamma Assume that the current price of a stock is $100 A call option on that stock with an exercise o price of $97 costs $7 A call option on the stock with the same expiration and an exercise price stock? w A) $4 w w of $103 costs $3 Using these options what is the cost of entering into a long bull spread on this B) $1 C) $0 Explanation The buyer of a bull spread buys the call with an exercise price below the current stock price and sells the call option with an exercise price above the stock price The cost of the strategy is the di erence between the cost of buying the option with the lower exercise price and selling the option with the higher exercise price which is $7 - $3 = $4 to enter into this strategy (Study Session 17, Module 33.2, LOS 33.b) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 1/21 10/12/2018 Learning Management System SchweserNotes - Book Question #3 of 33 Which of the following is equivalent to a pay- xed interest rate swap? A) Selling a cap and buying a oor B) Buying a cap and selling an interest rate collar .in C) Buying a cap and selling a oor Explanation (Study Session 17, Module 33.5, LOS 33.d) SchweserNotes - Book m Question #4 of 33 bo ok c Related Material en tre A pay- xed interest rate swap has the same payo s as a long position in the corresponding interest rate collar (with the strike rate equal to the swap xed rate) .o An option dealer is delta hedging a short call position on a stock As the stock price increases, in w w order to maintain the hedge, the dealer would most likely have to: A) buy T-bills w B) buy more shares of the stock C) sell some the shares of the stock Explanation As the value of the underlying increases, the delta of a call option increases This means more of the underlying asset is needed to hedge the position (Study Session 17, Module 33.6, LOS 33.e) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 2/21 10/12/2018 Learning Management System Question #5 of 33 An investor believes that a stock they own will continue to oscillate in price and may trend downward in price The best course of action for them to take would be to: A) sell call options on the stock B) buy put options on the stock C) enter into both a covered call and protective put strategy Explanation (Study Session 17, Module 33.1, LOS 33.a) SchweserNotes - Book m Question #6 of 33 bo ok c Related Material en tre in With a stock that is oscillating in price in which it is not trending upward, a covered call strategy is appropriate in which the investor owns the underlying asset and sells call options to enhance income This strategy will work as long as the stock price does not go above the call strike price In a downward trending market in which the investor believes the stock price will decrease, a protective put is appropriate in which they purchase a put on the underlying stock A) $25 w B) -$25 w w stock price is $125? o What is the expiration payo of a long straddle, with an exercise price $100, if the underlying C) $0 Explanation A long straddle consists of a long call and put with the same exercise price and the same expiration, at a stock price of $125 the put will expire worthless and the call value will be $25 (Study Session 17, Module 33.3, LOS 33.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 3/21 10/12/2018 Learning Management System Linda Morgan is in a training program at a large investment bank Currently, she is spending three months at her rm's Derivatives Trading desk One of the traders, Jason Gover, CFA, asks her to compare di erent option trading strategies Gover would like Morgan to pay particular attention to strategy costs and their potential payo s Morgan is not very comfortable with option models and must rst investigate how to properly price European and American style equity options Gover has given her software that provides a variety of analytical information Morgan has decided to begin her analysis using two di erent scenarios to evaluate option behavior Her scenarios are illustrated in Exhibit and Exhibit Note that all of the rates and yields are on a continuous compounding basis .in Exhibit $100 Call Strike Price (X) $100 Price $5.51 Exhibit Exhibit $100 Put Strike Price (X) o Price m Stock Price (S) bo ok c Stock Price (S) en tre Exhibit $100 $5.68 w w Gover instructs Morgan to consider using a straddle in which a at-the-money call and put w option would be purchased Assume all other variables remain identical Question #7 of 33 Jason explains to Linda that the volatility of returns of the underlying stock has the most in uence over the price of an option Following his explanation he queries Linda on how exactly does volatility a ect option values If the volatility were to increase would the price of the option change? A) Yes, the option price will increase B) Yes, the option price will decrease C) It depends whether the option is a call option or a put option https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 4/21 10/12/2018 Learning Management System Explanation Since an option has an asymmetric payo , higher volatility always increases an option price since the chance of a high payo from the option is increased without signi cantly increasing the downside risk (Study Session 17, Module 33.3, LOS 33.b) Related Material SchweserNotes - Book in Question #8 of 33 en tre After computing the maximum loss of the straddle Linda wonders why an investor would want to set up a straddle Under what circumstances would an investor want to purchase a straddle? When the investor expects: A) Prices to stay close to the exercise price of the options bo ok c B) Prices to increase or decrease substantially C) Prices to increase Explanation m An investor would purchase a straddle when they expect a large movement in the price of a stock, but are unsure of the direction w w Related Material o (Study Session 17, Module 33.3, LOS 33.b) w SchweserNotes - Book Question #9 of 33 Linda returns her attention to the straddle using the information in Exhibits and She computes the minimum payo of the straddle at expiration Which of the following is closest to Linda's answer? A) $0.00 B) -$4.42 C) -$11.31 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 5/21 10/12/2018 Learning Management System Explanation Since a long straddle consists of a long position in a call and a put option, the owner of these options has a right but not an obligation to exercise so the option payo can never be negative Therefore, the worst payo resulting from this strategy is zero Do not confuse the maximum loss with the payo at expiration (Study Session 17, Module 33.3, LOS 33.b) Related Material SchweserNotes - Book in Question #10 of 33 en tre Linda now wants to compute the breakeven points for the straddle using the options and underlying stock in Exhibits and Which of the following are the closest to the breakeven points for the straddle? bo ok c A) $88.81, $111.19 B) $95.58, $104.42 C) $93.11, $106.89 Explanation o m This is the exercise price plus/minus the maximum loss Since the total cost of the straddle is $11.19, the breakeven points are $100 +/- 11.19 w w (Study Session 17, Module 33.3, LOS 33.b) Related Material w SchweserNotes - Book Question #11 of 33 A stock's value on the date of option expiration is $88.50 For a call purchased with a $2.20 premium and an exercise price of $85, what is the breakeven price? A) $86.30 B) $87.20 C) $88.50 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 6/21 10/12/2018 Learning Management System Explanation The breakeven price is the exercise price plus the premium The stock's value on the date of expiration is not necessary information for this problem (Study Session 17, Module 33.1, LOS 33.b) Related Material SchweserNotes - Book in Question #12 of 33 Assume that the current price of a stock is $100 A call option on that stock with an exercise en tre price of $97 costs $7 A call option on the stock with the same expiration and an exercise price of $103 costs $3 Using these options what is the pro t for a long bull spread if the stock price at expiration of the options is equal to $110? bo ok c A) $6 B) -$2 C) $2 Explanation w w o m The buyer of a bull spread buys the call with an exercise price below the current stock price and sells the call option with an exercise price above the stock price Therefore, for a stock price of $110 at expiration of the options, he gets a payo $13 from his long position and a payo of -$7 from his short position for a net payo of $6 The cost of the strategy is $4 Hence the pro t is equal to $2 (Study Session 17, Module 33.2, LOS 33.b) w Related Material SchweserNotes - Book Question #13 of 33 An investor makes the following transactions in calls on a stock: (1) buys one call with a premium of $3.50 and exercise price of $20, (2) buys one call with a premium of $1.00 and exercise price of $25, and (3) sells two calls with a premium of $2.00 each and an exercise price of $22.50 What is (are) the breakeven price(s)? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 7/21 10/12/2018 Learning Management System A) $20.50 and $24.50 B) $21 only C) $21 and $26 Explanation (Study Session 17, Module 33.2, LOS 33.b) bo ok c Related Material en tre in The transaction describes a butter y spread The total amount spent on purchasing the calls was $3.50 + $1.00 = $4.50 and the total amount received from the sale of the calls was $2 + $2 = $4 so the investor is - $.50 from the purchase and sale of the calls The rst exercise price on one of the calls purchased is $20 so the stock price would have to go up to $20.50 to reach the rst breakeven point At $22.50, the two written calls and the purchased call with the higher strike price will all expire worthless, while the call with the strike price of $20 will be exercised for a pro t of $2.50 The total transaction will result in a pro t of (+$2.50 + 4.00 4.50 = 2) The second breakeven price is $24.50 At this price, the two written calls will breakeven ($2 loss + $2 premium = for each call), the call with the $20 strike price will be exercised for a pro t of $1.00 ($4.50 gain - $3.50 premium), and the call with the $25 strike price will expire worthless, resulting in the loss of the $1.00 premium At a price of $24.50, the total of the transactions will be zero (+$4.00 – 4.00 + 1.00 – 1.00 = 0) SchweserNotes - Book Dennis Austin works for O'Reilly Capital Management and manages endowments and trusts for m large clients The fund invests most of its portfolio in S&P 500 stocks, keeping some cash to facilitate purchases and withdrawals The fund's performance has been quite volatile, losing o over 20 percent last year but reporting gains ranging from percent to 35 percent over the w w previous ve years O'Reilly's clients have many needs, goals, and objectives, and Austin is called upon to design investment strategies for their clients Austin is convinced that the best way to deliver performance is to, whenever possible, combine the fund's stock portfolio with w option positions on equity Question #14 of 33 Given the following scenario: Performance to Date: Up 3% Client Objective: To maintain a positive stock position and retain upside potential Austins scenario: Expect low stock price volatility between now and the end of year Which is the best option strategy to meet the client's objective? https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 8/21 10/12/2018 Learning Management System A) Protective put B) Long butter y C) Bull call Explanation The client wants to stay positive on the stock and a protective put will retain the stock upside with limited down side risk In addition volatility is low which will make option prices low Both of the other strategies will compromise stock upside potential and involve selling options to reduce initial investment cost Lowering initial investment was not a speci c goal and it makes little sense to so while option prices are low (Study Session 17, Module 33.2, LOS 33.b) in Related Material en tre SchweserNotes - Book Given the following scenario: bo ok c Question #15 of 33 Performance to Date: Up 16% Client Objective: Earn at least 15% m Austin's scenario: Good chance of large gains or large losses between now and end of o year w w Which is the best option strategy to meet the client's objective? A) Long straddle w B) Long butter y C) Short straddle Explanation Long straddle produces gains if prices move up or down, and limited losses if prices not move Short straddle produces signi cant losses if prices move signi cantly up or down Long Butter y also produces losses should prices move either up or down The condor is similar to the long butter y, although the gains for no movement are not as great (Study Session 17, Module 33.3, LOS 33.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 9/21 10/12/2018 Learning Management System Question #16 of 33 Given the following scenario: Performance to Date: Up 16% Client Objective: Earn at least 15% Austin's scenario: Good chance of large losses between now and end of year Which is the best option strategy to meet the client's objective? in A) Short call options B) Long put options en tre C) Long call options Explanation bo ok c Long put positions gain when stock prices fall and produce very limited losses if prices instead rise Short calls also gain when stock prices fall but create losses if prices instead rise The other two positions will not protect the portfolio should prices fall (Study Session 17, Module 33.1, LOS 33.b) Related Material o m SchweserNotes - Book w w Question #17 of 33 A rm purchases a cap with two semi-annual payo s, a strike rate of 4%, a notional principal of w $3 million, and semiannual settlement The reference rate at the initiation of the cap is 5%, falls to 4.5% at the next settlement and then to 4% one year after the cap's initiation The total payo s (without discounting) over the maturity of the cap would be: A) $22,792 B) $7,625 C) $22,500 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 10/21 10/12/2018 Learning Management System Since the number of days is not given for each period, approximate it with 182 in the rst period and 183 in the second period Remember that payments are made in arrears and there is no payment made at months on the rst payo since the interest rate is known at the initiation of the cap Payo made at 12 months based on 4.5% reference rate at months = $7,625 = $3,000,000 × max(0, 0.045 − 0.04) × (183/360) Payo based on the reference rate of 4% at 12 months = $0 = $3,000,000 × max(0, 0.04 − 0.04) × (182/360) Total = $7,625 (Study Session 17, Module 33.5, LOS 33.d) Related Material en tre in SchweserNotes - Book Question #18 of 33 bo ok c A rm purchases a collar with oor rate of 3% and a cap rate of 4.4% The cap and oor have quarterly settlement and a notional principal of $10 million The maximum out ow and in ow the buyer can expect on a given settlement is (assume equal settlement periods): A) $110,000 and maximum in ow = $140,000 m B) $75,000 and maximum in ow = $140,000 w w Explanation o C) $75,000 and maximum in ow = in nite w Given the possible answers, this must be a collar consisting of a short oor and long cap The rm's maximum out ow would occur from the oor when the reference rate is zero: $10,000,000 × (0.03 − 0) / = $75,000 Although interest rates cannot go to in nity, there is no upper limit on what the owner can expect from the cap Thus "in nite" is the best answer (Study Session 17, Module 33.5, LOS 33.d) Related Material SchweserNotes - Book Question #19 of 33 A manager would delta hedge a position to: https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 11/21 10/12/2018 Learning Management System A) place a oor on the position while leaving the potential for upside risk B) earn the risk-free rate C) earn extra “dividend” income on a given position Explanation A delta hedged position should earn the risk-free rate The position does not earn a "dividend" although it should increase in value gradually (at the risk-free rate) The upside potential is limited to the risk-free rate The manager would have to constantly monitor and adjust the position to achieve the goal (Study Session 17, Module 33.6, LOS 33.e) Related Material en tre in SchweserNotes - Book Question #20 of 33 bo ok c Suppose that a 1-year cap has a cap rate of percent and a notional amount of $500 million The frequency of settlement is quarterly, and the reference rate is 3-month LIBOR The contract begins on January and the settlements are on July 1, October 1, and the following January Given the indicated LIBOR rates on those dates in the table below, what is the maximum payo Dt Payo 6.15% - Apr 6.15% - July 6.15% 91 ? Oct 6.10% 92 ? Jan 6.10% 92 ? w w w Jan o Date m and on what date did it occur on? (The days in each settlement period have been provided.) A) $187,500 on April B) $127,778 on Jan C) $191,666 on Oct Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 12/21 10/12/2018 Learning Management System Remember that payments are made in arrears payo on July = $189,583 = $500,000,000 × max(0, 0.0615 – 0.06) × (91/360) payo on Oct = $191,666 = $500,000,000 × max(0, 0.0615 – 0.06) × (92/360) payo on Jan = $127,778 = $500,000,000 × max(0, 0.0610 – 0.06) × (92/360) (Study Session 17, Module 33.5, LOS 33.d) Related Material in SchweserNotes - Book en tre Question #21 of 33 A short position in naked calls on an asset can be delta hedged by: A) shorting the underlying asset bo ok c B) buying the put C) buying the underlying asset Explanation m Delta hedging a naked call can be accomplished by owning the underlying asset in an amount that will make the value of the short-call/long-asset portfolio immune to changes in the price of the underlying asset w w Related Material o (Study Session 17, Module 33.6, LOS 33.e) w SchweserNotes - Book Question #22 of 33 The buyer of a straddle on a stock is most likely to bene t: A) under all conditions because the straddle is guaranteed a risk-free rate of return B) if the volatility of the underlying asset’s price increases C) if the volatility of the underlying asset’s price decreases Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 13/21 10/12/2018 Learning Management System in The buyer of the straddle purchases both a call and a put This position will bene t from large swings of the price of the underlying stock in either direction If the position expires worthless, which occurs when the stock price stays at, the investor will lose 100% of the investment The payo diagram is: (Study Session 17, Module 33.3, LOS 33.b) en tre Related Material Question #23 of 33 bo ok c SchweserNotes - Book In delta-hedging a call position, which of the following pairs of conditions would lead to the m gamma e ect being the most important? The call is: A) out-of-the-money and near expiration .o B) at-the-money and near expiration w w C) at-the-money and has a long time until expiration Explanation w Gamma refers to the change in value of the delta given the change in value of the underlying stock Gamma will be most important when the call option being hedged is either at the money or near expiration (Study Session 17, Module 33.6, LOS 33.f) Related Material SchweserNotes - Book Question #24 of 33 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 14/21 10/12/2018 Learning Management System In 60 days, a bank plans to lend $10 million for 180 days The lending rate is LIBOR plus 200 basis points The current LIBOR is 4.5% The bank buys an interest-rate put that matures in 60 days with a notional principal of $10 million, days in underlying of 180 days, and a strike rate of 4.3% The put premium is $4,000 What is the e ective annual rate of the loan if at expiration LIBOR = 4.1%? A) 0.0648 B) 0.0640 C) 0.0619 Explanation in The e ective amount the bank parts with or "lends"at time of the loan is: If LIBOR at maturity equals 4.1%, the payo en tre $10,004,043 = $10,000,000 + $4,000 × (1 + (0.045 + 0.02) × (60/360)) of the put would be: = ($10,000,000) × [max(0, 0.043 – 0.041) × (180/360) payo = $10,000 The dollar interest earned is: bo ok c payo $305,000=$10,000,000 × (0.041 + 0.02) × (180/360), and EAR = [($10,000,000 + $10,000 +$305,000) / ($10,004,043)](365/180) - m EAR = 0.0640 or 6.40% Related Material o (Study Session 17, Module 33.2, LOS 33.c) w w w SchweserNotes - Book Question #25 of 33 Which of the following statements regarding covered call options on an underlying stock is most correct? A) The maximum loss is equal to the purchase price of the stock less the call premium B) The breakeven price is equal to the strike price of the stock less the call premium C) The strategy is used to generate additional portfolio income by speculating that the underlying stock price will change signi cantly https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 15/21 10/12/2018 Learning Management System Explanation The maximum loss is the cost of the stock, o set by the premium earned by selling the call The maximum loss is denoted as S0 – C0 The breakeven price is equal to the cost of the stock less the call premium, denoted as S0 – C0 (Study Session 17, Module 33.1, LOS 33.a) Related Material in SchweserNotes - Book en tre Question #26 of 33 In 50 days, Munro Co (Munro) will be borrowing $10 million for 120 days based on a rate of LIBOR plus 200 basis points LIBOR is currently 3% Munro purchases an interest rate call for $10,000 that has a 50-day maturity with a notional principal of $10 million, 120 days in bo ok c underlying, and a strike rate of 4% Based on the information provided, which of the following statements is correct? A) If LIBOR is 6%, then the e ective annual rate of the loan at expiration is 8.67% B) If LIBOR is 3%, then the call option is in-the-money because the total borrowing cost m of 5% exceeds the 4% strike rate w w w Explanation o C) If LIBOR is 6%, then the e ective annual rate of the loan at expiration is 6.53% https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 16/21 10/12/2018 Learning Management System Implied net amount to be borrowed after the cost of the call: $10,000,000 - $10,000 [1 + (0.03 + 0.02) (50 / 360)] = $9,989,931 When LIBOR is 6%, the call option is in the money: Payo = $10,000,000 x (6% - 4%) x (120 / 360) = $66,667 E ective interest cost = [$10,000,000 x 8% x (120 / 360)] – 66,667 = $200,000 E ective annual rate = ($10,200,000 / $9,989,931)(365/120) – = 6.53% in In order to accurately measure the e ect on the borrowing costs, ensure that you compute the future value of the call at the date of the loan, using the rm's cost of borrowing (LIBOR + 200 basis points) Also, ensure when calculating the e ective rate, that you use 365 days in the exponent (and not 360 days) (Study Session 17, Module 33.2, LOS 33.c) Related Material Question #27 of 33 bo ok c SchweserNotes - Book en tre The strike rate is compared to LIBOR (and not the total borrowing rate of LIBOR plus 2%) Therefore, if LIBOR is 3% and the strike rate is 4%, then the call option is out-of-the-money m Joe purchases a stock for $55 and simultaneously purchases a put for $2 that has a strike price o of $45 Which of the following statements is correct? w w A) The maximum pro t is unlimited B) The maximum loss is $8 w C) The breakeven price is $47 Explanation The maximum pro t is the future stock price less the cost of the stock ($55) less the put premium ($2) Theoretically, the future stock price is unlimited and so the maximum pro t is also unlimited The maximum loss is the di erence between the cost of the stock and the strike price ($55 $45) plus the put premium ($2), for a total of $12 The breakeven price is the cost of the stock ($55) plus the put premium ($2), for a total of $57 (Study Session 17, Module 33.1, LOS 33.a) Related Material https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 17/21 10/12/2018 Learning Management System SchweserNotes - Book Question #28 of 33 In delta-hedging, gamma would be important if the price of the underlying asset: A) had a large move upward or downward B) had a large move upward only .in C) remained constant Explanation bo ok c (Study Session 17, Module 33.6, LOS 33.f) en tre Gamma refers to the change in value of delta given the change in value of the underlying stock Typically, larger swings in the price of an asset will cause larger changes in delta, thus impacting the delta hedge This means that the larger the move in the underlying asset in either direction, the more important is the second-order gamma e ect Related Material m SchweserNotes - Book o Question #29 of 33 w w An investor purchases a stock for $38 and a put for $0.50 with a strike price of $35 The investor sells a call for $0.50 with a strike price of $40 What is the maximum pro t and loss for w this position? A) maximum pro t = $2.00 and maximum loss = -$3.00 B) in nite pro t and maximum loss = -$4.00 C) maximum pro t = $3.00 and maximum loss = -$4.00 Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 18/21 10/12/2018 Learning Management System The option position described is a zero cost collar It is zero cost because the premium paid for the protective put is o set by the premium received for writing a covered call The collar will put a band around the prospective returns by limiting the upside and downside of position The upside will be limited by the strike price on the covered call ($40), while the downside will be limited by the strike price of the put ($35) Maximum pro t = $40 - $38 = $2 Maximum loss = $35 - $38 = -$3 (Study Session 17, Module 33.3, LOS 33.b) Related Material in SchweserNotes - Book en tre Question #30 of 33 In 90 days, a rm wishes to borrow $10 million for 180 days The borrowing rate is LIBOR plus 200 basis points The current LIBOR is 4% The rm buys an interest-rate call that matures in 90 bo ok c days with a notional principal of $10 million, 180 days in underlying, and a strike rate of 4.1% The call premium is $9,000 What is the e ective annual rate of the loan if at expiration LIBOR = 4%? A) 0.0637 w w Explanation o C) 0.0787 m B) 0.0619 w The call option is out-of-the-money The implied net amount to be borrowed after the cost of the call is: $9,990,865 =$10,000,000 - $9,000 × (1 + (0.04+0.02) × (90/360)) For LIBOR = 0.04 at expiration, the dollar cost is: $300,000 = $10,000,000 × 0.06 × (180/360) The e ective annual rate is: 0.0637 = ($10,300,000 / $9,990,865)(365/180) - (Study Session 17, Module 33.2, LOS 33.c) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 19/21 10/12/2018 Learning Management System Question #31 of 33 In 30 days, a rm wishes to borrow $15 million for 90 days The borrowing rate is LIBOR plus 250 basis points The current LIBOR is 3.8% The rm buys an interest-rate call that matures in 30 days with a notional principal of $15 million, 90 days in underlying, and a strike rate of 4% The call premium is $4,000 What is the maximum e ective annual rate the rm can anticipate paying? A) 0.0603 .in B) 0.0671 en tre C) 0.0687 Explanation First we compute the implied net amount to be borrowed after the cost of the call: $14,995,979 = $15,000,000 − $4,000 × (1 + (0.038 + 0.025) × (30 / 360)) bo ok c The most the rm will expect to pay is the rate associated with the strike rate: 4% plus the 250 basis-point spread equals 6.5% This gives the nominal cost of the loan: $243,750 = $15,000,000 × 0.065 (90 / 360) The highest e ective annual rate is: m 0.0687 = ($15,243,750 / $14,995,979)(365/90) − w w Related Material o (Study Session 17, Module 33.2, LOS 33.c) w SchweserNotes - Book Question #32 of 33 Assume that the current price of a stock is $100 A call option on that stock with an exercise price of $97 costs $7 A call option on the stock with the same expiration and an exercise price of $103 costs $3 Using these options what is the expiration pro t of a bear call spread if the stock price is equal to $110? A) -$6 B) $2 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 20/21 10/12/2018 Learning Management System C) -$2 Explanation The trader of a bear call spread sells the call with an exercise price below the current stock price and buys the call option with an exercise price above the stock price Therefore, for a stock price of $110 at expiration of the options, the buyer realizes a payo of -$13 from his short position and a positive payo of $7 from his long position for a net payo of -$6 The revenue of the strategy is $4 Hence the pro t is equal to -$2 (Study Session 17, Module 33.2, LOS 33.b) Related Material en tre in SchweserNotes - Book Question #33 of 33 Jason has written 150 call options (delta of 0.81) on Stock A and has taken the appropriate steps bo ok c with Stock A within his investment portfolio to delta hedge his overall exposure In the following week, the price volatility of Stock A increases sharply What is the impact on the value of his investment portfolio as a result of the change in volatility? A) Unchanged m B) Decrease w w Explanation o C) Increase w Having written call options on Stock A, Jason would need to buy an appropriate number of shares of Stock A in order to delta hedge his exposure With an increase in volatility, the value of Stock A does not change However, the value of the short calls would decrease, thereby decreasing the value of his investment portfolio (Study Session 17, Module 33.6, LOS 33.e) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83448104/print 21/21 ... t = $40 - $38 = $2 Maximum loss = $35 - $38 = - $3 (Study Session 17, Module 33 .3, LOS 33 .b) Related Material in SchweserNotes - Book en tre Question #30 of 33 In 90 days, a rm wishes to borrow... 33 .6, LOS 33 .f) Related Material SchweserNotes - Book Question #24 of 33 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 48104/print... Module 33 .1, LOS 33 .b) Related Material o m SchweserNotes - Book w w Question #17 of 33 A rm purchases a cap with two semi-annual payo s, a strike rate of 4%, a notional principal of w $3 million,