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Reading 62: Option Markets and Contracts Los e~Q26-33

 

Q26. Williamson is very interested in the total return swap. He asks Potter how much it would cost to enter into this transaction. Which of the following is the cost of the swap at inception?

A)   $0.

B)   $340,885.

C)   $45,007.

 

Q27. Williamson likes the characteristics of the swap arrangement in Table 1 but would like to consider the options in Table 3 before making an investment decision. Given Williamson's current situation which of the following option trades makes the most sense in the short-term (all options are on Reston stock)?

A)   Buy out of the money call options.

B)   Buy at the money put options.

C)   Sell at the money call options.

 

Q28. Joel Franklin, CFA, has recently been promoted to junior portfolio manager for a large equity portfolio at Davidson Sherman (DS), a large multinational investment banking firm. The portfolio is subdivided into several smaller portfolios. In general, the portfolios are composed of U.S. based equities, ranging from medium to large-cap stocks. Currently, DS is not involved in any foreign markets. In his new position, he will now be responsible for the development of a new investment strategy that DS wants all of its equity portfolios to implement. The strategy involves overlaying option strategies on its equity portfolios. Recent performance of many of their equity portfolios has been poor relative to their peer group. The upper management at DS views the new option strategies as an opportunity to either add value or reduce risk.

Franklin recognizes that the behavior of an option’s value is dependent upon many variables and decides to spend some time closely analyzing this behavior. He took an options strategies class in graduate school a few years ago, and feels that he is fairly knowledgeable about the valuation of options using the Black-Scholes model. Franklin understands that the volatility of the underlying asset returns is one of the most important contributors to option value. Therefore, he would like to know when the volatility has the largest effect on option value. Upper management at DS has also requested that he further explore the concept of a delta neutral portfolio. He must determine how to create a delta neutral portfolio, and how it would be expected to perform under a variety of scenarios. Franklin is also examining the change in the call option's delta as the underlying equity value changes. He also wants to determine the minimum and maximum bounds on the call option delta. Franklin has been authorized to purchase calls or puts on the equities in the portfolio. He may not, however, establish any uncovered or “naked” option positions. His analysis has resulted in the information shown in Exhibits 1 and 2 for European style options.

Exhibit 1

Input for European Options

Stock Price (S)

100

Strike Price (X)

100

Interest Rate (r)

0.07

Dividend Yield (q)

0

Time to Maturity (years) (t)

1

Volatility (Std. Dev.) (sigma)

0.2

Black-Scholes Put Option Value

$4.7809

 

Exhibit 2

European Option Sensitivities

Sensitivity

Call

Put

Delta

0.6736

?0.3264

Gamma

0.0180

0.0180

Theta

?3.9797

2.5470

Vega

36.0527

36.0527

Rho

55.8230

?37.4164

 

What does it mean to make an options portfolio delta neutral?  The option portfolio:

A)   is insensitive to price changes in the underlying security.

B)   moves exactly in line with the stock price.

C)   moves exactly in the opposite direction with the stock price.

 

Q29. Which of the following most accurately describes the sensitivity of the call option value to changes the underlying asset’s volatility? The sensitivity to changes in the volatility of the underlying is the greatest when the call option is:

A)   in the money.

B)   at the money.

C)   it depends on the other inputs.

 

Q30. Which of the following most accurately describes when the call option delta reaches its minimum bound? The call option reaches its minimum bound when call option is:

A)   at the money.

B)   the option's delta has no minimum bound.

C)   far out of the money.

 

Q31. If the portfolio has 10,000 shares of the underlying stock and he wants to completely hedge the price risk using options, what kind of options should Franklin buy?

A)   Call and put options.

B)   Put options.

C)   Call options.

 

Q32. Compute the number of shares of stock necessary to create a delta neutral portfolio consisting of 100 long put options in Exhibit 2 and the stock.

A)   67.36.

B)   ?32.64.

C)   32.64.

 

Q33. Compute the number of shares of stock necessary to create a delta neutral portfolio consisting of 100 long call options in Exhibit 2 and the stock.

A)   ?32.64.

B)   67.36.

C)   ?67.36.

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