10e CH 20

CHAPTER 20AN INTRODUCTION TO DERIVATIVE MARKETS AND
SECURITIES
TRUE/FALSE
1. A cash or spot contract is an agreement for the immediate delivery of an asset such as the purchase of
stock on the NYSE.
ANS: T PTS: 1
2. Forward and future contracts, as well as options, are types of derivative securities.
ANS: T PTS: 1
3. All features of a forward contract are standardized, except for price and number of contracts.
ANS: F PTS: 1
4. Forward contracts are traded over-the-counter and are generally not standardized.
ANS: T PTS: 1
5. The forward market has low liquidity relative to the futures market.
ANS: T PTS: 1
6. A futures contract is an agreement between a trader and the clearinghouse of the exchange for delivery
of an asset in the future.
ANS: F PTS: 1
7. A primary function of futures markets is to allow investors to transfer risk.
ANS: T PTS: 1
8. The futures market is a dealer market where all the details of the transactions are negotiated.
ANS: F PTS: 1
9. Futures contracts are slower to absorb new information than forward contracts.
ANS: F PTS: 1
10. The initial value of a future contract is the price agreed upon in the contract.
ANS: F PTS: 1
11. A futures contract eliminates uncertainty about the future spot price that an individual can expect to
pay for an asset at the time of delivery.
ANS: T PTS: 1
12. Investment costs are generally higher in the derivative markets than in the corresponding cash markets.
ANS: F PTS: 1
13. An option buyer must exercise the option on or before the expiration date.
ANS: F PTS: 1
14. The minimum value of an option is zero.
ANS: T PTS: 1
15. An option to sell an asset is referred to as a call, whereas an option to buy an asset is called a put.
ANS: F PTS: 1
16. If an investor wants to acquire the right to buy or sell an asset, but not the obligation to do it, the best
instrument is an option rather than a futures contract.
ANS: T PTS: 1
17. Investors buy call options because they expect the price of the underlying stock to increase before the
expiration of the option.
ANS: T PTS: 1
18. A call option is in the money if the current market price is above the strike price.
ANS: T PTS: 1
19. A put option is in the money if the current market price is above the strike price.
ANS: F PTS: 1
20. The price at which the stock can be acquired or sold is the exercise price.
ANS: T PTS: 1
21. The minimum amount that must be maintained in an account is called the maintenance margin.
ANS: T PTS: 1
22. A forward contract gives its holder the option to conduct a transaction involving another security or
commodity.
ANS: F PTS: 1
23. In the forward market both parties are required to post collateral or margin.
ANS: F PTS: 1
24. The option premium is the price the call buyer will pay to the option seller if the option is exercised.
ANS: F PTS: 1
25. The payoffs to both long and short position in the forward contact are symmetric around the contract
price.
ANS: T PTS: 1
26. Forward contracts are much easier to unwind than futures contracts due to the standardization of the
contracts.
ANS: F PTS: 1
27. Forward contracts do not require an upfront premium.
ANS: T PTS: 1
28. The payoffs diagrams to both long and short positions in a forward contract are asymmetrical around
the contract price.
ANS: F PTS: 1
MULTIPLE CHOICE
1. Which of the following statements is false?

a. Derivatives help shift risk from risk-adverse investors to risk-takers.
b. Derivatives assist in forming cash prices.
c. Derivatives provide additional information to the market.
d. In many cases, the investment in derivatives (both commissions and required investment)
is more than in the cash market.
e. None of the above (that is, all are reasons)
ANS: D PTS: 1 OBJ: Multiple Choice
2. Derivative instruments exist because

a. They help shift risk from risk-averse investors to risk-takers.
b. They help in forming prices.
c. They have lower investment costs.
d. Choices a and b
e. All of the above
ANS: E PTS: 1 OBJ: Multiple Choice
3. There are a number of differences between forward and futures contracts. Which of the following
statements is false?
a. Futures have less liquidity risk than forward contracts.
b. Futures have less credit risk than forward contracts.
c. Futures have more default risk than forward contracts.
d. In futures, the exchange becomes the counterparty to all transactions.
e. None of the above (that is, all statements are true)
ANS: C PTS: 1 OBJ: Multiple Choice
4. Futures differ from forward contracts because

a. Futures have more liquidity risk.
b. Futures have more credit risk.
c. Futures have more maturity risk.
d. All of the above
e. None of the above
5. The price at which a futures contract is set at the end of the day is the
a. Stock price.
b. Strike price.
c. Maintenance price.
d. Settlement price.
e. Parity price.
6. Which of the following statements is true?

a. The buyer of a futures contract is said to be long futures.
b. The seller of a futures contract is said to be short futures.
c. The seller of a futures contract is said to be long futures.
d. The buyer of a futures contract is said to be short futures.
e. Choices a and b
7. The CBOE brought numerous innovations to the option market, which of the following is not such an
innovation?
a. Creation of a central marketplace
b. Creation of a non-liquid secondary option market
c. Introduction of a Clearing Corporation
d. Standardization of all expiration dates
e. Standardization of all exercise prices
ANS: B PTS: 1 OBJ: Multiple Choice
8. Which of the following factors is not considered in the valuation of call and put options?
a. Current stock price
b. Exercise price
c. Market interest rate
d. Volatility of underlying stock price
e. none of the above (that is, all are factors which should be considered in the valuation of
call and put options)
9. Which of the following statements is a true definition of an in-the-money option?

a. A call option in which the stock price exceeds the exercise price.
b. A call option in which the exercise price exceeds the stock price.
c. A put option in which the stock price exceeds the exercise price.
d. An index option in which the exercise price exceeds the stock price.
e. A call option in which the call premium exceeds the stock price.
ANS: A PTS: 1 OBJ: Multiple Choice
10. The value of a call option just prior to expiration is (where V is the underlying asset's market price and
X is the option's exercise price)
a. Max [0, V X]
b. Max [0, X V]
c. Min [0, V X]
d. Min [0, X V]
e. Max [0, V > X]
11. Which of the following is not a factor needed to calculate the value of an American call option?
a. The price of the underlying stock.
b. The exercise price.
c. The price of an equivalent put option.
d. The volatility of the underlying stock.
e. The interest rate.
12. In the valuation of an option contract, the following statements apply except
a. The value of an option increases with its maturity.
b. There is a negative relationship between the market interest rate and the value of a call
option.
c. The value of a call option is negatively related to its exercise price.
d. The value of a call option is positively related to the volatility of the underlying asset.
e. The value of a call option is positively related to the price of the underlying stock.
13. You own a stock that has risen from $10 per share to $32 per share. You wish to delay taking the profit
but you are troubled about the short run behavior of the stock market. An effective action on your part
would be to
a. Buy a put option on the stock.
b. Write a call option on the stock.
c. Purchase an index option.
d. Utilize a bearish spread.
e. Utilize a bullish spread.
14. A vertical spread involves buying and selling call options in the same stock with
a. The same time period and exercise price.
b. The same time period but different exercise price.
c. A different time period but same exercise price.
d. A different time period and different price.
e. Quotes in different options markets.
15. The value of a put option at expiration is

a. Max [0, S(T) X]
b. Max [0, X S(T)]
c. Min [0, S(T) X]
d. Min [0, X S(T)]
e. X
16. In the two state option pricing model, which of the following does not influence the option price?
a. Past stock price
b. Up and down factors u and d
c. The risk free rate
d. The exercise price
e. Current stock price
17. The cost of carry includes all of the following except

a. Storage costs.
b. Insurance.
c. Current price.
d. Financing costs.
e. Risk free rate.
18. A call option in which the stock price is higher than the exercise price is said to be
a. At-the-money.
b. In-the-money.
c. Before-the-money.
d. Out-of-the-money.
e. Above-the-money.
19. The price paid for the option contract is referred to as the
a. Forward price.
b. Exercise price.
c. Striking price.
d. Option premium.
e. Call price.
20. A stock currently sells for $75 per share. A call option on the stock with an exercise price $70 currently
sells for $5.50. The call option is
a. At-the-money.
b. In-the-money.
c. Out-of-the-money.
d. At breakeven.
e. None of the above.
21. A stock currently sells for $150 per share. A call option on the stock with an exercise price $155
currently sells for $2.50. The call option is
a. At-the-money.
b. In-the-money.
d. At breakeven.
22. A stock currently sells for $75 per share. A put option on the stock with an exercise price $70 currently
sells for $0.50. The put option is
a. At-the-money.
b. In-the-money.
d. At breakeven.
a. At-the-money.
b. In-the-money.
d. At breakeven.
a. At-the-money.
b. In-the-money.
d. At breakeven.
25. An equity portfolio manager can neutralize the risk of falling stock prices by entering into a hedge
position where the payoffs are
a. Not correlated with the existing exposure.
b. Positively correlated with the existing exposure.
c. Negatively correlated with the existing exposure.
d. Any of the above.
26. The derivative based strategy known as portfolio insurance involves

a. The sale of a put option on the underlying security position.
b. The purchase of a put on the underlying security position.
c. The sale of a call on the underlying security position.
d. The purchase of a call on the underlying security position.
e. b and d.
27. A hedge strategy known as a collar agreement involves the simultaneous

a. Purchase of an in-the money put and purchase of an out-of-the-money call on the same
underlying asset with same expiration date and market price.
b. Sale of an out-of-the money put and sale of an out-of-the-money call on the same
c. Purchase of an in-the money put and purchase of an in-the-money call on the same
d. Purchase of an out-of-the money put and sale of an out-of-the-money call on the same
e. Sale of an in-the money put and purchase of an in-the-money call on the same underlying
asset with same expiration date and market price.
28. A call option differs from a put option in that

a. a call option obliges the investor to purchase a given number of shares in a specific
common stock at a set price; a put obliges the investor to sell a certain number of shares in
a common stock at a set price.
b. both give the investor the opportunity to participate in stock market dealings without the
risk of actual stock ownership.
c. a call option gives the investor the right to purchase a given number of shares of a
specified stock at a set price; a put option gives the investor the right to sell a given number
of shares of a stock at a set price.
d. a put option has risk, since leverage is not as great as with a call.
e. none of the above
29. Which of the following statements is a true definition of an out-of-the-money option?

a. A call option in which the stock price exceeds the exercise price.
b. A call option in which the exercise price exceeds the stock price.
c. A call option in which the exercise price exceeds the stock price.
d. A put option in which the exercise price exceeds the stock price.
e. A call option in which the call premium exceeds the stock price.
30. According to put/call parity

a. Stock price + Call Price = Put Price + Risk Free Bond Price
b. Stock price + Put Price = Call Price + Risk Free Bond Price
c. Put price + Call Price = Stock Price + Risk Free Bond Price
d. Stock price Put Price = Call Price + Risk Free Bond Price
e. Stock price + Call Price = Put Price Risk Free Bond Price
31. Futures contracts are similar to forward contracts in that they both
a. Have volatile price movements and strong interest from buyers and sellers.
b. Give the holder the option to make a transaction in the future.
c. Have similar liquidity.
d. Have similar credit risk.
32. Which of the following statements are true?

a. Futures contracts have less liquidity risk and credit risk than forward contracts.
b. Futures contract prices are strongly linked to the prevailing level of the underlying spot
index.
c. Futures contract decrease in price, the further forward in time the delivery date is set.
d. All of the above.
33. A buyer of the call option is speculating on the

a. Direction of the price movement of the underlying investment.
b. Timing of the price movement of the underlying investment.
c. Leverage that a call option creates with respect to the underlying investment.
d. All of the above.
34. Which of the following is consistent with put-call-spot parity?

a. S + C = P + X/(1 + RFR)
b. S + P = C + X/(1 + RFR)
c. S C = P + X/(1 + RFR)
d. S P = C + X/(1 + RFR)
e. S = P C + X/(1 + RFR)
35. Holding a put option and the underlying security at the same time is an example of
a. Collar
b. Straddle
c. Income generation
d. Portfolio insurance
36. Derivative securities can be used

a. By investors in the same way as the underlying security
b. To modify the risk and expected return characteristics of existing investment portfolios
c. To duplicate cash flow patterns for arbitrage opportunities
d. All of the above
37. An advantage of a forward contract over a futures contract is that

a. The terms of the contract are flexible
b. It is more liquid
c. It trades through a centralized market exchange
d. It is easier to unwind due to contract homogeneity
38. A forward contract is similar to an option contract because they both

a. Can provide insurance against the price of the underlying stock
b. Are paid for up front in the form of premiums
c. Are paid for at the end of the contract in the form of premiums
d. Require a future settlement payment
39. An expiration date payoff and profit diagram for forward positions illustrates
a. Gains and losses are usually small
b. The payoffs to both long and short positions in the forward contract are asymmetrical
around the contract price
c. Forward contracts are zero-sum games
d. Long positions benefit from falling prices
40. A one year call option has a strike price of 50, expires in 6 months, and has a price of $5.04. If the risk
free rate is 5%, and the current stock price is $50, what should the corresponding put be worth?
a. $3.04
b. $4.64
c. $6.08
d. $3.83
e. $0
ANS: D
p(t) = $5.04 $50+ $50(1 + .05)1/2 = $3.83
PTS: 1 OBJ: Multiple Choice Problem
a. $12.74
b. $10.48
c. $5.00
d. $9.00
e. $8.30
ANS: D
p(t) = $4.74 $45+ $50(1 + .03) 1/2 = $9.0
a. $5.00
b. $4.56
c. $5.50
d. $7.08
e. $7.54
ANS: C
p(t) = $2.5 $55+ $60(1 + .07) 1/2 = $5.50
a. $5.34
b. $8.00
c. $10.68
d. $14.33
e. $13.33
ANS: D
p(t) = $7.34 $62 + $70(1 + .06) 1/4 = $14.33
Exhibit 20.1
USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
December futures on the S&P 500 stock index trade at 250 times the index value of 1187.70. Your
broker requires an initial margin of 10% percent on futures contracts. The current value of the S&P
500 stock index is 1178.
44. Refer to Exhibit 20.1. How much must you deposit in a margin account if you wish to purchase one
contract?
a. $267,232.5
b. $29,450
c. $29,692.50
d. $30,000
e. $265,050
ANS: C
Margin = 0.10 250 1187.70 = $29,692.50
45. Refer to Exhibit 20.1. Suppose at expiration the futures contract price is 250 times the index value of
1170. Disregarding transaction costs, what is your percentage return?
a. 1.87%
b. 0.68%
c. 14.90%
d. 10.36%
ANS: C
Purchase December contract
250 1187.7 = $296,925
Sell December contract

250 1170 = $292,500
Loss in futures = $292,500 $296,925 = $4425
Rate of return = $4425/29,692.50 = .1490 or 14.9%
46. Refer to Exhibit 20.1. Calculate the return on a cash investment in the S&P 500 stock index if the
ending index value is 1170 over the same time period.
a. 1.87%
b. 0.68%
c. 14.90%
d. 10.36%
ANS: B
Return on cash investment in the index = (1170 1178)/1178 = 0.0068 or 0.68%
Exhibit 20.2
A futures contract on Treasury bond futures with a December expiration date currently trade at 103:06.
The face value of a Treasury bond futures contract is $100,000. Your broker requires an initial margin
of 10%.
47. Refer to Exhibit 20.2. Calculate the current value of one contract.
a. $100,000
b. $103,600.5
c. $103,187.5
d. $102,306.3
e. $104,293.5
ANS: C
Current price is 103 6/32 percent of face value of $100,000
= 1.031875 100,000 = $103,187.50
48. Refer to Exhibit 20.2. Calculate the initial margin deposit.

a. $10,000
b. $10,360.50
c. $10,318.75
d. $10,230.63
e. $10,429.35
ANS: C
Margin deposit = 0.10 103,187.5 = $10,318.75
49. Refer to Exhibit 20.2. If the futures contract is quoted at 105:08 at expiration calculate the percentage
return.
a. 1.99%
b. 19.99%
c. 20.62%
d. 25.37%
e. 13.65%
ANS: B
Purchase December contract
103 6/32 percent of 100,000 = $103,187.50
Sell December contract
105 8/32 percent of $100,000 = $105,250
Gain in futures = $105,250 $103,187.50 = $2,062.50
Rate of return = 2062.5/10318.75 = 0.1999 or 19.9%
Exhibit 20.3
On the last day of October, Bruce Springsteen is considering the purchase of 100 shares of Olivia
Corporation common stock selling at $37 1/2 per share and also considering an Olivia option.
Calls Puts
Price December March December March
35 3 3/4 5 1 1/4 2
40 2 1/2 3 1/2 4 1/2 4 3/4
50. Refer to Exhibit 20.3. If Bruce decides to buy a March call option with an exercise price of 35, what is
his dollar gain (loss) if he closes his position when the stock is selling at 43 1/2?
a. $225.00 loss
b. $350.00 loss
c. $225.00 gain
d. $350.00 gain
e. $850.00 gain
ANS: D
43 1/2 35 = 8.5
8.5 5 = 3.5. $3.5/share 100 shares/contract = $350.00
51. Refer to Exhibit 20.3. If Bruce buys a March put option with an exercise price of 40, what is his dollar
gain (loss) if he closes his position when the stock is selling at 43 1/2?
a. $825.00 loss
b. $475.00 loss
c. $350.00 loss
d. $25.00 loss
e. He has a gain
ANS: B
The option is worthless so he loses the $475 he paid for the contract.
Exhibit 20.4
Rick Thompson is considering the following alternatives for investing in Davis Industries which is
now selling for $44 per share:
(1) Buy 500 shares, and

(2) Buy six month call options with an exercise price of 45 for $3.25 premium.
52. Refer to Exhibit 20.4. Assuming no commissions or taxes what is the annualized percentage gain if the
stock reaches $50 in four months and a call was purchased?
a. 161.54% gain
b. 53.85% gain
c. 161.54% loss
d. 11.11% gain
e. 53.85% loss
ANS: A
[(50 45 3.25) 3.25] 3 = 161.54% gain
53. Refer to Exhibit 20.4. Assuming no commissions or taxes, what is the annualized percentage gain if
the stock is at $30 in four months and the stock was purchased?
a. 9.54% loss
b. 95.45% loss
c. 0.9545% gain
d. 95.45% gain
e. 9.54% gain
ANS: B
[(30 44) 44] 3 = 95.45% loss
54. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson
Walker put option with an exercise price of $105.00 for $20.00. What is his dollar gain if at expiration
the stock is selling for $80.00 per share?
a. $200 loss
b. $700 loss
c. $200 gain
d. $700 gain
ANS: A
Profit on put = 105 80 20 = 5
5 100 = $500.00
Loss on stock = $700.00
Net loss = $700.00 500.00 = $200.00 (loss)
55. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson
Walker put option with an exercise price of $105.00 for $20.00. What is Tom's dollar gain/loss if at
expiration the stock is selling for $105.00 per share?
a. $1000 gain
b. $200 loss
c. $1000 loss
d. $200 gain
ANS: B
Put value = 0, therefore, loss = $2,000.00
Stock (105 87)(100) = $1,800.00
Net loss = $2,000 1,800 = $200.00 (loss)
Exhibit 20.5
Sarah Kling bought a 6-month Peppy Cola put option with an exercise price of $55 for a premium of
$8.25 when Peppy was selling for $48.00 per share.
56. Refer to Exhibit 20.5. If at expiration Peppy is selling for $42.00, what is Sarah's dollar gain or loss?
a. $420 gain
b. $420 loss
c. $475 loss
d. $475 gain
ANS: D
[(55 42 8.25) 100] = $475 gain
57. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss?

a. 11.51% gain
b. 115.15% gain
c. 11.51% loss
d. 115.15% loss
ANS: B
[(55 42 8.25) 8.25] 2 = 115.15% gain
58. Refer to Exhibit 20.5. If at expiration Peppy is selling for $47.00, what is Sarah's dollar gain or loss?
a. $25 loss
b. $250 loss
c. $25 gain
d. $250 gain
ANS: A
[(55 47 8.25) 100] = $25 loss
59. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss?

a. 60.60% gain
b. 6.06% loss
c. 60.60% loss
d. 6.06% gain
ANS: B
[(55 47 8.25) 8.25] 2 = 6.06% loss
60. A stock currently trades for $25. January call options with a strike price of $30 sell for $6. The
appropriate risk free bond has a price of $30. Calculate the price of the January put option.
a. $11
b. $24
c. $19
d. $30
e. $25
ANS: A
P = 6 + 30 25 = $11
61. A stock currently trades for $115. January call options with a strike price of $100 sell for $16, and
January put options a strike price of $100 sell for $5. Estimate the price of a risk free bond.
a. $120
b. $15
c. $105
d. $116
e. $104
ANS: E
Bond price = 115 + 5 16 = $104
62. Assume that you have purchased a call option with a strike price $60 for $5. At the same time you
purchase a put option on the same stock with a strike price of $60 for $4. If the stock is currently
selling for $75 per share, calculate the dollar return on this option strategy.
a. $10
b. $4
c. $5
d. $6
e. $15
ANS: D
Profit on call = (75 60) 5 = 10
Profit on put = 4
Total = $6

63. Assume that you purchased shares of a stock at a price of $35 per share. At this time you purchased a
put option with a $35 strike price of $3. The stock currently trades at $40. Calculate the dollar return
on this option strategy.
a. $3
b. $2
c. $2
d. $3
e. $0
ANS: C
Profit on stock = 40 35 = 5
Profit on put = 3
Total = $2
64. Assume that you purchased shares of a stock at a price of $35 per share. At this time you wrote a call
option with a $35 strike and received a call price of $2. The stock currently trades at $70. Calculate the
dollar return on this option strategy.
a. $25
b. $2
c. $2
d. $25
e. $0
ANS: C
Profit on stock = 70 35 = 35
Profit on call = 35 70 + 2 = 23
Total = $2
65. A stock currently trades at $110. June call options on the stock with a strike price of $105 are priced at
$4. Calculate the arbitrage profit that you can earn.
a. $0
b. $1
c. $5
d. $4
ANS: B
Arbitrage profit = 110 105 4 = $1
66. Datacorp stock currently trades at $50. August call options on the stock with a strike price of $55 are
priced at $5.75. October call options with a strike price of $55 are priced at $6.25. Calculate the value
of the time premium between the August and October options.
a. $0.50
b. $0
c. $0.50
d. $5
e. $5
ANS: C
Time premium = 6.25 5.75 = $0.50
67. A stock currently trades at $110. June put options on the stock with a strike price of $100 are priced at
$5.25. Calculate the dollar return on one put contract.
a. $525
b. $1000
c. $0
d. $1000
e. $525
ANS: A
Dollar return = (100 110 5.25)(100) = $525
68. A stock currently trades at $110. June call options on the stock with a strike price of $120 are priced at
$5.75. Calculate the dollar return on one call contract.
a. $1000
b. $1000
c. $575
d. $575
e. $0
ANS: D
Dollar return = (110 120 5.75)(100) = $575
69. Consider a stock that is currently trading at $65. Calculate the intrinsic value for a put option that has
an exercise price of $55.
a. $10
b. $50
c. $55
d. $10
e. $0
ANS: E
Put = Max[55 65, 0] = $0
70. Consider a stock that is currently trading at $20. Calculate the intrinsic value for a put option that has
a. $15
b. $55
c. $35
d. $15
e. $0
ANS: A
Put = Max[35 20, 0] = $15
71. Consider a stock that is currently trading at $45. Calculate the intrinsic value for a call option that has
a. $25
b. $35
c. $0
d. $10
e. $10
ANS: E
Call = Max[45 35, 0] = $10
72. Consider a stock that is currently trading at $10. Calculate the intrinsic value for a call option that has
a. $25
b. $5
c. $0
d. $20
e. $5
ANS: C
Call = Max[10 15, 0] = $0
Exhibit 20.6
The current stock price of ABC Corporation is $53.50. ABC Corporation has the following put and call
option prices that expire 6 months from today. The risk-free rate of return is 5% and the expected
return on the market is 11%.
Exercise Price Put Price Call Price

50 $1.50 $5.75
55 $3.25 ---
73. Refer to Exhibit 20.6. What should the price be of a call option that expires 6 month from today with
an exercise price of $55?
a. $1.33
b. $3.08
c. $4.58
d. $6.07
e. $6.33
ANS: B
C = P + S X/(1 + RFR)t = 3.25 + 53.50 $55/(1.05)0.5 = 56.75 53.67 = 3.08

74. Refer to Exhibit 20.6. What is the value of a synthetic stock created with put and call options that
expire in 6 months with an expiration price of $50?
a. $53.04
b. $53.53
c. $54.54
d. $55.03
e. $56.23
ANS: A
S = C P + X/(1 + RFR)t = 5.75 1.50 + $50/(1.05)0.5 = 4.25 + 48.79 = 53.04
75. Refer to Exhibit 20.6. How could an investor create arbitrage profits?
a. Sell the stock short, write a put, buy a call and invest the proceeds at the risk-free rate.
b. Buy the stock, write a put, buy a call and invest the proceeds at the risk-free rate.
c. Sell the stock short, buy a put, write a call and invest the proceeds at the risk-free rate.
d. Buy the stock, write a put, buy a call and borrow the strike price at the risk-free rate.
e. Sell the stock short, write a put, buy a call and borrow the strike price at the risk-free rate.
ANS: A
The stock price is $53.50 and the synthetic stock price is $53.04. The synthetic stock price is created
by combining a long call, short put, and the present value of the strike price. The synthetic stock and
stock price must converge. So shorting the stock (S) and going long the synthetic stock (C P +
PV(X)) will create an arbitrage profit.
76. A stock currently trades for $63. Call options with a strike price of $62 sell for $4.00 and expire in 6
months. If the risk-free rate is 4% what should the price of a put option with an exercise price of $62
be worth?
a. $0.62
b. $0.98
c. $1.80
d. $3.00
e. $5.80
ANS: C
P = C + X/(1 + RFR)t S = $4 + $62/(1.04)0.5 $63 = $4 + $60.80 $63 = $1.80
77. You own a call option and put option that both have the same exercise price of $50 and their respective
prices are $4 and $3. The stock is currently trading at $60. Calculate the dollar return on this strategy.
a. $1.00
b. $2.00
c. $3.00
d. $4.00
e. $5.00
ANS: C
$60 $50 $7 = $3

Exhibit 20.7
The current stock price of Zanco Corporation is $50. Zanco Corporation has the following put and call
option prices with exercise prices at $45 and $50.
Exercise Price Put Price Call Price

$45 $1.50 $6.75
$50 $3.75 $4.25
78. Refer to Exhibit 20.7. The time premium for the put option with a $45 exercise price is
a. $0.00
b. $1.50
c. $2.75
d. $5.25
e. $6.50
ANS: B
The time premium for the put option with a $45 exercise price is $1.50.
The put option is out of the money so the market price is purely a time premium.
79. Refer to Exhibit 20.7. The intrinsic value for the put option with a $50 exercise price is
a. $0.00
b. $1.50
c. $2.25
d. $3.75
e. $8.75
ANS: A
The intrinsic value for the put option with a $50 exercise price is $0.00.
The put option is out of the money so there is no intrinsic value.
80. Refer to Exhibit 20.7. The intrinsic value for the call option with a $45 exercise price is
a. $0.00
b. $1.50
c. $5.00
d. $5.25
e. $6.75
ANS: C
The intrinsic value for the call option with a $45 exercise price is $5.00.
The call option is in the money so the difference between the current stock price of $50 and the strike
price equals the intrinsic value.
81. Refer to Exhibit 20.7. The time premium for the call option with a $50 exercise price is
a. $0.00
b. $1.50
c. $1.75
d. $4.25
e. $9.25
ANS: D
The time premium for the call option with a $50 exercise price is $4.25.
The call option is out of the money so the market price is purely a time premium.

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CHAPTER 20AN INTRODUCTION TO DERIVATIVE MARKETS AND

7. A primary function of futures markets is to allow investors to transfer risk.

14. The minimum value of an option is zero.

27. Forward contracts do not require an upfront premium.

1. Which of the following statements is false?

2. Derivative instruments exist because

4. Futures differ from forward contracts because

6. Which of the following statements is true?

9. Which of the following statements is a true definition of an in-the-money option?

15. The value of a put option at expiration is

17. The cost of carry includes all of the following except

26. The derivative based strategy known as portfolio insurance involves

27. A hedge strategy known as a collar agreement involves the simultaneous

28. A call option differs from a put option in that

29. Which of the following statements is a true definition of an out-of-the-money option?

30. According to put/call parity

ANS: B PTS: 1 OBJ: Multiple Choice

32. Which of the following statements are true?

33. A buyer of the call option is speculating on the

34. Which of the following is consistent with put-call-spot parity?

ANS: B PTS: 1 OBJ: Multiple Choice

36. Derivative securities can be used

37. An advantage of a forward contract over a futures contract is that

38. A forward contract is similar to an option contract because they both

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

Sell December contract

Loss in futures = $292,500 $296,925 = $4425

Rate of return = $4425/29,692.50 = .1490 or 14.9%

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

48. Refer to Exhibit 20.2. Calculate the initial margin deposit.

PTS: 1 OBJ: Multiple Choice Problem

Gain in futures = $105,250 $103,187.50 = $2,062.50

Rate of return = 2062.5/10318.75 = 0.1999 or 19.9%

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

(1) Buy 500 shares, and

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

Loss on stock = $700.00

Net loss = $700.00 500.00 = $200.00 (loss)

PTS: 1 OBJ: Multiple Choice Problem

Stock (105 87)(100) = $1,800.00

Net loss = $2,000 1,800 = $200.00 (loss)

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

57. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss?

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

59. Refer to Exhibit 20.5. What is Sarah's annualized gain/loss?

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem

PTS: 1 OBJ: Multiple Choice Problem