Chapters 20, 22 & 24

CHAPTER 20

AN INTRODUCTION TO DERIVATIVE MARKETS AND SECURITIES

TRUE/FALSE QUESTIONS

(t) 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.

(t) 2 Forward and future contracts, as well as options, are types of derivative securities.

(f) 3 All features of a forward contract are standardized, except for price and number of contracts.

(t) 4 Forward contracts are traded over-the-counter and are generally not standardized.

(t) 5 The forward market has low liquidity relative to the futures market.

(f) 6 A futures contract is an agreement between a trader and the clearinghouse of the exchange for delivery of an asset in the future.

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

(f) 8 The futures market is a dealer market where all the details of the transactions are negotiated.

(f) 9 Futures contracts are slower to absorb new information than forward contracts.

(f) 10 The initial value of a future contract is the price agreed upon in the contract.

(t) 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.

(f) 12 Investment costs are generally higher in the derivative markets than in the corresponding cash markets.

(f) 13 An option buyer must exercise the option on or before the expiration date.

(t) 14 The minimum value of an option is zero.

(f) 15 An option to sell an asset is referred to as a call, whereas an option to buy an asset is called a put.

(t) 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.

(t) 17 Investors buy call options because they expect the price of the underlying stock to increase before the expiration of the option.

(t) 18 A call option is in the money if the current market price is above the strike price.

(f) 19 A put option is in the money if the current market price is above the strike price.

(t) 20 The price at which the stock can be acquired or sold is the exercise price.

(t) 21 The minimum amount that must be maintained in an account is called the maintenance margin.

MULTIPLE CHOICE QUESTIONS

(d) 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)

(e) 2 Derivative instruments exist becausea) 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 be) All of the above

(c) 3 There are in 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)

(d) 4 Futures differ from forward contracts becausea) Futures have more liquidity risk.b) Futures have more credit risk.c) Futures have more maturity risk.d) None of the abovee) All of the above

(d) 5 The price at which a futures contract is set at the end of the day is thea) Stock price.b) Strike price.c) Maintenance price.d) Settlement price.e) Parity price.

(e) 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

(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 marketplaceb) Creation of a non-liquid secondary option marketc) Introduction of a Clearing Corporationd) Standardization of all expiration datese) Standardization of all exercise prices

(e) 8 Which of the following factors is not considered in the valuation of call and put options?a) Current stock priceb) Exercise pricec) Market interest rated) Volatility of underlying stock pricee) none of the above (that is, all are factors which should be considered in the

valuation of call and put options)

(a) 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.

(a) 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]

(c) 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.

(b) 12 In the valuation of an option contract, the following statements apply excepta) 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.

(a) 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 toa) 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.

(b) 14 A vertical spread involves buying and selling call options in the same stock witha) 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.

(b) 15 The value of a put option at expiration isa) 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

(a) 16 In the two state option pricing model, which of the following does not influence the option price?a) Past stock priceb) Up and down factors u and dc) The risk free rated) The exercise pricee) Current stock price

(c) 17 The cost of carry includes all of the following excepta) Storage costs.b) Insurance.c) Current price.d) Financing costs.e) Risk free rate.

(b) 18 A call option in which the stock price is higher than the exercise price is said to bea) At-the-money.b) In-the-money.c) Before-the-money.d) Out-of-the-money.e) Above-the-money.

(d) 19 The price paid for the option contract is referred to as thea) Forward price.b) Exercise price.c) Striking price.d) Option premium.a) Call price.

(b) 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.

(c) 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.c) Out-of-the-money.d) At breakeven.e) None of the above.

(c) 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.c) Out-of-the-money.d) At breakeven.e) None of the above.

(a) 23 A stock currently sells for $15 per share. A put option on the stock with an exercise price $15 currently sells for $1.50. The put option is a) At-the-money.b) In-the-money.c) Out-of-the-money.d) At breakeven.e) None of the above.

(b) 24 A stock currently sells for $15 per share. A put option on the stock with an xercise price $20 currently sells for $6.50. The put option is a) At-the-money.b) In-the-money.c) Out-of-the-money.d) At breakeven.e) None of the above.

(c) 25 An equity portfolio manager can neutralize the risk of falling stock prices by entering into a hedge position where the payoffs area) 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.e) None of the above.

(b) 26 The derivative based strategy known as portfolio insurance involvesa) 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).

(d) 27 A hedge strategy known as a collar agreement involves the simultaneousa) 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 underlying asset with same expiration date and market price.c) Purchase 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.d) Purchase of an out-of-the money put and sale of an out-of-the-money call

on the same underlying asset with same expiration date and market price.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.

(c) 28 A call option differs from a put option in thata) 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

(b) 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.

(b) 30 According to put/call paritya) Stock price + Call Price = Put Price + Risk Free Bond Priceb) Stock price + Put Price = Call Price + Risk Free Bond Pricec) Put price + Call Price = Stock Price + Risk Free Bond Priced) Stock price - Put Price = Call Price + Risk Free Bond Pricee) Stock price + Call Price = Put Price - Risk Free Bond Price

MULTIPLE CHOICE PROBLEMS

(d) 1 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) $3.04b) $4.64c) $6.08d) $3.83e) $0

(d) 2 A one year call option has a strike price of 50, expires in 6 months, and has a price of $4.74. If the risk free rate is 3%, and the current stock price is $45, what should the corresponding put be worth?b) $12.74a) $10.48c) $5.00d) $9.00e) $8.30

(c) 3 A one year call option has a strike price of 60, expires in 6 months, and has a price of $2.5. If the risk free rate is 7%, and the current stock price is $55, what should the corresponding put be worth?a) $5.00b) $4.56c) $5.50d) $7.08e) $7.54

(d) 4 A one year call option has a strike price of 70, expires in 3 months, and has a price of $7.34. If the risk free rate is 6%, and the current stock price is $62, what should the corresponding put be worth?a) $5.34b) $8.00c) $10.68d) $14.33e) $13.33

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

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.

(c) 5 How much must you deposit in a margin account if you wish to purchase one contract?a) $267,232.5b) $29,450c) $29,692.50d) $30,000e) $265,050

(c) 6 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%e) None of the above

(b) 7 Calculate the return on a cash investment in the S&P 500 stock index over the same time perioda) 1.87%b) -0.68%c) -14.90%d) 10.36%e) None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

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%.

(c) 8 Calculate the current value of one contracta) $100,000b) $103,600.5c) $103,187.5d) $102,306.3e) $104,293.5

(c) 9 Calculate the initial margin deposita) $10,000b) $10,360.50c) $10,318.75d) $10,230.63e) $10,429.35

(b) 10 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%

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

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 1/4 240 2 1/2 3 1/2 4 1/2 4 3/4

(d) 11 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 lossb) $350.00 lossc) $225.00 gaind) $350.00 gain

e) $850.00 gain

(b) 12 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 lossc) $350.00 lossd) $25.00 losse) He has a gain


Rick Thompson is considering the following alternatives for investing in Davis Industries which is now selling for $44 per share:

1) Buy 500 shares, and2) Buy six month call options with an exercise price of 45 for $3.25 premium.

(a) 13 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% gainb) 53.85% gainc) 161.54% lossd) 11.11% gaine) 53.85% loss

(b) 14 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% lossb) 95.45% lossc) 0.9545% gaind) 95.45% gaine) 9.54% gain

(a) 15 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 lossb) $700 lossc) $200 gaind) $700 gaine) None of the above

(b) 16 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 gainb) $200 lossc) $1000 lossd) $200 gaine) None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

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.

(d) 17 If at expiration Peppy is selling for $42.00, what is Sarah’s dollar gain or loss?a) $420 gainb) $420 loss

c) $475 lossd) $475 gaine) None of the above

(b) 18 What is Sarah’s annualized gain/loss?a) 11.51% gainb) 115.15% gainc) 11.51% lossd) 115.15% losse) None of the above

(a) 19 If at expiration Peppy is selling for $47.00, what is Sarah’s dollar gain or loss?a) $25 lossb) $250 lossc) $25 gaind) $250 gaine) None of the above

(b) 20 What is Sarah’s annualized gain/loss?a) 60.60% gainb) 6.06% lossc) 60.60% lossd) 6.06% gaina) None of the above

(a) 21 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) $11b) $24c) $19d) $30e) $25

(e) 22 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) $120b) $15c) $105d) $116e) $104

(d) 23 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) $10b) -$4c) $5d) $6e) $15

(c) 24 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) $3b) -$2c) $2d) -$3e) $0

(c) 25 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) $25b) -$2c) $2d) -$25e) $0

(b) 26 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 earna) $0b) $1c) $5d) $4e) None of the above

(c) 27 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) -$0.50b) $0c) $0.50d) $5

e) -$5

(a) 28 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) -$525b) $1000c) $0d) -$1000e) $525

(d) 29 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) -$1000b) $1000c) $575d) -$575e) $0

(e) 30 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) $10b) $50c) $55d) -$10e) $0

(a) 31 Consider a stock that is currently trading at $20. Calculate the intrinsic value for a put option that has an exercise price of $35.a) $15b) $55c) $35d) -$15e) $0

(e) 32 Consider a stock that is currently trading at $45. Calculate the intrinsic value for a call option that has an exercise price of $35.a) $25b) $35c) $0d) -$10e) $10

(c) 33 Consider a stock that is currently trading at $10. Calculate the intrinsic value for a call option that has an exercise price of $15.a) $25b) -$5c) $0d) $20e) $5

CHAPTER 20

ANSWERS TO PROBLEMS

1 p(t) = $5.04 - $50+ $50(1 + .05)-½ = $3.83

2 p(t) = $4.74 - $45+ $50(1 + .03)-½ = $9.0

3 p(t) = $2.5 - $55+ $60(1 + .07) -½ = $5.50

4 p(t) = $7.34 - $62+ $70(1 + .06)-1/4 = $14.33

5 Margin = 0.10 x 250 x 1187.70 = $29,692.50

6 Purchase December contract 250 x 1187.7 = $296,925

Sell December contract 250 x 1170 = $292,500

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

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

7 Return on cash investment in the index = (1170 – 1178)/1178 = -0.0068 or 0.68%

8 Current price is 103 6/32 percent of face value of $100,000

= 1.031875 x 100,000 = $103,187.50

9 Margin deposit = 0.10 x 103,187.5 = $10,318.75

10 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%

11 43 1/2 - 35 = 8.58.5 - 5 = 3.5 $3.5/share x 100 shares/contract = $350.00

12 The option is worthless so he loses the $475 he paid for the contract.

13 [(50 - 45 - 3.25) ÷ 3.25] x 3 = 161.54% gain

14 [(30 - 44) ÷ 44] x 3 = 95.45% loss

15 Profit on put = 105 - 80 - 20 = 55 x 100 = $500.00

Loss on stock = $700.00

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

16 Put value = 0, therefore, loss = $2,000.00

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

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

17 [(55 - 42 - 8.25) x 100] = $475 gain

18 [(55 - 42 - 8.25) 8.25] x 2 = 115.15% gain

19 [(55 - 47 - 8.25) x 100] = $25 loss

20 [(55 - 47 - 8.25) 8.25] x 2 = 6.06% loss

21 P = 6 + 30 –25 = $11

22 Bond price = 115 + 5 – 16 = $104

23 Profit on call = (75 – 60) – 5 = 10Profit on put = -4Total = $6

24 Profit on stock = 40 – 35 = 5Profit on put = -3Total = $2

25 Profit on stock = 70 – 35 = 25Profit on call = 35 – 70 + 2 = -23Total = $2

26 Arbitrage profit = 110 – 105 – 4 = $1

27 Time premium = 6.25 – 5.75 = $0.50

28 Dollar return = (100 – 110 – 5.25)(100) = -$525

29 Dollar return = (110 – 120 – 5.75)(100) = -$575

30 Put = Max[55 – 65, 0] = $0

31 Put = Max[35 – 20, 0] = $15

32 Call = Max[45 – 35, 0] = $10

33 Call = Max[10 – 15, 0] = $0

CHAPTER 22

OPTION CONTRACTS


(t) 1 The Chicago Board Options Exchange has the largest share of stock option trading.

(f) 2 Index options are settled by delivery of the stocks that make up the index.

(t) 3 In index options, the aggregate market takes the place of the individual stock issues being traded, as in stock options.

(f) 4 Risk management is the driving force behind the futures options market.

(t) 5 The longer the time to expiration, the greater the value of a call option.

(f) 6 There is an inverse relationship between the market interest rate and the value of a call option.

(f) 7 Credit risk in the options market is only a concern to the option seller.

(t) 8 The standardization of option contracts and the creation of the Options Clearing Corporation are two important results of the opening of the Chicago Board of Options Exchange.

(f) 9 Stock options expire on the Sunday following the third Saturday of the designated month.

(t) 10 A price spread (or vertical spread) involves buying and selling an option for the same stock and expiration date but with different exercise prices.

(t) 11 A portfolio containing a share of stock and a put option will have the same value as a portfolio containing a call option and the risk-free discount bond.

(f) 12 A strip is a call option on a stock that is written by someone that owns the stock.

(t) 13 The buyer of a straddle expects stock prices to move strongly in either direction.

(t) 14 A long strip position indicates that an investor is bullish but conservative.

(t) 15 Index options can only be settled in cash.

(f) 16 Unlike stock options, futures options require the holder to enter into a utures contract.

(f) 17 It is a violation of the securities laws to combine option contracts to achieve a customized payoff.

(t) 18 European options can only be exercised on the expiration date.

(f) 19 The owner of a call option on a futures contract has the obligation to buy the futures contract at a predetermined strike price during a specified time period.

(f) 20 Options on futures expire at the same time the futures contract expires.

(f) 21 The underlying stock price and the value of the put option are factors that impact the value of an American call option.

(t) 22 The binomial option pricing model approximates the price of an option obtained using the Black-Scholes option pricing model as the number of subintervals increases.

(f) 23 Investors should purchase market index put options if they anticipate an increase in the index value.


(d) 1 The creation of the CBOE led to all the following innovations in options except a) The creation of a central marketplace.b) The introduction of a clearing corporation.c) The standardization of expiration dates.d) The creation of a primary market.e) The creation of a secondary market.

(b) 2 A calendar spread requires the purchase and sale of two calls or two puts in the same stock witha) The same expiration date but different exercise prices.b) The same exercise price but different expiration dates.c) Different exercise prices and different expiration dates.d) The same exercise price and the same expiration month.e) Traded in different markets.

(b) 3 In a money spread, an investor would a) Buy two in-the-money call options on the same stock with different

exercise dates.

b) Buy two out-of-the-money call options on the same stock with different exercise dates.

c) Sell two in-the-money call options on the same stock with different exercise dates.

d) Sell an out-of-the-money call and purchase an in-the-money call on the same stock with the same exercise date.

e) Sell two out-of-the-money call options on the same stock with different exercise dates.

(b) 4 A money spread involves buying and selling call options in the same stock witha) 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 exercise price.e) Options in different markets.

(b) 5 If you were to purchase an October option with an exercise price of 50 for 8 and simultaneously sell an October option with an exercise price of 60 for 2, you would bea) Bullish and taking a high risk.b) Bullish and conservative.c) Bearish and taking a high risk.d) Bearish and conservative.e) Neutral.

(a) 6 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 toa) Purchase a put.b) Purchase a call.c) Purchase an index option.d) Utilize a bearish spread.e) Utilize a bullish spread.

(b) 7 If you were to purchase an October option with an exercise price of 50 for $8 and simultaneously sell an October option with an exercise price of 60 for $2, you would bea) Bullish and taking a high risk.b) Bullish and conservative.c) Bearish and taking a high risk.d) Bearish and conservative.e) Neutral.

(b) 8 A vertical spread involves buying and selling call options in the same stock witha) The same time period and price.b) The same time period but different price.

c) A different time period but same price.d) A different time period and different price.e) Options in different markets.

(c) 9 Which of the following is not a factor needed to calculate the value of an American call option?a) The stock priceb) The exercise pricec) The exchange on which the option is listedd) The volatility of the underlying stocke) The interest rate

(a) 10 Buying a bear spread is equivalent to a) Selling a bull spread.b) Buying an out-of-the-money call and selling an in-the-money call on the

same stock with the same exercise date.c) Selling an out-of-the-money call and buying an in-the-money call on the

same stock with a different exercise price.d) Choices a and b only.e) None of the above

(c) 11 A currency call is like being in the currency futures.a) Out-of-the-moneyb) In-the-moneyc) Longd) Shorte) At-the-money

(a) 12 A straddle is the simultaneous purchase (or sale) of a put and call option with the same underlying asset,a) Same exercise price, and expiration date.b) Same exercise price but different expiration date.c) Same expiration date but different exercise price.d) Either choices b or c.e) None of the above.

(b) 13 In the Black-Scholes option pricing model, an increase in security price (S) will causea) An increase in call value and an increase in put valueb) An increase in call value and a decrease in put valuec) An decrease in call value and an increase in put valued) An decrease in call value and a decrease in put value

e) An increase in call value and an increase or decrease in put value

(c) 14 In the Black-Scholes option pricing model, an increase in exercise price (X) will causea) An increase in call value and an increase in put valueb) An increase in call value and a decrease in put valuec) An decrease in call value and an increase in put valued) An decrease in call value and a decrease in put valuee) An increase in call value and an increase or decrease in put value

(e) 15 In the Black-Scholes option pricing model, an increase in time to expiration (T) will causea) An increase in call value and an increase in put valueb) An increase in call value and a decrease in put valuec) An decrease in call value and an increase in put valued) An decrease in call value and a decrease in put valuee) An increase in call value and an increase or decrease in put value

(b) 16 In the Black-Scholes option pricing model, an increase in the risk free rate (RFR) will causea) An increase in call value and an increase in put valueb) An increase in call value and a decrease in put valuec) An decrease in call value and an increase in put valued) An decrease in call value and a decrease in put valuee) An increase in call value and an increase or decrease in put value

(a) 17 In the Black-Scholes option pricing model, an increase in security volatility (σ) will causea) An increase in call value and an increase in put valueb) An increase in call value and a decrease in put valuec) An decrease in call value and an increase in put valued) An decrease in call value and a decrease in put valuee) An increase in call value and an increase or decrease in put value

(d) 18 The value of a call option is positively related to:a) Underlying stock price.b) Time to expirationc) Exercise price.d) a) and b)e) b) and c)

(c) 19 The value of a call option is inversely related to:

a) Underlying stock price.b) Time to expirationc) Exercise price.d) a) and b)e) b) and c)

(b) 20 If the hedge ratio is 0.50, this indicates that the portfolio should holda) Two shares of stock for every call option written.b) One share of stock for every two call options written.c) Two shares of stock for every call option purchased.d) One share of stock for every two call options purchased.e) Two call options for every put option written.

(e) 21 Options can be used toa) Modify an equity portfolio's systematic risk.b) Modify an equity portfolio's unsystematic risk.c) Manage currency exposures in international equity portfolios.d) Change a portfolio’s exposure to a particular asset e) All of the above


USE THE FOLLOWING INFORMATION FOR THE NEXT SIX PROBLEMS

Option Type Currency Canadian dollarContract Size 50000 Canadian dollarsExpiry April

Strike Call Put$0.815 $0.0118$0.820 $0.0068

(d) 1 How much must an investor pay for one call option contract?a) $680b) $815c) $625d) $590e) $340

(c) 2 How much must an investor pay for one put option contract?a) $680b) $815c) $340d) $625e) $590

(c) 3 If the spot rate at expiration is $0.90 and the call option was purchased, what is the dollar gain or loss?

a) $0b) $3750 gainc) $3660 gaind) $4650 losse) $2680 loss

(b) 4 If the spot rate at expiration is $0.80 and the call option was purchased, what is the dollar gain or loss?a) $123 gainb) $590 lossc) $312 gaind) $237 gaine) $0

(a) 5 If the spot rate at expiration is $0.85 and the put option was purchased, what is the dollar gain or loss?a) $340 lossb) $125 gainc) $750 gaind) $750 losse) $200 loss

(d) 6 If the spot rate at expiration is $0.75 and the put option was purchased, what is the dollar gain or loss?a) $0b) $200 lossc) $200 gaind) $3160 gaine) $1187 loss

USE THE FOLLOWING INFORMATION FOR THE NEXT TEN PROBLEMS

XYZ CORP

EXERCISE NYSEDATE PRICE PRICE CLOSE

CALLS OCT 85 16 3/4 101 11/16OCT 90 12 101 11/16OCT 95 7 5/8 101 11/16

PUTS OCT 85 1/8 101 11/16OCT 90 3/8 101 11/16OCT 95 13/16 101 11/16

(a) 7 If you establish a long straddle using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $18.75 lossb) $18.75 gainc) $1,668.75 gaind) $1,668.75 losse) $1,687.50 loss

(d) 8 If you establish a long strap using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $1,687.50 lossb) $3,362.50 lossc) $3,675.50 gaind) $13.00 gaine) $13.00 loss

(e) 9 If you establish a long strip using the options with an 85 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $1,668.75 gainb) $1,700.00 gainc) $1,700.00 lossd) $31.25 gaine) $31.25 loss

(a) 10 If you establish a long straddle using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $68.75 lossb) $68.75 gainc) $37.50 lossd) $1,200.00 losse) $1,200.00 gain

(c) 11 If you establish a long strap using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $37.50 lossb) $37.50 gainc) $100.00 lossd) $100.00 gaine) $2,437.50 loss

(b) 12 If you establish a long strip using the options with an 90 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $106.25 gainb) $106.25 lossc) $1,275.00 lossd) $1,275.00 gaine) $75.00 loss

(d) 13 If you establish a long straddle using the options with an 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $668.75 gainb) $668.75 lossc) $94.56 gaind) $94.56 losse) $81.25 loss

(d) 14 If you establish a long strap using the options with an 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $81.25 lossb) $1,606.25 gainc) $1,606.25 lossd) $268.75 losse) $268.75 gain

(a) 15 If you establish a long strip using the options with a 95 exercise price, what is your dollar gain or loss if at expiration XYZ is still trading at 101 11/16?a) $256.25 lossb) $256.25 gainc) $925.00 lossd) $668.75 gaine) $668.75 loss

(b) 16 If XYZ were trading at $90/share and you formed a bull money spread, what is your profit if XYZ is trading at $110 at expiration?

a) $912.50 lossb) $87.50 gainc) $87.50 lossd) $1,000.00 gaine) $1,000.00 loss

THE FOLLOWING INFORMATION IS FOR THE NEXT TWO PROBLEMS

A stock currently trades for $130 per share. Options on the stock are available with a strike price

of $125. The options expire in 10 days. The risk free rate is 3% over this time period, and the

expected volatility is 0.35.

(d) 17 Use the Black-Scholes option pricing model to calculate the price of a call option.a) $5.19b) $4.35c) $3.93d) $6.19e) $8.17

(a) 18 Calculate the price of the put option.a) $1.086b) $0.862c) $6.234d) $0.623e) $2.317

(a) 19 Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock.

Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $65.

a) $71.75 b) $76.75c) $58.25d) $81.75e) None of the above

(d) 20 Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock.

Suppose that you buy a call with a strike price of $70 and a price of $6.75. Calculate the effective price paid to repurchase the stock if the price after 35 days is $80.


(d) 21 Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock.

Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $70.


(a) 22 Assume that you have just sold a stock for a loss at a price of $75, for tax purposes. You still wish to maintain exposure to the sold stock.

Suppose that you sell a put with a strike price of $80 and a price of $7.25. Calculate the effective price paid to repurchase the stock if the price after 35 days is $85.

a) $77.75 b) $87.25c) $82.25d) $72.75e) None of the above.

USE THE FOLLOWING INFORMATION FOR THE NEXT 12 QUESTIONS

Consider the following information on put and call options for Citigroup

Strike Price Put Price Call Price$32.50 $2.85 $1.65

(b) 23 Calculate the net value of a protective put position at a stock price at expiration of $20, and a stock price at expiration of $45.a) $6.35, $18.85b) $29.65, $42.15c) $21.65, $34.15d) $8, $8

e) -$8, -$8

(b) 24 A protective put is an appropriate strategy ifa) An investor wishes to generate additional income.b) An investor wished to insure against a decline in share values.c) An investor expected share prices to be volatile.d) An investor expected share prices to remain in a trading range.e) An investor expected share prices to be volatile, but was inclined to be

bullish.

(c) 25 Calculate the net value of a covered call position at a stock price at expiration of $20, and a stock price at expiration of $45.a) $6.35, $18.85b) $29.65, $42.15c) $21.65, $34.15d) $8, $8e) -$8, -$8

(a) 26 A covered call is an appropriate strategy ifa) An investor wishes to generate additional income.b) An investor wished to insure against a decline in share values.c) An investor expected share prices to be volatile.d) An investor expected share prices to remain in a trading range.e) An investor expected share prices to be volatile, but was inclined to be

bullish.

(d) 27 Calculate the payoffs of a long straddle at a stock price at expiration of $20 and a stock price at expiration of $45.a) $6.35, $18.85b) $29.65, $42.15c) $21.65, $34.15d) $8, $8e) -$8, -$8

(c) 28 A long straddle is an appropriate strategy ifa) An investor wishes to generate additional income.b) An investor wished to insure against a decline in share values.c) An investor expected share prices to be volatile.d) An investor expected share prices to remain in a trading range.e) An investor expected share prices to be volatile, but was inclined to be

bullish.

(e) 29 Calculate the payoffs of a short straddle at a stock price at expiration of $20 and a stock price at expiration of $45.a) $6.35, $18.85b) $29.65, $42.15c) $21.65, $34.15d) $8, $8e) -$8, -$8

(d) 30 A short straddle is an appropriate strategy ifa) An investor wishes to generate additional income.b) An investor wished to insure against a decline in share values.c) An investor expected share prices to be volatile.d) An investor expected share prices to remain in a trading range.e) An investor expected share prices to be volatile, but was inclined to be

bullish.

(a) 31 Calculate the payoffs of a long strap at a stock price at expiration of $20 and a stock price at expiration of $45.a) $6.35, $18.85b) $29.65, $42.15c) $21.65, $34.15d) $8, $8e) -$8, -$8

(e) 32 A long strap is an appropriate strategy ifa) An investor wishes to generate additional income.b) An investor wished to insure against a decline in share values.c) An investor expected share prices to be volatile.d) An investor expected share prices to remain in a trading range.e) An investor expected share prices to be volatile, but was inclined to be

bullish.

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT THREE QUESTIONS

The information provided is relevant in the context of a one period (one year) binomial option pricing model. A stock currently trades at $50 per share, a call option on the stock has an exercise price of $45. The stock is equally likely to rise by 25% or fall by 25%. The one-year risk free rate is 2%.

(b) 33 Calculate the possible prices of the stock one year from todaya) $37.50 or $17.50.b) $62.50 or $37.50.c) $62.50 or $17.50.d) $50 or $45.e) None of the above.

(a) 34 Estimate n, the number of call options that must be written

a) -1.4286b) -2.9286c) -2.8571d) -2.5714e) -1.1111

(c) 35 Calculate the price of the call option today (C0)a) $7.56b) $17.48c) $9.26d) $5.0e) $17.15

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FOUR QUESTIONS

The following information is provided in the context of a two period (two six month periods) binomial option pricing model. A stock currently trades at $60 per share, a call option on the stock has an exercise price of $65. The stock is equally likely to rise by 15% or fall by 15% during each six month period. The one-year risk free rate is 3%.

(c) 36 Calculate the possible prices of the stock at the end of one yeara) $69, $51, $79.35b) $51, $79.35, $58.65c) $79.35, $58.65, $43.35d) $58.65, $43.35, $14.35e) None of the above

(a) 37 Calculate the price of the call option after the stock price has already moved up in value once (Cu)a) $7.77b) $14.35c) $0d) $4.21e) $6.44

(c) 38 Calculate the price of the call option after the stock price has already moved down in value once (Cd)a) $7.77b) $14.35c) $0d) $4.21e) $6.44

(d) 39 Calculate the price of the call option today (C0)a) $7.77

b) $14.35c) $0d) $4.21e) $6.44

CHAPTER 22

ANSWERS TO PROBLEMS

1 (US$/Can$)(0.0118)(50,000 Can$) = $590

2 (US$/Can$)(0.0068)(50,000 Can$) = $340

3 Cost = $590Net gain = (0.90 - 0.815)(50,000) -590 = $3,660

4 Cost = $590Payoff = (0) – 590 = -$590 (Option expires worthless)

5 Cost = $340Payoff = (0) – 340 = -$340 (Option expires worthless)

6 Cost = $340Payoff = (0.82 – 0.75)(50,000) - $340= $3160

7 Long straddle: purchase one OCT 85 put and one OCT 85 callCost of one call = 16 3/4(100) = $1,675.00Cost of one put = 1/8(100) = $12.50 Total cost = $1,687.50

Payoff on one call = 100(101 11/16 - 85) = $1,668.75Payoff on one put = 0, expires out of the moneyNet gain/loss = $1,668.75 - $1,687.50 = $18.75 loss

8 Long strap: purchase two OCT 85 calls and one OCT 85 put

Cost of 2 calls = 2(16.75(100) = $3,350.00Cost of one put = 1/8(100) = $12.50 Total cost = $3,362.50

Payoff on 2 calls = 2(100)(101 11/16 - 85) = $3,375.00Payoff on one put = 0, expires out of the moneyNet gain/loss = $3,375.50 - $3,362.50 = $13.00 gain

9 Long strip: purchase one OCT 85 call and two OCT 85 putsCost of one call = 16 3/4(100) = $1,675.00Cost of two puts = 2(1/8)(100) = $25.00

Total cost = $1,700.00

Payoff on one call = 100(101 11/16 - 85) = $1,668.75Payoff on two puts = 0, expires out of the moneyNet gain/loss = $1,668.75 - $1,700.00 = $31.25 loss

10 Long straddle: purchase one OCT 90 put and one OCT 90 callCost of one call = 12(100) = $1,200.00Cost of one put = 3/8(100) = $37.50 Total cost = $1,237.50

Payoff on one call = 100(101 11/16 - 90) = $1,168.75Payoff on one put = 0, expires out of the moneyNet gain/loss = $1,168.75 - $1,237.50 = $68.75 loss


Cost of 2 calls = 2(12.00(100) = $2,400.00Cost of one put = 3/8(100) = $37.50 Total cost = $2,437.50

Payoff on 2 calls = 2(100)(101 11/16 - 90) = $2,337.50Payoff on one put = 0, expires out of the moneyNet gain/loss = $2,337.50 - $2,437.50 = $100.00 loss

12 Long strip: purchase one 90 call and two OCT 90 putsCost of one call = 12(100) = $1,200.00Cost of two puts = 2(3/8)(100) = $75.00 Total cost = $1,275.00

Payoff on one call = 100(101 11/16 - 90) = $1,168.75Payoff on two puts = 0, expires out of the moneyNet gain/loss = $1,168.75 - $1,275.00 = $106.25 loss

13 Long straddle: purchase one OCT 95 put and one OCT 95 call

Cost of one call = 7 5/8(100) = $762.50Cost of one put = 13/16(100) = $81.25 Total cost = $763.31

Payoff on one call = 100(101 11/16 - 95) = $668.75Payoff on one put = 0, expires out of the moneyNet gain/loss = $668.75 - $763.31 = $94.56 loss


Cost of 2 calls = 2(7 5/8)(100) = $1,525.00Cost of one put = 13/16(100) = $81.25 Total cost = $1,606.25

Payoff on 2 calls = 2(100)(101 11/16 - 95) = $1,337.50Payoff on one put = 0, expires out of the moneyNet gain/loss = $1,337.50 - $1,606.25 = $268.75 loss

15 Long strip: purchase one 95 call and two OCT 95 puts

Cost of one call = 7 5/8(100) = $762.50Cost of two puts = 2(13/16)(100) = $162.50 Total cost = $925.00

Payoff on one call = 100(101 11/16 - 95) = $668.75Payoff on two puts = 0, expires out of the moneyNet gain/loss = $668.75 - $925.00 = $256.25 loss

16 Bull money spread = buy the in-the-money call, i.e., OCT 85 and sell the out-of-the-money call, i.e., OCT 95

Cost of buying OCT 85 call = 100(16 3/4) = $1,675.00Proceeds from selling OCT 95 call = 100(7 5/8) = $762.50 Net cost $912.50

Payoff on OCT 85 call = 100(110 - 85) = $2,500.00Payoff on OCT 95 call = 100(110 - 95) = ($1,500.00)Net payoff = $2,500.00 - 1,500.00 = $1,000.00Total gain/loss = $1,000.00 - 912.50 = $87.50 gain

17 Price using the B-S option pricing model

d1 = ln(130/125) + [(.03 + 5(.352))(.0833)]/(.35(.02778.5)) = 0.715807

d2 = 0.715807 - (.35(.02778.5)) = 0.657474

N(d1) = 0.762945N(d2) = 0.744562

Call price = Pc = 120[0.762945– 125(e-.03(.02778))( 0.744562] = $6.19

18 Put price = 6.19 + 125(e-.03(.02778)) – 130 = $1.086

19 The effective price is 65 + 6.75 = $71.75

The option expires worthless so your effective price is the current price plus the option premium.

20 The effective price is 70 + 6.75 = $76.75

The option is exercised so your effective price is the strike price plus the option premium.

21 The effective price is 80 – 7.25 = $72.75

The option is exercised so your effective price is the strike price less the option premium.

22 The effective price is 85 – 7.25 = $77.75

The option expires worthless so your effective price is the current price less the option premium.

23 At S = 20Net value of protective put = (32.5 – 20) – 2.85 + 20 = 29.65At S = 45Net value of protective put = – 2.85 + 45 = 42.15

24 This strategy is appropriate if an investor wished to insure against a decline in share values.

25 At S = 20Net value of covered call = 1.65 + 20 = 21.65At S = 45Net value of covered call = -(45 – 32.5) + 1.65 + 45 = 34.15

26 This strategy is appropriate if an investor wished to generate additional income.

27 At S = 20Net payoff on a long straddle = (32.5 – 20) -1.65 – 2.85 = 8At S = 45Net payoff on a long straddle = (45 - 32.5) -1.65 – 2.85 = 8

28 This strategy is appropriate if an investor expected share prices to be volatile.

29 At S = 20Net payoff on a short straddle = -(32.5 – 20) + 1.65 + 2.85 = -8At S = 45Net payoff on a long straddle = -(45 - 32.5) + 1.65 + 2.85 = -8

30 This strategy is appropriate if an investor expected share prices to remain in a trading range.

31 At S = 20

Net payoff on a long strap = (32.5 – 20) – (2)(1.65) – 2.85 = 6.35At S = 45Net payoff on a long straddle = (2)(45 - 32.5) – (2)(1.65) – 2.85 = 18.85

32 This strategy is appropriate if an investor expected share prices to be volatile.

33 If the stock rises the price one year for now will be = 50(1 + 0.25) = $62.50

If the stock falls the price one year for now will be = 50(1 - 0.25) = $37.50

34 Current stock price = $50Exercise price = $45Risk free rate = 2%Price in one year if stock rises = 50(1.25) = $62.50Price in one year if stock declines = 50(1.25) = $37.50

Intrinsic value of call option if stock rises to $62.50 = Max[0, 62.50 – 45] = $17.50

Intrinsic value of call option if stock falls to $37.50 = Max[0, 37.50 – 45] = $0

Estimate the number calls needed by setting:The hedge portfolio will consist of one share of stock held long plus some number of call options written.Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls

62.50 + (17.5)(n) = 37.50 + (0)(n)

n = -1.4286

35 Value of hedge portfolio today = 50 – (1.4286)(C0) = 37.5/(1.02)

C0 = $9.26

36 Current stock price = $60Price in one year if stock rises 15% per six month period= 60(1.15)(1.15) = $$79.35

Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35

37 Current stock price = $60Exercise price = $65Risk free rate = 3% or 1.49% per six month period = (1.03)0.5 – 1 = 0.0149Price in six months if stock rises 15% = 60(1.15) = $69Price in six month if stock falls 15% = 60(0.85) = $51

Price in one year if stock rises 15% per six month period= 60(1.15)(1.15) = $79.35

Price in one year if stock rises 15%, then falls 15% = 60(1.15)(0.85) = $58.65

Price in one year if stock declines 15% per period = 60(0.85)(0.85) = $43.35

Intrinsic value of call option if stock rises to $79.35 = Max[0, 79.35 – 65] = $14.35

Intrinsic value of call option if stock falls to $58.65= Max[0, 58.65 – 65] = $0Intrinsic value of call option if stock falls to $43.35 = Max[0, 43.35 – 65] = $0

Estimate the number calls needed by constructing a hedge portfolio.The hedge portfolio will consist of one share of stock held long plus some number of call options written.

At the end of the first six month period:Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls

79.35 + (14.35)(n) = 58.65 + (0)(n)

n = -1.44251

Value of hedge portfolio at the end of first six months = 69 – (1.44251)(Cu) = 58.65/(1.0149)

Cu = $7.7719

38 Cd = 0. Since the ending stock prices of $58.65 and $43.35 are both below the exercise price.

39 To solve for the value of the call today (C0), first determine the number of calls by constructing a hedge portfolio where:

Right now:Value of hedge portfolio if stock rises = Value of hedge portfolio if stock falls

69 + (7.7719)(n) = 51 + (0)(n)

n = -2.31603

Value of hedge portfolio now = 60 – (2.31603)(C0) = 51/(1.0149)

C0 = $4.2092

CHAPTER 24

PROFESSIONAL ASSET MANAGEMENT


(t) 1 Management and advisory firms can advise clients on how to structure their own portfolios.

(t) 2 In an investment company, the invested funds belong to many individuals.

(t) 3 The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value.

(f) 4 A portfolio is generally managed by the board of directors of an investment company.

(f) 5 A closed-end investment company is normally referred to as a mutual fund.

(f) 6 The market price of shares of a closed-end fund is typically determined by supply and demand.

(t) 7 An open-end investment company differs from a closed-end investment company by the way they operate after the initial public offering.

(t) 8 Open-end investment companies continue to sell and repurchase shares after their initial public offering.

(f) 9 A no-load fund imposes a substantial sales charge and sells shares at their NAV.

(t) 10 All investment firms charge annual management fees to compensate the professional manager of the fund.

(t) 11 Hedge funds are far less liquid than mutual fund shares.

(t) 12 The primary purpose of government regulations and voluntary standards in the professional asset management industry is to ensure that managers deal with all investors fairly and equitably and that information about investment performance is accurately reported.

(f) 13 Hedge funds have no limitations on when and how often capital can be contributed or removed from the partnership.

(f) 14 The returns received by the average individual investor on funds managed by investment companies will probably be superior to the average results for a specific U.S. or international market.

(t) 15 An investor should be cautious when selecting a fund based solely on the manager’s past performance, since past performance may not be repeated in the future.

(t) 16 Diversifying a portfolio to eliminate unsystematic risk is one of the major benefits of investing in mutual funds.

(f) 17 High Portfolio turnover lowers mutual fund costs.

(t) 18 The total market value of all assets of a mutual fund divided by the number of shares of the fund is known as the net asset value.

(f) 19 Income distributions and capital gains distributions are the only source of returns for mutual funds.

(t) 20 The market price of shares of a closed-end fund is typically determined by supply and demand.

(f) 21 Closed-end investment companies never sell at discounts to their NAV.

(t) 22 Market index funds attempt to match the composition and performance of a specified market indicator series.

(f) 23 Open-end and closed-end investment companies are similar in that both companies will repurchase shares on demand.


(d) 1 Which of the following is an approach to asset management?a) Management and advisory firmsb) Investment companiesc) Strategic managementd) Choices a and b onlye) All of the above

(b) 2 An open-end investment company is commonly referred to as a(n)a) Balanced fund.b) Mutual fund.c) Money market fund.d) Accessible fund.

e) Unit trust.

(a) 3 The main difference between a closed-end fund and an open-end fund isa) The way each is traded after the initial public offering.b) There is no significant difference.c) The minimum initial investment.d) The type of allowable investments.e) The way in which each is regulated by the SEC.

(b) 4 Net asset value (NAV) is determined bya) The total market value of all its assets multiplied by the number of fund

shares outstanding.b) The total market value of all its assets divided by the number of fund shares

outstanding.c) The total market value of all its assets divided by the number of

shareholders.d) Supply and demand for the investment company stock in the secondary market.e) Supply and demand for the investment company stock in the primary market.

(a) 5 The market price of a closed-end investment company has generally beena) 5 to 20 percent below the NAV.b) 25 to 35 percent below the NAV.c) Equal to the NAV (within a 2 percent range).d) 5 to 20 percent above the NAV.e) 25 to 35 percent above the NAV.

(c) 6 The closed-end fund index isa) Value weighted and based on market values.b) Value weighted and based on NAVs.c) Price weighted and based on market values.d) Price weighted and based on NAVs.e) Equally weighted and based on market values.

(d) 7 Open-end mutual funds that charge a sales fee when the fund is initially offered to the investor are known asa) 12b-1.b) Americus trusts.c) Unit investment trusts.d) Load funds.e) Contingency funds.

(c) 8 A 12b-1 plan allows funds toa) Charge a redemption fee.b) Deduct 7 to 8 percent commission at the initial offering.c) Deduct .75 percent of the average net assets per year.

d) Charge a contingent deferred sales load.e) Switch from closed-end to open-end.

(d) 9 When the offer price and the NAV of a mutual fund are equal it is an indication thata) The fund’s assets are in equilibrium.b) The fund is trading at par.c) It is strictly a coincidence.d) The fund has no initial fee.e) The fund is backloaded.

(c) 10 All investment companies charge an annual a) 12b-1 fee.b) Marketing and distribution.c) Management fee.d) Maintenance fee.e) Market adjustment.

(b) 11 The offering price of a load fund equals the NAV of the funda) Less an initial requirement.b) Plus a sales charge.c) Plus a sales charge and an administrative fee.d) Less a negotiated discount.e) At its stated value.

(b) 12 Funds that normally contain a combination of common stock and fixed income securities are known asa) Section 401(k) plans.b) Balanced funds.c) Contractual plans.d) Income funds.e) Flexible funds.

(d) 13 Funds that attempt to provide current income, safety of principal and liquidity are known asa) Balanced funds.b) Flexible funds.c) Income funds.d) Money market funds.e) Index funds.

(e) 14 A money market fund would be likely to invest in a portfolio containing all of the following excepta) Commercial paper.b) Banker's acceptances.c) U.S. Treasury bills.

d) Bank certificates of deposit.e) U.S. Treasury notes.

(d) 15 A mutual fund typically performs all of the following functions, excepta) Provides alternative risk-return options.b) Eliminates unsystematic risk.c) Provides diversification.d) Derives a risk-adjusted performance that is consistently superior to risk-

adjusted net return of the aggregate market.e) Administers the account, keeps records and provides timely information.

(b) 16 Mutual fund performance studies have shown that most fundsa) Have risks and returns that are inconsistent with their stated objectives.b) Have risks and returns that are consistent with their stated objectives.c) Do not have stated objectives.d) Have experienced risk-adjusted returns above the market.e) Have changed their objectives over time.

(c) 17 The text offers a number of suggestions for investing in mutual funds. Which of the following is not such a suggestion?a) Choose only those mutual funds which are consistent with your objectives

and constraints.b) Invest in no-load funds whenever possible.c) Avoid investing in index funds.d) Use a dollar cost average strategy.e) None of the above (that is, all are valid suggestions for investing in mutual

funds)

(e) 18 The gross return of closed-end investments companies has typically beena) 10 - 20 percent less than their NAV.b) 10 - 15 percent less than their NAV.c) Less than the net return.d) About the same as the net return.e) None of the above

(e) 19 A major question in modern finance regarding closed-end investment companies is a) Why do these funds sell at discounts?b) Why do the discounts differ between funds?c) What are the returns available to investors from funds that sell at a large

discount?d) Choices a and b onlye) All of the above

(b) 20 A portfolio manager should be able to perform all of the following functions, excepta) Determine risk-return preferences.b) Eliminate systematic risk.c) Maintain diversification ensuring a stabilized risk class.d) Attempt to derive a risk-adjusted performance that is superior to the market.e) Administer the account, keep records and provide timely information.

(b) 21 An investment company isa) A corporation that handles the administrative functions for a fund.b) A corporation that has its major assets in a portfolio of securities.c) A corporation that invests in financial services firms.d) a) and b).e) a) and c).

(a) 22 An investment management company isa) A corporation that handles the administrative functions for a fund.b) A corporation that has its major assets in a portfolio of securities.c) A corporation that invests in financial services firms.d) a) and b).e) a) and c).

(d) 23 In the case of private management firms

a) Investors deal with a fund company and do not have separate accounts tailored to their specific needs.

b) Investors deal with a fund company and have separate accounts tailored to their specific needs.

c) Investors deal with an asset manager and do not have separate accounts tailored to their specific needs.

d) Investors deal with an asset manager have separate accounts tailored to their specific needs.

e) None of the above.

(a) 24 In the case of investment companiesa) Investors deal with a fund company and do not have separate accounts

tailored to their specific needs.b) Investors deal with a fund company and have separate accounts tailored to

their specific needs.c) Investors deal with an asset manager and do not have separate accounts

tailored to their specific needs.d) Investors deal with an asset manager have separate accounts tailored to their

specific needs.e) None of the above.

(e) 25 In the case of open-end investment companies, shares of the companya) Trade on the secondary market.b) Can be bought from or sold to the investment company at the NAV.c) Are determined by supply and demand.d) a) and c).e) b) and c).

(d) 26 In the case of closed-end investment companies, shares of the companya) Trade on the secondary market.b) Can be bought from or sold to the investment company at the NAV.c) Are determined by supply and demand.d) a) and c).e) b) and c).

(d) 27 The following are examples of mutual fund companiesa) Common stock funds.b) Bond funds.c) Hedge funds.d) a) and b).e) a), b) and c)

(b) 28 An example of an international fund would be one that consisted of investments in securities froma) The U.S., Germany, and Japan.b) Germany, Italy, and the U.K.c) The U.S., Korea, and Argentina.d) All of the above.e) None of the above.

(d) 29 The Investment Company Act of 1940a) Contains various anti-fraud provisions and record keeping and reporting

requirements for fund advisors.b) Regulates broker-dealers.c) Requires federal registration of all public offerings of securities.d) Regulates the structure and operations of mutual funds.e) Contains a code of ethics and standards of professional conduct.

(c) 30 The Securities Act of 1933a) Contains various anti-fraud provisions and record keeping and reporting

requirements for fund advisors.b) Regulates broker-dealers.c) Requires federal registration of all public offerings of securities.d) Regulates the structure and operations of mutual funds.

e) Contains a code of ethics and standards of professional conduct.

(b) 31 The Securities Exchange Act of 1934a) Contains various anti-fraud provisions and record keeping and reporting


(a) 32 The Investment Advisors Act of 1940a) Contains various anti-fraud provisions and record keeping and reporting


(d) 33 Soft dollars are generated whena) A manager commits to paying a higher than normal brokerage fee in

exchange for additional bundled services.b) A manager commits to paying a higher than normal brokerage fee in

exchange for secretarial services.c) A manager commits to paying a higher than normal brokerage fee in

exchange for office equipment.d) All of the above.e) None of the above.

(a) 34 Which of the following is a characteristic of hedge fundsa) They are generally less restricted in how and where they can make

investments.b) They are more liquid than mutual fund shares.c) They have no limitations on when and how often investment capital can be

contributed or removed.d) All of the above.e) None of the above.

(a) 35 In a long short-short hedge fund strategya) Managers take long positions in undervalued stocks and short positions in

overvalued stocks.b) Managers take short positions in undervalued stocks and long positions in

overvalued stocks.c) Managers take offsetting risk positions on the long and short side.d) All of the above.e) None of the above.

(b) 36 In a convertible arbitrage strategy hedge fund managers attempt toa) Generate profits by taking advantage of convertible bond pricing

disparities caused by changing market events.b) Generate profits by taking advantage of disparities in the relationship

between prices for convertible bonds and the underlying common stock.c) Generate profits by taking advantage of disparities in the relationship

between prices for convertible bonds and the underlying common stock option.

d) All of the above.e) None of the above.

(d) 37 Ethical conflicts may arise as a result ofa) Incentive compensation schemes.b) Soft dollar arrangements.c) Marketing investment management services.d) All of the above.e) None of the above.

(d) 38 Which of the following are guiding principles for ethical behavior in the asset management industry as put forward by the CFA Center for Financial Market Integritya) The interests of investment professional come first.b) The preferred method for promoting fair and efficient markets is to set up

a central oversight board.c) Financial markets in various countries should develop high-quality

standards for reporting financial information that reflect local customs.d) Financial statements should be reported from the perspective of firm

shareholders.e) All of the above.

(c) 39 Which of the following are functions that a portfolio manager should perform for clientsa) Determine investment objectives and constraints, diversify the portfolio,

eliminate tax payments.b) Determine investment objectives, diversify the portfolio, maintain ethical

standards and eliminate tax payments.c) Determine investment objectives and constraints, diversify the portfolio,

and maintain ethical standards.d) Determine constraints, diversify the portfolio, eliminate tax payments.e) Determine investment objectives and constraints, diversify the portfolio,

eliminate tax payments, and achieve risk adjusted return superior to the relevant benchmark.



Suppose ABC Mutual fund owned only 4 stocks as follows:

Stock Shares Price W 2500 $11 X 2100 14 Y 2700 23 Z 1900 15

(b) 1 The fund originated by selling $100,000 of stock at $10.00 per share. What is its current NAV?a) $ 1.47b) $ 14.75c) $ 16.03d) $ 27.62e) $234.12

(d) 2 What is the offering price for the fund if the NAV is $25.25 and a the load is 6 percent?a) $26.19b) $23.74c) $25.25d) $26.77e) $24.13

(d) 3 Suppose Mega Mutual Fund owns only the 4 stocks shown below with no liabilities.Stock Shares Price

A 1800 15B 2200 11C 2300 9D 1900 18

The fund originated by selling $300,000 of stock at $30.00 per share. What is its current NAV?a) $106.10b) $12.94c) $129.40d) $10.61e) None of the above

(a) 4 Suppose Under Mutual Fund owns only the 3 stocks shown below with no liabilities.Stock Shares Price

A 2900 15B 3100 14C 3200 12

The fund originated by selling $500,000 of stock at $50.00 per share. What is its current NAV?a) $12.53b) $15.29c) $152.90d) $125.30e) None of the above

(b) 5 Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 14% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 9% and charges a 1/2 percent redemption fee. Which is better and by how much?a) Funds are equalb) Load fund by $32.65c) Load fund by $50.55d) No-load fund by $64.55e) No-load fund by $44.30

(d) 6 Suppose you consider investing $1,000 in a load fund which charges a fee of 2%, and you expect the fund to earn 11% over the next year. Alternatively, you could invest in a no-load fund with similar risk that is expected to earn 7% and charges a 1/2 percent redemption fee. Which is better and by how much?a) Funds are equalb) No-load fund by $36.98c) Load fund by $45.25d) Load fund by $23.15e) No-load fund by $15.52

(b) 7 Suppose you consider investing $15,000 in a load fund from which a fee of 5% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much?a) Load fund by $318.45b) No load fund by $457.50c) Funds are equald) Load fund by $415.10e) No load fund by $211.51

(b) 8 Suppose you consider investing $10,000 in a load fund from which a fee of 3% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 0 percent redemption fee. Which is better and by how much?a) Load fund by $151b) No load fund by $136c) Funds are equald) No load fund by $421e) Load fund by $115

(b) 9 Suppose you consider investing $5,000 in a load fund from which a fee of 8% is deducted and you expect the fund to earn 12% over the next year. Alternatively, you could invest in a no load fund which is expected to earn 10% and which takes a 1/2 percent redemption fee. Which is better and by how much?a) Load fund by $57.50b) Load fund by $575.50c) Funds are equald) No load fund by $575.50e) No load fund by $57.50

(b) 10 On January 2, 2003, you invest $10,000 in Megabucks Mutual Fund, a load fund that charges a fee of 2%. The fund’s returns were 13% in 2003, 11% in 2004, 8% in 2005. On December 31, 2005 you redeem all your shares. The dollar value isa) $13,600.00b) $13,275.51c) $13,297.67d) $13,995.75e) $10,000.00

(c) 11 On January 2, 2003, you invest $50,000 in the Lizbiz Mutual Fund, a load fund that charges a fee of 5%. The fund’s returns were 14.6% in 2003, -6.4% in 2004, 15.2% in 2005. On December 31, 2005 you redeem all your shares. The dollar value isa) $66,722.27b) $15,200.00c) $58,695.74d) $33,366.25e) $10,000.00

(b) 12 On January 2, 2003, you invest $100,000 in the Jeffers Mutual Fund, a load fund that charges a fee of 5%. The fund’s returns were -14.6% in 2003, -6.4% in 2004, 35% in 2005. On December 31, 2005 you redeem all your shares. The dollar value is:a) $95,600.57b) $102,515.90c) $83,297.75d) $133,995.75e) $100,000.00

(c) 13 On January 2, 2003, you invest $10,000 in the Tiger Fund, a load fund that charges a fee of 6%. The fund’s returns were 25% in 2003, 35% in 2004, -5% in 2005. On December 31, 2005 you redeem all your shares of Tiger. The dollar value isa) $5,200.89b) $13,345.89c) $7,931.25d) $15,896.34e) $8,646.91

(e) 14 On January 2, 2003, you invest $10,000 in the W.O.W. Mutual Fund, a load fund that charges a fee of 5%. The fund’s returns were 13.6% in 2003, 12.2% in 2004, 8.3% in 2005. On December 31, 2005 you redeem all your W.O.W. shares. The dollar value isa) $13,600.00b) $13,664.13c) $10,000.00d) $131,136.40e) $13,113.64

(b) 15 On January 2, 2003, you invest $10,000 in the Dog Mutual Fund, a load fund that charges a fee of 7%. The fund’s returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares. The dollar value isa) $12,800.00b) $12,892.50c) $100,000.00d) $128,925.00e) $10,000.00

(a) 16 On January 2, 2003, you invest $50,000 in A Mutual Fund, a load fund that charges a fee of 7%. The fund’s returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your shares in A. The dollar value isa) $64,462.57b) $644,625.70c) $50,000.00d) $6,446.25e) $10,000.00

(d) 17 On January 2, 2003, you invest $100,000 in Righteous, a load fund that charges a fee of 7%. The fund’s returns were 12.8% in 2003, 13.9% in 2004, 7.9% in 2005. On December 31, 2005 you redeem all your Righteous shares. The dollar value isa) $12,800.00b) $12,892.50c) $100,000.00d) $128,925.00e) $10,000.00

(b) 18 Consider the Defiance Bond Fund that consists of the 3 bonds shown below and has no liabilities.

Company Current Bond Value # BondsKomko 980 120Hijack 1010 150Mitsue 1200 100

If initially the value of the fund was $250,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund?a) $25.00b) $38.91c) $39.81d) $31.98e) $39.91

(d) 19 Consider X Bond Fund which consists of the 5 bonds shown below with no liabilities.

Company Current Bond Value # BondsKomko 980 120Hijack 1010 150Mitsue 1200 100Smitsu 800 120Jones 600 150

If initially the value of the fund was $1,000,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund?a) $25.00b) $27.68c) $25.68d) $28.76

e) $26.78

(a) 20 Consider the Compliance Bond Fund that consists of the 7 bonds shown below and has no liabilities.Company Current Bond Value # Bonds

Komko 980 120Hijack 1010 150Mitsue 1200 100Smitsu 800 120Jones 600 150GMM 1000 150ATP 950 150

If initially the value of the fund was $2,500,000 and the original shares were offered to the public with a NAV of $25 per share, what is the current NAV of the fund?a) $27.11b) $25.00c) $26.11d) $21.67e) $26.27

(b) 21 Given the following fees and expected returns for fund X, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years.

Investment E(Return) Load 12b-1 fee Rear-end load Years X 10% 2.5% 0.25%

0% 5 years

a) $1069.82b) $1550.77c) $1042.36d) $1689.95e) $1389.95

(d) 22 Given the following fees and expected returns for fund Y, assuming an initial investment of $1000 calculate the value of the investment at the end of 5 years

Investment E(Return) Load 12b-1 fee Rear-end load Years Y 8% 0% 0.50%

3% 5 years

a) $1069.82b) $1550.77c) $1642.36d) $1389.95e) $1362.59

(c) 23 Calculate the annual rate of return for a mutual fund with the following fees and expected returns

Investment E(Return) Load 12b-1 fee Years Held

Mutual Fund 7% 4% 0.50% 7 years

a) 4.95%b) 5.0%c) 5.85%d) 2.5%e) 6.55%

CHAPTER 24

ANSWERS TO PROBLEMS

1 Original number of shares = $100,000/$10 = 10,000

Shares Price MVW 2500 $11 $27,500X 2100 14 $29,400Y 2700 23 $62,100Z 1900 15 $28,500

TOTAL $147,500

NAV = $147,500/10,000 = $14.75

2 Offering price = NAV + NAV x Load percentage

= $25.25 + 25.25(0.06)

= $26.77

3 Original number of shares = $300,000 $30 = 10,000

Stock Shares Price Market Price A 1800 15 27,000B 2200 11 24,200C 2300 9 20,700D 1900 18 34,200

Total = 106,100

NAV = $106,100 10,000 = $10.61

4 Original number of shares = $500,000 $50 = 10,000

Stock Shares Price Market Price AA 2900 15 43,500BB 3100 14 43,400CC 3200 12 38,400

Total = 125,300

NAV = $125,300 10,000 = $12.53

5 Load Fund: $1,000 (1.00 - 0.02) (1.14) = $1117.20

No-Load Fund: $1,000 (1.09)(1.00 - 0.005) = $1084.55

The difference is 1117.20 - 1084.55 = $32.65

Load fund is better.

6 Load Fund: $1,000 (1.00 - 0.02) (1.11) = $1087.80

No-Load Fund: $1,000 (1.07)(1.00 - 0.005) = $1064.65

The difference is $1087.80 - $1064.65= $23.15


7 Load Fund $15,000 (1.00 - 0.05) (1.12) = $15960

No-Load Fund $15,000 (1.10) (1.00 - .005) = $16417.50

The difference is $16417.50 - $15960 = $457.50

No-Load fund is better.

8 Load Fund $10,000 (1.00 - 0.03) (1.12) = $10864

No-Load Fund $10,000 (1.10) = $11000

The difference is $11000 - $10864 = $136

No-Load fund is better.

9 Load Fund $5,000 (1.00 - 0.08) (1.12) = $6048.00

No-Load Fund $5,000 (1.10) (1.00 - .005) = $5472.50

The difference is $6048.00 - $5472.50 = $575.50


10 Dollar value = $10,000 (1.13)(1.11)(1.08)(1.00 - 0.02) = $13275.51

11 Dollar value = $50,000 (1.146)(0.936)(1.152)(1.00 - 0.05) = $58695.74

12 Dollar value = $100,000 (0.854)(0.936)(1.35)(1.00 - 0.05) = $102515.90

13 Dollar value = $10,000 (1.25)(1.35)(0.5)(1.00 - 0.06) = $7931.25

14 Dollar value = $10,000 (1.136)(1.122)(1.083)(1.00 - 0.05) = $13,113.64

15 Dollar value = $10,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $12,892.50

16 Dollar value = $50,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $64,462.51

17 Dollar value = $100,000 (1.128)(1.139)(1.079)(1.00 - 0.07) = $128,925.02

18 Original # of shares = 250,000 25 = 10,000NAV = 389,000 10,000 = $38.91



21 $1000(1 - 0.025)(1 + .10)5(1 - 0.0025)5 = $1,550.77

22 $1000(1 + 0.08)5(1 - 0.005)5(1 - .03) = $1,389.95

23 $1(1 – 0.04)(1 + 0.07)7(1 - 0.005)7 = $1.4884

Annual return = 1.48841/7 – 1 = 0.05845 = 5.85%

Chapters 20, 22 & 24

Documents

Transcript of Chapters 20, 22 & 24