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FIN 3506 Lecture Notes - Lecture 8: Straddle, Covered Call, Arbitrage

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bronzeturtle979
6 Oct 2016
School
Temple University
Department
Finance
Course
FIN 3506
Professor
Bruce B.Rader

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Document Summary

Learning objectives: understand the different options strategies and their profiles. Options are traded for two purposes for speculation and hedging. A speculator takes on risk in order to profit from moves in the market. He/she does this by buying or selling options or combinations of options to profit from trading or to take advantage of market inefficiencies through a process called arbitrage. Pure arbitrage is defined as the making of a return without risk or investment. Hedgers on the other hand try to reduce risk of holding assets or the future purchase of assets. For a speculator there is a good general rule by which he/she will make money. This means the major determinate of the value of an option is its volatility and that when volatility is high the it is the time to sell puts and calls naked which means with out owning the underlying asset.

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Related Questions

4. If you __________, then you may be forced to buy the underlying stock.

  1. Buy a Call Option
  2. Buy a Put Option
  3. Sell a Call Option
  4. Sell a Put Option

5. Lower risk free rates results in __________ Put Option prices and ______ Call Option Prices.

  1. Higher, Higher
  2. Higher, Lower
  3. Lower, Lower
  4. Lower,Higher

6. Which Statement is correct?

  1. Speculators make money by setting up transactions and are the go betweens in the derivatives market.
  2. A firm should always hedge in order to reduce risk whenever they can
  3. Hedgers do not mind losing money as long as they are reducing their risk
  4. Brokers try to find mispricings in the market where they can buy at a low price and simultaneously sell at a high price without taking on any risk.

7. Which statement regarding executive stock options is correct?

  1. They are short term and usually expire after one year.
  2. They should reduce agency costs by making managers act like shareholders
  3. They are included as compensation expense on the income statement.
  4. Managers can sell the options on an exchange

8. Which of the following statements are correct?

  1. Forward contracts are standardized and trade on an exchange
  2. Profits and Losses on Futures contracts are marked to market on a daily basis.
  3. Delivery of the assets almost never occurs in the forward market
  4. Futures contracts allow you to buy or sell individual stocks for a preset price on the expiration date.

9. You need a barrel of oil next month. You could either buy the oil today and keep it for a month, wait and buy the oil next month when you need it, you could enter into a futures contract to buy oil at the current futures price $81, or you can pay $2 for a call option that gives you the right to buy oil for $80. The current spot price is $79 and the risk free rate is 2%, and carrying costs are $2. If the price ends up being $84 next month, then you should have ______________.

  1. Waited to buy the oil
  2. Entered into a futures contract
  3. Bought a call option
  4. Buy the oil today and store it for a month.

10. Which of these should cause the dollar to appreciate?

  1. A decline in foreign demand for US goods and services
  2. An increase in US demand for foreign goods and services
  3. An increase in foreign demand for US financial assets
  4. An increase in the amount of gold held by the US central bank

6. Institutional portfolios can take advantage of what is called "portfolio margining" under the rules of the CBOE and other options exchanges. What IS portfolio margining? Choose only one answer.

A. You only pay attention to the bottom margin of the portfolio.

B. Great leverage is possible, as the intercorrelations and natural offsets (or what we call in English a "wash") are taken into consideration.

C. No margin is required, because these are not individual investors.

7. What does the symbol ^VVIX mean?

A. Apple's volatility.

B. An exchange-traded (ETF) volatility fund.

C. The implied volatility of the VIX options themselves.

8. An example of purchasing a "real" option is a company's opening of a Shanghai office, in order to have the capacity to pursue business in China.

True

False

9. A hedge fund is "short" a portfolio of VIX call options. It's "theta" is $16,788 per day. This means, barring some big market or political or terrorist event, the fund's net asset value will increase by about $16,788 per day.

True

False

10. Imagine an equity-oriented state pension fund (such as the State of Maryland Pension funds). Suppose their equity portfolio is NOT identical to the S&P 500 index. Further, suppose that due to a state budget shortfall, the year's additions to the pension fund are likely to be less than actuarially sound. Thus, the fund is becoming very risk-averse. And it needs to implement this feeling by hedging. CHOOSE THE BEST ANSWER, even though there might be more than one true answer. This is actually a question about hedge ratios. A. If the equity portfolio's beta is close to 0, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

B. If the equity portfolio's beta is close to .4, then they would have a tough time using S&P 500 contracts, so they would instead use foreign exchange contracts.

C. If the equity portfolio's beta is close to 1, then they could decide to match the overall exposure, via S&P Index futures contracts, to the fund's value. That is, # of contracts times the contract multiplier times the index would approximately equal the value of the fund.

11. Go to CMEGROUP.COM We are going to hedge ULSD https://en.wikipedia.org/wiki/Ultra-low-sulfur_diesel for a railroad, that uses ultra-light diesel fuel. Choose June 2017 as the underlying future. Let's pretend we are buying ten futures contracts. What would ten contracts cost you, using the last trade as our price? Show your math, i.e., #gallons times price per futures contract. Is this contract in contango, or normal backwardation?

12. Long options positions(long does not mean long-dated) have positive gamma, and short positions have negative gamma.

True

False

13. In valuing credit default swaps, one must estimate default probabilities. A start would be to obtain historical data for default rates from rating agencies such as Standard & Poor's. But a more complete risk profile, or risk prediction, limiting ourselves to the US market (US-based companies) would be to [pick only one choice, the best one, in your opinion]:

A. Also consider the risk of another earthquake in Japan.

B. Also consider the systematic risk associated with an economic downturn in the US, accompanied by a downturn in US stocks.

C. Also consider the possibility that Facebook options are trading at an implied volatility that is not as high as it should be, considering the lofty level of its P/E ratio.

14. A total return swap can be a form of financing vehicle to allow an investor to buy a specific bond, because: (there are two correct answers, you must pick two)

A. The payer (a financial institution) could agree to pay the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

B. The payer (a financial institution) could agree to receive the bond's capital appreciation or depreciation, plus the interest payments, in return for receiving LIBOR plus some basis points.

C. The payer retains ownership of the bond for the life of the contract.

As a newly minted MBA. you've taken a management position with Exotic Cuisines, Inc., a restaurant chain that just went public last year. The company's restaurants specialize in exotic main dishes, using ingredients such as alligator, buffalo, and ostrich. A concern you had going in was that the restaurant business is very risky. However, after some due diligence, you discovered a common misperception about the restaurant industry. It is widely thought that 90 percent of new restaurants close within three years; however, recent evidence suggests the failure rate is closer to 60 percent over three years. So, it is a risky business, although not as risky as you originally thought. During your interview process, one of the benefits mentioned was employee stock options. Upon signing your employment contract, you received options with a strike price of $50 for 10,000 shares of company stock. As is fairly common, your stock options have a three-year vesting period and a 10-year expiration, meaning that you cannot exercise the options for a period of three years, and you lose them if you leave before they vest. After the three-year vesting period, you can exercise the options at any time. Thus, the employee stock options are European (and subject to forfeit) for the first three years and American afterward. Of course, you cannot sell the options, nor can you enter into any sort of hedging agreement. If you leave the company after the options vest, you must exercise within 90 days or forfeit. Exotic Cuisines stock is currently trading at $26.12 per share, a slight increase from the initial offering price last year. There are no market traded options on the company's stock. Because the company has only been traded for about a year, you are reluctant to use the historical returns to estimate the standard deviation of the stock's return. However, you have estimated that the average annual standard deviation for restaurant company stocks is about 55 percent. Since Exotic Cuisines is a newer restaurant chain, you decide to use a 65 percent standard deviation in your calculations. The company is relatively young, and you expect that all earnings will be reinvested back into the company for the near future. Therefore, you expect no dividends will be paid for at least the next 10 years. A three-year Treasury note currently has a yield of 1.5 percent, and a 10-year Treasury note has a yield of 2.6 percent.

4. Why do you suppose employee stock options usually have a vesting provision? Why must they be exercised shortly after you depart the company even after they vest?

5. A controversial practice with employee stock options is repricing. What happens is that a company experiences a stock price decrease, which leaves employee stock options far out of the money or "underwater." In such cases, many companies have "repriced" or "restruck" the options, meaning that the company leaves the original terms of the option intact, but lowers the strike price. Proponents of repricing argue that since the option is very unlikely to end in the money because of the stock price decline, the motivational force is lost. Opponents argue that repricing is in essence a reward for failure. How do you evaluate this argument? How does the possibility of repricing affect the value of an employee stock option at the time it is granted?

6. As we have seen, much of the volatility in a company's stock price is due to systematic or marketwide risks. Such risks are beyond the control of a company and its employees. What are the implications for employee stock options? In light of your answer, can you recommend an improvement over traditional employee stock options?