Options and Hedging Quiz

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Questions and Answers

What happens when a futures contract is held to the expiration date without being offset?

Both parties are obliged to fulfill their respective payment and delivery obligations. (correct)

The buyer must deliver the underlying asset to the seller.

The contract becomes void and neither party is liable.

The seller is only required to accept payments.

Which statement accurately describes cash-settled futures contracts?

They primarily involve the trading of physical commodities.

The parties must accept delivery of the underlying asset's shares.

They are settled by the exchange of cash based on asset performance. (correct)

They require the physical delivery of the underlying asset at expiration.

What is a key benefit of the standardization of futures contracts?

It prevents the offsetting of positions before expiration.

It eliminates the need for clearinghouses in transactions.

It facilitates easier offsetting of contracts prior to expiration. (correct)

It allows for more complex contracts to be created.

Which of the following statements about the roles of buyer and seller in a futures contract is true?

The buyer is obligated to accept the underlying asset unless the contract is offset. Signup and view all the answers

In the context of futures contracts, which party holds the short position?

The party that agrees to sell the underlying asset. Signup and view all the answers

What does the term 'offsetting a position' in a futures contract refer to?

Closing a position by entering another contract of equal size in the opposite direction. Signup and view all the answers

What is a key advantage of the OTC market compared to exchange-traded derivatives?

Tailored contract terms for specific users Signup and view all the answers

What is the intrinsic value of an option?

The potential profit if exercised immediately Signup and view all the answers

Which term describes an option that has no intrinsic value?

Out-of-the-money Signup and view all the answers

Which of the following is a characteristic of the Montréal Exchange?

It provides options on stocks, indexes, and U.S. currency Signup and view all the answers

What does the expiration date of an option refer to?

The last day the option can be exercised Signup and view all the answers

Why have OTC and exchange-traded derivatives co-existed successfully?

They offer distinct advantages for different users Signup and view all the answers

What is a significant distinction between the privacy levels of OTC derivatives and exchange-traded derivatives?

OTC transactions remain confidential to the general public Signup and view all the answers

Which of the following best describes a covered call?

Selling a call option while simultaneously holding a long position in the underlying asset Signup and view all the answers

In the context of derivative exchanges, what does standardization refer to?

Uniform terms and specifications for all contracts Signup and view all the answers

What is meant by 'marking to market' in trading?

Calculating the profit or loss for an open position daily Signup and view all the answers

What does a put option give its holder the right to do?

Sell the underlying asset at a fixed price Signup and view all the answers

Which of the following correctly describes the nature of transactions on organized exchanges?

All transactions are publicly known but counterparties may remain anonymous Signup and view all the answers

What issue did the evolution of derivative exchanges primarily address?

Concerns around standardization and liquidity Signup and view all the answers

Which of the following terms is synonymous with a strike price?

Exercise price Signup and view all the answers

Which of the following terms best captures the nature of OTC derivatives compared to those on exchanges?

More flexible but less monitored Signup and view all the answers

What purpose does a performance bond serve in trading derivatives?

It acts as collateral for potential losses in a transaction Signup and view all the answers

What does 'open interest' refer to in derivatives trading?

The total number of outstanding options contracts that have not been settled Signup and view all the answers

What exemplifies the role of the Montréal Exchange in Canada's derivative landscape?

Offering a variety of options and futures on diverse assets Signup and view all the answers

How do users typically benefit from exchange-traded derivatives?

By enjoying greater liquidity and lower default risk Signup and view all the answers

What is a key characteristic of exchange-traded derivatives compared to over-the-counter derivatives?

They are standardized contracts. Signup and view all the answers

Which of the following statements is true regarding over-the-counter derivatives?

They are agreed upon between buyer and seller. Signup and view all the answers

In what way do exchange-traded derivatives handle gains and losses?

They accrue gains and losses continuously (marking to market). Signup and view all the answers

What role does a clearinghouse play in exchange-traded derivatives?

It guarantees the contract's performance. Signup and view all the answers

Which feature distinguishes the regulation of exchange-traded derivatives from over-the-counter derivatives?

Exchange-traded derivatives are heavily regulated. Signup and view all the answers

How are fees typically structured for over-the-counter derivatives?

Fees are built into the price of the contract. Signup and view all the answers

Which type of investor predominantly uses exchange-traded derivatives?

All types of investors including retail, corporations, and institutions. Signup and view all the answers

What is often a consequence of the lack of transparency in over-the-counter derivatives?

Pricing can vary significantly based on negotiation power. Signup and view all the answers

What type of settlement is most common for delivery in exchange-traded derivatives?

Cash settlement predominantly. Signup and view all the answers

Which of the following is NOT a characteristic of over-the-counter derivatives?

They are typically standardized. Signup and view all the answers

What is the intrinsic value of the options if XYZ shares increase to $60, with a strike price of $55?

$5 Signup and view all the answers

If the net purchase price for the investor after exercising the call options is $57 and she sold the stock short at $52.50, what is her loss per share?

$4.50 Signup and view all the answers

What happens to the options when XYZ shares are trading at $45 just prior to the expiration date?

The options will expire worthless. Signup and view all the answers

What is the effective purchase price for the investor if she buys shares in the market at $45 after letting the options expire?

$47 Signup and view all the answers

What is the primary reason investors write call options?

To earn income from premiums. Signup and view all the answers

Which type of call option writer owns the underlying stock and uses it to cover obligations?

Covered call writer Signup and view all the answers

What must a naked call writer do if assigned after writing call options?

Buy the underlying stock in the market first. Signup and view all the answers

What happens when the price of the stock exceeds the strike price for call options?

Call option writers face unlimited risk. Signup and view all the answers

In a situation where the call option buyer exercises their option, what does the writer face?

Obligation to sell stocks at the strike price. Signup and view all the answers

What is the primary characteristic that distinguishes covered call writers from naked call writers?

Covered writers own the underlying stock. Signup and view all the answers

Study Notes

Introduction to Derivatives

Significant growth in derivatives market over the past two decades.
Derivative exchanges maintain rules for fairness, order, and transparency.
Canada’s primary derivative exchange: The Montréal Exchange, offering options on stocks, indexes, and U.S. currency.

Exchange-Traded vs. Over-the-Counter Derivatives

Exchange-Traded Derivatives:
- Standardized contracts allowing for easy trading.
- Operate under a regulated environment with a transparent public record.
- Gains and losses marked to market daily.
- Performance bonds required based on contract type.
- Clearinghouse acts as a guarantor, ensuring contract performance.
Over-the-Counter (OTC) Derivatives:
- Tailored contracts to meet specific needs of users.
- Privacy in transactions; general public unaware of details.
- Less regulation and no third-party guarantor.
- Gains and losses settled at the end of the contract, not daily.

Key Concepts of Options

Types of Options:
- American-style options can be exercised anytime before expiration.
- European-style options can only be exercised at expiration.
Option Terminology:
- In-the-money: Option with intrinsic value.
- Out-of-the-money: Option without intrinsic value.
- At-the-money: Option where the stock price equals the strike price.

Options Pricing and Profitability

Intrinsic value calculated as the difference between the current stock price and the strike price.
Premium paid to purchase options affects the net purchase price upon exercise.
Example: Stock priced at $60 with a strike price of $55 has an intrinsic value of $5.

Writing Options

Call Options:
- Writers profit from the premium received regardless of stock price changes.
- Writers classified as covered (own underlying stock) or naked (do not own stock).
Naked Call Risks:
- When assigned, must buy stock at market price before selling it at the strike price, which can lead to significant losses.

Futures Contracts

Establish prices for future trades without immediate delivery of the underlying asset.
Most parties offset positions before expiration, minimizing actual market delivery.
Cash-Settled Futures:
- Common with financial futures where delivery is impractical.
- Profits/losses based on price changes rather than physical delivery.

Conclusion

Derivatives provide investors with unique ways to manage risk and leverage financial positions but come with specific strategies and regulations that users must navigate.

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Description

Test your knowledge on American-style options, including key concepts such as hedging, arbitrage, and intrinsic value. This quiz covers important terminology and concepts that are crucial for understanding options trading in a financial context.