Principle Protected Notes and Trading Strategies

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Questions and Answers

What is the primary benefit of investing in a Principal Protected Note (PPN)?

Investors are guaranteed to earn interest on their investment.

Investors have unlimited potential gains.

Investors receive regular dividend payments.

Investors can take risky positions without risking their principal. (correct)

In a Bull Spread created from call options, what will happen if the stock price exceeds the higher strike price on expiration?

The payoff will be the difference between the two strike prices. (correct)

The payoff will be zero.

The payoff will be capped at the higher strike price.

The payoff will be the value of the stock price.

Which of the following statements about the potential payoff from a PPN is incorrect?

Investors may lose their chance to earn interest or dividends.

Investors are guaranteed to make a profit on their investment. (correct)

Investors receive their original principal back at maturity.

The option within a PPN has no value if the portfolio decreases.

What is a key characteristic of a Bull Spread strategy?

It aims for stock price appreciation. Signup and view all the answers

If an investor enters a Bull Spread with strike prices K1 and K2 and the stock price is below K1 at expiration, what is the investor's payoff?

The payoff is zero. Signup and view all the answers

What could be a method for a bank to create a viable 3-year PPN product?

Capping the return for the investor. Signup and view all the answers

What occurs when the stock price on the expiration date lies between K1 and K2 in a Bull Spread?

The payoff is $St - K1$. Signup and view all the answers

Which of the following describes the risk associated with investing in a PPN?

Opportunity cost due to lost income or dividends. Signup and view all the answers

What is the cost of a bull spread strategy if an investor buys a call option for $3 and sells a call option for $1?

$2 Signup and view all the answers

In which scenario does a bull spread generate a payoff of zero?

When stock price is below both strike prices Signup and view all the answers

Which type of bull spread involves both call options being initially out of the money?

Type 1 Signup and view all the answers

How does a bear spread strategy hope to profit?

By anticipating a stock price decline Signup and view all the answers

What is the key characteristic of a butterfly spread?

Involves three different strike prices Signup and view all the answers

What happens if the stock price moves significantly in either direction for a butterfly spread?

It leads to a small loss Signup and view all the answers

In a straddle option trading strategy, what is bought together?

A call and a put with the same strike price Signup and view all the answers

What happens if the stock price is close to the strike price at expiration in a straddle strategy?

A loss is incurred Signup and view all the answers

Which statement accurately describes the type of payoff structure for a bear spread?

It has a payoff of K2 - K1 when the stock price is above K2 Signup and view all the answers

Which strategy is considered conservative within the bull spread types?

Type 2 Signup and view all the answers

Study Notes

Principle Protected Notes (PPNs)

PPNs are designed for conservative investors in the retail market.
An investor's principal is protected; if the underlying portfolio value falls, the investor loses no principal.
If the portfolio increases, the investor receives the original principal plus any gains. This is a partial participation strategy.
The worst-case scenario is that the investor loses any potential earned income, such as dividends or interest.
Banks can create viable PPNs by adjusting the strike price to trigger gains at specific levels, capping investor returns, using average prices instead of final prices, or implementing knockout barriers.

Trading Strategies with a Single Option and a Stock

Spreads

Spread strategies use multiple options of the same type (e.g., calls or puts).
Bull spreads are common strategies used when the investor anticipates a rise in the underlying stock price.

Bull Spreads (Call Options)

A bull spread involves buying a low-strike call and selling a higher-strike call with the same expiration.
Requires an initial cost; the investor benefits from smaller stock movements.
Payoff (Call):
- If stock price at expiration is above the higher strike price (K2), payoff = K2 - K1.
- If stock price is between the two strike prices (K1 and K2), payoff = Stock Price (St) - K1.
- If stock price is below the lower strike price (K1), payoff = 0.
- Example: Buying a $30 strike call for $3 and selling a $35 strike call for $1.
Cost: $2
Profit Model:
- Profit is dependent on the stock price at expiration.
Bull Spread Advantages:
- Limits both upside and downside risk.
- Investors give up some upside potential for lower initial costs.
Bull Spread Types:
- Type 1: Both calls are initially out-of-the-money.
- Type 2: One call is initially in-the-money; the other is out-of-the-money.
- Type 3: Both calls are initially in-the-money. Type 1 is least conservative and has a high payout potential.
Bull Spreads with Puts: Bull spreads can also be constructed using put options.

Bear Spreads

Bear spreads are used when the investor is anticipating a decline in the underlying stock price.
Bear spreads involve buying a high-strike put and selling a low-strike put.
Payoff (Put):
- If stock price at expiration is below the lower strike price (K1), the payoff = K2- K1
- If the stock price is between K1 and K2, the payoff=K1 – Stock Price (St)
- If the stock price is greater than K2, the payoff is zero.

Butterfly Spreads

Butterfly spread involves positions in options with three different strike prices.
Investor believes stock price will remain steady.
Butterfly Spreads use either Calls or Puts (reverse strategies). A similar structure to the other strategies above is used.

Straddles

Straddles involve simultaneously buying both a call and a put on the same stock, with the same strike price and expiration.
Profits are realized when the stock price moves significantly in either direction away from the strike price.
Straddles are considered speculative strategies when the investor expects large price swings without a directional bias.

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Description

This quiz covers the fundamentals of Principle Protected Notes (PPNs) and various trading strategies, focusing on market safety for conservative investors. Learn about bull spreads and how to implement spread strategies using options. Test your knowledge on these investment concepts and enhance your trading acumen.