Chapter 1
Primer on Derivatives
1. Must the underlier of a derivative transaction be an asset that can be delivered at
maturity?
If so, explain why. If not, explain what happens when the contract matures. What are
the
two major requirements for an underlier to be successful?
Answer: The underlier does not have to be deliverable at maturity. For example, weather,
credit,
and stock index derivatives have underliers that would be impossible or difficult
to deliver. When a derivative contract on a nondeliverable underlier matures, it is
settled in cash. The two major requirements for a successful underlier are it has to
be something that can be quantified, and many people have to want to buy and sell
derivatives based on this quantified measure.
2. Suppose forward price for a contract maturing on December 15 is $50/share.
a. Draw the payoff profile of a short forward contract. How much would you earn or lose
if the spot price at maturity was $68/share? How much would you earn or lose if the
spot price at maturity was $48/share?
Answer:
At $68, you would lose $18.
At $48, you would gain $2.
, b. Draw the payoff profile of a long forward contract. How much would you earn or lose if
the spot price at maturity was $68/share? How much would you earn or lose if the spot
price at maturity was $48/share?
Answer:
At $68, you would gain $18.
At $48, you would lose $2.
3. Define the following terms: call option, put option, long call, short call, long put, short
put,
at-the-money call, at-the-money put, in-the-money call, in-the-money put, out-of-the-
money
call, out-of-the-money put, premium, strike price, exercise, margin, maintenance
margin,
and margin call.
Answer: Call option: The right, but not the obligation, to buy the underlier at a specific
price (i.e., the strike price) on or before maturity
Put option: The right, but not the obligation, to sell the underlier at a
specific price
(i.e., the strike price) on or prior to maturity
Long call: The purchase of a call option. The owner has the right, but not
the obligation, to buy the underlier at the strike price on or prior to
maturity.
Short call: The sale of a call option. If exercised, the call option seller has
the obligation to sell the underlier at the strike price on or prior to
maturity.
Long put: The purchase of a put option. The owner has the right, but not
the obligation, to sell the underlier at the strike price on or prior to
maturity.
Short put: The sale of a put option. If exercised, the put option seller has
the obligation to buy the underlier at the strike price on or prior to
maturity.
At-the-money call: If the market price of the underlier is equal to the
strike price of a call option
, At-the-money put: If the market price of the underlier is equal to the strike
price of a put option
In-the-money call: If the market price of the underlier is greater than the
strike price of the call option
In-the-money put: If the market price of the underlier is less than the
strike price of the put option
Out-of-the-money call: If the market price of the underlier is less than the
strike price of the call option
Out-of-the-money put: If the market price of the underlier is greater than
the strike price of the put option
Premium: The price that the buyer of an option pays to the seller
Strike price: The price at which an option can be exercised
Exercise: To exercise a call option means to employ the right to purchase
the underlier at the strike price. To exercise a put option means to employ
the right to sell the underlier at the strike price.
Margin: A fixed payment per contract made to an exchange, which is
usually a very small percent of the contract’s overall notional value.
Margin is not really a down payment on the underlier as much as it is a
performance bond that ensures the broker and exchange that the contract
will be settled in due course.
Maintenance margin: Disbursements that must be made on a daily (or
intraday basis) for exchange-traded derivative contracts due to adverse
movements in the price of the underlier. Also called “variation margin
payments
Margin call: If a margin account falls below the maintenance (variation)
margin requirement (i.e., the minimum level to which the margin account
is allowed to fall before broker calls the trader for more funds), a margin
call is issued, and the account must be brought immediately up to the full
initial margin level.
4. Suppose it is July 10, and the current spot price of a Microsoft share is $40. Rank the
following call options from the most valuable to the least valuable.
a. September 10 Microsoft call option with a strike price of $45/share.
b. September 10 Microsoft call option with a strike price of $40/share.
c. September 10 Microsoft call option with a strike price of $35/share.
Answer: Option C is more valuable than Option B, which (in turn) is more valuable than
Option A. Option C is in-the-money, Option B is at-the-money, and Option A is
out of the money.
5. Suppose it is July 10, and the current spot price of a Microsoft share is $40. Rank the
following put options from the most valuable to the least valuable.
, a. September 10 Microsoft put option with a strike price of $45/share.
b. September 10 Microsoft put option with a strike price of $40/share.
c. September 10 Microsoft put option with a strike price of $35/share.
Answer: Option A is more valuable than Option B, which (in turn) is more valuable than
Option C. Option A is in-the-money, Option B is at-the-money, and Option C is
out of the money.
6. Draw the profit/loss profiles of the following options and explain their risks.
a. Long September 16 call @ $100/share $4.
Answer:
If the price of the underlier is at or below the strike price (i.e., $100), the
buyer does not exercise the option and, therefore, loses the option premium
(plus any sacrificed interest). For every dollar the underlier’s price rises above
$100, the buyer gains $1. Breakeven is at $104 (not counting sacrificed
interest).
Primer on Derivatives
1. Must the underlier of a derivative transaction be an asset that can be delivered at
maturity?
If so, explain why. If not, explain what happens when the contract matures. What are
the
two major requirements for an underlier to be successful?
Answer: The underlier does not have to be deliverable at maturity. For example, weather,
credit,
and stock index derivatives have underliers that would be impossible or difficult
to deliver. When a derivative contract on a nondeliverable underlier matures, it is
settled in cash. The two major requirements for a successful underlier are it has to
be something that can be quantified, and many people have to want to buy and sell
derivatives based on this quantified measure.
2. Suppose forward price for a contract maturing on December 15 is $50/share.
a. Draw the payoff profile of a short forward contract. How much would you earn or lose
if the spot price at maturity was $68/share? How much would you earn or lose if the
spot price at maturity was $48/share?
Answer:
At $68, you would lose $18.
At $48, you would gain $2.
, b. Draw the payoff profile of a long forward contract. How much would you earn or lose if
the spot price at maturity was $68/share? How much would you earn or lose if the spot
price at maturity was $48/share?
Answer:
At $68, you would gain $18.
At $48, you would lose $2.
3. Define the following terms: call option, put option, long call, short call, long put, short
put,
at-the-money call, at-the-money put, in-the-money call, in-the-money put, out-of-the-
money
call, out-of-the-money put, premium, strike price, exercise, margin, maintenance
margin,
and margin call.
Answer: Call option: The right, but not the obligation, to buy the underlier at a specific
price (i.e., the strike price) on or before maturity
Put option: The right, but not the obligation, to sell the underlier at a
specific price
(i.e., the strike price) on or prior to maturity
Long call: The purchase of a call option. The owner has the right, but not
the obligation, to buy the underlier at the strike price on or prior to
maturity.
Short call: The sale of a call option. If exercised, the call option seller has
the obligation to sell the underlier at the strike price on or prior to
maturity.
Long put: The purchase of a put option. The owner has the right, but not
the obligation, to sell the underlier at the strike price on or prior to
maturity.
Short put: The sale of a put option. If exercised, the put option seller has
the obligation to buy the underlier at the strike price on or prior to
maturity.
At-the-money call: If the market price of the underlier is equal to the
strike price of a call option
, At-the-money put: If the market price of the underlier is equal to the strike
price of a put option
In-the-money call: If the market price of the underlier is greater than the
strike price of the call option
In-the-money put: If the market price of the underlier is less than the
strike price of the put option
Out-of-the-money call: If the market price of the underlier is less than the
strike price of the call option
Out-of-the-money put: If the market price of the underlier is greater than
the strike price of the put option
Premium: The price that the buyer of an option pays to the seller
Strike price: The price at which an option can be exercised
Exercise: To exercise a call option means to employ the right to purchase
the underlier at the strike price. To exercise a put option means to employ
the right to sell the underlier at the strike price.
Margin: A fixed payment per contract made to an exchange, which is
usually a very small percent of the contract’s overall notional value.
Margin is not really a down payment on the underlier as much as it is a
performance bond that ensures the broker and exchange that the contract
will be settled in due course.
Maintenance margin: Disbursements that must be made on a daily (or
intraday basis) for exchange-traded derivative contracts due to adverse
movements in the price of the underlier. Also called “variation margin
payments
Margin call: If a margin account falls below the maintenance (variation)
margin requirement (i.e., the minimum level to which the margin account
is allowed to fall before broker calls the trader for more funds), a margin
call is issued, and the account must be brought immediately up to the full
initial margin level.
4. Suppose it is July 10, and the current spot price of a Microsoft share is $40. Rank the
following call options from the most valuable to the least valuable.
a. September 10 Microsoft call option with a strike price of $45/share.
b. September 10 Microsoft call option with a strike price of $40/share.
c. September 10 Microsoft call option with a strike price of $35/share.
Answer: Option C is more valuable than Option B, which (in turn) is more valuable than
Option A. Option C is in-the-money, Option B is at-the-money, and Option A is
out of the money.
5. Suppose it is July 10, and the current spot price of a Microsoft share is $40. Rank the
following put options from the most valuable to the least valuable.
, a. September 10 Microsoft put option with a strike price of $45/share.
b. September 10 Microsoft put option with a strike price of $40/share.
c. September 10 Microsoft put option with a strike price of $35/share.
Answer: Option A is more valuable than Option B, which (in turn) is more valuable than
Option C. Option A is in-the-money, Option B is at-the-money, and Option C is
out of the money.
6. Draw the profit/loss profiles of the following options and explain their risks.
a. Long September 16 call @ $100/share $4.
Answer:
If the price of the underlier is at or below the strike price (i.e., $100), the
buyer does not exercise the option and, therefore, loses the option premium
(plus any sacrificed interest). For every dollar the underlier’s price rises above
$100, the buyer gains $1. Breakeven is at $104 (not counting sacrificed
interest).
