-
Categories
-
Archives
-
Recent Posts
- Questions to Ask Yourself as an Options Trader
- Are You A Stock Option Dabbler?
- An Option Trader’s Mind
- Why Uncle Sam Likes Index Option Spreads
- Trading LEAP Options
- Rolling out of an OTM Covered Call
- Volatility and Options Trading
- Trading Options with Japanese Candlesticks
- Options and Modern Portfolio Theory
- Fundamental Considerations When Trading Stock Options
Pages
Press Release
Our Blog Partners
Bookmarking |
Feeds
Oct
26
Chapter Five Answers
1) Which of the following represents a synthetic long call?
d) Long stock + long put
Using the basic formula S + P – C = 0, we can rearrange it to solve for a long call. This can easily be done by simply taking the – C to the other side of the equal sign. Once we do, we see that a long call is synthetically equivalent to long stock plus a long put.
2) The put-call parity formula shows us that an at-the-money call will be priced higher than the at-the-money put. How much higher will the price of the call be?
a) Stock – Pv (E)
The put-call parity formula can be arranged to show that C – P = S – Pv (E). This shows that the difference between a call and put (same strike) is equal to the difference between the stock and present value of the exercise price. In other words, the call will cost more than the put by the interest that could be earned on the exercise price. *explain why doesn’t work with pricing model *
3) A call option’s price can be broken down into three components. The first is the intrinsic value. The second is the cost of carry on the exercise price. What is the third component?
d) Long put
Call options have an implicit put option built into their price. It is this put that gives the call the limited downside risk.
4) Which of the following is a synthetic T-bill (or long bond)?
a) Long stock + long put + short call
The combination of long stock, long put, and a short call behaves just like a T-bill. You will purchase the three assets at a discount from the exercise price and will collect the full exercise price at expiration.
5) Which of the following is a synthetic long put?
c) Short stock + long call
Using the basic formula S + P – C = 0, we can rearrange it to solve for a long put. Since the put is already “+” or long on the left side, we just need to bring the S and C over to the right side of the equal sign and change their signs in the process. The result is P = -S + C, which means that a long put is equal to short stock plus a long call.
6) Which of the following is synthetic long stock?
d) Long call + short put
The formula S + P – C = 0 can be rearranged to solve for long stock. Since the stock is already long on the left side, we just need to bring the P and C over to the right side of the equal sign and we end up with S = C – P. This tells us that the synthetic equivalent to long stock is a long call plus a short put.
7) Which of the following is synthetic short stock?
a) Short call + long put
Once again, we just need to rearrange the formula S + P – C = 0 to solve for short stock, which we can do by moving the S to the right side of the equal sign thus changing its sign to negative. The result is P – C = - S, which means that a long put plus a short call is the synthetic equivalent to a short stock position.
Which of the following is a variation of the put-call parity equation?a)S + P – C = Pv (E)
9) Which of the following is one of the biggest advantages of the put-call parity equation? It can identify:
c) The most efficient trades
10) When using the put-call parity equation, you will end up with plus and minus signs with each variation. What do these signs represent?
a) Plus = long position, Minus = short position
11) In the put-call parity formula, what does S + P – C equal?
a)The present value of the exercise price
12) Which of the following is the technical name for the three combined position: S + P – C?
a)Conversion
These three positions together make up a conversion, which is a “locked” trade meaning that it has no risk. If the opposite set of transactions were taken (-S, -P, +C) then it is called a “reverse conversion” or reversal.
13) Which of the following is a synthetic short put?
b) Long stock + short call
If you buy stock and sell a call you are doing exactly the same thing as someone who sells (shorts) a put.
14) Which of the following is a synthetic short call?
b) Short stock + short put
If you buy stock and sell a put you are doing exactly the same thing as someone who sells (shorts) a call.
15) Put-call parity shows that call options are really put options and vice versa depending on:
a)How the calls or puts are paired with the underlying stock
16) Any time you see the negative of the present value of the exercise price, – Pv (E), in the put-call parity formula, that represents:
d) Borrowing of funds
If you are short the present value of the exercise price it means that you have borrowed the present value and must repay the exercise price at expiration. It is similar to selling a bond. Bond sellers receive cash up front (borrow money) but must repay the higher face value at maturity (pay back with interest).
17) Before exercising a call early to collect a dividend, you should check the bid of the corresponding (same strike as the call) put. If the bid price is higher than the dividend, you should:
d) Sell the put
By selling the put, you have created a synthetic long stock position, which is effectively what you are doing by exercising the call. However, because the bid of the put is higher than the dividend, you have more money for not taking on any additional risk when compared to exercising the call.
18) Put-call parity can show us why it is not optimal to exercise a call option early. When you exercise a call option early, you are throwing away the value of the:
d) Both a and c
If you exercise a call option early, you are effectively throwing away the interest that could have been earned on your money by paying for the stock too early. In addition, you also throw away the protective value of the put option.
19) Interest rates are 5%. You observe that ABC stock is trading for $20 per share. The one-year, $20 call is $3 and the one-year $20 put is $1. Using put-call parity, what would you expect to happen to the call and put prices?
b) Call prices should fall and put prices rise
This one is tricky. You could borrow money and buy 1,000 shares of stock for $20,000. Then you could sell 10 $20 calls and receive $3,000 and buy 10 $20 puts for $1,000. The net cost to you is $18,000, which you could borrow at 5% thus owing $18,000 * .05 = $900 in interest for a total of $18,900 at the end of one year. However, the position (conversion) is guaranteed to have a value of $20,000 at expiration thus paying back far more money than you own. At these prices, you could create a risk-free money machine. As traders discover this, they will continue to demand conversions thus putting buying pressure on the puts and selling pressure on the calls. This means that the call prices will fall and put prices will rise.
20) Interest rates are 5%. You observe that ABC stock is trading for $20 per share. The one-year $20 put is $1. Using put-call parity, what would you expect to see the one-year $20 call trading for?
a) $1.95
Put-call parity tells us that S + P – C must equal the present value of the exercise price. In this case, a one-year $20 call has a present value of $20/1.05 = $19.05 if interest rates are five percent. We now know that the three-sided package containing S + P – C must be worth $19.05. The stock is worth $20 and the put is $1 so $21 – C = $19.05. We find that the call must be worth $1.95. You should have recognized that answers C and D could not be correct as they are less than the value of the put and we know that the same-strike call must always be more than the put by the cost of carry.
To be continued…..
Comments
Leave a Reply
You must be logged in to post a comment.
Enter Your Primary Email Address To
Download Our Blog Reader and Get
The Latest Market Commentary
& Blog Updates Automatically:-
Search Blog
-
-
Blogroll
