64. Assume we have a stock currently worth $100. We also assume the interest rate is zero, and
we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $5
with equal probability over the option period, and the option cannot be exercised until the
expiration date, what is the time value of the option?
a. $10
b. $5
c. $0
d. None of the answers is correct.
65. Assume we have a stock currently worth $50. We also assume the interest rate is zero, and
we can buy options for this stock with a strike price of $50. If the stock can rise or fall by $10
with equal probability over the option period, and the option cannot be exercised until the
expiration date, what is the time value of the option?
a. $5
b. $10
c. $50
d. $40
66. As the volatility of the stock price increases, the time value of the option:
a. decreases.
b. is zero.
c. increases.
d. doesn’t change.
67. An option’s value will never be less than zero because:
a. the intrinsic value is always less than zero.
b. the option seller is required to make up any shortfall faced by the option buyer.
c. an option holder will never make an additional payment to exercise the option.
d. the time value of the option is always less than zero.
68. The intrinsic value of a call option:
a. is the difference between the option price and the interest rate.
b. must be less than or equal to zero.
c. is the greater of zero or the difference between the price of the underlying asset and the
strike price.
d. will be negative if the time value of the option is negative.
69. At expiration, the value of an option:
a. is greater than the intrinsic value.
b. is less than the intrinsic value.
c. is equal to the time value of the option.
d. is equal to the intrinsic value.
70. At expiration, the time value of an option:
a. is equal to the intrinsic value.
b. is greater than the intrinsic value.
c. is zero.
d. is less than the intrinsic value.
71. The time value of the option should:
a. decrease the longer the time to expiration.
b. increase the longer the time to expiration.
c. not change with time to expiration.
d. approach infinity at expiration.
72. If the price of an underlying asset has a standard deviation of zero:
a. options for this asset would likely not exist.
b. option for this asset would be highly valued.
c. the intrinsic value of options for this asset would equal the asset’s price.
d. options for this asset would have a time value of the option equal to the price of the asset.
73. Considering a put option; if the price of the underlying asset increases:
a. the value of the put option also increases.
b. the intrinsic value of the option increases.
c. the value of the option decreases.
d. the time value of the option decreases.
74. Considering a call option, if the price of the underlying asset decreases:
a. the intrinsic value of the option decreases if it is above zero.
b. the intrinsic value of the option increases if it is above zero.
c. the strike price decreases.
d. the value of the option increases.
75. Considering a put option, an increase in the strike price:
a. causes the intrinsic value of the option to decrease if it is above zero.
b. causes the intrinsic value of the option to increase if it is above zero.
c. causes the value of the option to decrease.
d. makes the option worthless.
76. If we have a stock selling for $95.00 and a call option for this stock has a strike price of
$82.00 and an option price of $13.60:
a. the intrinsic value of the option is $0.60 and the time value of the option is $13.00.
b. the intrinsic value is $82.00 and the time value of the option is $13.60.
c. the intrinsic value of the option is $13.00 and the time value of the option is $0.60.
d. the intrinsic value is $0 since the option is out of the money.
77. We have a stock selling for $90.00. There is a put option for this stock with a strike price of
$85 and an option price of $1.20:
a. the intrinsic value of this option is $0.00 and the time value of the option is $1.20.
b. the intrinsic value of this option is $90.00 and the time value of the option is $1.20.
c. the intrinsic value of this option is -$5.00 and the time value of the option is $1.20.
d. you cannot determine the intrinsic value or time value of the option since the strike price is
less than the underlying asset price.
78. For a given call option price, which of the following statements is correct?
a. The closer the strike price is to the current price of the underlying asset, the smaller the time
value of the option.
b. The closer the strike price is to the current price of the underlying asset, the larger is the time
value of the option.
c. As the strike price approaches the price of the underlying asset, the time value of the option
approaches zero.
d. As the strike price approaches the price of the underlying asset, the intrinsic value of the
option increases and the time value of the option decreases.
79. Which of the following would tend to decrease the size of the time value of the option?
a. The price volatility of the underlying asset is high.
b. The time to expiration of the contract is far
a
w
a
y.
c
. The underlying price of the asset approaches the strike price.
d. The time to expiration of the options contract is near.
80. Interest-rate swaps are:
a. exchanges of equity securities for debt securities.
b. agreements between two parties to exchange periodic interest-rate payments over some future
period.
c. agreements involving swapping of option contracts.
d. agreements that allow both parties to convert floating interest rates to fixed interest rates.
81. A key use of interest-rate swaps is to:
a. eliminate risk for both parties involved in the transaction.
b. earn the fees for constructing the swaps.
c. provide a hedge against interest-rate risk.
d. manage government revenues.
82. The principal in an interest rate swap is:
a. always transferred from the originator to the counterparty of the swap.
b. is usually held by a clearinghouse to guarantee payment.
c. usually borrowed from a third party.
d. is not borrowed, lent, or exchanged. It just serves as the basis for the calculation of cash flows.
83. Considering interest-rate swaps, the swap rate is:
a. the benchmark rate plus a premium.
b. the rate being offered on U.S. Treasury securities of similar maturities.
c. another name for the swap spread.
d. a measure of overall risk in the economy.
84. Considering interest-rate swaps, the swap spread is:
a. another name for the swap rate.
b. the difference between the benchmark rate and the swap rate.
c. the benchmark rate plus the swap rate.
d. a measure of the time value of the swap.
85. One key difference between swaps and option contracts is:
a. swaps are derivative agreements and options are not.
b. swaps do not involve any risk and options do.
c. options transfer risk, swaps create risk.
d. options trade on organized exchanges and swaps do not.
86. The primary risk in swaps is that:
a. interest rates will not change.
b. one of the parties will default.
c. they are highly liquid and the market price will change.
d. high U.S. government deficits will limit the availability of swaps.
87. Standardization of derivative contracts:
a. results in increased risk for the parties involved.
b. makes them more difficult to understand and therefore leads to increased misuse.
c. makes the premiums involved with these contracts increase.
d. leads to greater liquidity and lower risk.
Short Answer Question
88. As the chapter points out, there have been many cases where derivatives have led to a lot
of abuse. If this is the case, why do derivatives exist?
89. Explain how an interest rate futures contract differs from an outright purchase of a bond.
90. What are the three main ways to categorize derivatives?
91. Explain why a forward contract may actually carry more risk than a futures contract.
92. Explain why the two parties in a futures contract technically do not make a bilateral
agreement with each other.
93. Explain how the clearing corporation reduces the risk it faces in the futures market through
the use of margin accounts and marking-to-market.
94. We have a futures contract for the purchase of 10,000 bushels of wheat at $3.00 per bushel.
If the price of wheat were to increase to $3.50, explain what happens to the parties involved in
the contract in terms of marking to market. Be sure to identify who is long and short and
specifically how much is transferred.
95. A lender obtains funds from depositors by offering short-term interest rates on savings
accounts. The lender uses these funds to make longer-term installment loans. Explain how the
lender might make use of the futures market to hedge the risk taken.
96. How can we link the lack of futures markets in poor countries to the fact that farmers in poor
countries are likely to remain poor?
97. What is the process that makes sure the market price of an underlying asset equals the price
of a futures contract at the settlement date? Provide an example.
98. Consider a call option; in terms of the option writer and option holder, who is the buyer?
Who is the seller? Finally, who has the option? Explain.
99. With a put option, what specifically does the option holder receive for the price paid for the
option?
100. Describe the condition that would have a call option in the money. Now describe the
condition that has a put option out of the money.
101. Explain the difference between American and European options.
102. If the option holder is the individual with the options, why is anyone an option writer?
103. Suppose you purchase a call option to purchase General Motors common stock at $80 per
share in March. The current price of GM stock is $83 and the time value of the option is $5.
What is the intrinsic value of the option? As the expiration date approaches, what will happen to
the size of the time value of the option?
104. Suppose you purchase a put option to sell General Motors common stock at $80 per share
in March. The current price of GM stock is $83 and the time value of the option is $1. What is
the intrinsic value of the option?
105. Why does the time value of the option tend to vary directly with the time to expiration?
106. What would be the value of an option on a stock that sells at a fixed price with a standard
deviation of zero? Explain.
107. Identify four factors that will cause the value of call options to increase.
108. Identify four factors that will cause the value of put options to decrease.
109. If the current closing price of the stock of XYZ, Inc. is $87.50 and the July expiration
call options with a strike price of $80 are selling for $9.45, what is the intrinsic value of the
option? What is the time value of the option?
110. If the current closing price in the stock of XYZ, Inc. is $87.50 and the July expiration put
options with a strike price of $80 are selling for $1.05, what is the intrinsic value of the
option? What is the option premium?
111. Why do government debt managers often use interest-rate swaps?
112. Explain the concept of notional principal used in swaps.
113. How does trading in over-the-counter markets increase systemic risk?
114. What is a credit-default swap?
115. How did CDS’ contribute to the financial crisis of 2007-2009?
Essay Questions
116. Imagine a baker who has the opportunity to bid on a contract to supply a local military base
with bread for an entire year. The problem is the baker must commit to a price today and hold to
that price for the entire year. Identify the risk faced by the baker, and explain how the use of a
futures contract could transfer the risk.
117. A futures contract is a forward contract with some important differences. Explain.
118. Explain the popularity of options in the sense of the potential gains and losses they offer.
119. Explain why for speculation, the purchase of an option may be more attractive than a
futures contract or the outright purchase of the underlying asset.
120. What questions should an employee ask before accepting options as part of or instead of a
salary?