Questions
1. Options versus Futures. Describe the general differences between a call option and a futures
contract.
ANSWER: A call option requires a premium above and beyond the price to be paid for the financial
2. Speculating with Call Options. How are call options used by speculators? Describe the conditions
under which their strategy would backfire. What is the maximum loss that could occur for a purchaser
of a call option?
ANSWER: Call options are purchased by speculators when the price of the underlying stock is
Call options are sold by speculators when the price of the underlying stock is expected to decrease in
3. Speculating with Put Options. How are put options used by speculators? Describe the conditions
under which their strategy would backfire. What is the maximum loss that could occur for a purchaser
of a put option?
ANSWER: Put options are purchased by speculators when the price of the underlying stock is
Put options are sold by speculators when the price of the underlying stock is expected to remain stable
4. Selling Options. Under what conditions would speculators sell a call option? What is the risk to
speculators who sell put options?
5. Factors Affecting Call Option Premiums. Identify the factors affecting the premium paid on a call
option. Describe how each factor affects the size of the premium.
ANSWER: The greater the volatility of the underlying stock’s price, the higher the premium. The
6. Factors Affecting Put Option Premiums. Identify the factors affecting the premium paid on a put
option. Describe how each factor affects the size of the premium.
ANSWER: The greater the volatility of the underlying stock’s price, the higher the premium. The
7. Leverage of Options. How can financial institutions with stock portfolios use stock options when
they expect stock prices to rise substantially but do not yet have sufficient funds to purchase more
stock?
ANSWER: They could purchase stock options on various stocks to lock in the maximum price they
8. Hedging with Put Options. Why would a financial institution holding Hinton stock consider buying
a put option on that stock rather than simply selling it?
ANSWER: If a financial institution is concerned about a possible temporary decline in ABC stock,
9. Call Options on Futures. Describe a call option on interest rate futures. How does it differ from
purchasing a futures contract?
ANSWER: A call option on interest rate futures provides the right to purchase a specified financial
futures contract that contains a specified price. The ownership of a call option on a financial futures
10. Put Options on Futures. Describe a put option on interest rate futures. How does it differ from
selling a futures contract?
ANSWER: A put option on interest rate futures provides the right to sell a specified interest rate
Advanced Questions
11. Hedging Interest Rate Risk. Assume a savings institution has a large amount of fixed-rate
mortgages and obtains most of its funds from short-term deposits. How could it use options on
financial futures to hedge its exposure to interest rate movements? Would futures or options on
futures be more appropriate if the institution is concerned that interest rates will decline, causing a
large number of mortgage prepayments?
ANSWER: The financial institution could purchase put options on interest rate futures. If interest
rates increase over time, the reduced spread (between interest revenues and interest expenses) could
If interest rates decrease, and mortgage prepayments increase, a put option on futures would be
12. Hedging Effectiveness. Three savings and loan institutions (S&Ls) have identical balance sheet
compositions: a high concentration of short-term deposits that are used to provide long-term,
fixed-rate mortgages. The S&Ls took the following positions one year ago.
Name of S&L Position
LaCrosse Sold financial futures
Stevens Point Purchased put options on interest rate futures
Whitewater Did not take any position in futures
Assume that interest rates declined consistently over the last year. Which of the three S&Ls would
have achieved the best performance based on this information? Explain.
ANSWER: Whitewater would have achieved the best performance because its long-term, fixed-rate
mortgages are insensitive to the lower interest rates, but its cost of funds would decline.
13. Change in Stock Option Premiums. Explain how and why the option premiums may change in
response to a surprise announcement that the Fed will increase interest rates even if stock prices are
not affected.
14. Speculating with Stock Options. The price of Garner stock is $40. There is a call option on Garner
stock that is at the money, with a premium of $2.00. There is a put option on Garner stock that is at
the money, with a premium of $1.80. Why would investors consider writing this call option and this
put option? Why would some investors consider buying this call option and this put option?
ANSWER: If the investors expected that the stock price would remain somewhat stable, they could
Some other investors may expect that the stock price will be very volatile, although they do not know
15. How Stock Index Option Prices May Respond to Prevailing Conditions. Consider the prevailing
conditions that could affect the demand for stocks, including inflation, the economy, the budget
deficit, and the Fed’s monetary policy, political conditions, and the general mood of investors. Based
on prevailing conditions, would you consider purchasing stock index options at this time? Offer some
logic to support your answer. Which factor do you think will have the biggest impact on stock index
option prices?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
16. Backdating Stock Options. Explain what backdating stock options entails. Is backdating consistent
with rewarding executives who help to maximize shareholder wealth?
ANSWER: Some firms also allowed the CEO to backdate options that they were granted to an earlier
period when their stock price was lower. This enabled the CEOs to exercise the options at a lower
17. CBOE Volatility Index How would you interpret a large increase in the CBOE volatility
index (VIX)? Explain why the VIX increased substantially during the credit crisis. The
CBOE volatility index (VIX) represents the implied volatility derived from options on the
S&P 500 index (an index of 500 large stocks). An increase in the index suggests that market
fear has increased, as investors who sell stock index options demand a high premium to incur
the risk that the stock index might move substantially above or below the exercise price.
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Our firm took a hit because we wrote put options just before the stock market crash.”
Writers of put options on stocks are obligated to purchase those stocks at a specified exercise
price if the options are exercised. The writers may then sell the stocks in the market at market
b. “Before hedging our stock portfolio with options on index futures, we search for the index that is
most appropriate.”
The ideal index option would represent the same composition of stocks as the portfolio, so that
any decline in the value of the portfolio could be offset by an equal increase in the value of put
c. “We prefer to use covered call writing to hedge our stock portfolios.”
Covered call writing involves the sale of call options on stocks that are already owned. If the
If stock prices decline substantially, covered call writing will not offset the losses as much as the
Managing in Financial Markets
As a stock portfolio manager, you have investments in many U.S. stocks and plan to hold these stocks
over a long-term period. However, you are concerned that the stock market may experience a temporary
decline over the next three months, and that your stock portfolio will probably decline by about the same
degree as the market. You are aware that options on S&P 500 index futures are available. The following
options on S&P 500 index futures are available and have an expiration date about three months from now:
Strike Price Call Premium Put Premium
1372 40 24
1428 24 40
The options on S&P 500 index futures are priced at $250 times the quoted premium. Currently, the S&P
500 index level is 1400. The strike price of 1372 represents a 2 percent decline from the prevailing index
level, and the strike price of 1428 represents an increase of 2 percent above the prevailing index level.
a. Assume that you wanted to take an options position to hedge your entire portfolio, which is
currently valued at about $700,000. How many index option contracts should you take a position
in to hedge your entire portfolio?
The prevailing index is worth 1400, so that $250 times the index is $350,000. If the underlying
b. Assume that you want to create a hedge so that your portfolio will lose no more than 2 percent
from its present value. How could you take a position in options on index futures to achieve this
goal? What is the cost to you as a result of creating this hedge?
You could purchase two put option contracts on S&P 500 index futures with a strike price of
1372, which reflects a decline of about 2 percent from the present index value. Since the index
There is a cost of creating this hedge. Since the put premium is 224 $250 = $6,000 for one
option contract, your cost is $12,000 for two options on futures contracts.
c. Given your expectations of a weak stock market over the next three months, how can you
generate some fees from the sale of options on S&P 500 index futures to help cover the cost of
purchasing options?
You could sell call options on S&P 500 index futures with a strike price of 1428 at a premium of
However, by selling the call options, you are obligated to make a payment to the owner of the call
options who exercises the option and purchases S&P 500 index futures. On the settlement date of
the futures contract, you would pay an amount that is equal to the differential between the