CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set questions, study session 15, reading 29

In my case, the lower limit will equal $19.73.” Reed then posed the following question to Hughes: Statement 2: “If I buy the put and the price of the bond falls to $93.27, what will the

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Questions 1(8852) through 6(8857) relate to Reading 29

Martin Reed Case Scenario

Martin Reed is a U.S portfolio manager working for a money management firm Reed owns a bond currently selling for $104.5 per $100 face value A call option on the bond is selling for

$12.45 and has an exercise price of $112 A put option on the bond with an exercise of $96 has

an option premium of $11.23 Reed is analyzing the consequences of adding either the call option or the put option to his long bond position For an opinion, Reed approached his

colleague, Adam Hughes, who also works for the firm as a portfolio manager Hughes made the following comment:

Statement 1: “If you add a short call to your bond position, you will limit your upside potential

as compared to adding a long put to the bond position However, the former strategy will generate cash up front, whereas the latter will require the payment of cash.”

Reed asked Hughes about the value of the position at expiration of the option if he decides to buy

a put option on the bond he holds Hughes told him that if the price of the bond exceeds $96, the position will be worth only the value of the bond Reed said that if, however, the price exceeds

$96 plus the option premium, the value of the position may be worth more

Reed is also concerned with breaking even in case he buys the put He is not sure about the bond price at which he would breakeven Hughes told him that if he bought the put, the bond price will have to increase by almost 10.75% over the life of the option for him to breakeven However, if

he sold the call, the breakeven price would equal $115.73

Reed knows that there are certain benefits to buying the put to complement his bond position While talking to Hughes about them, Reed made the following comment:

“Buying the put will help provide a limit on the downside with no limit on the upside In my case, the lower limit will equal $19.73.”

Reed then posed the following question to Hughes:

Statement 2: “If I buy the put and the price of the bond falls to $93.27, what will the value and

profit of my position be?”

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1 With regards to statement 1, Hughes is most likely:

A correct

B incorrect with respect to the upside potential

C incorrect with respect to the initial cash transaction

FinQuiz Question ID: 8853

2 Are Hughes and Reed most likely accurate with respect to the value of the position at

expiration of the put option?

A Yes No

B No Yes

C Yes Yes

3 Is Hughes most likely correct with respect to the breakeven price at expiration, in case of

adding a long put or a short call to his long bond position?

A No Yes

B Yes No

C No No

4 Is Reed most likely accurate with respect to her comment about the benefit of buying a put?

A Yes

B No, because buying the put will also limit the upside because of the option premium

C No, because the lower limit does not equal $19.73

5 If Reed decides to add the long put to her bond portfolio, the maximum profit that he can

earn from the position is closest to:

A $115.73

B $93.27

C ∞

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6 What is the most appropriate response to statement 2?

A The value will equal $93.27 and the profit will equal -$8.5

B The value will equal $96 and the profit will equal $2.73

C The value will equal $96 and the profit will equal -$19.73

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James Torres Case Scenario

James Torres is a U.S portfolio manager who believes that the S&P 500 index would go up in the near future He therefore buys a call on the index with an exercise price of 2500 for $76.05 Torres plans to hold the option till expiration that is six months from now During a discussion with his friend, John Powell, Torres made the following comments about the call he had just purchased:

Statement 1: “If the index value is greater than the exercise price, the value of the option will

move up one-for one with the index value, but the profit will not.”

Statement 2: “When graphed, the breakeven is the price of the index corresponding to the point

where the profit line crosses the x-axis.”

Statement 3: “The value of this call option at expiration will either be zero or the index value

less the exercise price, whichever is greater.”

7 With regards to statement 1, Torres is most likely:

8 Torres is most accurate with respect to:

A Statement 2 only

B Statement 3 only

C both statements 2 and 3

9 The breakeven price of the underlying, at expiration of the call option, is closest to:

A 2,576.05

B 2,423.95

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10.If the price of the underlying at expiration is 2650, the value at expiration and profit for

Torres will be closest to:

A 0 –76.05

B 150 73.95

C 2650 150

11.The maximum profit and maximum loss to the seller of the call option is closest to:

A ∞ 76.05

B 76.05 ∞

C 2,576.05 2,423.95

12.What will be the value and profit for the seller of the call option if the price of the underlying

is 2010, and 2,550 respectively?

A Value: 490, Profit: 566.05 Value: 0, Profit: 76.05

B Value: -490, Profit: -413.95 Value: 50, Profit: 126.05

C Value: 0, Profit = 76.05 Value:-50, Profit: 26.05

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Richard Watson Case Scenario

Richard Watson, a portfolio manager, is writing a research report on the use of option strategies

to alter the risk and return profile of a position In his report, he mentioned the concept of spreads and explained their construction He wrote the following statements:

Statement 1: “Option spread strategies can be of two types In one strategy, an investor sells an

option and buys another one that is identical to the first in all respects except time

to expiration In the other strategy, the second option differs only with respect to the exercise price.”

Statement 2: “One option strategy that attempts to gain from movements in the price of the

underlying is a bull spread A bull spread has some similarities to another option strategy.”

Candia Hamilton is Watson’s close friend and came to him for advice She expects the market to

go up and wants to benefit from the increase using derivatives Watson told her that one way she could benefit from the increase in the market is to buy a call with a high exercise price and sell a call with a low exercise price Such a strategy would result in a profit if the value of the

underlying increases

Although Hamilton expects the overall market to go up, she believes the stock of RoadLand Enterprises, an automobile spare parts manufacturer, to go down Hamilton is not sure which strategy to use to benefit from this decrease in price so she asked Watson for an opinion She specifically mentioned that she does not want to spend any money for implementing the strategy Hamilton recently attended a seminar on money spread strategies by the CEO of a large

investment bank in the U.S During his speech, the CEO made the following comments:

Statement 3: “A bear put strategy and a bear call strategy have identical payoffs and

investments, since they both benefit from a decrease in the price of the underlying, and have identical graphical depictions.”

Statement 4: “Both a bull call spread and a bear put spread have limited gains and a limited

loss potential.”

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13.What are the option spread strategies, mentioned in statement 1?

A Expiration Spread Exercise Spread

B Time Spread Money Spread

C Maturity Spread Price Spread

14.The former strategy, mentioned by Watson in statement 1, most likely attempts to exploit:

A differences in perceptions of volatility of the underlying

B perceived mispricing of options with different maturities

C time differences in different regions of the world

15.The option strategy Watson is most likely referring to in statement 2 is a:

A butterfly spread

B straddle

C covered call

16.Watson’s advice to Hamilton for benefiting from an increase in the market is most likely:

A correct

B incorrect, because Hamilton should buy a call with a low exercise price and sell one with

a high exercise price

C incorrect, because Hamilton should buy a put with a high exercise price and sell a put with a low exercise price

17.The most appropriate strategy for Hamilton to use for the stock of RoadLand Enterprises is a:

A bear call spread

B bear put spread

C protective put

18.The CEO is most accurate with respect to:

A Statement 3 only

B Statement 4 only

C both statements 3 and 4

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Rosewood Case Scenario

Rosewood Investment Company is an asset management firm in Texas Candice Price works as a portfolio manager at the firm and manages portfolios for many of the firm’s clients Price

recently implemented a strategy for a client by buying a call on a stock currently selling for $50 She simultaneously sold a call on the same stock with the same time to expiration as the long call The long call has an exercise price of $55 with an option premium of $15 The short call has

an exercise price of $65 with an option premium of $7 The options will expire in one month During a meeting with the client, Price made the following comments:

Statement 1: “For a bear spread using puts, both puts need to have exercise prices lower than

the current price of the underlying.”

Statement 2: “For a bull spread using calls, both calls need to have exercise prices lower than

the current price of the underlying.”

One of Price’s clients has implemented a bear put spread When asked about the outcomes of the strategy, Price mentioned that such a strategy would earn a maximum profit if both puts expire in the money He also said that the breakeven price is such that leaves one put in the money and the other out of money

19.Price is most accurate with respect to:

A statement 1 only

B statement 2 only

C neither statement 1 nor statement 2

20.If at expiration of the calls the price of the underlying is $62, the profit to Price’s client will

be closest to:

A $7

B – $1

C $15

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21.For the position Price took, the maximum profit and maximum loss is closest to:

A $2 $8

B $8 – $2

C $28 $22

22.For the position Price took, the breakeven stock price at expiration is closest to:

A $47

B $77

C $63

23.Is Price most likely accurate about the maximum profit and breakeven price of a bear put

24.Which of the following about option strategies is most accurate?

A The payoff and profits for a bear call spread are the exact opposite of the payoff and profits for a bull call spread

B The worst outcome for a bear put spread occurs when the stock price is less than the exercise price of the short put

C The maximum a bull call spread can gain is the difference between the exercise prices of the short call and the long call

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Tactical Management Inc (TMI) Case Scenario

Tactical Management Inc (TMI) is a firm that specializes in implementing option strategies to benefit from movements in asset prices Recently the firm transacted in two put options on a bond selling for $103 per $100 par One put has an exercise price of $95 and is selling for $12 The other put has an exercise price of $105 and is selling for $17 Both puts expire in three months

Cindy Flores works at TMI and is going to hold a seminar to educate freshly graduated finance students about the concept and construction of option spread strategies Flores plans to make the following comments during her speech:

Statement 1: “The maximum profit for both a bull call spread and a bear put spread is similar:

the difference between the exercise prices of the options less the initial outlay.”

Statement 2: “The breakeven price for the underlying in a bull call spread and a bear put spread

is also similar: the lower exercise price plus the initial outlay.”

25.If TMI implemented a bear spread using the puts mentioned above, the value and profit,

assuming the price of the bond is $92 at expiration, are closest to:

A $5 $0

B $10 $5

C $20 $15

26.Using the scenario in Part 1, which of the following is most accurate?

A The profit for the position will be the same for all prices of the bond above $105

B The profit for the position will be the same for all prices of the bond below $103

C The profit for the position will vary as the price of the underlying falls below the exercise price of the short put

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27.If TMI implemented a bear spread using the puts, the breakeven price of the bond will be

closest to:

A $100

B $66

C $76

28.If TMI implemented a bear spread using the puts, the maximum profit will most likely be:

A only $2 greater than the maximum loss

B only $12 greater than the maximum loss

C equal to the maximum loss

29.Flores is least accurate with respect to:

A Statement 1 only

B Statement 2 only

C neither Statement 1 nor Statement 2

30.If TMI implemented a bear put spread, the profit, if the bond’s price stays within the exercise prices of the puts, will vary from:

A –$5 to $5

B $0-to $10

C –$5 to $15

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Patrick Payne Case Scenario

Patrick Payne is using a bull call spread to benefit from an increase in the market The equity market index is currently at 1400 and Payne has bought a call with an exercise price of 1350 and sold a call with an exercise price of 1600 The long call is selling for $18 and the short call is selling for $13 Payne is not sure how much the market should move for him to break even Payne has been considering using a butterfly spread but is uncertain about its construction and outcomes To get an expert opinion, Payne visited Harry Palmer, a portfolio manager and a close friend Palmer told Payne that a butterfly spread is basically a combination of a bull spread and a bear spread He also told him that a butterfly spread with calls constitutes three different

exercises prices, and most often the difference between two times the exercise price of the sold options and the sum of the other two exercise prices is zero

Payne is not sure how much cash he would need to spend upfront to establish the butterfly

spread When he asked Palmer, Palmer made the following comment:

“The initial value of the butterfly spread is usually negative This means that there will most likely be a cash inflow at the initiation of the position.”

While talking about the profit for a butterfly spread, Palmer made the following comment:

“The maximum profit occurs if the price of the underlying is either greater than or less than the exercise price of the sold options.”

Payne is going to use the following call options to construct the butterfly spread:

1 Call 1 with an exercise price of $20 selling for $8

31.For Payne to breakeven in his bull call spread, the market must:

A move down by 3.21%

B move up by 3.57%

C move down by 3.93%

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