Chapter 20 End-chapter essay questions solutions

On top of the selected homework questions, you can use the remaining questions as
an extra study resource to help you learn.

1 With reference to the relationship between stock prices and options values, explain
what boards of directors are trying to achieve when they award CEOs options as part of
their executive compensation packages. (LO 20.1)
ANSWER

 Option contract—gives the buyer of the option the right, but not the obligation, to
buy or sell a specific asset on a specified date at a price determined today.
 Call options increase in value as the underlying share price increases.
 If the board of directors believes that the job of the CEO is to create market value
for the shareholders, one way to align the CEO’s behaviour with this goal is to
award the CEO options that will increase in value as the share price rises.
 In theory, it would be expected that the CEO would make better decisions and
work harder to find projects that return more than they cost in order to create
shareholder value.
 In practice, it might lead the CEO to take undue risks in order to boost the share
price and his or her own net wealth.

Section 20.1

2 In what ways are option contracts more flexible than futures contracts?  (LO 20.1)
ANSWER

 An options contract gives the buyer the right, but not the obligation, to buy or
sell.

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  Consider an option on interest rates. If rates rise, the option contract provides
protection to the borrower, however, if interest rates fall, the borrower is able to
take advantage of the lower rate by not exercising the contract and allowing the
option to lapse.
 The same applies in other contexts. Imagine a portfolio manager who is planning
to invest in ANZ shares in 6 months time. The funds are not yet available. In the
meantime, there is the risk that the ANZ share price will increase. The portfolio
manager can purchase call options on ANZ. If the share price rises, he or she can
exercise those options. If not, he or she can let the options expire and purchase
shares at the lower market price.

Section 20.1

3 Explain why American options will usually have a higher value than European
options, even when all of the other features (strike price, expiry date, etc.) are the same.
(LO 20.1)
ANSWER

 An American [type] option is an option that can be exercised by the holder any
time between its origination and expiration.
 A European [type] option gives the option buyer the right to buy or sell at the
exercise price only at a specified date or dates.
 The American type option is a much more flexible product; for example, the
holder of an American type option to buy Westpac Banking Corporation shares
at $20.35 may exercise the right to buy at any time during the life of the option,
particularly if Westpac shares are trading in the market above the $20.35 exercise
price.
 The European type option is relatively cheaper in that a lower premium is
payable; for example, the buyer of a put option to sell BHP Billiton shares at

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 $30.00 will hold the option to exercise that right on the expiration date specified
in the option contract.
 This lower cost type of option may be attractive to risk managers who have a
specific date related risk to hedge.
 The buyer of an American type of option will be required to pay a higher
premium than would otherwise be payable for the same European type option.
The higher premium on the American type option, or the lower premium on the
European type option, reflects the relevant risk relationships.
 The writer of the American type option will be compensated for providing a
much more flexible risk management product.

Section 20.1

4 Aurizon Holdings Limited shares trade at $5.21. An investor enters into a long-call
option on Aurizon with an exercise price of $5.80 per share in four months, and a
premium of $0.28 per share.

a. Calculate the break-even price for the short-call position.

ANSWER

 The short call position is held by the writer of the option. The writer of the option
receives the $0.28 premium. The break-even for the writer is the exercise price
plus the premium.
 That is, $5.80 + $0.28 = $6.08

Section 20.2

b. Draw a fully labelled diagram of the long-call and short-call positions.

ANSWER

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 Section 20.2

c. At what minimum stock price will the option buyer exercise the option on the
expiration date? (LO 20.2)
ANSWER

 The option buyer will exercise the option when the share price in the stock
market is above $5.80
 While the share price is between $5.80 and $6.08, the buyer will exercise the
option in order to recover some of the premium already paid.

Section 20.2

5 Wesfarmers shares currently trade at $43.00. A fund manager is holding a large

number of Wesfarmers shares in an investment portfolio and wishes to protect the value
of the investment. The manager buys a long put option with an exercise price of $42.50
per share and pays a premium of $1.30 per share.

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a. By entering into this options strategy, explain whether the fund manager will
exercise the option if the spot price is above or below the exercise price.
ANSWER

 The fund manager has bought the right to sell Wesfarmers shares at $42.50
 The manager will exercise the option if the share price is below the option
exercise price of $42.50

Section 20.2

b. Calculate the break-even price for the long put position.

ANSWER

 The break-even point for the buyer of the option (long put) is the exercise price
less the premium; that is: $42.50 – $1.30 = $41.20
 Note: the option holder will exercise the option when the share price is between
$41.20 and $42.50 as he/she will be able to offset the cost of at least part of the
premium that has already been paid. If the share price falls below $41.20 the
option holder will be in-the-money.

Section 20.2

c. Draw a fully labelled diagram of the long put and the short put positions. (LO 20.2)
ANSWER

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 Section 20.2

6 A speculator has written an option on the shares of Sonic Healthcare.

a. Discuss the differences between a covered option and a naked call option.
ANSWER

 A covered option is one where the writer or seller holds the underlying shares or
asset. A naked option is one where the writer does not hold the underlying asset.
 A writer of a naked option is required to pay a margin. The option writer will
usually be liable for daily margin payments while the contract is open.
 Writing naked options can be particularly risky. For example, the writer of a call
option faces potentially unlimited losses if the price of the underlying security
increases. If, for example, Sonic Healthcare traded at $17.00 per share, a naked
call writer would begin to suffer losses as the share price increases. Obviously,
an unexpected positive announcement that increased the share price significantly
could be disastrous for the call writer.

Section 20.2

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 b. What requirements will be applied by an options exchange to ensure that the option
writer can meet the contract obligations? (LO 20.2)
ANSWER

 The potential loss that may be incurred by the writer of an option contract could
extend well beyond the amount of the premium received.
 An option is covered when there is a guarantee that the writer of the option can
complete the contract.
 The writer of a call option would be considered to have written a covered call
option if the writer owned sufficient of the underlying asset to meet the
requirements of the option contract in the event that it is exercised; for example,
if the call option gave the right to the option-holder to buy shares in Sonic
Healthcare, the option would be covered if the writer held enough of those shares
to meet the requirements under the option.
 Under an alternative arrangement, an option-writer would be covered if a third
party, such as a securities custodian, provided a guarantee that the option-writer
could borrow the underlying security on or before the options contract settlement
date.

Section 20.2

7 a. Options exchanges tend to specialise in certain option contracts. Discuss this

statement within the context of the international options markets.
ANSWER

 Globalisation of the financial markets, coupled with the use of electronic

communication and product delivery systems means that options trading can take
place 24-hours a day around the globe. The tyranny of distance is no longer a
constraint on trading.

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 Price with the markets is directly influenced by the level of liquidity in the
market. Highly liquid markets tend to have lower costs and tighter margins, and
therefore become more competitive.
 Exchanges now tend to specialise in options products in which they have strength
and liquidity
 The strong options contracts are typically based on underlying local physical
market commodities and financial instruments; for example, in Australia options
contracts offered by the ASX are based on shares listed on the Australian
exchange.

Section 20.3

b. Option contracts may be traded by open outcry or through electronic trading

systems. Briefly explain each of these methods used for trading option contracts. (LO
20.3)
ANSWER

 Open outcry occurs on the floor of the exchange. Clients will contact their
brokers who will forward the orders directly to traders on the floor of the
exchange. The trader will use a combination of voice and hand-signals to try and
execute the order with another trader on the floor. To an observer, floor trading
looks very colourful and noisy, but it may be argued that it is less efficient than
electronic trading.
 The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange
(CME) are both open outcry exchanges.
 Electronic trading uses sophisticated communication and computer-based trading
and settlement systems. Clients contact their broker who enters the order directly
into the exchange’s electronic trading system. The system automatically matches
buy and sell orders and provides the information to the clearing-house.

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  The clearing-house uses its settlement system to accept margin calls, record
contracts and facilitate delivery as required.
 The Australian Stock Exchange (ASX), including the Sydney Futures Exchange
(SFE) is an example of an electronic exchange.
 Electronic systems would appear to be more efficient in the conduct of trades and
also allow price information to be more quickly provided to the market.

Section 20.3

8 One of the categories of options available to investors and speculators is LEPOs.

Assuming 7.00 per cent margin, what would be the percentage return and dollar profit
to an investor who purchased one LEPO (for 1000 shares) for a premium of $26 220
and later closed out the position when the LEPO premium was $28 430? (LO 20.3)
ANSWER

 A LEPO premium of $26 220 indicates a LEPO price of $26.22 for this
company. Just like any other derivative, the LEPO price will reflect changes
underlying share price.
 The LEPO buyer must pay, in this case, 7 per cent margin. Hence, the buyer
would have to pay $1835.40.
 The buyer closes out the position at a LEPO price of $28.43 per share or a LEPO
premium of $28 430.
 The total profit is worked out on the basis of the initial margin. The investor paid
$1835.40 in an initial margin outlay. The LEPO position has increased in value
by $2210 (28 430 – $26 220).
 The dollar profit is therefore $2210.
 The percentage return is 120 per cent ($2210/$1835.40).

Section 20.3

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 9 Discuss the relationship between the exercise price of an option, the current market
price of the underlying asset and the intrinsic value of the option. In your answer
explain the money position of an option. (LO 20.4)
ANSWER

 The relationship between the current market price of the underlying asset and the
exercise price of an option determines whether or not the option actually has a
value if the option was exercised immediately. This value is referred to as the
intrinsic value of the option.
 If an option could be exercised immediately and a profit made, the price that
would be paid to buy such an option should be equal to the intrinsic value of the
option.
 The greater the intrinsic value of the option, the higher is the value of the option,
that is, the larger the premium.
 The relationship between the price of an asset and the option exercise price
determines whether an option is in-the-money or not. An option is in-the-money
if it can be exercised at a profit, that is, if it has a positive intrinsic value.
 If the exercise price is equal to the price of the asset in the physical market, the
option is said to be at-the-money.
 In the situation where an option would not be exercised, the option is described
as being out-of-the-money.

Section 20.4

10 During periods of market distress, investors’ risk aversion increases and implied
volatility in the options markets moves higher to reflect declines in the physical markets
and the increased uncertainty confronting investors (when people are more risk averse,
they will pay more to protect or hedge their portfolios). Develop a basic trading strategy
for a speculator who believes that risk aversion will soon abate. (LO 20.4)
ANSWER

 This situation is a favourite among hedge funds but it involves particular risks
that must be monitored carefully.

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  A number of trading strategies might be designed. However, the simplest is to
take a position that will profit as risk aversion and implied volatility decline or
return to normal levels.
 The simplest trading strategy is to write pairs of options, puts and calls. As
implied volatility declines, the options premiums should also decline (it will be
recalled that volatility is one of the determining factors of options prices) and the
options writer can reverse positions at lower premiums and collect the
differential.
 A strategy of writing options under these circumstances is called ‘shorting the
vol’ (vol being short for volatility). The options writer is, in this case, akin to an
insurance provider. Investors are extremely worried about further volatility and
are willing to pay to insure their portfolios (by purchasing options). The options
writer must judge whether the insurance premiums, the options prices, are
sufficiently high to justify the risk that volatility might increase further. If so, the
options writer provides the insurance by writing options and collects when the
insured disaster fails to materialise.
 The options writer bears the risk that markets may become more volatile. This
type of trade was at the centre of Long Term Capital Management’s (LTCM)
collapse in the late 1990s.

Section 20.4

11 A company knows that it will need to borrow $500 000 in six months’ time and is
concerned that interest rates may rise before that date. The company wishes to protect
itself against a rise in interest rates and decides to use an options collar strategy. Explain
how a collar strategy is structured and why the company might consider this type of
strategy. (LO 20.5)
ANSWER

 A collar is an interest rate risk management strategy using a combination of an

options cap and an options floor. Caps, floors and collars are over-the-counter

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 options that are negotiated between a financial intermediary and a borrower. A
cap is a strategy that may be adopted by a company that wishes to place an upper
limit on the interest rate payable on a future borrowing commitment.
 The borrower would pay a premium to buy the cap.
 At the same time, the company may sell an option contract that places a
minimum limit, or floor, on how low the interest rate payable may fall. The
borrower would receive the premium for writing the floor.
 The combination of a cap and floor is called a collar. This strategy is designed to
lower the overall cost of the cover; the premium paid for the cap is offset by the
premium received for the floor.
 The success of this strategy will depend upon the forecast direction and volatility
of future interest rates; for example, if interest rates in the market are generally
expected to rise over the contract period, the cost of the cap premium will be
higher than the premium received from the sale of the floor, therefore, the
premium offset of a cap and a floor of the same contract period will not usually
be equal.

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 Section 20.5

12 An investor has a quite bullish view that prices in the share market will rise, but is
concerned that there is still some risk that prices might fall. Draw and explain the
relevant profit profiles for a call bull spread strategy for (a) the holder of a call option,
(b) the writer of a call option and (c) the long call plus short call. (LO 20.5)
ANSWER

 The investor will position the option strategy so that if the asset price rises a
profit would be made, but at the same time, they gain some protection in the low
probability situation that prices might fall. One way of achieving this would be to
simultaneously buy and sell call options.
 The purchase of the call option provides the potential profit if the share market
rises.
 The premium paid on the purchase of the call option may be high since there is
an expectation that the market will rise.

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 One way of recouping some of the cost of the option would be to simultaneously
write a call option and thus earn a premium.
 The short call would be written at an exercise price higher than that for the long
call option.
 The profit profile for the combined short put and long call strategy follows.

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IRM to accompany Viney & Phillips Financial Institutions, Instruments and Markets, 9th edition
© 2019 McGraw-Hill Education (Australia)