TUTORIAL 7: DERIVATIVES (OPTIONS)

1. Explain the term option.

2. Discuss how a call and a put option work.

3. “Losses of an investor can be limited by purchasing a call or a put option”. Justify the above
statement.

4. Stock ABC is currently trading at RM 20.50 in the market, and KC, an investor is anticipating
the decrease in price of Stock ABC due to the losing competitive advantage among its peers. An
6-month expiration option is written by an underwriter with a strike price of RM21.00 and
premium of RM205 per contract. Consider that each option contract consist of 100 shares.

a) Explain how KC can make profit from trading the option of Stock ABC if the market is up to
his expectation.

b) Explain the maximum amount of loss will KC face if the market is not up to his expectation.

c) Calculate the profit/loss that KC make if the market price is rising to RM35 at expiry if he has
purchase the option based on his expectation.

d) Calculate the profit/loss that KC make if the market price is falling to RM10 at expiry if he
has purchase the option based on his expectation.

5. On 1 April 2016, Steve bought 10 contracts of call option with a strike price of RM 24, and
the expiration of the option is 6 months later. However, each contract consists of 100 shares and
the cost of the option is RM 250 per contract.

a) Determine whether Steve's call option is in the money or out of money if the shares is
trading at RM 30 on 1 June 2016. Will the price volatility influence the profit and loss after 1
June 2016?

b) Should Steve exercise the option on expiry if the market price rises to RM26? Justify your
answer.

c) Should Steve exercise the option on expiry if the market price falls to RM20? Justify your
answer.
6. Using appropriate example, explain the physical settlement and cash settlement for option.

7. Determine the intrinsic value of a call option with a strike price of RM38.

a) if the market price of the underlying security is RM55

b) if the market price of the underlying security is RM25

8) Suppose an investor purchases a call option on a Treasury bond futures contract with a strike
price of $90 and the cost of the option is 5% of the security’s price.

a. If at the expiration date the price of the Treasury bond futures contract is $96, will the investor
exercise the call option; if so, and how is the settlement for the option?

b. If at the expiration date the price of the Treasury bond futures contract is $89, will the investor
exercise the call option; if so, how is the settlement for the option?

9. How can the writer of a call option cancel his or her obligation?

10. Explain the reason why the naked option is riskier for an option writer.