Derivatives 1st Edition Sundaram Test

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 Test Bank for
Derivatives: Principles & Practice
Chapter 8. Options: Payoffs & Trading Strategies
Rangarajan K. Sundaram
Sanjiv R. Das
August 1, 2010

1. In a covered call strategy:

(a) The gross payoff is greater than the net payoff.
(b) The gross payoff is equal to the net payoff.
(c) The gross payoff is smaller than the net payoff.
(d) None of the above is always true.
Answer c. Since the position involves a short call where the premium is received,
the net payoff exceeds the gross payoff.
2. A stock is currently trading at $50. A one-year at-the-money put costs $10. The
stock price at the end of one year can be equally likely to be one of the following
three values: {20, 50, 80}. What is the expected one-year return of a protective put
portfolio?
(a) −16.67%
(b) 0%
(c) +16.67%
(d) +50%
Answer b. The protective put position is long the stock and long the put. The cost
of the protective put position is $50 + $10 = $60. Given the three possible stock
price outcomes, the gross payoff after one year will be: {50, 50, 80}. The return in
these three cases is {(50 − 60)/60, (50 − 60)/60, (80 − 60)/60} =
{−10/60, −10/60, 20/60} = {−0.1667, −0.1667, +0.3333} . Taking an equally
weighted average, the expected return is
2 1
 (−10/60) +  (20/60) = 0
3 3

3. The combination of a position in a covered call and a position in a protective put on

a stock index (where the options have the same strike and maturity) is similar to:
(a) A leveraged long position in the stock.
(b) A leveraged short position in the stock.
(c) A long position in a balanced index fund (i.e., long stock and long investment
at the risk-free rate).
(d) A short position in a balanced index fund. (i.e., short stock and borrowing at
the risk-free rate).
Answer c. Let S denote the present value of the index and ST its value at
maturity. The payoff at maturity of the combined portfolio is
ST − max{ST − K , 0} + ST + max{K − ST , 0},
which is the same thing as
 ST + min{K − ST , 0} + ST + max{K − ST , 0} = 2ST + K − ST = ST + K .
This payoff may be replicated by buying a share of the index today and investing
the present value of K , so holding the portfolio is equivalent to holding a
balanced index fund which invests S in the index and PV ( K ) at the risk-free
rate.
4. If you go short a covered call and buy a protective put portfolio on a given stock
(with the options having the same strike and maturity), what you have is
(a) A long position in a straddle.
(b) Insensitive to the stock price at maturity of the options.
(c) Positive cashflow at inception.
(d) All of the above.
Answer a. The portfolio you hold is
−( S − C ) + ( S + P) = − S + C + S + P = C + P.
This is a long straddle.
5. The three-month 90-strike call is priced at $5 and the three-month 100-strike call is
priced at $3. What is the maximum possible net payoff on a bullish vertical spread
using these options?
(a) $5
(b) $7
(c) $8
(d) $10
Answer c. The bullish vertical spread has a long position in the 90-strike call and
a short position in the 100-strike call. The net premium paid is $2. At maturity the
net payoff is max(0, ST − 90) − max(0, ST − 100) − 2 . When ST  100 , this is
maximized, and has a value of $8.
6. The three-month 90–strike put is priced at $2 and the three-month 100–strike put is
priced at $7. What is the maximum possible net payoff on a bearish vertical
spread using these options?
(a) $5
(b) $7
(c) $8
(d) $10
Answer a. The bearish vertical spread has a long position in the 100–strike put
and a short position in the 90–strike put. The premium paid is net $5. At maturity
the net payoff is max(0,100 − ST ) − max(0,90 − ST ) − 5 . When ST  90 , this is
maximized, and has a value of $5.
7. A long position in a bearish 90/100 call spread plus a long position in a bullish
90/100 put spread for the same maturity is:
(a) An options strategy to short the stock.
(b) An options strategy to go long the stock.
(c) Always in-the-money at maturity.
(d) A sophisticated approach to borrowing money.
Answer d. With the strikes in parentheses, the portfolio is
 −C (90) + C (100) + P (90) − P (100) . The payoff at maturity is:
• If ST < 90 : 0 + 0 + 90 − ST − (100 − ST ) = −10 .
• If 90  ST < 100 : −( ST − 90) + 0 + 0 − (100 − ST ) = −10 .
• If ST  100 : −( ST − 90) + ST − 100 + 0 + 0 = −10 .
Thus, the portfolio always leads to a cash outflow of $10 today, i.e., it represents a
borrowing with $10 due at the maturity of the options.
8. The 90–, 100–, and 110–strike calls are trading at $12, $5, $3, respectively. The
stock price is at $100. What is the maximum net payoff on a long butterfly spread
using these options?
(a) −$5
(b) $0
(c) $5
(d) $10
Answer c. The butterfly spread is C (90) − 2C (100) + C (110) for a net premium
paid of $5. The highest gross payoff is when ST = 100 , i.e., a payoff of $10.
Hence, the maximum net payoff is $5.
9. The 90–, 100–, and 110–strike calls are trading at $12, $5, $3, respectively. The
stock price is at $100. What is the maximum net payoff on a short butterfly spread
using these options?
(a) −$5
(b) $0
(c) $5
(d) $10
Answer c. The maximum payoff is $5, just the net premium collected when the
stock ends up less than 90 or greater than 100.
10. What happens to the long position in a 90–100–110–strike call butterfly spread if
all the calls are replaced with puts of identical strike and maturity?
(a) There is no change in the risks and cash flows of the original position.
(b) The new position is the same as holding a short position in the original call
butterfly spread.
(c) The new position is the mirror image of the original one if you consider the x-
axis as a mirror.
(d) The gross payoffs remain the same, but the net payoffs are different.
Answer a. Draw a gross payoff diagram for the new position with puts and
confirm that it is the same as that of the original one with calls. The result may be
surprising but it is true.
11. You are long an at-the-money straddle on a stock index. Which of the following
statements is valid?
(a) Your position increases in value if, ceteris paribus, the index rises.
(b) Your position increases in value if, ceteris paribus, the index falls.
(c) Your position increases in value if, ceteris paribus, the volatility of the index
rises.
(d) All of the above.
 Answer d.
12. Consider a position in a long straddle at strike 90 and a short straddle at strike
100, both for the same maturity. which of the following properties is valid for this
position?
(a) The payoff is increasing in the stock price.
(b) The payoff is always positive.
(c) The payoff is always negative.
(d) The payoff is unbounded.
Answer a. The portfolio is C (90) + P(90) − C (100) − P(100) which is the same
thing as being long a 90/100 call bull spread and long a 90/100 put bull spread.
Both spreads are bullish, so the combined position is also bullish.
13. A long position in a strangle is:
(a) A short squeeze on a straddle.
(b) Worth more than a straddle whose strike lies within that of the strangle.
(c) Worth less than a straddle whose strike lies within that of the strangle.
(d) A choke hold on someone else’s throat.
Answer c.
14. A combination of a long position in a strip and a long position in a strap for the
same strike and maturity (and with similar but opposite proportions of calls and
puts) is similar to:
(a) A strangle position.
(b) A straddle position.
(c) A collar position.
(d) None of the above.
Answer b. It is a position in a number of straddles depending on how many puts
and calls form the strip and strap. Since they are individually asymmetric, but
mirror images of each other, adding them up results in a symmetric number of
puts and calls, i.e., a certain number of straddles.
15. If you are interested in creating a retirement portfolio where the downside is
protected and you retain at least some upside, the following portfolio will be
consistent with your goal:
(a) A long stock position plus a long collar position.
(b) A short position in a protective put structure.
(c) A long position in a covered call structure.
(d) A short collar.
Answer a. Here, the position consists of a stock plus a long put at strike K1 and a
short call position at strike K 2 , where K1 < K 2 . This position has a floor value of
K 2 , but it is also capped because of the short call at K1 . The capped upside is a
cost that subsidizes paying for the put that protects the downside.
16. Consider a condor made up of calls at strikes 90, 95, 100, 105, and a butterfly call
spread at strikes 90, 97.5, 105. Which of the following statements is valid?
(a) A condor is worth less than the butterfly spread irrespective of the level of the
stock price.
 (b) A condor is worth more than the butterfly spread irrespective of the level of
the stock price.
(c) A condor is worth less than the butterfly spread when the stock price is less
than 90.
(d) A condor is worth more than the butterfly spread when the stock price is
greater than 105.
Answer b. The condor pays off at least as much as the butterfly spread at all
possible stock price levels at maturity. Therefore, it will always be worth more
irrespective of what the current stock price might be.

17. Consider a ratio spread comprising a call at strike K1 and short two calls at strike
K 2 > K1 . The current stock price is at K1 . The market view for this trade is most
likely to be:
(a) That the stock is more likely to fall in price than rise in price.
(b) That volatility of the stock is likely to rise.
(c) That the stock is likely to experience high levels of positive skewness in
returns.
(d) That the stock will rise but not by an indefinite amount.
Answer d. All the other views are inconsistent with the ratio spread.
18. You anticipate a recession with increased stock volatility and greater negative
skewness in stock prices. Which of the following option positions would be most
consistent with your view?
(a) A straddle.
(b) A strip.
(c) A strap.
(d) A vanilla put.
Answer b. you want to use more puts than calls.
19. Consider a long position in a 100–strike straddle added to a short position in a
90/110–strike strangle. The underlying is a stock index. This is equivalent to:
(a) A stock index contract that pays the absolute return on the index up to 10%
and then pays nothing if the return is outside the range 10% .
(b) A long position in a 90–strike straddle plus a long position in a 110–strike
straddle plus a short position in a 100–strike straddle.
(c) A short position in a 90-100-110–strike butterfly call spread plus a zero-
coupon bond of face value 10.
(d) A long position in a 90-100-110–strike butterfly call spread plus a long put at
90 and long call at 110.
Answer c. This may be easily verified diagramatically.
20. Suppose your portfolio consists of one share of Goldman Sachs (GS) and a
European put option on GS with a strike of $105 and a maturity of a year. At
maturity, the value of your portfolio must be
(a) Equal to or less than $105
(b) Equal to $105
(c) Equal to or greater than $105
(d) None of the above
Answer c. This is a protective put position.
21. Suppose you are short a call and long a put on the S&P 500 index with the same
strike and same maturity. Then, you are essentially holding
(a) A long forward on the S&P 500 index
(b) A long straddle on the S&P 500 index
(c) A short forward on the S&P 500 index
(d) A short straddle on the S&P 500 index
Answer c.
22. A stock is currently trading at a price of 22. You observe the following prices for
European call options on the stock (the strikes are in parentheses): C (20) = 3.25 ,
C (22) = 1.95 , and C (24) = 0.40 . You can conclude from this that
(a) The 20-strike call is overvalued.
(b) The 24-strike call is undervalued.
(c) The prices of the calls are inconsistent with no-arbitrage.
(d) The stock is mispriced.
Answer c. This violates the convexity relationship where
0.5[C (20 + C (24)]  C (22) . See the chapter Appendix.

23. A stock is currently trading at a price of 22. You observe the following prices for
European put options on the stock (the strikes are in parentheses): C (20) = 3.35
and C (22) = 1.95 . Given this information, you can conclude that the minimum
price of the 24-strike call consistent with no-arbitrage is
(a) 0.00.
(b) 0.55.
(c) 1.40.
(d) 2.00.
Answer b. Use convexity of the options in the strike price.
24. The FTSE index is at 5,100. You are short a straddle on the FTSE 100 struck at
5,100 and long a 5,000/5,200 strangle. If volatility were to increase,
(a) The value of your position would increase.
(b) The value of your position would be unaffected.
(c) The value of your position would decrease.
(d) Any of the above is possible.
Answer c.
25. The FTSE index is at 5,100. You are short a straddle on the FTSE 100. struck at
5,100 and long a 5,000/5,200 strangle. You are also short a 5,000-5,100-5,200
butterfly. Ceteris paribus, an increase in the level of the FTSE
(a) Increases the value of your portfolio.
(b) Has no effect on the value of your portfolio.
(c) Decreases the value of your portfolio.
(d) Any of the above is possible.
Answer b. Your portfolio’s payoff is flat and independent of the level of the
FTSE.