All other factors constant, an increase in volatility of the underlying will most likely:

Consider the following statements:
Statement 1: There is never a reason to exercise an American call option early.
Statement 2: There is never a reason to exercise an American put option early.
Which of the following is most likely if the underlying on the options is a non-dividend-paying stock?

Only Statement 2 is incorrect.

•At times it may be beneficial to exercise an American option on a dividend-paying stock early. However, there is never a reason to exercise an American call option on a non- dividend-paying stock before expiration.
• An American put option may be exercised early if the underlying company is in or nearing bankruptcy.

The time value of an option is most accurately described as:

equal to the entire premium for an out-of-the-money option.

The price (or premium) of an option is its intrinsic value plus its time value. An out-of-the-money option has an intrinsic value of zero, so its entire premium consists of time value. Time value is zero at an options expiration date. Time value is the amount by which an options premium exceeds its intrinsic value.

At initiation of a forward contract and a futures contract with identical terms, their prices are most likely to be different if:

short-term interest rates are negatively correlated with futures prices.

Forward and futures prices may differ for otherwise identical contracts if interest rates are positively or negatively correlated with futures prices. The difference arises from the fact that futures are marked to market daily while forwards are not. A futures contract holder can earn interest on mark-to-market-gain and face an opportunity cost of interest of mark-to-market losses.

Which of the following statements about call options is least accurate?

The buyer of a call option has an obligation to perform.

Call options represent an obligation to perform in the case of the seller. The owner of the option (buy) has the right, but not an obligation, to purchase an underlying good at a specified price for a specified rime from the seller.

Under which of the following conditions does a forward contract have a positive value to the short party at expiration?

The spot price of the underlying asset is less than the forward price.

At expiration, a forward contract has positive value to the short party (and an equal negative value to the long party) if the spot price of the underlying asset is less than the price specified in the forward contract.

An investor has a call option on a stock that is currently selling for $35. The call option is in the money by $3. The call option’s strike price is:

$32.

When the stock's price (S) - the strike price (X) is positive, a call option is in the money. 35 - X = 3, so X = 32.

An investor buys a stock for $40 per share and simultaneously sells a call option on the stock with an exercise price of $42 for a premium of $3 per share. Ignoring dividends and transaction costs, what is the maximum profit the writer of this covered call can earn at expiration?

$5.

This is an out-of-the-money covered call. The net cost is $37 (40 - 3) and the maximum payoff on the position is the exercise price, $42. Thus, the maximum profit is $5

Henry sold a call option with an exercise price of $75 for $4. Henry’s profit if the stock trades at $81 at option expiration is closest to:

$2 loss.

Call option writer’s profit (loss) = payoff + premium = 75 − 81 + 4 = –$2

An analyst sells a call option for $7 on a stock that he already owns. Assuming that the exercise price of the option is $88 and that the stock currently trades at $86, her breakeven point on the strategy is closest to:

$79.

Breakeven point of a covered call strategy = S − C = 86 − 7 = $79

Open interest in a futures market is most accurately described as the total number of:

contracts outstanding.

Open interest is the total number of contracts (long/short position pairs) outstanding. The number of contracts that change hands in a given period is volume, not open interest.

Compared to an otherwise identical European put option, one that has a longer time to expiration:

may be worth less than the put that is nearer to expiration.

Normally, options with greater time to expiration are worth more than otherwise identical options that are nearer to expiration. However, in some circumstances, this relationship may not hold for European puts. For example, if the price of the underlying asset goes to zero, the European put with less time to expiration may be worth more because the put holder will receive the exercise price earlier.

In the futures market, if a trader receives a margin call, she must make a deposit in her margin account such that the balance in her account is at least equal to the:

Initial margin requirement.

In the futures market, the amount that must be deposited to satisfy a margin call should restore the initial margin requirement. Note that in the equity market, in a margin transaction, the amount that must be deposited to satisfy a margin call should restore the maintenance margin.

A put on a stock with a strike price of $50 is priced at $4 per share, while a call with a strike price of $50 is priced at $6. What is the maximum per share loss to the writer of the put?

$46.

Writer of puts maximum loss = $50 - $4 = $46

Given the put-call parity relationship, a synthetic underlying asset can be created by forming a portfolio of a:

long call, short put, and long risk-free bond.

An asset underlying put and call options can be replicated with a long European call option, a short European put option, and a long position in a risk-free bond that pays the exercise price on the expiration date.

Two Level I CFA candidates are discussing futures and make the following statements:
Candidate 1: Futures are traded using standardized contracts. They require margin and incur interest charges on the margin loan.
Candidate 2: If the margin balance falls below the maintenance margin amount due to a change in the contract price for the underlying assets, the investor must add funds to bring the margin back up to the initial margin requirement.
Are the candidates’ statements correct or incorrect?

Only one of the statements is correct.

Candidate 1 is incorrect. In the futures markets, margin is a performance guarantee. It is money deposited by both the long and the short. There is no loan involved (as opposed to in the equity markets) and thus no interest charges. Candidate 2 is correct.

All other factors constant, an increase in volatility of the underlying will most likely:

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