DERIVATIVES │ CFA LEVEL I Derivatives I Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I April 20, 2010.

DERIVATIVES │ CFA LEVEL I Derivatives I Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I April 20, 2010

DERIVATIVES │ CFA LEVEL I Jeffery Lippens Lecturer Tray Spilker Teaching Assistant Derivatives I Problem Solving Session

DERIVATIVES │ CFA LEVEL I Derivatives Topic Area Weights for the CFA Exam Topic AreaLevel I Ethical and Professional Standards (total)15 Quantitative Methods12 Economics10 Financial Reporting and Analysis20 Corporate Finance8 Investment Tools (total)50 Equity Investments10 Fixed Income12 Derivatives5 Alternative Investments3 Asset Classes (total)30 Portfolio Management and Wealth Planning (total)5 Total100

DERIVATIVES │ CFA LEVEL I Introduction to Derivative Markets & Instruments Options Markets, Puts & Calls, & Put-Call Parity Risk Management Applications of Option Strategies Derivates I Problem Solving Session Study Session 17 Readings 67,70 & 72

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 1. A derivative security is: A. a financial asset that bears no risk. B. a financial asset that offers a return based on the return of another asset or security. C. a financial asset with no maturity.

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 2. Exchange-traded derivatives: A. are standardized and backed by a clearinghouse. B. are largely unregulated and backed by a dealer counterparty. C. include forwards and swaps.

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 3. A customized, or bespoke, agreement to sell 37,500 pounds of coffee in one month is an example of: A. a futures contract. B. a swaption. C. a forward commitment.

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 4. A futures contract is most likely: A. adjusted daily to account for profits and losses. B. a contingent claim. C. traded over-the-counter (OTC).

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 5. A swap is least likely: A. the exchange of one asset for another. B. a series of options contracts. C. traded over-the-counter (OTC).

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 6. The right but not the obligation to sell an asset at a particular price in the future is an example of: A. a short futures position. B. a call option. C. a put option.

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 7. Which of the following could be considered benefits of derivatives: they (1) provide price information, (2) allow investors to manage risk, (3) provide access to leverage, and (4) reduce transactions costs? A. 2 & 4 B. 1, 2, & 4 C. All of the above

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 8. The “law of one price” argues that: A. two assets with identical payoffs will have the same price. B. arbitrage opportunities do not exist. C. risk management is futile.

DERIVATIVES │ CFA LEVEL I Introduction to Derivatives 8. Explained:  Arbitrage is the process of creating “risk- less” profit when assets with identical payoffs become mispriced; buy the lower priced asset and sell (short) the higher priced asset. The Law of One Price enforces this relationship.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 9. Which of the following is in the money? A. a put option with S > X B. a call option with S – X > 0 C. a put option with S – X > 0

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 10. Which of the following is not in the money? A. a put option with X – S < 0 B. a put option with S < X C. a call option with S – X > 0

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 11. Contrary to European options, American options: A. cannot be exercised prior to maturity. B. will always vary in price against a European option due to exchange rate risk. C. may have a higher value versus a similar European option.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 11. Explained:  An American option gives the option holder the right to exercise the option prior to expiration

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 12. Which of the following about puts and calls is most accurate? A. Option prices are positively correlated to the time to maturity. B. The price of the underlying security will exhibit more volatility than the option. C. An increase in market interest rates will increase the value of a call and decrease the value of a put.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 12. Five inputs to options prices: –S = price of underlying stock –X = exercise price of the option –T = time to expiration –R f = risk-free rate –V = volatility of underlying stock price  Positive Correlation: –Calls  S, T, R f, & V – Puts  X, T, & V  Negative Correlation: –Calls  X – Puts  S & R f

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 12. Explained (cont)  C = S + P – X / (1+R f ) T  P = C – S + X / (1 + R f ) T  As R f ↑  X / (1 + R f ) T ↓  Call ↑  Put ↓

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 13. Which of the following is least accurate? A. The holder of a put has the right to sell to the writer of the option. B. The writer of a call has the obligation to buy to the holder of the option. C. The holder of a call has the right to buy from the writer of the option.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 13. Explained:  Writer: has the obligation to buy from a put holder and sell to a call holder.  Holder: has the right, but not the obligation, to buy when holding a call, or sell when holding a put.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Question 14 – 16: Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 14. What is the time value of the call? A. $7.50 B. $5.00 C. $2.50

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 14. What is the time value of the call? A. $7.50 B. $5.00 C. $2.50 Intrinsic Value = S – X = $50 - $42.50 = $7.50 Time Value = $10 - $7.50 = $2.50

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Question 14 – 16: Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 15. What is the lower bound of the call price? A. $7.50 B. $5.00 C. $2.50

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Question 14 – 16: Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 15. What is the lower bound of the call price? A. $7.50 B. $5.00 C. $2.50 Lower Bound of a Call: C t = max [0, S t – X] = max [0, $50 – $42.50]= $7.50

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Question 14 – 16: Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 16. What is the upper bound of the call price? A. $10.00 B. $50.00 C. $42.50

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts Question 14 – 16: Consider a call option with a strike of $42.50, priced at $10, when the underlying stock trades at $50 16. What is the upper bound of the call price? A. $10.00 B. $50.00 C. $42.50 Upper Bound of a Call: C t ≤ S t  Why pay more for the right to buy an asset than the asset is worth?

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 16. What is the lower bound of a European put option with a strike of $50, when the underlying stock trades at $40, the risk- free rate is 2%, and there is 3 months to maturity? A. $10.00 B. $9.75 C. $9.02

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 16. What is the lower bound of a European put option with a strike of $50, when the underlying stock trades at $40, the risk- free rate is 2%, and there is 3 months to maturity? A. $10.00 B. $9.75 C. $9.02 Max [0, X / (1+R f ) T – S] Max [0, 50/(1.02) (.25) – 40 Max [0, 9.75] = $9.75

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 17. What is the lower bound of an American call option on non-dividend paying stocks? A. Max [0, X – S] B. Max [0, X/(1+R f ) T – S] C. Max [0, S – X/(1+R f ) T ]

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 17. Explained:  C = Max [0, X – S]  c = Max [0, s – x/(1+r f ) T ]  Because the American option has greater properties than the European option, S – X/(1+R f ) T ] must also be the lower bound for an American call option  Thus, C = Max [0, S – X/(1+R f ) T ]

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 18. How would an investor adjust the put- call parity formula for assets that generate cash flows? A. Reduce the strike price by the future value of the cash flows. B. Reduce the underlying asset value by the present value of the cash flows. C. Add the future value of cash flows to the underlying asset value.

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 19. A forward rate agreement, has the same payoff as: A. A long position in an interest rate call option B. A short position in an interest rate put option C. A long position in an interest rate call and a short position in an interest rate put option

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 19. Explained: Assume Libor = 6%, Fixed = 5%  Long call payoff: float–fixed;  Max[0, 6% - 5%] = 1%  Short put payoff: fixed–float;  -(Max[0, 6% - 5%]) = 0%  FRA payoff: pay fixed, receive float;  = -5% + 6% = 1%  = long call + short put = 1%

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 20. From the issuers perspective, an interest rate floor on a FRN is equivalent to a series of: A. Short interest rate puts B. Long interest rate puts C. Short interest rate calls

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 20. Explained:  When market rates falls below the strike at expiration, the FRN issuers will pay the difference to the put purchaser.  Why would a FRN issuer write an interest rate put option? Don’t they want rates to fall?  To fund an interest rate call purchase / cap; create a collar

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 21. Which of the following relationships is inaccurate? A. C = S + P – X / (1+R f ) T B. P = C – S – X / (1+R f ) T C. X / (1+R f ) T – P = S – C

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 22. Which of the following will decrease the value of a put option? A. A decrease in volatility B. A decrease in R f C. An increase in X

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 22. Explained:  Positive Correlation: –Calls  S, T, R f, & V – Puts  X, T, & V  Negative Correlation: –Calls  X – Puts  S & R f

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 23. A put and call option of $40 with 3- months to maturity is trading at $10 and $2 respectively. The underlying stock is selling at $30 and the risk-free rate is 5%. How much can be made through arbitrage? A. $0 B. $2.36 C. $0.24

DERIVATIVES │ CFA LEVEL I Option Markets and Contracts 23. Explained:  Synthetic Stock: S = C – P + X / (1+R f ) T  $40 = $2 – $10 + $30/(1.05).25  $40 > $37.64  Thus, sell the stock and buy the synthetic for an immediate arbitrage profit of $2.36

DERIVATIVES │ CFA LEVEL I Risk Management Applications 24. Which of the following poses the highest risk? A. Long Call B. Short Call C. Short Put

DERIVATIVES │ CFA LEVEL I Risk Management Applications 24. Explained:  Buying a put or a call exposes you only to the premium.  When writing a put, your loss is limited by the lower bound of a stock price (0) minus the premium you received.  When writing a call, however, your loss potential is unbounded as stock prices can go up infinitely.

DERIVATIVES │ CFA LEVEL I Risk Management Applications 25. A put option with a strike of $25 sells for $4 while the underlying stock trades at $30. If the option were exercised, which of the following is most accurate? A. The put writer loses $1 on the transaction. B. The put buyer loses $4 on the transaction. C. The put writer gains $5 on the transaction.

DERIVATIVES │ CFA LEVEL I Risk Management Applications 25. A put option with a strike of $25 sells for $4 while the underlying stock trades at $30. If the option were exercised, which of the following is most accurate? A. The put writer loses $1 on the transaction. B. The put buyer loses $4 on the transaction. C. The put writer gains $1 on the transaction.

DERIVATIVES │ CFA LEVEL I Risk Management Applications 25. Explained: A. Put Buyer Payoff: Max[0, X-S] – Premium Paid = Max[0, 25-30] – 4 = -$4 B. Put Writer Payoff: Min[0,X-S] + Premium Received = -(Max[0, 25-30]) + 4 = $4

DERIVATIVES │ CFA LEVEL I Risk Management Applications 26. A call option with a strike of $25 sells for $4 while the underlying stock trades at $30. If the option were exercised, which of the following is most accurate? A. The call buyer gains $5 on the transaction. B. The call writer gains $5 on the transaction. C. The call writer loses $1 on the transaction.

DERIVATIVES │ CFA LEVEL I Risk Management Applications 26. Explained:  Call Buyer Payoff:  Max[0, S-X] – Premium Paid =  Max[0, 30-25] – 4 = $1  Call Writer Payoff:  -(Max[0,S-X]) + Premium Received =  -(Max[0, 30-25]) + 4 = -$1

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 27 – 28: –An investor is long 100 shares of Pfizer stock at $15. The investor writes one call contract (100 multiplier) at a strike of $25 for $1. 27. What is the maximum result possible for the investor? A. A gain of $100 B. A gain of $1,100 C. Unlimited Loss

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 27 – 28: –An investor is long 100 shares of Pfizer stock at $15. The investor writes one call contract (100 multiplier) at a strike of $25 for $1. 27. What is the maximum result possible for the investor? A. A gain of $100 B. A gain of $1,100 C. Unlimited Loss 100[($25 - $15) + $1] = $1,100

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 27 – 28: –An investor is long 100 shares of Pfizer stock at $15. The investor writes one call contract (100 multiplier) at a strike of $25 for $1. 28. What will be the payoff if the stock increases to $30? A. A gain of $600 B. A loss of $400 C. A gain of $100

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 27 – 28: –An investor is long 100 shares of Pfizer stock at $15. The investor writes one call contract (100 multiplier) at a strike of $25 for $1. 28. What will be the payoff if the stock increases to $30? A. A gain of $600 B. A loss of $400 C. A gain of $100 100[($25 - $30) + $1] = $400

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 29 – 30: –An investor is long 100 shares of Pfizer stock at $15. The investor buys one put contract (100 multiplier) at a strike of $5 for $1. 29. What is the minimum result possible for the investor? A. Unlimited Gain B. Loss of $600 C. Loss of $1,100

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 29 – 30: –An investor is long 100 shares of Pfizer stock at $15. The investor buys one put contract (100 multiplier) at a strike of $5 for $1. 29. What is the minimum result possible for the investor? A. Unlimited Gain B. Loss of $600 C. Loss of $1,100 100[($5 - $15) - $1] = - $1,100

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 29 – 30: –An investor is long 100 shares of Pfizer stock at $15. The investor buys one put contract (100 multiplier) at a strike of $5 for $1. 30. What will be the payoff if the stock increases to $30? A. Gain of $1,400 B. Gain of $1,500 C. Gain of $1,100

DERIVATIVES │ CFA LEVEL I Risk Management Applications –Question 29 – 30: –An investor is long 100 shares of Pfizer stock at $15. The investor buys one put contract (100 multiplier) at a strike of $5 for $1. 30. What will be the payoff if the stock increases to $30? A. Gain of $1,400 B. Gain of $1,500 C. Gain of $1,100 100[($30 - $15) - $1] = - $1,400

DERIVATIVES │ CFA LEVEL I Risk Management Applications 31. Which of the following combination of options and underlying assets have similar payoff diagrams? A. Long call combined with a short put vs. a long stock. B. Covered call vs. a protective put. C. Short put and long call vs. a protective put

DERIVATIVES │ CFA LEVEL I Risk Management Applications 31. Explained:  Long call combined with a short put vs. a long stock. Long Call & Short Put Long Stock Long Call Short Put

DERIVATIVES │ CFA LEVEL I Risk Management Applications 31. Explained:  Covered call vs. a protective put. Covered Call Protective Put Short Call Long Stock Put Protective Put Covered Call

DERIVATIVES │ CFA LEVEL I Risk Management Applications 31. Explained:  Short put and long call vs. a protective put Protective Put Long StockPut Protective Put Long Call & Short Put Long Call Short Put

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards Which of the following statements clearly conflicts with the recommended procedures for compliance presented in the CFA Institute Standards of Practice Handbook? A. Firms should disclose to clients the personal investing policies and procedures established for their employees. B. For confidentiality reasons, personal transactions and holdings should not be reported to employers unless mandated by regulatory organizations. C. Personal transactions should be defined as including transactions in securities owned by the employee and members of his or her immediate family and transactions involving securities in which the employee has a beneficial interest.

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards “…Employers should compare personal transactions of employees with those of clients on a regular basis regardless of the existence of requirement by a regulatory organization.” - Standards of Practice Handbook, 9 th Ed., Pg 153

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards Ward is scheduled to visit the corporate headquarters of Evans Industries. Ward expects to use the information obtained to complete his research report on Evans stock. Ward learns that Evans plans to pay all of Ward’s expenses for the trip, including costs of meals, hotel room, and air transportation. Which of the following actions would be the best course for Ward to take under the Code and Standards? A. Accept the expense-paid trip and write an objective report B. Pay for all travel expenses, including costs of meals and incidental items. C. Accept the expense-paid trip but disclose the value of the services accepted in the report.

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards Ward is scheduled to visit the coprorate headquarters of Evans Industries. Ward expects to use the information obtained to complete his research report on Evans stock. Ward learns that Evans plans to pay all of Ward’s expenses for the trip, including costs of meals, hotel room, and air transportation. Which of the following actions would be the best course for Ward to take under the Code and Standards? A. Accept the expense-paid trip and write an objective report B. Pay for all travel expenses, including costs of meals and incidental items. C. Accept the expense-paid trip but disclose the value of the services accepted in the report.

DERIVATIVES │ CFA LEVEL I Ethics & Professional Standards Standard I(B) Independence and Objectivity: “Members and Candidates must yse reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.” - Standards of Practice Handbook, 9 th Ed., Pg 15

DERIVATIVES │ CFA LEVEL I Derivatives I Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I April 20, 2010.

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DERIVATIVES │ CFA LEVEL I Derivatives I Problem Solving Session Harvard Extension School MGMT E-2900b CFA Exam Level I April 20, 2010.

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