Option MCQ

1. A long put option is normally considered to have the potential for:

• A. unlimited profit and unlimited loss

• B. limited profit and limited loss

• C. unlimited profit and limited loss

• D. limited profit and unlimited loss

Answer explanation

Loss is limited to the premium paid. Profit is limited to the exercise price, less the premium (as the underlying price cannot fall below zero).

A European put option has a strike price of 350p and the current price of the underlying instrument is 275p and the premium 65p. What is the best course of action for an investor?

• A. Buy the option and sell the underlying

• B. Sell the option and buy the underlying

• C. Buy the option and buy the underlying

• D. Sell the option and sell the underlying

Answer explanation

Exercise price (350p) – underlying price (275p) = intrinsic value (75p). The premium is 10p under its intrinsic value. The investor takes advantage of the low premium to buy both the option and the underlying so as to be able to deliver the underlying for a risk-free profit of 10p.

What are the key advantages of a FLEX facility?

• A. Standardised terms with customised settlement, between wholesale counterparties

• B. Standardised terms with OTC delivery, between retail and wholesale counterparties

• C. Customised terms with standard exchange settlement, between wholesale counterparties

• D. Customised terms with standard exchange settlement, between retail or wholesale counterparties

Answer explanation

The FLEX facility combines the flexibility of the OTC market in customising a transaction, with the clearing and other advantages of exchange trading. This reduces some of the risks normally associated with OTC trading. Typically, this facility is only open to exchange members, ie, for wholesale business.

How do you create a synthetic long future?

• A. Buy a call and buy a put

• B. Buy a call and sell a put

• C. Sell a call and sell a put

• D. Sell a call and buy a call

Answer explanation

A synthetic long future results where matching short put and long call options positions are taken on a future. An investor will buy a call and sell a put with the same strike price and expiry.

The only credit risk associated with OTC options trading exists for a:

• A. bank that has sold an in-the-money put to a client

• B. customer who has sold an at-the-money call to its broker

• C. bank that has sold an in-the-money call to another bank

• D. broker who has bought an out-of-the-money call from a client

Answer explanation

Since an option buyer usually buys the premium upfront, the only credit risk lies with any option buyer, no matter what type of option has been purchased.

The interest rate parity theorem states that:

• A. in FX forward rates, the higher interest rate currency commands a premium in the FX forward market

• B. in FX swaptions, the lower interest rate currency commands a lower premium payment

• C. in FX forward rates, the lower interest rate currency commands a premium in the FX forward market

• D. Forward rate agreement (FRA) rates are determined by the relative swap rates of the two currencies involved in an FX FRA

Answer explanation

The interest rate parity theorem is the basis for the FX forward market, to ensure that arbitrage opportunities do not exist.

Which of the following best describes when a put option is out-of-the-money (OTM)?

• A. When the strike price plus the premium is greater than the current market price

• B. When the strike price plus the premium is less than the current market price

• C. When the strike price minus the premium is less than the current market price

• D. When the strike price is less than the current market price

Answer explanation

An out-of-the-money option is where there is no intrinsic value. The intrinsic value is the difference between the strike price and the underlying asset price. If the strike price is less than the current market price, a put option is out-of-the-money.

The writer of an option who agrees to buy the underlying at a given date and price has gone:

• A. short a call option

• B. long a call option

• C. long a put option

• D. short a put option

Answer explanation

The writer sells (goes short) the option for the buyer to sell them the underlying at a fixed price in the future, hoping the price will rise and the buyer will abandon the option, leaving the writer with the premium.

March ABC plc 700 Call @ 30. What will be the price at which it will break even for the buyer of the option

• a. 730

• b. 710

• c. 670

• d. 700

Answer explanation

What Happens at Expiry? It will depend on the price of ABC shares on the expiry day: • If the share price prevailing in the market is below 700p, the option expires worthless and the holder will abandon the option. Would you pay 700p for the share if you could buy it for less in the market? • If the prevailing share price is above 700p, the holder has the right to buy the shares for 700p, which is a lower price than in the cash market. They will, therefore, exercise the option, paying 700p for the share, and then may sell it in the market for the higher price. Even if the market price is 701p, the option is worth exercising as the holder will make a profit of 1p per options contract, which can then be used to offset the upfront cost of the premium. • The break-even price of the call is its strike plus its premium; in this case, the break-even is 730p (ie, 700p + 30p).

What is the maximum profit for short put positioin?

• Unlimited

• Limited to premium

• Strike price less premium (underlying asset price would have to fall to zero)

• Strike price