Examples of Possible Mid-Term Questions

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EXAMPLES OF POSSIBLE MIDTERM QUESTIONS (These are not the actual midterm questions)

1. You would like to speculate on the rise in the price of a certain stock. The current stock price is $87 and a three month call with a strike price of $90 costs $8.70. You have $17,400 to invest. Identify two alternative strategies, one involving stocks, the other involving options. Briefly identify the advantages and disadvantages of each. (10 marks)

2. A US company expects to have to pay GBP sterling 1 million in six months. a. What are the advantages and disadvantages of hedging the exchange rate risk with forward contracts, futures contracts and options. (10 marks) b. If the value of the dollar falls rapidly over the next six months relative to GBP sterling, which one of these three would turn out to be better and best, and why? (10 marks)

3. Annualized U.S. and U.K. spot interest rates for a six-month horizon are 4.5% and 5.5% per annum respectively. The spot foreign exchange rate for converting pound sterling to dollars is $2.00 per pound sterling. What will be the forward exchange rate in dollars/pound for a forward contract maturing six months later? (10 marks)

4. Options Trading Strategies a. Explain how a long stock and long put strategy equals the cash flow from a long call strategy. (5 marks) b. Why is a straddle position considered a speculation on the asset’s volatility? (5 marks) c. Can a butterfly spread ever be constructed to have zero initial premium? Why or why not? (5 marks) d. Explain in simple terms why a call option on a non-dividend paying stock should never be exercised early. (5 marks)

5. Consider an index futures arbitrage opportunity. a. What is the effect of dividend uncertainty on the no-arbitrage window and why? (5 marks) b. What is the effect of marking to market cash flows on the no-arbitrage window and why? (5 marks) c. Why and…...

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