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Unformatted text preview: CHAPTER 23 OPTION CONTRACTS Answers to Questions 1. A long straddle consists of a long call and a long put on the same stock and profits from dramatic price movement by the stock. A short straddle involves the sale of a call and a put on the same stock and profits from little or no stock price change. Investors going long would anticipate volatility in excess of that discounted by the options’ prices while investors going short would expect volatility below that already discounted. Since volatility enhances option prices, long straddles would tend to pay higher premiums for more volatile options, whereas short straddles must accept lower premiums for less volatile options. 2. A range forward is actually an option strategy that combines a long call and a short put (or vice versa) through a costless transaction. Because the options will not have the same striking price, the combination is classified as a range forward as opposed to an actual forward, created by combining long and short options with the same striking price. It is fair to view actual forwards as a special case (or zero-cost version) of range forwards. 3. CFA Examination II (1993) Call options give the owner the right, but not the obligation, to purchase SFr’s for a pre- specified amount of domestic currency. Purchasing an at-the-money call option would guarantee the current exchange rate over the life of the option. If the SFr declines in value, the call will not be exercised since francs can be purchased more cheaply in the open market and redeeming the bond issue will be less costly. Contrasting characteristics: (1) Currency options are traded worldwide and enjoy a liquid market. (2) Exchange-traded currency option contracts have standard amounts, maturities, etc. (3) Over-the-counter options could be tailored to meet Michelle’s needs. (4) The initial cash outflow would be the premium. (5) The use of options preserves the ability to profit. (6) No counterparty credit risk. (7) Must roll to match year obligation. Currency forward contracts commit the seller to deliver the specified amount of currency to the buyer on a specified future date at a fixed price. A short position in a forward contract requires delivery. Contrasting characteristics: (1) The market for forward contracts is over-the-counter and sometimes may not be as liquid as option or futures market. (2) Forward contracts may be custom-designed for specific applications. (3) Cash does not change hands until a forward contract is settled. (4) Counterparty credit risk. (5) Can best match 5-year obligation. 23 - 1 Currency futures are like forward contracts except the gain or loss on the contract is settled daily under the supervision of an organized exchange. A short position in the futures requires either offset or delivery at expiration....
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