1.Consider an option strategy where an investor buys one call option with an exercise price of $55 for $7, sells two call options with an exercise price of $60 for $4, and buys one call option with an exercise price of $65 for $2. If the stock price declines to $25, what will be the profit or loss on the strategy?
A. -$3.
B. -$1.
C. $1.
D. $2.
2.An Asian option can be hedged dynamically because the:
A. average value of the underlying asset price decreases uncertainty the closer the option gets to expiration.
B. average value of the underlying asset price increases uncertainty the closer the option gets to expiration.
C. maximum value of the underlying asset price decreases uncertainty the closer the option gets to expiration.
D. minimum value of the underlying asset price increases uncertainty the closer the option gets to expiration.
3.Which of the following statements is an example of basis risk? Purchasing:?
A. an oil contract with delivery in a different geographical region.
B. a commodity with a desired distant delivery with near-term contracts.
C. a eurodollar contract, due to lack of commodity futures.
D. All of the above statements are correct.
Answer:
1.B
The strategy described is a butterfly spread where the investor buys a call with a low exercise price, buys another call with a high exercise price, and sell two calls with a price in between. In this case, if the option moves to $25, none of the call options will be in the money, so the profit is equal to the net premium paid, which is -$7 + (2x $4) - $2 = -$ 1.
2.A
Dynamic hedging can be used to hedge Asian options because uncertainty in the expiration value is decreased the closer one gets to expiration. This occurs because the intrinsic value becomes “set” due to the averaging effect over the life of the option.
3.D
All are examples of basis risk, which results from the inability of commodities to create a perfect hedge. Differences due to timing, grade, storage costs, or transportation costs create basis risk.