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What are options? What are their differences from futures contracts?
Answer: Options are contracts that give the purchaser the option, or right, to buy or sell the
underlying asset at a specified price, called the exercise price or strike price, within a specific
time period called the term to expiration. The seller, sometimes called the writer, of the option is
obligated to buy or sell the asset to the purchaser if the owner of the option exercises the right to
sell or buy. Because the right to buy or sell an asset at a specified price has value, the owner of
an option is willing to pay an amount for it called premium. There are two types of option
contracts: American options can be exercised at any time up to the expiration date of the
contract, and European options can be exercised only on the expiration date.
Diff: 2 Type: SA Page Ref: 334 - 336
Skill: Recall
Objective List: 14.3 Explain how managers of financial institutions use financial derivatives to
manage interest-rate and foreign-exchange risk
Why have options on financial futures become the most widely traded option contracts?
Answer: Option contracts are more likely to be written on financial futures than on underlying
financial instruments such as bonds. As we know, at the expiration date, the price of the futures
contract and of the deliverable debt instrument will be the same because of arbitrage. So it would
seem that investors would be indifferent about having the option written on the asset or on the
futures contract. However, financial futures contracts have been so well designed that their
markets are often more liquid than the markets in the underlying assets. Investors would rather
have the option written on the more liquid instrument, in this case the futures contract.
Diff: 3 Type: SA Page Ref: 339 - 340
Skill: Recall
Objective List: 14.3 Explain how managers of financial institutions use financial derivatives to
manage interest-rate and foreign-exchange risk
What is the value of a call option at expiration? use an appropriate graph to show the profit
and loses of the buyer and seller of a call option.
Answer: The value of a call option at expiration, or intrinsic value is given by: C = max (0, S -
X). The net profit for the buyer is equal to C - α. Students must use a graph similar to the one on
page 332 to explain the profit and loses of the buyer and the seller of a call option.
Diff: 3 Type: SA Page Ref: 336
Skill: Applied
Objective List: 14.3 Explain how managers of financial institutions use financial derivatives to
manage interest-rate and foreign-exchange risk
What is the value of a put option at expiration? use an appropriate graph to show the profit
and loses of the buyer and seller of a put option.
Answer: The value of a put option at expiration, or intrinsic value is given by: P = max (X - S,
0). The net profit for the buyer is equal to P - β. Students must use a graph similar to the one on
page 333 to explain the profit and loses of the buyer and the seller of a put option.
Diff: 3 Type: SA Page Ref: 336
Skill: Applied
Objective List: 14.3 Explain how managers of financial institutions use financial derivatives to
manage interest-rate and foreign-exchange risk