THROUGH 36 RELATE TO RISK MANAGEMENT APPLICATION OF DERIV...

Questions 31 through 36 relate to Risk Management Application of Derivatives Gregory Sparks Case Scenario Gregory Sparks, CFA, is a derivatives specialist at a large investment bank. He is currently addressing the demands of three clients. He will be required to determine the optimal options strategy for each client. Client 1: Frontal Pension Plan (FPP) The plan’s chief investment officer has requested that the policy portfolio’s exposure to Delta Corp’s stock be synthetically reduced. Sparks explores a covered call strategy. Exercise prices and premium per option data have been compiled by Sparks (Exhibit 1). Sparks determines that FPP will need to sell 20,000 call options to implement the strategy. The current stock price is $45 and FPP owns 100,000 shares of Delta Corp. Exhibit 1 Call Option Exercise Prices and Premiums (in $) Option Exercise Price Premium 1 60 12.25 2 55 13.15 3 40 14.25 When describing the strategy to the investment officer, Sparks makes the following statements: Statement 1: “The strategy will help reduce overall risk exposure at the expense of reducing overall expected returns.” Statement 2: “The maximum loss will occur when the underlying stock price declines to zero.” Client 2: Sue Mackintosh Mackintosh has approached Sparks after reading an article which speculates that small-cap stocks are expected to decline. She would like to profit from this decline and has asked Sparks to present a solution. Sparks recommends a bear put strategy with the underlying options based on the S&P 600 index. The current index price is $125. Details on the index options have been collected by Sparks (Exhibit 2). Exhibit 2 S&P 600 Index Options Exercise Prices And Premiums (in $) 1 145 60 2 125 52 Client 3: Hanver Corporation (HC) HC has come to Sparks in search of a unique solution. HC is not much of a risk taker and would like the specialist to recommend a strategy which would benefit from a lower than market expectation of volatility. Spark feels that either a box spread or butterfly strategy will be suitable for the client and collects 1-month call and put exercise price and premium data (Exhibit 3). The one-month annualized risk-free rate is 1.50%. Exhibit 3 1-month Call and Put Exercise Prices and Premiums (in $) Option Call Exercise Price Premium Put Exercise Price Premium 1 70 11.45 70 22.80 2 60 12.45 60 14.25 After serving his clients, Sparks resumes his work on an article he is writing for an investment newsletter. His article explains option strategies in detail. He intends to include the following two statements in his article: Statement 3: Collars are similar to bull spreads in their performance. Statement 4: In contrast to the put-call parity, the box spread strategy is cheaper and requires the binomial model to hold during high market volatility.

CFA Level III Mock Exam 3 – Solutions (PM)

31. If the stock price rises to $55, the profit on the covered call strategy with the highest initial inflow is closest to: A. $945,000 B. $985,000 C. $1,000,000 32. Is Sparks correct with respect to the statements made to the investment officer? A. Yes. B. Only with respect to Statement 1. C. Only with respect to Statement 2. 33. The breakeven asset price of Mackintosh’s proposed strategy is closest to: A. $133. B. $137. C. $153. 34. In light of HC’s expectations, Sparks is correct with respect to his proposal concerning: A. the butterfly strategy only. B. the box spread strategy only. C. neither of the two strategies. 35. Should Sparks implement a box spread strategy for HC, he will most likely conclude that the box spread is: A. overpriced. B. fairly priced. C. underpriced. 36. With regard to the two statements to be included in his article, Sparks is most likely incorrect with respect to: A. both statements. B. Statement 3 only. C. Statement 4 only.