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Investment Analysis Questions: Bonds, Options, and Risk

1. What is the conversion value of the bond as stock?

2. What would be the lowest price that you expect the bond to sell for if the price of the stock were $38? Explain and verify your answer.

3. What is the range of stock prices that virtually assures the investor would expect the bond to be called?

4. What is the implication if the bond were called and the investor does convert? Briefly explain.

5. What is the bond’s income advantage?

T F Technical analysis employs moving averages as the basis for making investment decisions.

T F The Dogs of the Dow strategy suggests buying the 10 Dow stock with the highest dividend yields.

T F Margin is required of those investors who take long or short positions in futures contracts.

T F Convertible bonds pay interest until the bond is converted into stock.

T F Federal government debt is believed to have minimal default risk because the government has a BBB rating.

T F Realized returns on all federal government securities are fixed and do not change with changes in interest rates.

T F The owner of a Ginnie Mae bond only receives monthly principal repayments.

T F Municipal bonds are registered with the Federal Reserve.

T F Yields on municipal bonds exceed yields on corporate bonds with the same term to maturity and credit rating.

T F If a firm expects to buy a commodity in the future, it may hedge against a price increase by taking a long position using a futures contract.

T F If speculators anticipate interest rates will rise, they enter into futures contracts to sell bonds.

T F A position in a futures contract is canceled (offset) by entering into the opposite position.

T F Margin is required of investors who take short positions in futures contracts.

T F A farmer hedges by selling futures contracts.

- reinvestment rate risk
- risk of inflation
- interest rate risk
- 1 and 2
- 1 and 3
- 2 and 3
- all of the above

1. If interest rates decline,

- the price of a Ginnie Mae falls
- the price of a Ginnie Mae rises
- the speed with which Ginnie Maes are retired increases
- the speed with which Ginnie Maes are retired declines
- 1 and 3
- 1 and 4
- 2 and 3
- 2 and 4

- are subject to interest rate risk
- have certain repayment schedules
- are not exempt from federal income taxation
- increase in value when interest rates rise
- 1 and 3
- 1 and 4
- 2 and 3
- 2 and 4

- illustrative of a revenue bond
- not illustrative of a tax-exempt bond
- supported by taxing authority
- secured by property

- fluctuations in interest rates
- reinvestment rate risk
- default risk
- 1 and 2
- 1 and 3
- 2 and 3
- all of the above

- supports efficient markets
- supports the use of technical analysis
- is not applicable to technical analysis
- only supports the use of moving averages

6. According to the Black/Scholes option valuation model, the value of a call option decreases if

- the option approaches expiration
- the return on the stock is less certain
- interest rates decline
- the standard deviation of the stock's return increases

7. According to the Black/Scholes option valuation model, the value of a put option increases if

- the option approaches expiration
- the return on the stock is more certain
- interest rates decline
- the standard deviation of the stock's return decreases

8. The hedge ratio determines

- the number of call options to offset movements in the price of the stock
- the number of call options to offset a straddle
- the number of put options to offset movements in the price of a call option
- the number of call options to offset the impact of changes in interest rates

9. Sources of risk to investors in foreign bonds include

- fluctuations in interest rates
- exchange rate risk
- default risk
- 1 and 2
- 1 and 3
- 2 and 3
- all of the above

10. Which of the following assumes the expectation of higher stock prices?

- buying a stock index call option
- buying a stock index put option
- selling a stock index call option
- selling a stock index put option
- 1 and 3
- 1 and 4
- 2 and 3
- 2 and 4

11. Given the following information,

price of a stock $52

annual dividend paid by the stock $0

strike price of a six-month call $50

market price of the call $5

strike price of a six-month put $50

market price of the put $2

12. Please finish the following sentences.

The intrinsic value of the call is ________.

The time premium paid for the put is _________.

If an investor established a covered call, the cash outflow or cash inflow is _________.

The maximum amount that the seller of a naked call can lose is ________.

The maximum amount the buyer of the put can lose is ________.

13. At the expiration of the options (i.e., after six months have lapsed), the price of the stock is $56.

The cash dividend received during the six months by the seller of the covered call is _______.

The profit (loss) from selling the naked call is _______.

The profit (loss) from buying the call is ________.

The profit (loss) from shorting the stock six months earlier is _________.

At expiration, the time premium paid for the put is _______.

If the investor exercises the call, the cost basis of the stock is _______.

14. Strike price of a put and a call is $100. Price of the stock is $106. The price of six month call option is $3.

a. What would you do? Explain and verify your answer

b. Will the writer of a naked put option sustain a loss if the price of the underlying stock rises? Why?

c. According to Black-Scholes, an increase in interest rates has what impact on the value of a call option? Explain.

d. Put-call parity asserts that a combination of a long position in the stock and the put produces the same return as a comparable position in a call and a risk-free bond. If not, at least one market is in disequilibrium. The resulting arbitrage alters the securities' prices until the value of the stock plus the put equals the prices of the call and the bond. The successful use of arbitrage generates a profit if the price of the stock rises or declines.

e. Currently, the price of a stock is $102 while the price of a call option at $100 is $6; the price of the put option at $100 is $2, and the price of a discounted bond ($100 face amount) is $95. Verify that arbitrage generates a profit if the price of the stock rises, falls, or does not change.

$90

95

100

105

110

f. An offer is made by FF to purchase AA for 1 share of FF. Prior to the offer, AA stock was selling for $25 but is now selling for $30. The offer is worth $34 based on FF price of $34. You realize that AA's price will rise if the merger occurs or decline if the merger is terminated. You expect that the merger will be completed within four months. Currently, six month call and put options are available to buy and sell AA stock at $30. Their prices are $3.00 and $2.00, respectively.

1. Construct a straddle using the options to take advantage of your expectation. What is your cash inflow or outflow?

2. Show the potential profits and losses on your position at the following prices of YY stock.

$25

28

31

34

37

40

43

3. What is the range of stock prices that generates a profit?

4. What is the maximum possible loss? For this loss to occur what must happen?

Fill in the blanks

1. If an individual does not own the underlying stock and sells a call option, that is illustrative of a ___________.

2. If the price of a stock is less than a call's strike price at the call's expiration, the option___________.

3. The good faith deposit required of buyers and sellers of futures contracts is called__________.

4. By hedging the financial manager seeks to ___________ the risk of loss from ___________.

5. The current price of a commodity is called the ______________ price.