A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by
Answer (B) is correct. A put option is the right to sell stock at a given price within a certain period. If the market price falls, the put option may allow the sale of stock at a price above
market, and the profit of the option holder will be the difference between the price stated in the put option and the market price, minus the cost of the option, commissions, and taxes. The company that issues the stock has nothing to do with put (and call) options.
When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying
Answer (D) is correct. Maturity matching, or equalizing the life of an asset and the debt instrument used to finance that asset, is a hedging approach. The basic concept is that the company has the entire life of the asset to recover the amount invested before having to pay the lender.
A distinguishing feature of a futures contract is that
Answer (D) is correct. A distinguishing feature of futures contracts is that their prices are marked to market every day at the close of the day. Thus, the market price is posted at the close of business each day. A mark-to-market provision minimizes a futures contract’s chance of default because profits and losses on the contracts must be received or paid each day through a clearinghouse.
The owner of a call option wants to know the respective effects on the call’s price of a
decrease in stock-return volatility and a decrease in time to expiration. The respective effects on the call’s price are which of the following?
Decrease in Stock-Return Volatility
Decrease in Time to Expiration
Answer (A) is correct. A decrease in stock-return volatility will cause the call’s price to decrease. A decrease in the time to expiration will also cause the call’s price to decrease. Thus, both of these effects will cause a decrease in the call’s price.
An investor wrote a $45 call option and bought a $50 put option, both of which had the same time to expiration. On the transaction date, the stock price was $45, and the prices for the call and put options were $8 and $10, respectively. Subsequently, the stock price fell by $10, where it remained through the option expiration date. As of the expiration date, the total profit on the combined option position, ignoring commissions and other transactions, is
Answer (C) is correct. The amount of gain and loss on a call option for the writer is calculated as the option price minus the excess of the market price over the exercise price, if any. Thus, the call option provides the investor a gain of $8 ($8 – $0). The amount of gain and loss on a put option for the buyer is calculated as the excess of the exercise price over the market price minus the option price. Thus, the put option provides the investor a gain of $5 [($50 – $35) – $10)]. The total profit on the combined option position is $13 ($8 gain + $5 gain).
A major homebuilder will use lumber to build a large development of homes next year. If the homebuilder plans to buy the lumber next year, it can hedge its future costs if it
Answer (B) is correct. Buying the futures contract allows the homebuilder to buy the lumber next year at a stated rate. This will hedge the future costs.
If a corporation’s stock price experiences increased volatility, what would happen to the value of the call options and the put options on the corporation’s stock?
Answer (D) is correct. Since options protect against volatility in the stock price, the more volatile a stock is, the more owning the options becomes valuable.
Which one of the following is not a characteristic of a negotiable certificate of deposit? Negotiable certificates of deposit
Answer (D) is correct. A certificate of deposit (CD) is a form of savings deposit that cannot be withdrawn before maturity without incurring a high penalty. A negotiable CD can be traded. CDs usually have a fairly high rate of return compared with other savings instruments because they are for fixed, usually long-term periods. However, their yield is less than that of commercial paper and bankers’ acceptances because they are less risky.
In smaller businesses in which the management of cash is but one of numerous functions performed by the treasurer, various cost incentives and diversification arguments suggest that surplus cash should be invested in
Answer (C) is correct.
A small firm with surplus cash should invest for the highest return and lowest risk. The ability to convert the investment into cash without a loss of principal is also important. Money market mutual funds invest in money market certificates such as treasury bills, negotiable CDs, and commercial paper. Because of diversification, these mutual funds are superior to any single instrument.
When managing cash and short-term investments, a corporate treasurer is primarily concerned with
Answer (D) is correct. Cash and short-term investments are crucial to a firm’s continuing success. Sufficient liquidity must be available to meet payments as they come due. At the same time, liquid assets are subject to significant control risk. Therefore, liquidity and safety are the primary concerns of the treasurer when dealing with highly liquid assets. Cash and short-term investments are held because of their ability to facilitate routine operations of the company. These assets are not held for purposes of achieving investment returns.