FIN4414 Financial Management Fall 2017

Written by Sehoon Kim

Homework 5
(Due Nov 29th)

For each question, find one answer. This is not a group assignment. You are allowed to work in groups,
but ALL HOMEWORKS ARE TO BE SUBMITTED IN-CLASS INDIVIDUALLY.

1. A forward contract:

(a) requires that payment be made in full when the contract is originated.

(b) buyer is obligated to take delivery and has the option to pay the lower of the spot market price or the
contract price.

(c) is marked to the market on a daily basis.

(d) buyer without any prior position has a payoff profile that is an upward sloping linear function of the
spot price.

2. Which of the following is true?

(a) The buyer of an option contract pays the option premium in exchange for locking in a future
transaction at the strike price.

(b) The buyer of an option contract pays the strike price at the time the option is purchased and in
exchange receives the right to exercise the option at any time during the option period.

(c) The buyer of a call option profits when the exercise price exceeds the market price.

(d) The seller of a put incurs a loss when a put is exercised.

3. Which of the following are key differences between an option contract and a forward contract?

I. Forward contracts can be resold but option contracts cannot

II. The option’s strike price is determined at settlement while the forward price is determined when the
contract is initiated
III. The option gives the right to the buyer whereas the forward contract is an obligation
IV. The nominal cost of initiating a contract is greater for buying an option than for buying a forward
contract

(a) I and III

(b) II and IV

(c) III and IV

(d) II, III and IV

4. A mining company sells platinum wholesale to jewelry retailers. The company currently has a sizable
platinum inventory. Which one of the following option positions would the company most likely take and
why?

(a) Buy a call, to hedge against a fall in platinum prices

(b) Sell a call, to hedge against a rise in platinum prices

(c) Buy a put, to hedge against a fall in platinum prices

(d) Sell a put, to hedge against a fall in platinum prices

5. Firms with which of the following characteristics are most apt to frequently use derivatives?

I. Firms with low financial distress costs

II. Firms facing convex tax functions due to progressive tax rates
III. Firms with shareholders who face low transaction costs
IV. Firms with constrained access to capital markets

(a) I and III

(b) II and IV

(c) II, III, and IV

(d) I, II, and III

6. You currently do not have any investments in gold, but decided to speculate in the market and sold 8
gold forward contracts at a forward price of $867.50 per ounce. The price of gold at the contract maturity
date was $730.40. What was your total profit or loss if each contract size was 100 ounces?

(a) -$109,680

(b) -$137.10

(c) $0, because the buyer does not exercise right

(d) $109,680

7. You are the buyer for a cereal company and you must buy 80,000 bushels of corn next month. The
futures contracts on corn are based on 5,000 bushels and are currently quoted at $4.15 per bushel for
delivery next month. If you want to hedge your cost, you should _____ contracts at a cost of _____ per
contract.

(a) buy 16; $20,750

(b) sell 16; $20,750

(c) buy 16; $332,000

(d) You do not want to hedge

8. Suppose a financial manager buys a call option on oil with an exercise price of $31 per barrel. She
simultaneously sells a put option on oil with the same exercise price of $31 per barrel. Her net profit per
barrel is _____ if the price per barrel is $29 and _____ if the price per barrel is $35. Ignore premiums and
taxes.

(a) -$4; $2

(b) -$2; $0

(c) $0; $2

(d) -$2; $4
9. Which of the following will decrease the value of a call option?

I. A decrease in the exercise price

II. A decrease in the value of the underlying security
III. An increase in the time to expiration
IV. An increase in the volatility of the underlying security

(a) II only

(b) I and II only

(c) I, II, and IV only

(d) I, II, and III only

10. Mark owns both a March $20 put and a March $20 call on Alpha stock (i.e. both expire in March and
have strike prices of $20). Which one of the following statements correctly relates to Mark's position?
Ignore taxes and transaction costs.

(a) A March $30 call is worth more than Mark's $20 call.

(b) If the payoff of Mark's put increases by $1 then the payoff of his call must either decrease by $1 or
equal zero.

(c) A price decrease in Alpha stock will increase the value of Mark's call option, and a price increase in
Alpha stock will increase the value of Mark's put.

(d) The time premium on an April $20 put is less than the time premium on Mark's put (Assume both puts
expire in the same calendar year).

11. Recall that equity shareholders have limited liability when the firm is unable to pay its debt, but have
claims to the company’s profits in excess of its debt obligations. Delta Importers has debt with market
value of $180,000. The assets of the firm are currently worth $265,000. The shareholders in this firm
basically own a _____ option on the assets of the firm with a strike price of _____.

(a) put; $180,000

(b) put; $265,000

(c) call; $180,000

(d) call; $265,000

12. An acquisition completed simply to diversify a firm will:

(a) create excessive synergy in almost all situations.

(b) lower systematic risk and increase the value of the firm.

(c) benefit the shareholders by providing otherwise unobtainable diversification.

(d) generally not add any value to the firm.

13. Which one of the following is true about the acquisition price in a merger agreement?

(a) The fair value that target shareholders should receive includes any synergies that may arise from the
merger

(b) The acquiring firm usually pays exactly the fair value of the target company

(c) Upon announcement of a merger agreement, the target stock price usually rises substantially

(d) Acquiring a firm is usually not a positive NPV project for the acquirer

14. Which one of the following is true about gains from a merger?

(a) The market for corporate control always ensures that mismanaged firms are acquired and improved

(b) In a tender offer, the acquirer needs to pay a marked up price such that much of the value from
synergy gains go to target shareholders

(c) Revenue enhancement is generally easier to achieve than cost reduction

(d) There are generally no gains to be made from a merger

15. Which one of the following is true about takeover defenses?

(a) Companies with entrenched management are more likely to have takeover defense mechanisms.

(b) Poison pills give shareholders of the acquiring company the right to buy target company shares at a
deep discount.

(c) Staggered boards make it easier for a corporate raider to obtain board seats.

(d) Takeover defense mechanisms always protect the target company shareholders from loss of
shareholder value