CISI IAD Derivatives – Options and Futures — Questions and Answers
Question 1: What is a 'call option' in derivatives?
- An option giving the holder the right but not the obligation to sell an asset at the strike price
- An option giving the holder the right but not the obligation to buy an asset at the strike price before or on the expiry date (Correct answer)
- A derivative that obligates the holder to buy an asset at a future date
- A contract that allows a firm to call back previously issued bonds
Correct answer: An option giving the holder the right but not the obligation to buy an asset at the strike price before or on the expiry date
A call option gives the buyer the right (but not the obligation) to purchase the underlying asset at the agreed strike price on or before the expiry date. The buyer pays a premium for this right. Call options are used to speculate on rising prices or hedge short positions.
Question 2: What is a 'put option' in derivatives?
- An option giving the holder the right but not the obligation to buy an asset at the strike price
- An option giving the holder the right but not the obligation to sell an asset at the strike price on or before expiry (Correct answer)
- A contract obligating the seller to deliver an asset at a future date
- An option to convert bonds into equity at a predetermined price
Correct answer: An option giving the holder the right but not the obligation to sell an asset at the strike price on or before expiry
A put option gives the buyer the right (but not the obligation) to sell the underlying asset at the agreed strike price on or before expiry. Put options are used to speculate on falling prices or to hedge an existing long position against downside risk.
Question 3: What is the 'premium' of an option?
- The profit made on an option trade
- The price paid by the option buyer to the option seller (writer) for the right conferred by the option contract (Correct answer)
- The excess of the strike price above the current market price
- The annual management fee charged by derivatives brokers
Correct answer: The price paid by the option buyer to the option seller (writer) for the right conferred by the option contract
The option premium is the price paid upfront by the option buyer to the seller (writer) in exchange for the rights conferred by the option. For the buyer, the premium is the maximum loss. For the writer, the premium is their maximum profit.
Question 4: What is a 'futures contract'?
- A contract giving the right but not the obligation to buy or sell an asset at a future date
- A legally binding agreement to buy or sell a standardised amount of an asset at a specified price on a specified future date (Correct answer)
- A contract that pays the difference in value of an asset between two dates
- A corporate bond that matures in more than 10 years
Correct answer: A legally binding agreement to buy or sell a standardised amount of an asset at a specified price on a specified future date
A futures contract is a standardised, exchange-traded agreement that obligates both parties — buyer and seller — to transact the underlying asset at the agreed price on the specified future delivery date. Unlike options, both parties have an obligation, not just a right.
Question 5: What is 'delta' in options pricing?
- The time value decay in an option's premium
- The sensitivity of an option's price to a £1 change in the price of the underlying asset, ranging from 0 to 1 for calls and -1 to 0 for puts (Correct answer)
- The volatility implied by the option's market price
- The difference between the option's intrinsic value and its time value
Correct answer: The sensitivity of an option's price to a £1 change in the price of the underlying asset, ranging from 0 to 1 for calls and -1 to 0 for puts
Delta measures how much an option's price changes for a £1 move in the underlying asset. A call option with a delta of 0.5 will increase by approximately 50p for each £1 rise in the underlying. Delta-hedging involves adjusting positions to maintain a neutral delta.
Question 6: What is the difference between an 'American' and a 'European' option?
- American options are traded in the USA; European options are traded in Europe
- An American option can be exercised at any time up to and including expiry; a European option can only be exercised on the expiry date itself (Correct answer)
- American options apply to equities; European options apply to currencies
- American options are always cheaper than European options
Correct answer: An American option can be exercised at any time up to and including expiry; a European option can only be exercised on the expiry date itself
The key distinction is exercise flexibility: American options can be exercised at any point before or on expiry, giving the holder more flexibility. European options can only be exercised on the specific expiry date. This makes American options typically more valuable.
CISI IAD Derivatives – Options and Futures
What is a 'call option' in derivatives?