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"Derivative"exercise:Exercise of a European put option
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Questions 1:
A swap that involves the exchange of a fixed payment for a floating payment is most likely equivalent to a series of:
A 、off-market forward contracts.
B 、forward contracts that all have an initial positive value.
C、 forward contracts that all have an initial value equal to the fixed payment
Questions 2:
Exercise of a European put option is most likely justified if:
A、 the option is out of the money.
B 、the exercise price exceeds the value of the underlying.
C、 the exercise value is negative.
View answer resolution
【Answer to question 1】A
【analysis】
A is correct. Because the cost of carrying an asset over different time periods will vary, the values of the implicit forward contracts embedded in the swap will not be equal: some may be positive, and some may be negative. Off-market forward contracts satisfy this condition because they can be set at any value.
B is incorrect. Because the initial market value of the swap is zero by definition, it cannot be replicated by a series of forward contracts with an initial positive value.
C is incorrect. Because the cost of carrying an asset over different time periods will vary, the prices of the implicit forward contracts embedded in the swap cannot all be equal.
【Answer to question 2】B
【analysis】
B is correct. If the exercise price exceeds the value of the underlying at expiration, the option has positive exercise value and may be exercised.
A is incorrect. An out-of-the-money option should not be exercised and will expire worthless.
C is incorrect. An option that generates a negative cash flow when exercised should not be exercised.
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