"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.
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.
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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