IV. TRUE or FALSE Tell whether the following statements are True or False and explain your reasoning. Your objective in each case is to demonstrate in a few words that you know what the truth is. IV.

1. If you sell a covered call using an option that is currently out-of-the-money, the standstill return is negative.

2. For a pair of European options with the same strike and maturity, at current market prices we have C - P < S - PV(X). The arbitrage position that you would set up to exploit this violation of put-call parity would include selling short the underlying stock.

3. In option pricing, only someone who is indifferent to risk would care about the "risk neutral probability". IV.4. A futures contract can become ineffective for investors' hedging needs if it allows too wide a rangeof securities that can be delivered.

IV.5. If your options position has positive vega, you would like the market to be volatile. IV.6. It is never rational to exercise an American put early. IV.7. The following are all factors which would make early exercise of an American call option on a dividend paying stock less likely: low dividend, high volatility, long time period between ex-dividend date and option expiration. IV.8. If the interest rate is 0, in theory you would never exercise an American put early. IV.9. Stock price movements must follow a lognormal diffusion for an option valuation formula to exist. IV.10. The principle of Risk Neutral Valuation means that an option has the same expected rate of return in our world as it would in a world in which all investors were risk neutral. (Make sure you have read this carefully, so that you answer what the question is actually asking about.) IV.11. If your option position is delta neutral and has a positive gamma, you would like the market to be very calm. IV.12. A high rate of dividend payout on the underlying stock makes an at the money put option more valuable. IV.13. If you are long an in-the-money put option, both your gamma and vega are positive. IV.14. Modern option pricing theory shows that in the Real World, the equilibrium expected return to buying a put option can't be negative. IV.15. The theoretical futures price for a stock index contract should always be less than the market's best forecast of where the index will be on the futures expiration date. IV.16. A CDS spread is another name for a "bullish call spread." IV.17. The ABC Fund and the XYZ Fund are holding similar stock portfolios and both decide to follow identical portfolio insurance strategies, except that ABC is going to replicate the option it wants using a dynamic trading strategy, like that developed by Leland and Rubinstein, while XYZ simply goes to a major derivatives firm and purchases the same option from them. A month after these plans are set up, in a flurry of activity the stock market goes up 15% in 3 days. XYZ is likely to be a lot less happy than ABC. IV.18. A "Special Purpose Vehicle" refers to a kind of large capacity heavy-duty truck that derivatives traders use in transporting their annual bonuses to the bank. IV.19. A CDO has been created and all of the tranche securities have been sold in the market. Then the market becomes convinced that default correlations have all gone up from what they were originally thought to be (but there is no change in the expected individual default probabilities). The equity tranche securities should increase in price and the senior tranche securities should fall.IV.20. In the Banamex deal described in the F.I.A.S.C.O. reading, the purpose of the plan was effectively to transform the underlying "Ajustabonos" into securities denominated in a different currency, with low risk of default. IV.21. Prepayment risk is an inherent feature of mortgage loans. Securitization of mortgage loans into GNMA pass-throughs effectively gets rid of this risk because the original lender bears it all. IV.22. If all of the bonds in a CDO are rated A, at least 50% of the CDO tranche securities that are created must be of credit quality A or below. IV.23. For the same individual default probabilities, higher default correlation among the reference entities in a CDO reduces the value of the equity tranche because it means that if there are defaults, there will tend to be more of them at the same time. IV.24. You are holding an American call on a dividend paying stock. As long as it is in the money just before the stock goes ex-dividend, you should exercise it. IV.25. If you are short a straddle, you would like implied volatility to go down tomorrow. IV.26. The only time the outstanding notional principal for some class of interest rate derivative could be greater than the dollar value of all outstanding U.S. government bonds would be when the derivative market is experiencing a speculative bubble. IV.27. Writing a naked put is a bullish position. IV.28. To get the most accurate forecast of future volatility from a series of past daily stock returns, you have to start by computing the mean return in your data, then subtract the mean from each observation and square the result, then take the standard deviation of these squared deviations from the mean. Finally, you annualize the daily return standard deviation to get volatility. IV. 29 In theoretical option pricing models, for the same return volatility, the price of a call option will be lower if the market expects the underlying stock to go down than if the market expects the stock to go up. IV.30 Implied volatility can change even if people think the actual volatility of market prices has not changed.