Question 6

A call option is a contract giving the owner the right, but not the obligation, to buy, or buy short, a specified amount of an underlying security at a pre-determined price within a specified time frame. The pre-determined price the call option buyer can buy at is called the strike price. Call options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes.

a) Suppose that an American call option to buy a share for S$10 costs S$2 and is held until end of the year. Under what circumstances will the buyer of the option make a profit? Under what circumstances will the option be exercised? (8 Marks)

b) Suppose that you own 1,000 shares worth S$10 each. How can call options be used to provide you protection against the decline in the value of your holding shares over the next four months? (8 Marks)