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FRM Part I · FRM Exam Part I · Exotic Options

A holder owns a put-on-call compound option with strike 3.00 on an underlying call. At the compound option's expiry, the underlying call is worth 2.50. What should the holder do, and what is the resulting payoff?

The holder should exercise and receive 0.50. A put-on-call gives the right to sell the underlying call at 3.00, and that call is worth only 2.50. The gain is the strike minus the call's value, so exercising is better than letting it lapse.

  1. AExercise and receive 0.50Correct
  2. BLet it expire because the underlying call is worth less than 3.00
  3. CExercise and receive 5.50
  4. DExercise and receive 3.00 only if the underlying asset is also delivered

Explanation

A put-on-call lets the holder sell the underlying call for the strike of 3.00. The call is worth 2.50, so exercise gives 3.00 - 2.50 = 0.50. Letting it expire would apply to a call-on-call in this situation, which is the confusion in option 2. Adding the values gives 5.50, which is wrong.

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