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FRM Part I · FRM Exam Part I · Introduction to Derivatives

A speculator believes an equity index, currently at 4,000, will rise. She can buy 100 units of the index for 400,000 or buy 100 call options at a premium of 100 each (total 10,000) with a strike of 4,000. At expiry the index is at 4,300. Ignoring financing costs, what are her percentage returns on the spot purchase and on the option purchase respectively?

The spot position returns 7.5% (30,000 gain on 400,000), while the options return 200% (30,000 payoff minus 10,000 premium gives 20,000 profit on 10,000 invested). This shows the leverage that derivatives provide to speculators.

  1. A7.5% on spot and 200% on optionsCorrect
  2. B7.5% on spot and 300% on options
  3. C3.0% on spot and 200% on options
  4. D7.5% on spot and 100% on options

Explanation

Spot profit is 100 x 300 = 30,000 on 400,000, which is 7.5%. Option payoff is 100 x 300 = 30,000 less the premium of 10,000, giving a 20,000 profit on 10,000, or 200%. The 300% figure ignores the premium when computing profit.

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