FRM Part I · FRM Exam Part I · Exotic Options
Which statement about a call option on a call option (a compound option) is correct?
The call on a call has a lower upfront premium than the underlying call, because it is only the right to buy that call for a further strike price later. The holder exercises only if the underlying call's value exceeds that strike.
- AIts upfront premium is lower than that of the underlying call, though exercising it means paying a further strike to acquire the call.Correct
- BIts upfront premium equals the premium of the underlying call.
- CIt must always be exercised at the first expiry date.
- DIts payoff can be negative if the underlying call is worth less than the first strike.
Explanation
A call on a call is the right to buy the underlying call for K1, so it is worth less than the underlying call today. The holder pays a small premium now and a further K1 later only if worthwhile. The other statements are false. Exercise is optional and occurs only if the call value exceeds K1. The holder will not exercise at a loss, so the payoff cannot be negative.
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