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CFA Institute Exam CFA-Level-II Topic 2 Question 93 Discussion

Actual exam question for CFA Institute's CFA-Level-II exam
Question #: 93
Topic #: 2
[All CFA-Level-II Questions]

Charles Mabry manages a portfolio of equity investments heavily concentrated in the biotech industry. He just returned from an annual meeting among leading biotech analysts in San Francisco. Mabry and other industry experts agree that the latest industry volatility is a result of questionable product safety testing methodologies. While no firms in the industry have escaped the public attention brought on by the questionable safety testing, one company in particular is expected to receive further attention---Biological Instruments Corporation (BIC), one of several long biotech positions in Mabry's portfolio. Several regulatory agencies as well as public interest groups have heavily criticized the rigor of BIC's product safety testing.

In an effort to manage the risk associated with BIC, Mabry has decided to allocate a portion of his portfolio to options on BIC's common stock. After surveying the derivatives market, Mabry has identified the following European options on BIC common stock:

Mabry wants to hedge the large BIC equity position in his portfolio, which closed yesterday (June 1) at $42 per share. Since Mabry is relatively inexperienced with utilizing derivatives in his portfolios, Mabry enlists the help of an analyst from another firm, James Grimell.

Mabry and Grimell arrange a meeting in Boston where Mabry discusses his expectations regarding the future returns of BIC's equity. Mabry expects BIC equity to make a recovery from the intense market scrutiny but wants to provide his portfolio with a hedge in case BIC has a negative surprise. Grimell makes the following suggestion:

"If you want to avoid selling the BIC position and are willing to earn only the risk-free rate of return, you should sell calls and buy puts on BIC stock with the same market premium. Alternatively, you could buy put options to manage the risk of your portfolio. I recommend waiting until the vega on the options rises, making them less attractive and cheaper to purchase."

If the premium on Put D on November 1 is $3.18, which of the following has most likely occurred?

Show Suggested Answer Hide Answer
Suggested Answer: B

The premium on Put D has risen from $2.31 to $3.18 and there is srill time left until expiration. Therefore, the increase in value must have come from either a decrease in stock price, an increase in volatility, or both of these events. Choice A would be correct if the option was at expiration and the $3.18 represented only intrinsic value. Since we are not yet at the expiration date, the stock price must be above $26.82. A negative earnings surprise would most likely cause a drop in the market price of the stock. Since there is no indication of the exact amount of the drop in price, the premium observed is a possibility. A decrease in BIG volatility would reduce the put premium, not increase it. (Study Session 17, LOS 60.d)


Contribute your Thoughts:

Queenie
1 months ago
I'm not sure about that. I think the answer might be B) BIC had a negative earnings surprise.
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Casandra
1 months ago
I agree with Osvaldo. If the premium on Put D has decreased, it means the volatility has decreased.
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Daryl
1 months ago
The key here is that the put premium is $3.18, which is pretty high. That suggests increased volatility, so I'd go with the negative earnings surprise option. Gotta love these finance questions - they really make you think!
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Carissa
5 days ago
Finance questions always keep us on our toes, that's for sure!
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Sharen
10 days ago
I think the negative earnings surprise is the most likely scenario.
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Alica
29 days ago
I agree, the high put premium indicates increased volatility.
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Carmelina
1 months ago
Haha, I bet Mabry is regretting not taking Grimell's advice to wait for the vega to rise and the options to get cheaper. He's probably kicking himself right now!
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Roselle
11 days ago
Mabry must be feeling the impact of not waiting for the options to get cheaper.
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Zona
19 days ago
If the premium on Put D on November 1 is $3.18, then the volatility of BIC stock has decreased.
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Shawnee
26 days ago
He should have listened to Grimell's advice and waited for the vega on the options to rise.
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Rima
27 days ago
I wonder if Mabry ended up buying the put options to manage the risk of his portfolio.
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Mona
2 months ago
Hmm, I'm not sure about that. A negative earnings surprise seems more likely to drive up the put premium, no? The stock price drop to $26.82 could just be a general market reaction.
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Jamey
1 months ago
It's possible that both factors could be at play here.
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Felix
1 months ago
But a decrease in the price of the stock to $26.82 could also lead to an increase in put premium.
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Pedro
1 months ago
True, a negative earnings surprise would likely increase the put premium.
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Osvaldo
2 months ago
I think the answer is C) Volatility of BIC stock has decreased.
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Jill
2 months ago
Okay, let's see... if the premium on Put D is $3.18, that means the price of BIC stock has decreased to $26.82. Volatility would have to be up for the put premium to be that high.
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Melodie
1 months ago
Okay, let's see... if the premium on Put D is $3.18, that means the price of BIC stock has decreased to $26.82. Volatility would have to be up for the put premium to be that high.
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Tambra
1 months ago
C) Volatility of BIC stock has decreased.
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Wenona
2 months ago
A) The price of BIC stock has decreased to $26.82.
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