Question

Questions:

1a. What does it mean to buy a call?

1b. What is an example of a trade where you bought a call and made a profit.

2a. What does it mean to sell an uncovered call?

2b. What is an example and use it to explain how the "sell an uncovered call" trade works, and what is it trying to accomplish to earn a profit.

3. What are the risks of the uncovered call approach?

4a. What does it mean to sell a put?

4b. What is an example of a trade where you sold a put and lost money.

5. What are the risks of selling a put?

6. If you could sell puts on mortgages (bundled as a security), when would you lose money?

7. What is a collateralized debt obligation (CDO)? How do they work?

8. What is a credit derivative? How do they work?

Solution Preview

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1. A. Buying a call means that the investor expects that the market price of the asset would increase in future. It gives the investor the right, not the obligation, to buy the asset at a predetermined price on a predetermined date.
B. If I bought a call and the market price of the asset increases above the strike price of the call, there would be profit. As an example, if I buy a call option to buy shares of IBM at $25 per share...

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