Tricky Question Episode 1
There are always some practice exam questions that students bring to our attention. These questions are generally confusing to them, even after reading the explanation. In this and upcoming posts, we’ll try to shed light on the more difficult exam questions we’ve written. If you have suggestions for future questions, let us know. Today we’re discussing a favorite from our Series 7 Course.
An investor who wishes to hedge a portfolio of preferred stocks would buy which TWO of the following options?
I. Yield-based option calls
II. Yield-based option puts
III. Interest-rate option calls
IV. Interest-rate option puts
A. I and III
B. I and IV
C. II and III
D. II and IV
The person who came up with Roman numeral questions deserves a spot in the test-writing hall of fame. This type of question is a very effective way to test your full understanding of a concept within the confines of a single question. Many students, however, dislike them with a passion.
The best way to approach them is to ignore the choices (a), (b), (c), and (d) at first and to focus on the Roman numerals (I), (II), (III), and (IV). Think about which numerals you feel may be correct and which ones may be incorrect. From there, you can usually eliminate choices and make a better decision or, in some cases, a better guess. For example, if you know that (I) is correct in the above question, you can eliminate choices (c) and (d), since neither choice includes (I).
As you analyze the stem of the question, you see that it states that an investor wishes to hedge preferred stock. This question requires that you know how preferred stock is priced—specifically, that its price is derived mostly from interest rates, just as with bonds. In general, preferred stock and bonds are much more alike than preferred and common stock. Preferred and bonds both pay fixed income. Both have a higher priority in the event of liquidation, and both prices move in the opposite direction of interest rates.
Remember, if interest rates are rising, preferred (or bond) prices are declining and vice versa. If an investor owns preferred stock (or bonds), she is concerned that the price of her shares will decline and interest rates will rise. To summarize, this investor needs to protect against (1) preferred stock/bond prices declining and (2) interest rates rising.
There are two types of options that will help protect the investor. The complicated part in answering the question is knowing that interest-rate options are price-based and yield options are yield-based. They’re sort of opposites of one another. Interest-rate options are really just bond options.* If you buy an interest-rate call, upon exercise you’re buying a Treasury bond. This is exactly how a stock option works. So, if you think the price of Treasury bonds will rise, buying an interest-rate call is a profitable strategy. This is why they’re called price-based options. In the question, though, we’re trying to profit (hedge against) when the price is falling, so we need to buy an interest-rate put option.** Now we’re closing in. Buying interest-rate puts is choice (IV), thereby eliminating choices (a) and (c).
*Which is why the term interest-rate options is a misleading name. They should’ve named them bond options.
**Buying options is typically the best hedge. Shorting options, while fun, is not a good hedge since the trader loses control if the option is exercised.
What about numerals (I) and (II), the yield-based options? Yield-based options are based on the yield. As a reminder, bond yields move in the same direction as interest rates. Investors who think yields or interest rates will rise should buy yield-based calls. This is why yield-based options are based on interest rates and yields.
How does an investor exercise these options? In theory, someone who buys a yield-based call, and then exercises it, would buy the yield. But, you can’t really do that. Those yields don’t exist tangibly like a bond exists. They’re just numbers.*** These options have some existential issues.
To work around the small issue of yields not existing, the exchanges have made them cash-settled. Cash-settled options are a lot like gambling. The buyer of a yield-based call, instead of buying anything, will simply receive money from the seller if yields rise. The amount he gets is simply the difference in the actual yield and the strike yield (i.e., the in-the-money amount).
Cash settlement has been a Pandora’s Box for financial markets, leading to things like this. Back to the question at hand, we need to hedge against interest rates (or yields) rising. So, the best option would be buying a yield-based call—numerals (I) and (IV) are correct, which is choice B. One down, 249 questions left to answer correctly for the regulatory examination.
*** I realize Treasury bonds are book-entry securities and aren’t really tangible either. In any event, the bond is much easier to buy conceptually than the yield is.
Thanks for reading; we hope you found it worthwhile.
-Securities Training Corporation