8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

A covered call is an attempt to earn premium income by selling calls while protecting against the downside by holding long the underlying. In case prices rise, the holder of the covered call can give away the held underlying. In case prices fall or stay below the strike price of the sold call, the holder of the covered call gets to keep the premium.

The holder of the covered call will suffer a loss if the price of the underlying declines due to the long position held in the underlying. However, these losses will be partly offset by the premiums earned on the calls sold.

Choice 'd' does not represent a correct statement as in the event of a rise in the price of the underlying the holder of the covered call will lose any upside, but will not have unlimited losses. In the event of a decline in stock prices, his losses will be equal to the loss on the underlying, minus the premium earned.

Choice 'b' is the correct answer. The other relationships are not correct.

Explanation:

If the spot rate is 1.1010 and the forward is 1.1040, the swap rate is 30 "points" (= 1.1040 - 1.1010). The annualized swap premium is the swap premium divided by the spot rate, and therefore =0.0030/1.1010 =0.27%, or 27 basis points.