Question

According to an article in the Wall Street Journal​, options traders were expecting a large move in the price of Facebook stock. They were buying both call options and put options with strike prices near the​ stock's current market price. The article described this strategy as a bet on the size of the​ [price] move instead of its direction.

​Source: Saumya​ Vaishampayan, Options Traders Betting on Big Move for Facebook ​Shares, Wall Street Journal​, April​ 27, 2016.

If the future price of Facebook stock increased above the current market​ price, traders would exercise the ▼(put options/call options)​, ▼(selling/buying) Facebook stock for ▼(less/more) than the then market price. If the price of Facebook stock decreased from the current market​ price, traders would exercise the ▼(call options/put options)​,▼(selling/buying) Facebook stock for ▼(more/less) than the then market price. Traders would make money using this strategy if the ▼(price of the unexercised options/ spread between the future and current market prices) was less than the ▼(spread between the future and current market prices/price of the unexercised options).

​[Related to the Making the Connection] In one of his annual letters to shareholders of Berkshire​ Hathaway, Warren Buffett wrote that trading derivatives has much more counterparty risk than does trading stocks or bonds because​ "a normal stock trade is completed in a few days with one party getting its​ cash, the other its securities. Counterparty risk therefore quickly​ disappears...."

​Source: Warren​ Buffett, "Chairman's​ Letter," Berkshire Hathaway Inc. 2008 Annual Report​, February​ 27, 2009.

Counterparty risk​ is:

A. the risk that the buyer or seller may be unwilling to fulfill the contract.

B. the risk that one party will sell the contract without notifying the other party.

C. the risk of bargaining.

D. the risk of the other party to the transaction defaulting.  

Counterparty risk is greater for trading in derivatives​ because:

A. the transaction is completed before the underlying asset matures.

B. the transaction is only completed after the underlying asset has matured.

C. some of the more complicated derivatives are traded on exchanges.

D. none of the above.

Answer 1

Answer:

Counter party risk is the risk of the other party to the transaction defaulting in fulfilling the obligation. Hence the answer to first question is option D

Counter party risk in trading in derivatives is higher than that in the normal stock trade. Because, in the normal stock trade, the transaction is completed in a short span of time while in the case of derivatives, time gap is longer and hence the probability of default is higher. Another reason is that in the normal stock trade, the contract is usually with a stock exchange while in the case of derivatives, the contract is between two parties who are not known to each other. These reasons are not stated in the set of options. Hence the answer to second question is option D- none of the above.