Conversions and Reverse Conversions for Actuaries: Practice Problems and Solutions

The Actuary's Free Study Guide for Exam 3F / Exam MFE - Section 3

This section of sample problems and solutions is a part of The Actuary's Free Study Guide for Exam 3F / Exam MFE, authored by Mr. Stolyarov.

This is Section 3 of the Study Guide. See Section 1 here. See Section 2 here.

In this section, we will explore conversions and reverse conversions - first through conceptual multiple-choice questions and then by means of practice problems that combine these concepts with the formulas for put-call parity discussed in Section 2.  

Problem CRC1. What does a conversion involve?

(a) Selling a call, selling a put, buying the stock

(b) Selling a call, buying a put, short-selling the stock

(c) Buying a call, buying a put, short-selling the stock

(d) Selling a call, buying a put, buying the stock

(e) Buying a call, selling a put, short-selling the stock

(f) Buying a call, selling a put, buying the stock

Solution CRC1. A conversion is a transaction that involves selling a call, buying a put, and buying the stock. So the answer is (d). A good way to concisely write this down and memorize it is via an ordered listing of two-letter abbreviations, where the first letter denotes the action and the second denotes the asset being bought or sold. In the first place, "B" stands for "buying" and "S" stands for "selling." In the second place, "C" stands for "call," "P" stands for "put," and "S" stands for "stock." So the way to describe a conversion using this notation is (SC, BP, BS). This is my original notation for it - meant to assist with memorization. Feel free to use it or any other device that helps you.

Problem CRC2. What does a reverse conversion involve?

(a) Selling a call, selling a put, buying the stock

(b) Selling a call, buying a put, short-selling the stock

(c) Buying a call, buying a put, short-selling the stock

(d) Selling a call, buying a put, buying the stock

(e) Buying a call, selling a put, short-selling the stock

(f) Buying a call, selling a put, buying the stock