CHAPTER 1: INTRODUCTION

1. A one-year forward contract is an agreement where

A. One side has the right to buy an asset for a certain price in one year’s time.
B. One side has the obligation to buy an asset for a certain price in one year’s time.
C. One side has the obligation to buy an asset for a certain price at some time during the next
year.
D. One side has the obligation to buy an asset for the market price in one year’s time.

2. Which of the following is NOT true

A. When a CBOE call option on IBM is exercised, IBM issues more stock
B. An American option can be exercised at any time during its life
C. An call option will always be exercised at maturity if the underlying asset price is greater
than the strike price
D. A put option will always be exercised at maturity if the strike price is greater than the
underlying asset price.

3. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put
option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call
options and one put option. The breakeven stock price above which the trader makes a profit is
A. $35
B. $40
C. $30
D. $36
Answer: When the stock price is $35, the two call options provide a payoff of 2× (35−30) or
$10. The put option provides no payoff. The total cost of the options is 2×3+4 or $10. The stock
price in A, $35, is therefore the breakeven stock price above which the position is profitable
because it is the price for which the cost of the options equals the payoff.

4. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put
option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call
options and one put option. The breakeven stock price below which the trader makes a profit is
A. $25
B. $28
C. $26
D. $20
Answer: When the stock price is $20 the two call options provide no payoff. The put option

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provides a payoff of 30−20 or $10. The total cost of the options is 2×3+4 or $10. The stock price
in D, $20, is therefore the breakeven stock price below which the position is profitable because it
is the price for which the cost of the options equals the payoff.

5. Which of the following is approximately true when size is measured in terms of the
underlying principal amounts or value of the underlying assets
A. The exchange-traded market is twice as big as the over-the-counter market.
B. The over-the-counter market is twice as big as the exchange-traded market.
C. The exchange-traded market is ten times as big as the over-the-counter market.
D. The over-the-counter market is ten times as big as the exchange-traded market.

6. Which of the following best describes the term “spot price”

A. The price for immediate delivery
B. The price for delivery at a future time
C. The price of an asset that has been damaged
D. The price of renting an asset

7. Which of the following is true about a long forward contract

A. The contract becomes more valuable as the price of the asset declines
B. The contract becomes more valuable as the price of the asset rises
C. The contract is worth zero if the price of the asset declines after the contract has been entered
into
D. The contract is worth zero if the price of the asset rises after the contract has been entered
into

8. An investor sells a futures contract an asset when the futures price is $1,500. Each
contract is on 100 units of the asset. The contract is closed out when the futures price is $1,540.
Which of the following is true
A. The investor has made a gain of $4,000
B. The investor has made a loss of $4,000
C. The investor has made a gain of $2,000
D. The investor has made a loss of $2,000
Answer: An investor who buys (has a long position) has a gain when a futures price increases.
An investor who sells (has a short position) has a loss when a futures price increases.

9. Which of the following describes European options?

A. Sold in Europe
B. Priced in Euros
C. Exercisable only at maturity
D. Calls (there are no European puts)

10. Which of the following is NOT true

A. A call option gives the holder the right to buy an asset by a certain date for a certain price
B. A put option gives the holder the right to sell an asset by a certain date for a certain price
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C. The holder of a call or put option must exercise the right to sell or buy an asset
D. The holder of a forward contract is obligated to buy or sell an asset

11. Which of the following is NOT true about call and put options:
A. An American option can be exercised at any time during its life
B. A European option can only be exercised only on the maturity date
C. Investors must pay an upfront price (the option premium) for an option contract
D. The price of a call option increases as the strike price increases

12. The price of a stock on July 1 is $57. A trader buys 100 call options on the stock with a
strike price of $60 when the option price is $2. The options are exercised when the stock price is
$65. The trader’s net profit is
A. $700
B. $500
C. $300
D. $600
Answer: The payoff from the options is 100×(65-60) or $500. The cost of the options is 2×100 or
$200. The net profit is therefore 500−200 or $300.

13. The price of a stock on February 1 is $124. A trader sells 200 put options on the stock
with a strike price of $120 when the option price is $5. The options are exercised when the stock
price is $110. The trader’s net profit or loss is
A. Gain of $1,000
B. Loss of $2,000
C. Loss of $2,800
D. Loss of $1,000
Answer: The payoff that must be made on the options is 200×(120−110) or $2000. The amount
received for the options is 5×200 or $1000. The net loss is therefore 2000−1000 or $1000.

14. The price of a stock on February 1 is $84. A trader buys 200 put options on the stock with
a strike price of $90 when the option price is $10. The options are exercised when the stock price
is $85. The trader’s net profit or loss is
A. Loss of $1,000
B. Loss of $2,000
C. Gain of $200
D. Gain of $1000
Answer: The payoff is 90−85 or $5 per option. For 200 options the payoff is therefore 5×200 or
$1000. However the options cost 10×200 or $2000. There is therefore a net loss of $1000.

15. The price of a stock on February 1 is $48. A trader sells 200 put options on the stock with
a strike price of $40 when the option price is $2. The options are exercised when the stock price
is $39. The trader’s net profit or loss is
A. Loss of $800
B. Loss of $200
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C. Gain of $200
D. Loss of $900
Answer: The payoff is 40−39 or $1 per option. For 200 options the payoff is therefore 1×200 or
$200. However the premium received by the trader is 2×200 or $400. The trader therefore has a
net gain of $200.

16. A speculator can choose between buying 100 shares of a stock for $40 per share and
buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For
second alternative to give a better outcome at the option maturity, the stock price must be above
A. $45
B. $46
C. $55
D. $50
Answer: When the stock price is $50 the first alternative leads to a position in the stock worth
100×50 or $5000. The second alternative leads to a payoff from the options of 1000×(50−45) or
$5000. Both alternatives cost $4000. It follows that the alternatives are equally profitable when
the stock price is $50. For stock prices above $50 the option alternative is more profitable.

17. A company knows it will have to pay a certain amount of a foreign currency to one of its
suppliers in the future. Which of the following is true
A. A forward contract can be used to lock in the exchange rate
B. A forward contract will always give a better outcome than an option
C. An option will always give a better outcome than a forward contract
D. An option can be used to lock in the exchange rate

18. A short forward contract on an asset plus a long position in a European call option on the
asset with a strike price equal to the forward price is equivalent to
A. A short position in a call option
B. A short position in a put option
C. A long position in a put option
D. None of the above

19. A trader has a portfolio worth $5 million that mirrors the performance of a stock index.
The stock index is currently 1,250. Futures contracts trade on the index with one contract being
on 250 times the index. To remove market risk from the portfolio the trader should
A. Buy 16 contracts
B. Sell 16 contracts
C. Buy 20 contracts
D. Sell 20 contracts
Answer: One futures contract protects a portfolio worth 1250×250. The number of contract
required is therefore 5,000,000/(1250×250)=16. To remove market risk we need to gain on the
contracts when the market declines. A short futures position is therefore required.

20. Which of the following best describes a central clearing party

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A. It is a trader that works for an exchange
B. It stands between two parties in the over-the-counter market
C. It is a trader that works for a bank
D. It helps facilitate futures trades

CHAPTER 2: MECHANICS OF FUTURES MARKETS

1. Which of the following is true?
A. Both forward and futures contracts are traded on exchanges.
B. Forward contracts are traded on exchanges, but futures contracts are not.
C. Futures contracts are traded on exchanges, but forward contracts are not.
D. Neither futures contracts nor forward contracts are traded on exchanges.

2. Which of the following is NOT true

A. Futures contracts nearly always last longer than forward contracts
B. Futures contracts are standardized; forward contracts are not.
C. Delivery or final cash settlement usually takes place with forward contracts; the same is
not true of futures contracts.
D. Forward contracts usually have one specified delivery date; futures contracts often have a
range of delivery dates.

3. In the corn futures contract a number of different types of corn can be delivered (with
price adjustments specified by the exchange) and there are a number of different delivery
locations. Which of the following is true
A. This flexibility tends to increase the futures price.
B. This flexibility tends to decrease the futures price.
C. This flexibility may increase and may decrease the futures price.
D. This flexibility has no effect on the futures price

4. A company enters into a short futures contract to sell 50,000 units of a commodity for 70
cents per unit. The initial margin is $4,000 and the maintenance margin is $3,000. What is the
futures price per unit above which there will be a margin call?
A. 78 cents
B. 76 cents
C. 74 cents
D. 72 cents

5. A company enters into a long futures contract to buy 1,000 units of a commodity for $60
per unit. The initial margin is $6,000 and the maintenance margin is $4,000. What futures price
will allow $2,000 to be withdrawn from the margin account?
A. $58
B. $62
C. $64
D. $66
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6. One futures contract is traded where both the long and short parties are closing out
existing positions. What is the resultant change in the open interest?
A. No change
B. Decrease by one
C. Decrease by two
D. Increase by one

7. Who initiates delivery in a corn futures contract

A. The party with the long position
B. The party with the short position
C. Either party
D. The exchange

8. You sell one December futures contracts when the futures price is $1,010 per unit. Each
contract is on 100 units and the initial margin per contract that you provide is $2,000. The
maintenance margin per contract is $1,500. During the next day the futures price rises to $1,012
per unit. What is the balance of your margin account at the end of the day?
A. $1,800
B. $3,300
C. $2,200
D. $3,700
Answer: The price has increased by $2. Because you have a short position you lose 2×100 or
$200. The balance in the margin account therefore goes down from $3,500 to $3,300.

9. A hedger takes a long position in a futures contract on a commodity on November 1,

2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31,
2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on March 1,
2013. What gain is recognized in the accounting year January 1 to December 31, 2013? Each
contract is on 1000 units of the commodity.
A. $0
B. $1,000
C. $3,000
D. $4,000

10. A speculator takes a long position in a futures contract on a commodity on November 1,

2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31,
2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on March 1,
2013. What gain is recognized in the accounting year January 1 to December 31, 2013? Each
contract is on 1000 units of the commodity.
A. $0
B. $1,000
B. $3,000
C. $4,000

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11. The frequency with which futures margin accounts are adjusted for gains and losses is
A. Daily
B. Weekly
C. Monthly
D. Quarterly

12. Margin accounts have the effect of

A. Reducing the risk of one party regretting the deal and backing out
B. Ensuring funds are available to pay traders when they make a profit
C. Reducing systemic risk due to collapse of futures markets
D. All of the above

13. Which entity in the United States takes primary responsibility for regulating futures
market?
A. Federal Reserve Board
B. Commodities Futures Trading Commission (CFTC)
C. Security and Exchange Commission (SEC)
D. US Treasury

14. For a futures contract trading in April 2012, the open interest for a June 2012 contract,
when compared to the open interest for Sept 2012 contracts, is usually
A. Higher
B. Lower
C. The same
D. Equally likely to be higher or lower

15. Clearing houses are

A. Never used in futures markets and sometimes used in OTC markets
B. Used in OTC markets, but not in futures markets
C. Always used in futures markets and sometimes used in OTC markets
D. Always used in both futures markets and OTC markets

16. A haircut of 20% means that

A. A bond with a market value of $100 is considered to be worth $80 when used to satisfy a
collateral request
B. A bond with a face value of $100 is considered to be worth $80 when used to satisfy a
collateral request
C. A bond with a market value of $100 is considered to be worth $83.3 when used to satisfy a
collateral request
D. A bond with a face value of $100 is considered to be worth $83.3 when used to satisfy a
collateral request

17. With bilateral clearing, the number of agreements between four dealers, who trade with
each other, is
A. 12

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B. 1
C. 6
D. 2

18. Which of the following best describes central clearing parties

A. Help market participants to value derivative transactions
B. Must be used for all OTC derivative transactions
C. Are used for futures transactions
D. Perform a similar function to exchange clearing houses

19. Which of the following are cash settled

A. All futures contracts
B. All option contracts
C. Futures on commodities
D. Futures on stock indices

20. A limit order

A. Is an order to trade up to a certain number of futures contracts at a certain price
B. Is an order that can be executed at a specified price or one more favorable to the
investor
C. Is an order that must be executed within a specified period of time
D. None of the above

CHAPTER 3: HEDGING STRATEGIES USING FUTURES

1. The basis is defined as spot minus futures. A trader is hedging the sale of an asset with a
short futures position. The basis increases unexpectedly. Which of the following is true?
A. The hedger’s position improves.
B. The hedger’s position worsens.
C. The hedger’s position sometimes worsens and sometimes improves.
D. The hedger’s position stays the same.

2. Futures contracts trade with every month as a delivery month. A company is hedging the
purchase of the underlying asset on June 15. Which futures contract should it use?
A. The June contract
B. The July contract
C. The May contract
D. The August contract

3. On March 1 a commodity’s spot price is $60 and its August futures price is $59. On July
1 the spot price is $64 and the August futures price is $63.50. A company entered into futures
contracts on March 1 to hedge its purchase of the commodity on July 1. It closed out its position
on July 1. What is the effective price (after taking account of hedging) paid by the company?
A. $59.50
8
B. $60.50
C. $61.50
D. $63.50
Answer: The user of the commodity takes a long futures position. The gain on the futures is
63.50−59 or $4.50. The effective paid realized is therefore 64−4.50 or $59.50. This can also be
calculated as the March 1 futures price (=59) plus the basis on July 1 (=0.50)

4. On March 1 the price of a commodity is $1,000 and the December futures price is
$1,015. On November 1 the price is $980 and the December futures price is $981. A producer of
the commodity entered into a December futures contracts on March 1 to hedge the sale of the
commodity on November 1. It closed out its position on November 1. What is the effective price
(after taking account of hedging) received by the company for the commodity?
A. $1,016
B. $1,001
C. $981
D. $1,014
Answer: The producer of the commodity takes a short futures position. The gain on the futures
is 1015−981 or $34. The effective price realized is therefore 980+34 or $1014. This can also be
calculated as the March 1 futures price (=1015) plus the November 1 basis (= − 1).

5. Suppose that the standard deviation of monthly changes in the price of commodity A is
$2. The standard deviation of monthly changes in a futures price for a contract on commodity B
(which is similar to commodity A) is $3. The correlation between the futures price and the
commodity price is 0.9. What hedge ratio should be used when hedging a one month exposure to
the price of commodity A?
A. 0.60
B. 0.67
C. 1.45
D. 0.90
Answer: The optimal hedge ratio is 0.9×(2/3) or 0.6.

6. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract
on an index is 900. Futures contracts on $250 times the index can be traded. What trade is
necessary to reduce beta to 0.9?
A. Long 192 contracts
B. Short 192 contracts
C. Long 48 contracts
D. Short 48 contracts
Answer: To reduce the beta by 0.3 we need to short 0.3×36,000,000/(900×250) or 48 contracts.

7. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract
on an index is 900. Futures contracts on $250 times the index can be traded. What trade is
necessary to increase beta to 1.8?
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A. Long 192 contracts
B. Short 192 contracts
C. Long 96 contracts
D. Short 96 contracts
Answer: To increase the beta by 0.6 we need to short 0.6×36,000,000/(900×250) or 96 contracts.

8. Which of the following is true?

A. The optimal hedge ratio is the slope of the best fit line when the spot price (on the y-axis) is
regressed against the futures price (on the x-axis).
B. The optimal hedge ratio is the slope of the best fit line when the futures price (on the y-axis)
is regressed against the spot price (on the x-axis).
C. The optimal hedge ratio is the slope of the best fit line when the change in the spot price
(on the y-axis) is regressed against the change in the futures price (on the x-axis).
D. The optimal hedge ratio is the slope of the best fit line when the change in the futures price
(on the y-axis) is regressed against the change in the spot price (on the x-axis).

9. Which of the following describes tailing the hedge?

A. A strategy where the hedge position is increased at the end of the life of the hedge
B. A strategy where the hedge position is increased at the end of the life of the futures contract
C. A more exact calculation of the hedge ratio when forward contracts are used for hedging
D. None of the above

10. A company due to pay a certain amount of a foreign currency in the future decides to
hedge with futures contracts. Which of the following best describes the advantage of hedging?
A. It leads to a better exchange rate being paid
B. It leads to a more predictable exchange rate being paid
C. It caps the exchange rate that will be paid
D. It provides a floor for the exchange rate that will be paid

11. Which of the following best describes the capital asset pricing model?
A. Determines the amount of capital that is needed in particular situations
B. Is used to determine the price of futures contracts
C. Relates the return on an asset to the return on a stock index
D. Is used to determine the volatility of a stock index

12. Which of the following best describes “stack and roll”?

A. Creates long-term hedges from short term futures contracts
B. Can avoid losses on futures contracts by entering into further futures contracts
C. Involves buying a futures contract with one maturity and selling a futures contract with a
different maturity
D. Involves two different exposures simultaneously

13. Which of the following increases basis risk?

A. A large difference between the futures prices when the hedge is put in place and when it is
10
 closed out
B. Dissimilarity between the underlying asset of the futures contract and the hedger’s
exposure
C. A reduction in the time between the date when the futures contract is closed and its delivery
month
D. None of the above

14. Which of the following is a reason for hedging a portfolio with an index futures?
A. The investor believes the stocks in the portfolio will perform better than the market but
is uncertain about the future performance of the market
B. The investor believes the stocks in the portfolio will perform better than the market and the
market is expected to do well
C. The portfolio is not well diversified and so its return is uncertain
D. All of the above

15. Which of the following does NOT describe beta?

A. A measure of the sensitivity of the return on an asset to the return on an index
B. The slope of the best fit line when the return on an asset is regressed against the return on the
market
C. The hedge ratio necessary to remove market risk from a portfolio
D. Measures correlation between futures prices and spot prices for a commodity

16. Which of the following is true?

A. Hedging can always be done more easily by a company’s shareholders than by the
company itself
B. If all companies in an industry hedge, a company in the industry can sometimes reduce its
risk by choosing not to hedge
C. If all companies in an industry do not hedge, a company in the industry can reduce its risk
by hedging
D. If all companies in an industry do not hedge, a company is liable increase its risk by
hedging

17. Which of the following is necessary for tailing a hedge?

A. Comparing the size in units of the position being hedged with the size in units of the
futures contract
B. Comparing the value of the position being hedged with the value of one futures
contract
C. Comparing the futures price of the asset being hedged to its forward price
D. None of the above

18. Which of the following is true?

A. Gold producers should always hedge the price they will receive for their production of gold
over the next three years
B. Gold producers should always hedge the price they will receive for their production of gold
11
 over the next one year
C. The hedging strategies of a gold producer should depend on whether it shareholders
want exposure to the price of gold
D. Gold producers can hedge by buying gold in the forward market

19. A silver mining company has used futures markets to hedge the price it will receive for
everything it will produce over the next 5 years. Which of the following is true?
A. It is liable to experience liquidity problems if the price of silver falls dramatically
B. It is liable to experience liquidity problems if the price of silver rises dramatically
C. It is liable to experience liquidity problems if the price of silver rises dramatically or falls
dramatically
D. The operation of futures markets protects it from liquidity problems

20. A company will buy 1000 units of a certain commodity in one year. It decides to hedge
80% of its exposure using futures contracts. The spot price and the futures price are currently
$100 and $90, respectively. If the spot price and the futures price in one year turn out to be $112
and $110, respectively. What is the average price paid for the commodity?
A. $92
B. $96
C. $102
D. $106
Answer: On the 80% (hedged) part of the commodity purchase the price paid will 112−(110−90)
or $92. On the other 20% the price paid will be the spot price of $112. The weighted average of
the two prices is 0.8×92+0.2×112 or $96.

CHAPTER 5: DETERMINATION OF FORWARD AND FUTURES PRICES

1. Which of the following is a consumption asset?
A. The S&P 500 index
B. The Canadian dollar
C. Copper
D. IBM stock

2. An investor shorts 100 shares when the share price is $50 and closes out the position six
months later when the share price is $43. The shares pay a dividend of $3 per share during the
six months. How much does the investor gain?
A. $1,000
B. $400
C. $700
D. $300
Answer: The investor gains $7 per share because he or she sells at $50 and buys at $43.
However, the investor has to pay the $3 per share dividend. The net profit is therefore 7−3 or $4
per share. 100 shares are involved. The total gain is therefore $400.

3. The spot price of an investment asset that provides no income is $30 and the risk-free rate
12
for all maturities (with continuous compounding) is 10%. What is the three-year forward price?
A. $40.50
B. $22.22
C. $33.00
D. $33.16

Answer: The 3-year forward price is the spot price grossed up for 3 years at the risk-free rate. It
is 30e0.1×3 =$40.50.

4. The spot price of an investment asset is $30 and the risk-free rate for all maturities is 10%
with continuous compounding. The asset provides an income of $2 at the end of the first year
and at the end of the second year. What is the three-year forward price?
A. $19.67
B. $35.84
C. $45.15
D. $40.50
Answer: The present value of the income is 2e-0.1×1+2e-0.1×2= $3.447. The three year forward price
is obtained by subtracting the present value of the income from the current stock price and then
grossing up the result for three years at the risk-free rate. It is (30−3.447)e 0.1×3 = $35.84.

5. An exchange rate is 0.7000 and the six-month domestic and foreign risk-free interest
rates are 5% and 7% (both expressed with continuous compounding). What is the six-month
forward rate?
A. 0.7070
B. 0.7177
C. 0.7249
D. 0.6930

6. Which of the following is true?

A. The convenience yield is always positive or zero.
B. The convenience yield is always positive for an investment asset.
C. The convenience yield is always negative for a consumption asset.
D. The convenience yield measures the average return earned by holding futures contracts.

7. A short forward contract that was negotiated some time ago will expire in three months
and has a delivery price of $40. The current forward price for three-month forward contract is
$42. The three month risk-free interest rate (with continuous compounding) is 8%. What is the
value of the short forward contract?
A. +$2.00
B. −$2.00
C. +$1.96
D. −$1.96

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Answer: The contract gives one the obligation to sell for $40 when a forward price negotiated
today would give one the obligation to sell for $42. The value of the contract is the present value
of − $2 or −2e-0.08×0.25 = −$1.96.

8. The spot price of an asset is positively correlated with the market. Which of the following
would you expect to be true?
A. The forward price equals the expected future spot price.
B. The forward price is greater than the expected future spot price.
C. The forward price is less than the expected future spot price.
D. The forward price is sometimes greater and sometimes less than the expected future spot
price.

9. Which of the following describes the way the futures price of a foreign currency is
quoted by the CME group?
A. The number of U.S. dollars per unit of the foreign currency
B. The number of the foreign currency per U.S. dollar
C. Some futures prices are always quoted as the number of U.S. dollars per unit of the
foreign currency and some are always quoted the other way round
D. There are no quotation conventions for futures prices

10. Which of the following describes the way the forward price of a foreign currency is
quoted?
A. The number of U.S. dollars per unit of the foreign currency
B. The number of the foreign currency per U.S. dollar
C. Some forward prices are quoted as the number of U.S. dollars per unit of the foreign
currency and some are quoted the other way round
D. There are no quotation conventions for forward prices

11. Which of the following is NOT a reason why a short position in a stock is closed out?
A. The investor with the short position chooses to close out the position
B. The lender of the shares issues instructions to close out the position
C. The broker is no longer able to borrow shares from other clients
D. The investor does not maintain margins required on his/her margin account

12. Which of the following is NOT true?

A. Gold and silver are investment assets
B. Investment assets are held by significant numbers of investors for investment purposes
C. Investment assets are never held for consumption
D. The forward price of an investment asset can be obtained from the spot price, interest rates,
and the income paid on the asset

13. What should a trader do when the one-year forward price of an asset is too low? Assume
that the asset provides no income.
A. The trader should borrow the price of the asset, buy one unit of the asset and enter into a
short forward contract to sell the asset in one year.

14
B. The trader should borrow the price of the asset, buy one unit of the asset and enter into a long
forward contract to buy the asset in one year.
C. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate,
enter into a short forward contract to sell the asset in one year
D. The trader should short the asset, invest the proceeds of the short sale at the risk-free
rate, enter into a long forward contract to buy the asset in one year

14. Which of the following is NOT true about forward and futures contracts?
A. Forward contracts are more liquid than futures contracts
B. The futures contracts are traded on exchanges while forward contracts are traded in the
over-the-counter market
C. In theory forward prices and futures prices are equal when there is no uncertainty about
future interest rates
D. Taxes and transaction costs can lead to forward and futures prices being different

15. As the convenience yield increases, which of the following is true?

A. The one-year futures price as a percentage of the spot price increases
B. The one-year futures price as a percentage of the spot price decreases
C. The one-year futures price as a percentage of the spot price stays the same
D. Any of the above can happen

16. As inventories of a commodity decline, which of the following is true?

A. The one-year futures price as a percentage of the spot price increases
B. The one-year futures price as a percentage of the spot price decreases
C. The one-year futures price as a percentage of the spot price stays the same
D. Any of the above can happen

17. Which of the following describes a known dividend yield on a stock?

A. The size of the dividend payments each year is known
B. Dividends per year as a percentage of today’s stock price are known
C. Dividends per year as a percentage of the stock price at the time when dividends are
paid are known
D. Dividends will yield a certain return to a person buying the stock today

18. Which of the following is an argument used by Keynes and Hicks?

A. If hedgers hold long positions and speculators holds short positions, the futures price
will tend to be higher than the expected future spot price
B. If hedgers hold long positions and speculators holds short positions, the futures price will
tend to be lower than the expected future spot price
C. If hedgers hold long positions and speculators holds short positions, the futures price will
tend to be lower than today’s spot price
D. If hedgers hold long positions and speculators holds short positions, the futures price will
tend to be higher than today’s spot price

19. Which of the following describes contango?

15
A. The futures price is below the expected future spot price
B. The futures price is below today’s spot price
C. The futures price is a declining function of the time to maturity
D. The futures price is above the expected future spot price

20. Which of the following is true for a consumption commodity?

A. There is no limit to how high or low the futures price can be, except that the futures price
cannot be negative
B. There is a lower limit to the futures price but no upper limit
C. There is an upper limit to the futures price but no lower limit, except that the futures
price cannot be negative
D. The futures price can be determined with reasonable accuracy from the spot price and
interest rates

CHAPTER 6: INTEREST RATE FUTURES

1. Which of following is applicable to corporate bonds in the United States?
A. Actual/360
B. Actual/Actual
C. 30/360
D. Actual/365

2. It is May 1. The quoted price of a bond with an Actual/Actual (in period) day count and
12% per annum coupon (paid semiannually) in the United States is 105. It has a face value of
100 and pays coupons on April 1 and October 1. What is the cash price?
A. 106.00
B. 106.02
C. 105.98
D. 106.04
Answer: The cash price is the quoted price plus accrued interest. There are 30 actual days
between April 1 and May 1 and 183 actual days between April 1 and October 1. In this case the
quoted price is 105 and the accrued interest is 0.06×100×30/183=0.98. The answer is therefore
105.98.

3. It is May 1. The quoted price of a bond with a 30/360 day count and 12% per annum
coupon in the United States is 105. It has a face value of 100 and pays coupons on April 1 and
October 1. What is the cash price?
A. 106.00
B. 106.02
C. 105.98
D. 106.04
Answer: The cash price is the quoted price plus accrued interest. There are 30 assumed days
between April 1 and May 1 and 180 assumed days between April 1 and October 1. In this case
the quoted price is 105 and the accrued interest is 0.06×100×30/180 = 1.00. The answer is

16
therefore 106.00.

4. The most recent settlement bond futures price is 103.5. Which of the following four
bonds is cheapest to deliver?
A. Quoted bond price = 110; conversion factor = 1.0400.
B. Quoted bond price = 160; conversion factor = 1.5200.
C. Quoted bond price = 131; conversion factor = 1.2500.
D. Quoted bond price = 143; conversion factor = 1.3500.

5. Which of the following is NOT an option open to the party with a short position in the
Treasury bond futures contract?
A. The ability to deliver any of a number of different bonds
B. The wild card play
C. The fact that delivery can be made any time during the delivery month
D. The interest rate used in the calculation of the conversion factor

6. A trader enters into a long position in one Eurodollar futures contract. How much does
the trader gain when the futures price quote increases by 6 basis points?
A. $6
B. $150
C. $60
D. $600
Answer: The trader gains $25 for each basis point. The gain is therefore 25×6 or $150.

7. The bonds that can be delivered in a Treasury bond futures contract are
A. Assets that provide no income
B. Assets that provide a known cash income
C. Assets that provide a known yield
D. None of the above

8. An ultra T-bond futures contract is one where

A. Bonds with maturities less than 3 years can be delivered
B. Bonds with maturities less than 10 years can be delivered
C. Bonds with maturities greater than 15 years can be delivered
D. Bonds with maturities greater than 25 year can be delivered

9. A portfolio is worth $24,000,000. The futures price for a Treasury note futures contract is
110 and each contract is for the delivery of bonds with a face value of $100,000. On the delivery
date the duration of the bond that is expected to be cheapest to deliver is 6 years and the duration
of the portfolio will be 5.5 years. How many contracts are necessary for hedging the portfolio?
A. 100
B. 200
17
C. 300
D. 400
Answer: The contract price is 110,000. The number of contracts is (24,000,000×5.5)/
(110,000×6.0) = 200

10. Which of the following is true?

A. The futures rates calculated from a Eurodollar futures quote are always less than the
corresponding forward rate
B. The futures rates calculated from a Eurodollar futures quote are always greater than
the corresponding forward rate
C. The futures rates calculated from a Eurodollar futures quote should equal the corresponding
forward rate
D. The futures rates calculated from a Eurodollar futures quote are sometimes greater than and
sometimes less than the corresponding forward rate

11. How much is a basis point?

A. 1.0%
B. 0.1%
C. 0.01%
D. 0.001%

12. Which of the following day count conventions applies to a US Treasury bond?
A. Actual/360
B. Actual/Actual (in period)
C. 30/360
D. Actual/365

13. What is the quoted discount rate on a money market instrument?

A. The interest rate earned as a percentage of the final face value of a bond
B. The interest rate earned as a percentage of the initial price of a bond
C. The interest rate earned as a percentage of the average price of a bond
D. The risk-free rate used to calculate the present value of future cash flows from a bond

14. Which of the following is closest to the duration of a 2-year bond that pays a coupon of
8% per annum semiannually? The yield on the bond is 10% per annum with continuous
compounding.
A. 1.82
B. 1.85
C. 1.88
D. 1.92

18
15. Which of the following is NOT true about duration?
A. It equals the years-to-maturity for a zero coupon bond
B. It equals the weighted average of payment times for a bond, where weights are proportional
to the present value of payments
C. Equals the weighted average of individual bond durations for a portfolio, where weights are
proportional to the present value of bond prices
D. The prices of two bonds with the same duration change by the same percentage amount
when interest rate moves up by 100 basis points

16. The conversion factor for a bond is approximately

A. The price it would have if all cash flows were discounted at 6% per annum
B. The price it would have if it paid coupons at 6% per annum
C. The price it would have if all cash flows were discounted at 8% per annum
D. The price it would have if it paid coupons at 8% per annum

17. The time-to-maturity of a Eurodollars futures contract is 4 years and the time-to-maturity
of the rate underlying the futures contract is 4.25 years. The standard deviation of the change in
the short term interest rate, σ = 0.011. What does the model in the text give as the difference
between the futures and the forward interest rate.
A. 0.105%
B. 0.103%
C. 0.098%
D. 0.093%
Answer: With the notation in the text, the futures rate exceeds the forward rate by 0.5σ2T1T2. In
this case σ=0.011, T1=4 and T2=4.25 so the difference between the futures and forward price is
0.5×0.011×4×4.25=0.00103.

18. A trader uses 3-month Eurodollar futures to lock in a rate on $5 million for six months.
How many contracts are required?
A. 5
B. 10
C. 15
D. 20
Answer: Each contract locks in the rate on $1 million dollars for three months. A six month
instrument is approximately twice as sensitive to rate movements as a three month instrument
because it has twice the duration. 2×5 = 10 contracts are therefore required

19. In the U.S. what is the longest maturity for 3-month Eurodollar futures contracts?

19
A. 2 years
B. 5 years
C. 10 years
D. 20 years

20. Duration matching immunizes a portfolio against

A. Any parallel shift in the yield curve
B. All shifts in the yield curve
C. Changes in the steepness of the yield curve
D. Small parallel shifts in the yield curve

CHAPTER 7: SWAPS
1. A company can invest funds for five years at LIBOR minus 30 basis points. The five-year
swap rate is 3%. What fixed rate of interest can the company earn by using the swap?
A. 2.4%
B. 2.7%
C. 3.0%
D. 3.3%

2. Which of the following is true?

A. Principals are not usually exchanged in a currency swap
B. The principal amounts usually flow in the opposite direction to interest payments at the
beginning of a currency swap and in the same direction as interest payments at the end
of the swap.
C. The principal amounts usually flow in the same direction as interest payments at the
beginning of a currency swap and in the opposite direction to interest payments at the end of
the swap.
D. Principals are not usually specified in a currency swap

3. Company X and Company Y have been offered the following rates

Fixed Rate Floating Rate

Company X 3.5% 3-month LIBOR plus 10bp
Company Y 4.5% 3-month LIBOR plus 30 bp
Suppose that Company X borrows fixed and company Y borrows floating. If they enter into a
swap with each other where the apparent benefits are shared equally, what is company X’s
effective borrowing rate?
A. 3-month LIBOR−30bp
B. 3.1%
C. 3-month LIBOR−10bp
D. 3.3%
20
4. Which of the following describes the five-year swap rate?
A. The fixed rate of interest which a swap market maker is prepared to pay in exchange for
LIBOR on a 5-year swap
B. The fixed rate of interest which a swap market maker is prepared to receive in exchange for
LIBOR on a 5-year swap
C. The average of A and B
D. The higher of A and B

5. Which of the following is a use of a currency swap?

A. To exchange an investment in one currency for an investment in another currency
B. To exchange borrowing in one currency for borrowings in another currency
C. To take advantage situations where the tax rates in two countries are different
D. All of the above

6. The reference entity in a credit default swap is

A. The buyer of protection
B. The seller of protection
C. The company or country whose default is being insured against
D. None of the above

7. Which of the following describes an interest rate swap?

A. The exchange of a fixed rate bond for a floating rate bond
B. A portfolio of forward rate agreements
C. An agreement to exchange interest at a fixed rate for interest at a floating rate
D. All of the above

8. Which of the following is true for an interest rate swap?

A. A swap is usually worth close to zero when it is first negotiated
B. Each forward rate agreement underlying a swap is worth close to zero when the swap is first
entered into
C. Comparative advantage is a valid reason for entering into the swap
D. None of the above

9. Which of the following is true for the party paying fixed in a newly negotiated interest
rate swap when the yield curve is upward sloping?
A. The early forward contracts underlying the swap have a positive value and the later ones have
a negative value
B. The early forward contracts underlying the swap have a negative value and the later
ones have a positive value
C. The swap is designed so that all forward rates have zero value
D. Sometimes A is true and sometimes B is true

21
10. A bank enters into a 3-year swap with company X where it pays LIBOR and receives
3.00%. It enters into an offsetting swap with company Y where is receives LIBOR and pays
2.95%. Which of the following is true:
A. If company X defaults, the swap with company Y is null and void
B. If company X defaults, the bank will be able to replace company X at no cost
C. If company X defaults, the swap with company Y continues
D. The bank’s bid-offer spread is 0.5 basis points

11. When LIBOR is used as the discount rate:

A. The value of a swap is worth zero immediately after a payment date
B. The value of a swap is worth zero immediately before a payment date
C. The value of the floating rate bond underlying a swap is worth par immediately after a
payment date
D. The value of the floating rate bond underlying a swap is worth par immediately before a
payment date

12. A company enters into an interest rate swap where it is paying fixed and receiving
LIBOR. When interest rates increase, which of the following is true?
A. The value of the swap to the company increases
B. The value of the swap to the company decreases
C. The value of the swap can either increase or decrease
D. The value of the swap does not change providing the swap rate remains the same

13. A floating for floating currency swap is equivalent to

A. Two interest rate swaps, one in each currency
B. A fixed-for-fixed currency swap and one interest rate swap
C. A fixed-for-fixed currency swap and two interest rate swaps, one in each currency
D. None of the above

14. A floating-for-fixed currency swap is equivalent to

A. Two interest rate swaps, one in each currency
B. A fixed-for-fixed currency swap and one interest rate swap
C. A fixed-for-fixed currency swap and two interest rate swaps, one in each currency
D. None of the above

15. An interest rate swap has three years of remaining life. Payments are exchanged annually.
Interest at 3% is paid and 12-month LIBOR is received. A exchange of payments has just taken
place. The one-year, two-year and three-year LIBOR/swap zero rates are 2%, 3% and 4%. All
rates an annually compounded. What is the value of the swap as a percentage of the principal
when LIBOR discounting is used.
A. 0.00
B. 2.66
C. 2.06
D. 1.06
22
Answer: Suppose the principal 100. The value of the floating rate bond underlying the swap is
100. The value of the fixed rate bond is 3/1.02+3/(1.03) 2+103/ (1.04)3=97.34. The value of the
swap is therefore 100−97.34 = 2.66 or 2.66% of the principal

16. A semi-annual pay interest rate swap where the fixed rate is 5.00% (with semi-annual
compounding) has a remaining life of nine months. The six-month LIBOR rate observed three
months ago was 4.85% with semi-annual compounding. Today’s three and nine month LIBOR
rates are 5.3% and 5.8% (continuously compounded) respectively. From this it can be calculated
that the forward LIBOR rate for the period between three- and nine-months is 6.14% with
semi-annual compounding. If the swap has a principal value of $15,000,000, what is the value of
the swap to the party receiving a fixed rate of interest?
A. $74,250
B. −$70,760
C. −$11,250
D. $103,790
Answer: The forward rates for the floating payment at time 9 months is 6.14%. The swap can
be valued assuming that the fixed payments are 2.5% of principal at 3 months and 9 months
and that the floating payments are 2.425% and 3.07% of the principal at 3 months and 9
months. The value of the swap to the party receiving fixed is therefore
1,000,000(0.025-0.02425)e-0.053×0.25+1,000,000(0.025-0.0307)e-0.058×0.75 = – $70,760

17. Which of the following describes the way a LIBOR-in-arrears swap differs from a plain
vanilla interest rate swap?
A. Interest is paid at the beginning of the accrual period in a LIBOR-in-arrears swap
B. Interest is paid at the end of the accrual period in a LIBOR-in-arrears swap
C. No floating interest is paid until the end of the life of the swap in a LIBOR-in-arrears swap,
but fixed payments are made throughout the life of the swap
D. Neither floating nor fixed payments are made until the end of the life of the swap

18. In a fixed-for-fixed currency swap, 3% on a US dollar principal of $150 million is

received and 4% on a British pound principal of 100 million pounds is paid. The current
exchange rate is 1.55 dollar per pound. Interest rates in both countries for all maturities are
currently 5% (continuously compounded). Payments are exchanged every year. The swap has 2.5
years left in its life. What is the value of the swap?
A. −$7.15
B. −$8.15
C. −$9.15
D. −$10.15
Answer: The value of the British pound bond underlying the swap is in millions
of pounds
4e-0.05×0.5+4e-0.05×1.5+104e-0.05×2.5 = 99.39
The value of the U.S. dollar bond is in millions of dollars
4.5e-0.05×0.5+4.5e-0.05×1.5+154.5e-0.05×2.5 = 144.91
23
The value of the swap is 144.91 – 99.39×1.55 = –9.15

24
19. Which of the following is a typical bid-offer spread on the swap rate for a plain vanilla
interest rate swap?
A. 3 basis points
B. 8 basis points
C. 13 basis points
D. 18 basis points

20. Which of the following describes the five-year swap rate?

A. The rate on a five-year loan to a AA-rated company
B. The rate on a five-year loan to an A-rated company
C. The rate that can be earned over five years from a series of short-term loans to
AA-rated companies
D. The rate that can be earned over five years from a series of short-term loans to A-rated
companies

CHAPTER 10: MECHANICS OF OPTIONS MARKETS

1. Which of the following describes a call option?
A. The right to buy an asset for a certain price
B. The obligation to buy an asset for a certain price
C. The right to sell an asset for a certain price
D. The obligation to sell an asset for a certain price

2. Which of the following is true?

A. A long call is the same as a short put
B. A short call is the same as a long put
C. A call on a stock plus a stock the same as a put
D. None of the above

3. An investor has exchange-traded put options to sell 100 shares for $20. There is a 2 for 1
stock split. Which of the following is the position of the investor after the stock split?
A. Put options to sell 100 shares for $20
B. Put options to sell 100 shares for $10
C. Put options to sell 200 shares for $10
D. Put options to sell 200 shares for $20

4. An investor has exchange-traded put options to sell 100 shares for $20. There is 25%
stock dividend. Which of the following is the position of the investor after the stock dividend?
A. Put options to sell 100 shares for $20
B. Put options to sell 75 shares for $25
C. Put options to sell 125 shares for $15
D. Put options to sell 125 shares for $16

25
5. An investor has exchange-traded put options to sell 100 shares for $20. There is a $1 cash
dividend. Which of the following is then the position of the investor?
A. The investor has put options to sell 100 shares for $20
B. The investor has put options to sell 100 shares for $19
C. The investor has put options to sell 105 shares for $19
D. The investor has put options to sell 105 shares for $19.05

6. Which of the following describes a short position in an option?

A. A position in an option lasting less than one month
B. A position in an option lasting less than three months
C. A position in an option lasting less than six months
D. A position where an option has been sold

7. Which of the following describes a difference between a warrant and an exchange-traded

stock option?
A. In a warrant issue, someone has guaranteed the performance of the option seller in the event
that the option is exercised
B. The number of warrants is fixed whereas the number of exchange-traded options in
existence depends on trading
C. Exchange-traded stock options have a strike price
D. Warrants cannot be traded after they have been purchased

8. Which of the following describes LEAPS?

A. Options which are partly American and partly European
B. Options where the strike price changes through time
C. Exchange-traded stock options with longer lives than regular exchange-traded stock
options
D. Options on the average stock price during a period of time

9. Which of the following is an example of an option class?

A. All calls on a certain stock
B. All calls with a particular strike price on a certain stock
C. All calls with a particular time to maturity on a certain stock
D. All calls with a particular time to maturity and strike price on a certain stock

10. Which of the following is an example of an option series?

A. All calls on a certain stock
B. All calls with a particular strike price on a certain stock
C. All calls with a particular time to maturity on a certain stock
D. All calls with a particular time to maturity and strike price on a certain stock

11. Which of the following must post margin?

A. The seller of an option
B. The buyer of an option
26
C. The seller and the buyer of an option
D. Neither the seller nor the buyer of an option

12. Which of the following describes a long position in an option?

A. A position where there is more than one year to maturity
B. A position where there is more than five years to maturity
C. A position where an option has been purchased
D. A position that has been held for a long time

13. Which of the following is NOT traded by the CBOE?

A. Weeklys
B. Monthlys
C. Binary options
D. DOOM options

14. When a six-month option is purchased

A. The price must be paid in full
B. Up to 25% of the option price can be borrowed using a margin account
C. Up to 50% of the option price can be borrowed using a margin account
D. Up to 75% of the option price can be borrowed using a margin account

15. Which of the following are true for CBOE stock options?
A. There are no margin requirements
B. The initial margin and maintenance margin are determined by formulas and are equal
C. The initial margin and maintenance margin are determined by formulas and are different
D. The maintenance margin is usually about 75% of the initial margin

16. The price of a stock is $67. A trader sells 5 put option contracts on the stock with a strike
price of $70 when the option price is $4. The options are exercised when the stock price is $69.
What is the trader’s net profit or loss?
A. Loss of $1,500
B. Loss of $500
C. Gain of $1,500
D. Loss of $1,000
Answer: Option payoff = 70 - 69 = $1
Gain = 4 - 1= $3
Options sold = 5 contracts x 100 = 500
Net gain = $3 x 500 = 1500

17. A trader buys a call and sells a put with the same strike price and maturity date. What is
the position equivalent to?
A. A long forward
27
B. A short forward
C. Buying the asset
D. None of the above

18. The price of a stock is $64. A trader buys 1 put option contract on the stock with a strike
price of $60 when the option price is $10. When does the trader make a profit?
A. When the stock price is below $60
B. When the stock price is below $64
C. When the stock price is below $54
D. When the stock price is below $50

19. Consider a put option and a call option with the same strike price and time to maturity.
Which of the following is true?
A. It is possible for both options to be in the money
B. It is possible for both options to be out of the money
C. One of the options must be in the money
D. One of the options must be either in the money or at the money

20. In which of the following cases is an asset NOT considered constructively sold?
A. The owner shorts the asset
B. The owner buys an in-the-money put option on the asset
C. The owner shorts a forward contract on the asset
D. The owner shorts a futures contract on the stock

CHAPTER 11: PROPERTIES OF STOCK OPTIONS

1. When the stock price increases with all else remaining the same, which of the following
is true?
A. Both calls and puts increase in value
B. Both calls and puts decrease in value
C. Calls increase in value while puts decrease in value
D. Puts increase in value while calls decrease in value

2. When the strike price increases with all else remaining the same, which of the following
is true?
A. Both calls and puts increase in value
B. Both calls and puts decrease in value
C. Calls increase in value while puts decrease in value
D. Puts increase in value while calls decrease in value

3. When volatility increases with all else remaining the same, which of the following is
true?
A. Both calls and puts increase in value
28
B. Both calls and puts decrease in value
C. Calls increase in value while puts decrease in value
D. Puts increase in value while calls decrease in value

4. When dividends increase with all else remaining the same, which of the following is
true?
A. Both calls and puts increase in value
B. Both calls and puts decrease in value
C. Calls increase in value while puts decrease in value
D. Puts increase in value while calls decrease in value

5. When interest rates increase with all else remaining the same, which of the following is
true?
A. Both calls and puts increase in value
B. Both calls and puts decrease in value
C. Calls increase in value while puts decrease in value
D. Puts increase in value while calls decrease in value

6. When the time to maturity increases with all else remaining the same, which of the
following is true?
A. European options always increase in value
B. The value of European options either stays the same or increases
C. There is no effect on European option values
D. European options are liable to increase or decrease in value

7. The price of a stock, which pays no dividends, is $30 and the strike price of a one year
European call option on the stock is $25. The risk-free rate is 4% (continuously compounded).
Which of the following is a lower bound for the option such that there are arbitrage opportunities
if the price is below the lower bound and no arbitrage opportunities if it is above the lower
bound?
A. $5.00
B. $5.98
C. $4.98
D. $3.98
Answer: The lower bound in S0 − Ke-rT. In this case it is 30 – 25e-0.04×1 = $5.98.

8. A stock price (which pays no dividends) is $50 and the strike price of a two year
European put option is $54. The risk-free rate is 3% (continuously compounded). Which of the
following is a lower bound for the option such that there are arbitrage opportunities if the price is
below the lower bound and no arbitrage opportunities if it is above the lower bound?
A. $4.00
B. $3.86
C. $2.86
D. $0.86
29
Answer: The lower bound in Ke-rT −S0. In this case it is 54e−0.03×2 – 50= $0.86.

9. Which of the following is NOT true? (Present values are calculated from the end of the
life of the option to the beginning)
A. An American put option is always worth less than the present value of the strike price
B. A European put option is always worth less than the present value of the strike price
C. A European call option is always worth less than the stock price
D. An American call option is always worth less than the stock price

10. Which of the following best describes the intrinsic value of an option?
A. The value it would have if the owner had to exercise it immediately or not at all
B. The Black-Scholes-Merton price of the option
C. The lower bound for the option’s price
D. The amount paid for the option

11. Which of the following describes a situation where an American put option on a stock
becomes more likely to be exercised early?
A. Expected dividends increase
B. Interest rates decrease
C. The stock price volatility decreases
D. All of the above

12. Which of the following is true?

A. An American call option on a stock should never be exercised early
B. An American call option on a stock should never be exercised early when no dividends
are expected
C. There is always some chance that an American call option on a stock will be exercised early
D. There is always some chance that an American call option on a stock will be exercised early
when no dividends are expected

13. Which of the following is the put-call parity result for a non-dividend-paying stock?
A. The European put price plus the European call price must equal the stock price plus the
present value of the strike price
B. The European put price plus the present value of the strike price must equal the European call
price plus the stock price
C. The European put price plus the stock price must equal the European call price plus the strike
price
D. The European put price plus the stock price must equal the European call price plus the
present value of the strike price

14. Which of the following is true when dividends are expected?

A. Put-call parity does not hold
B. The basic put-call parity formula can be adjusted by subtracting the present value of
expected dividends from the stock price
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C. The basic put-call parity formula can be adjusted by adding the present value of expected
dividends to the stock price
D. The basic put-call parity formula can be adjusted by subtracting the dividend yield from the
interest rate

15. The price of a European call option on a non-dividend-paying stock with a strike price of
$50 is $6. The stock price is $51, the continuously compounded risk-free rate (all maturities) is
6% and the time to maturity is one year. What is the price of a one-year European put option on
the stock with a strike price of $50?
A. $9.91
B. $7.00
C. $6.00
D. $2.09
Answer: Put-call parity is c+Ke-rT=p+S0. In this case K=50, S0=51, r=0.06, T=1, and c=6. It
follows that
p=6+50e-0.06×1−51 = 2.09.

16. The price of a European call option on a stock with a strike price of $50 is $6. The stock
price is $51, the continuously compounded risk-free rate (all maturities) is 6% and the time to
maturity is one year. A dividend of $1 is expected in six months. What is the price of a one-year
European put option on the stock with a strike price of $50?
A. $8.97
B. $6.97
C. $3.06
D. $1.12
Answer: Put-call parity is c+Ke-rT=p+S0. In this case K=50, S0=51, r=0.06, T=1, and c=6. The
present value of the dividend is 1×e−0.06×0.5 = 0.97. It follows that
p=6+50e-0.06×1−(51-0.97) = 3.06.

17. A European call and a European put on a stock have the same strike price and time to
maturity. At 10:00am on a certain day, the price of the call is $3 and the price of the put is $4. At
10:01am news reaches the market that has no effect on the stock price or interest rates, but
increases volatilities. As a result the price of the call changes to $4.50. Which of the following is
correct?
A. The put price increases to $6.00
B. The put price decreases to $2.00
C. The put price increases to $5.50
D. It is possible that there is no effect on the put price
Answer: The price of the call has increased by $1.50. From put-call parity the price of the put
must increase by the same amount. Hence the put price will become 4.00 +1.50 = $5.50.

18. Interest rates are zero. A European call with a strike price of $50 and a maturity of one
year is worth $6. A European put with a strike price of $50 and a maturity of one year is worth
$7. The current stock price is $49. Which of the following is true?
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A. The call price is high relative to the put price
B. The put price is high relative to the call price
C. Both the call and put must be mispriced
D. None of the above
Answer: In this case because interest rates are zero c+K=p+S0. The left side of this equation is
50+6=56. The right side is 49+7=56. There is no mispricing.

19. Which of the following is true for American options?

A. Put-call parity provides an upper and lower bound for the difference between call
and put prices
B. Put call parity provides an upper bound but no lower bound for the difference between
call and put prices
C. Put call parity provides an lower bound but no upper bound for the difference between
call and put prices
D. There are no put-call parity results

20. Which of the following can be used to create a long position in a European put option on
a stock?
A. Buy a call option on the stock and buy the stock
B. Buy a call on the stock and short the stock
C. Sell a call option on the stock and buy the stock
D. Sell a call option on the stock and sell the stock

CHAPTER 12 TRADING STRATEGIES INVOLVING OPTIONS

1. Which of the following creates a bull spread?
A. Buy a low strike price call and sell a high strike price call
B. Buy a high strike price call and sell a low strike price call
C. Buy a low strike price call and sell a high strike price put
D. Buy a low strike price put and sell a high strike price call

2. Which of the following creates a bear spread?

A. Buy a low strike price call and sell a high strike price call
B. Buy a high strike price call and sell a low strike price call
C. Buy a low strike price call and sell a high strike price put
D. Buy a low strike price put and sell a high strike price call

3. Which of the following creates a bull spread?

A. Buy a low strike price put and sell a high strike price put
B. Buy a high strike price put and sell a low strike price put
C. Buy a high strike price call and sell a low strike price put
D. Buy a high strike price put and sell a low strike price call

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4. Which of the following creates a bear spread?
A. Buy a low strike price put and sell a high strike price put
B. Buy a high strike price put and sell a low strike price put
C. Buy a high strike price call and sell a low strike price put
D. Buy a high strike price put and sell a low strike price call

5. What is the number of different option series used in creating a butterfly spread?
A. 1
B. 2
C. 3
D. 4

6. A stock price is currently $23. A reverse (i.e short) butterfly spread is created
from options with strike prices of $20, $25, and $30. Which of the following is true?
A. The gain when the stock price is greater than $30 is less than the gain when the stock
price is less than $20
B. The gain when the stock price is greater than $30 is greater than the gain when the
stock price is less than $20
C. The gain when the stock price is greater than $30 is the same as the gain when
the stock price is less than $20
D. It is incorrect to assume that there is always a gain when the stock price is greater
than $30 or less than $20
The gain from a very high stock price or a very low stock price is the same. Suppose calls are
used. In the case of a very low stock price none are exercised and the gain is c1+c3−2c2 from the
option premium. In the case of a very high stock price all options are exercised. The net payoff
is zero and the gain is the same.

7. Which of the following is correct?

A. A calendar spread can be created by buying a call and selling a put when the strike
prices are the same and the times to maturity are different
B. A calendar spread can be created by buying a put and selling a call when the strike
prices are the same and the times to maturity are different
C. A calendar spread can be created by buying a call and selling a call when the strike
prices are different and the times to maturity are different
D. A calendar spread can be created by buying a call and selling a call when the
strike prices are the same and the times to maturity are different

8. What is a description of the trading strategy where an investor sells a 3-month call
option and buys a one-year call option, where both options have a strike price of $100 and the
underlying stock price is $75?
A. Neutral Calendar Spread

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B. Bullish Calendar Spread
C. Bearish Calendar Spread
D. None of the above

9. Which of the following is correct?

A. A diagonal spread can be created by buying a call and selling a put when the strike
prices are the same and the times to maturity are different
B. A diagonal spread can be created by buying a put and selling a call when the strike
prices are the same and the times to maturity are different
C. A diagonal spread can be created by buying a call and selling a call when the
strike prices are different and the times to maturity are different
D. A diagonal spread can be created by buying a call and selling a call when the strike
prices are the same and the times to maturity are different

10. Which of the following is true of a box spread?

A. It is a package consisting of a bull spread and a bear spread
B. It involves two call options and two put options
C. It has a known value at maturity
D. All of the above

11. How can a straddle be created?

A. Buy one call and one put with the same strike price and same expiration date
B. Buy one call and one put with different strike prices and same expiration date
C. Buy one call and two puts with the same strike price and expiration date
D. Buy two calls and one put with the same strike price and expiration date

12. How can a strip trading strategy be created?

A. Buy one call and one put with the same strike price and same expiration date
B. Buy one call and one put with different strike prices and same expiration date
C. Buy one call and two puts with the same strike price and expiration date
D. Buy two calls and one put with the same strike price and expiration date

13. How can a strap trading strategy be created?

A. Buy one call and one put with the same strike price and same expiration date
B. Buy one call and one put with different strike prices and same expiration date
C. Buy one call and two puts with the same strike price and expiration date
D. Buy two calls and one put with the same strike price and expiration date

14. How can a strangle trading strategy be created?

A. Buy one call and one put with the same strike price and same expiration date
B. Buy one call and one put with different strike prices and same expiration date
C. Buy one call and two puts with the same strike price and expiration date
D. Buy two calls and one put with the same strike price and expiration date
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15. Which of the following describes a protective put?
A. A long put option on a stock plus a long position in the stock
B. A long put option on a stock plus a short position in the stock
C. A short put option on a stock plus a short call option on the stock
D. A short put option on a stock plus a long position in the stock

16. Which of the following describes a covered call?

A. A long call option on a stock plus a long position in the stock
B. A long call option on a stock plus a short put option on the stock
C. A short call option on a stock plus a short position in the stock
D. A short call option on a stock plus a long position in the stock

17. When the interest rate is 5% per annum with continuous compounding, which of
the following creates a principal protected note worth $1000?
A. A one-year zero-coupon bond plus a one-year call option worth about $59
B. A one-year zero-coupon bond plus a one-year call option worth about $49
C. A one-year zero-coupon bond plus a one-year call option worth about $39
D. A one-year zero-coupon bond plus a one-year call option worth about $29

A one-year zero-coupon bond is worth 1000e-0.05×1 or about $951. This leaves 1000−951
= $49 for buying the option.

18. A trader creates a long butterfly spread from options with strike prices $60, $65, and
$70 by trading a total of 400 options. The options are worth $11, $14, and $18. What is the
maximum net gain (after the cost of the options is taken into account)?
A. $100
B. $200
C. $300
D. $400
The butterfly spread involves buying 100 options with strike prices $60 and $70 and selling
200 options with strike price $65. The maximum gain is when the stock price equals the
middle strike price, $65. The payoffs from the options are then, $500, 0, and 0, respectively.
The total payoff is $500. The cost of setting up the butterfly spread is
11×100+18×100−14×200 = $100. The gain is 500−100 or $400.
19. A trader creates a long butterfly spread from options with strike prices $60, $65, and
$70 by trading a total of 400 options. The options are worth $11, $14, and $18. What is the
maximum net loss (after the cost of the options is taken into account)?
A. $100
B. $200
C. $300
D. $400
35
The butterfly spread involves buying 100 options with strike prices $60 and $70 and selling 200
options with strike price $65. The maximum loss is when the stock price is less than $60 or
greater than $70. The total payoff is then zero. The cost of setting up the butterfly spread is
11×100+18×100−14×200 = $100. The loss is therefore $100.

20. Six-month call options with strike prices of $35 and $40 cost $6 and $4,
respectively. What is the maximum gain when a bull spread is created by trading a total of
200 options?
A. $100
B. $200
C. $300
D. $400
The bull spread involves buying 100 calls with strike $35 and selling 100 calls with strike price
$40. The cost is 6×100−4×100=$200. The maximum payoff (when the stock price is greater than
or equal to $40) is $500. The maximum gain is therefore 500 −200 = $300.

CHAPTER 18 FUTURES OPTIONS

1. Which of the following is acquired (in addition to a cash payoff) when the holder
of a put futures exercises?
A. A long position in a futures contract
B. A short position in a futures contract
C. A long position in the underlying asset
D. A short position in the underlying asset

2. Which of the following is acquired (in addition to a cash payoff) when the holder
of a call futures exercises?
A. A long position in a futures contract
B. A short position in a futures contract
C. A long position in the underlying asset
D. A short position in the underlying asset

3. The risk-free rate is 5% and the dividend yield on the S&P 500 index is 2%. Which of
the following is correct when a futures option on the index is being valued?
A. The futures price of the S&P 500 is treated like a stock paying a dividend
yield of 5%.
B. The futures price of the S&P 500 is treated like a stock paying a dividend yield
of 2%.
C. The futures price of the S&P 500 is treated like a stock paying a dividend yield
of 3%.
D. The futures price of the S&P 500 is treated like a non-dividend-paying stock.

36
4. Which of the following is NOT true?
A. Black’s model can be used to value an American-style option on futures
B. Black’s model can be used to value a European-style option on futures
C. Black’s model can be used to value a European-style option on spot
D. Black’s model is widely used by practitioners

5. Which of the following is true when the futures price exceeds the spot price?

A. Calls on futures should never be exercised early

B. Put on futures should never be exercised early
C. A call on futures is always worth at least as much as the corresponding call on spot
D. A call on spot is always worth at least as much as the corresponding call on futures

6. Which of the following describes a futures-style option?

A. An option on a futures
B. An option on spot with daily settlement
C. A futures on an option payoff
D. None of the above

7. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to

34 cents in the next six months. The risk-free interest rate is 6%. What is the probability of an
up movement in a risk-neutral world?

A. 0.4
B. 0.5
C. 0.72
D. 0.6

The probability of an up movement is (1-d)/(u-d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25=0.6.

8. A futures price is currently 40 cents. It is expected to move up to 44 cents or down

to 34 cents in the next six months. The risk-free interest rate is 6%. What is the value of a
six-month put option with a strike price of 37 cents?
A. 3.00 cents
B. 2.91 cents
C. 1.16 cents
D. 1.20 cents

The probability of an up movement is (1-d)/(u-d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25=0.6. The option pays off zero if there is
an up movement and 3 cents if there is a down movement. The value of the option is therefore
0.4×3×e-0.06×0.5= 1.16 cents.

37
9. A futures price is currently 40 cents. It is expected to move up to 44 cents or down
to 34 cents in the next six months. The risk-free interest rate is 6%. What is the value of a
six month call option with a strike price of 39 cents?

A. 5.00 cents
B. 2.91 cents
C. 3.00 cents
D. 4.21 cents

The probability of an up movement is (1-d)/(u-d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25=0.6. The option pays off 5 cents if there is
an up movement and zero if there is a down movement. The value of the option is therefore
0.6×5×e-0.06×0.5= 2.91 cents.

10. Which of the following are true?

A. Futures options are usually European
B. Futures options are usually American
C. Both American and European futures options trade actively are exchanges
D. Both American and European futures options trade actively in the OTC market

11. Which of the following is true for a September futures option?

A. The expiration month of option is September
B. The option was first traded in September
C. The delivery month of the underlying futures contract is September
D. September is the first month when the option can be exercised

12. What is the cash settlement if a put futures option on 50 units of the
underlying asset is exercised?
A. (Current Futures Price – Strike Price) times 50
B. (Strike Price – Current Futures Price) times 50
C. (Most Recent Futures Settlement Price – Strike Price) times 50
D. (Strike Price – Most Recent Futures Settlement Price) times 50

13. What is the cash component of the payoff if a call futures option on 50 units of
the underlying asset is exercised?
A. (Current Futures Price – Strike Price) times 50
B. (Strike Price – Current Futures Price) times 50
C. (Most Recent Futures Settlement Price – Strike Price) times 50
D. (Strike Price – Most Recent Futures Settlement Price) times 50

14. Which of the following is true?

A. A futures option is settled daily
B. A futures-style option is settled daily

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C. Both a futures option and a futures-style option are settled daily D. Neither a futures
option nor a futures-style option is settled daily

15. Which of the following is true about a futures option and a spot option on the same
underlying asset when they have the same strike price? The expiration dates of the two options
and the futures are all the same.
A. A European call spot option and an American call futures option are equivalent
B. An American call spot option and a European call futures option are equivalent
C. A European put spot option and European put futures option are equivalent
D. An American put spot option and American put futures option are equivalent

16. What is the value of a European call futures option where the futures price is 50, the
strike price is 50, the risk-free rate is 5%, the volatility is 20% and the time to maturity is three
months?
A. 49.38N(0.05)-49.38N(-0.05)
B. 50N(0.05)-50N(-0.05)
C. 49.38N(0.1)-49.38N(-0.1)
D. 50N(0.1)-49.38N(-0.1)

17. What is the expected growth rate of an index futures price in the risk-neutral world?
A. The excess of the risk-free rate over the dividend yield
B. The risk-free rate
C. The dividend yield on the index
D. Zero

18. When Black’s model used to value a European option on the spot price of an
asset, which of the following is NOT true?
A. It is necessary to know the futures or forward price for a contract maturing at the same
time as the option
B. It is not necessary to estimate income on the underlying asset
C. It is not necessary to know the risk-free rate
D. The underlying asset can be an investment or a consumption asset

39
19. Consider a European one-year call futures option and a European one-year put
futures options when the futures price equals the strike price. Which of the following is true?
A. The call futures option is worth more than the put futures option B. The put futures option is
worth more than the call futures option C. The call futures option is sometimes worth more
and sometimes worth less than the put futures option
D. The call futures option is worth the same as the put futures option

Put call parity is

c+ Ke-rT =p+ F0e-rT
When F0=K it follows that c = p.

20. One-year European call and put options on an asset are worth $3 and $4 respectively
when the strike price is $20 and the one-year risk-free rate is 5%. What is the one-year
futures price of the asset if there are no arbitrage opportunities? (Use put-call parity.)
A. $19.55
B. $18.95
C. $20.95
D. $20.45

Put call parity is

c+ Ke-rT =p+ F0e-rT
Hence
F0=K+(c-p)erT =20+(3-4)e0.05×1= $18.95

40