DERIVATIVES

45.1
1. Which of the following statements most accurately describes a derivative
security? A derivative:
A. always increases risk.
B. has no/expiration date.
C. has a payoff based on an asset value or interest rate.

2. Which of the following statements about exchange-traded derivatives is least

accurate? Exchange-traded derivatives:
A. are liquid.
B. are standardized contracts.
C. carry significant default risk.

3. Which of the following derivatives is a forward commitment?

A. Stock option.
B. Interest rate swap.
C. Credit default swap.

4. A custom agreement to purchase a specific T'bond next Thursday for $1,000 is:
A. an option.
B. a futures contract.
C. a forward commitment.

45.2
1. Interest rate swaps are:
A. highly regulated.
B. equivalent to a series of forward contracts.
C. contracts to exchange one asset for another.

2. A call option is
A. the right to sell at a specific price.
B. the right to buy at a specific price.
C. an obligation to buy at a certain price.

3. At expiration, the exercise value of a put option is;

A. positive if the underlying asset price is less than the exercise price.
B. zero only if the underlying asset price is equal to the exercise price.
C. negative if the underlying asset price is greater than the exercise price.

4. At expiration, the exercise value of a call option is:

A. the underlying asset price minus the exercise price.
B. the greater of zero or the exercise price minus the underlying asset price.
C. the greater of zero or the underlying asset price minus the exercise price.

5. An investor writes a put option with an exercise price of $40 when the stock price
is $12. The option premium is $1. At expiration the stock price is $37. The investor
will realize:
A. a loss of $2
B. a loss of $3.
C. a profit of $1.

6. Derivatives are least likely to:

A. improve liquidity.
B. provide price information.
C. prevent arbitrage.

7. Arbitrage prevents:
A. market efficiency.
B. earning returns higher than the risk free rate of return.
C. two assets with identical payoffs from selling at different prices.

46.1
1. Derivatives pricing models use the risk-free rate to discount future cash flows
because these models:
A. are based on portfolios with certain payoffs.
B. assume that derivatives investors are risk-neutral.
C. assume that risk can be eliminated by diversification.

2. The price of a forward or futures contract:

A. is typically zero at initiation.
B. is equal to the spot price at settlement.
C. remains the same over the term of the contract.
3. For a forward contract on an asset that has no costs or benefits from holding it to
have zero value at initiation, the arbitrage-free forward price must equal:
A. the expected future spot price.
B. the future value of the current spot price.
C. the present value of the expected future spot price.

4. The underlying asset of a derivative is most likely to have a convenience yield

when the asset:
A. is difficult to sell short.
B. pays interest or dividends.
C. must be stored and insured.

46.2
1. How can a bank create a synthetic 60-day forward rate agreement on a 180-day
interest rate?
A. Borrow for 180 days and lend the proceeds for 60 days.
B. Borrow for 180 days and lend the proceeds for 120 days.
C) Borrow for 240 days and lend the proceeds for 60 days.

2. For the price of a futures contract to be greater than the price of an otherwise
equivalent forward contract, interest rates must be:
A. uncorrelated with futures prices.
B. positively correlated with futures prices.
C. negatively correlated with futures prices.

3. The price of a fixed-for floating interest rate swap:

A. is specified in the swap contract.
B. is paid at initiation by the floating rate receiver.
C. may increase or decrease during the life of the swap contract.

46.3, 46.4
1. The price of an out-of the money option is:
A. less than its time value.
B. equal to its time value.
C. greater than its time value.

2. A decrease in the risk-free rate of interest will:

A. increase put and call option prices.
B. decrease put option prices and increase call option prices.
C. increase put option prices and decrease call option prices.

3. The put call parity relationship for European options must hold because a
protective put will have the same payoff as:
A. a covered call.
B. a fiduciary call.
C. an uncovered call.

4. The put call forward parity relationship least likely includes:

A. a risk-free bond.
B. call and put options.
C. the underlying asset.

5. In a one-period binomial model, the value of an option is best described as the

present value of
A. a probability-weighted average of two possible outcomes.
B. a probability-weighted average of a chosen number of possible outcomes.
C. one of two possible outcomes based on a chosen size of increase or decrease.

6. An American call option is most likely to be exercised early when:

A. the option is deep in the money.
B. the underlying asset pays dividends.
C. the risk-free interest rate has increased.

Quiz
1. Which of the following characteristics is associated with over-the-counter
derivatives?
A. Trading occurs in a central location.
B. They are more regulated than exchange-listed derivatives.
C. They are less transparent than exchange-listed derivatives.

2. Which of the following distinguishes forwards from swaps?

A. Forwards are OTC instruments, whereas swaps are exchange traded.
B. Forwards are regulated as futures, whereas swaps are regulated as securities.
C. Swaps have multiple payments, whereas forwards have only a single payment.
3. With respect to a forward contract, as market conditions change:
A. Only the price fluctuates.
B. Only the value fluctuates.
C. Both the price and the value fluctuate.

4. If a call option is priced higher than the binomial model predicts, investors can
earn a return in excess of the risk-free rate by:
A. investing at the risk-free rate, selling a call, and selling the underlying
B. borrowing at the risk-free rate, buying a call, and buying the underlying
C. borrowing at the risk-free rate, selling a call, and buying the underlying

5. Which of the following is not a forward commitment?

A. An agreement to take out a loan at a future date at a specific rate
B. An offer of employment that must be accepted or rejected in two weeks
C. An agreement to lease a piece of machinery for one year with a series of fixed monthly
payments

6. Which of the following characteristics is least likely to be a benefit associated with

using derivatives?
A. More effective management of risk
B. Payoffs similar to those associated with the underlying
C. Greater opportunities to go short compared with the spot market

7. Which of the following is a limit to arbitrage?

A. Clearinghouses restrict the transactions that can be arbitraged.
B. Pricing models do not show whether to buy or sell the derivative.
C. It may not always be possible to raise sufficient capital to engage in arbitrage.

8. A swap is equivalent to a series of:

A. forward contracts, each created at the swap price.
B. long forward contracts, matched with short futures contracts.
C. forward contracts, each created at their appropriate forward prices.

9. Which of the following combinations replicates a long derivative position?

A. Short derivative and a long asset
B. Long asset and a short risk-free bond
C. Short derivative and a short risk-free bond

10. From put–call parity, which of the following transactions is risk-free?

A. Long asset, long put, short call
B. Long call, long put, short asset
C. Long asset, long call, short bond

11. Consider a call option selling for $4 in which the exercise price is $50. Determine
the profit for a seller if the price of the underling at expiration is $49.
A. $4
B. $0
C. –$1

12. Suppose you believe that the price of a particular underlying, currently selling at
$99, is going to decrease substantially in the next six months. You decide to purchase
a put option expiring in six months on this underlying. The put option has an
exercise price of $95 and sells for $5. Determine the profit for you if the price of the
underlying six months from now is $85.
A. $10
B. $5
C. $0

13. Stocks BWQ and ZER are each currently priced at $100 per share. Over the
next year, stock BWQ is expected to generate significant benefits whereas stock ZER
is not expected to generate any benefits. There are no carrying costs associated with
holding either stock over the next year. Compared with ZER, the one-year forward
price of BWQ is most likely:
A. Lower
B. The same
C. Higher

14. The value of a swap is equal to the present value of the:

A. fixed payments from the swap
B. net cash flow payments from the swap
C. underlying at the end of the contract

15. The table below shows three European call options on the same underlying:
The option with the highest value is most likely:
A. Option 1
B. Option 2
C. Option 3

16. The recent price per share of Win Big, Inc. is €50 per share. Verna Hillsborough
buys 100 shares at €50. To protect against a fall in price, Hillsborough buys one put,
covering 100 shares of Win Big, with a strike price of €40. The put premium is €1
per share. If Win Big closes at €45 per share at the expiration of the put and
Hillsborough sells her shares at €45, Hillsborough’s profit from the stay/put is
closest to:
A. – €1,100
B. – €600
C. €900

17. The recent price per share of Dragon Vacations, Inc. is $50 per share. Calls with
exactly six months left to expiration are available on Dragon with strikes of $45, $50,
and $55. The prices of the calls are $8.75, $6.00, and $4.00, respectively. Assume that
each call contract is for 100 shares of stock and that at initiation of the strategy the
investor purchases 100 shares of Dragon at the current market price. Further
assume that the investor will close out the strategy in six months when the options
expire, including the sale of any stock not delivered against exercise of a call,
whether the stock price goes up or goes down. If the closing price of Dragon stock in
six months is exactly $60, the profit to a covered call using the $50 strike call is
closest to:
A. $400
B. $600
C. $1,600
18. Consider a currency selling for $0.875. A put option selling for $0.075 has an
exercise price of $0.90. Answer the following questions about a protective put.
A. Determine the value at expiration and the profit under the following outcomes:
i. The price of the currency at expiration is $0.96.
ii. The price of the currency at expiration is $0.75.
B. Determine the following:
i. The maximum profit.
ii. The maximum loss.
C. Determine the breakeven price of the currency at expiration.

19. A Fund’s client currently owns 5,000 common non-dividend-paying shares of

Vivivyu Inc. (VIVU), a digital media company, at a spot price of USD173 per share.
The client enters a forward commitment to sell half of its VIVU position in six
months at a price of USD175.58. Which of the following market events is most likely
to result in the greatest gain in the VIVU forward contract MTM value from the
client’s perspective?
A. An increase in the risk-free rate
B. An immediate decline in the VIVU spot price following contract inception
C. A steady rise in the spot price of VIVU stock over time

20. A Fund’s client has entered into a long six-month MXN/USD FX forward
contract—that is, an agreement to sell MXN and buy USD. The MXN/USD spot
exchange rate at inception is 19.8248 (MXN19.8248 = USD1), the six-month MXN
risk-free rate is 4.25%, and the six-month USD risk-free rate is 0.5%. Fund’s
market strategist predicts that the Mexican central bank (Banco de Mexico) will
surprise the market with a 50 bp short-term rate cut at its upcoming meeting.
Which of the following statements best describes how the client’s existing FX
forward contract will be impacted if this prediction is realized and other parameters
remain unchanged?
A. The lower interest rate differential between MXN and USD will cause the MXN/USD
contract forward rate to be adjusted downward.
B. The client will realize an MTM gain on the FX forward contract due to the decline in
the MXN versus USD interest rate differential.
C. The lower interest rate differential between MXN and USD will cause the client to
realize an MTM loss on the MXN/USD forward contract.
21. One of ABC’s investor clients has entered a long six-month forward transaction
with ABC on 100 shares of Xenaliya (XLYA), a non-dividend-paying technology
stock. The stock’s spot price per share, S0, is €85, and the risk-free rate is a constant
1% for all maturities. ABC has hedged the client transaction with a long six-month
XLYA futures contract at a price f0(T) of €85.42 and posted initial margin of €1,000.
Three months after the forward and futures contracts are initiated, XYLA
announces a strategic partnership with a major global technology firm, and its spot
share price jumps €15 on the day’s trading to close at €123. Which of the following
statements best characterizes the impact of the day’s trading on the MTM value of
the forward versus the futures contract?
A. ABC’s client realizes an MTM gain of approximately €1,500 (= €15 × 100) on its
margin account, which ABC must deposit at the end of the day to cover its margin call.
B. ABC’s client benefits from an MTM unrealized gain on its forward contract with
ABC, and ABC has a corresponding MTM gain of approximately €1,500 (= €15 × 100)
deposited in its margin account by the exchange.
C. Because ABC has entered a hedge of its client’s long forward position on XLYA by
executing a futures contract with otherwise identical terms, the two contract MTM values
exactly offset one another, and no cash is exchanged on either transaction.

22. The Viswan Family Office (VFO) owns non-dividend-paying shares of Biomian
Limited that are currently priced (S0) at INR 295 per share. VFO’s CIO is
considering an offer to sell shares at a forward price (F0(T)) of INR 300.84 per
share in six months based on a risk-free rate of 4%. VFO is considering a sold call
strategy to generate income from the sale of a call. In your scenario analysis of the
sold call option alternative, VFO has asked you to value the call option in three
months’ time if Biomian’s spot price is INR 325 per share. Given an estimated call
price of INR 46.41 at that time, which of the following correctly reflects the
relationship between the call’s exercise value and its time value?
A. The call’s exercise value is INR 24.16, and its time value is INR 22.25.
B. The call’s exercise value is INR 27.10, and its time value is INR 19.31.
C. The call’s exercise value is INR 20.99, and its time value is INR 25.42.

23. Which of the following best describes the value of the forward contract at
expiration? The value is the spot price of the underlying:
A) minus the forward price
B) divided by the forward price
C) minus the compounded forward price
24. A forward contract:
a. has zero value at the start.
b. is recorded as an asset by the buyer and as a liability by the seller. can be settled only
c. the delivery of the underlying asset.

25. The price of a forward contract:

A. is the amount paid at initiation.
B. is the amount paid at expiration.
C. fluctuates over the term of the contract.

26. Assume an asset pays no dividends or interest, and also assume that the asset
does not yield any non-financial benefits or incur any carrying cost. At initiation,
the price of a forward contract on that asset iS:
a. lower than the value of the contract.
b. equal to the value of the contract.
c. greater than the value of the contract.

27. The value of a forward contract at expiration is:

A. positive to the long party if the spot price is higher than the forward price.
B. negative to the short party if the forward price is higher than the spot price.
C. positive to the short party if the spot price is higher than the forward price.

28. At the initiation of a forward contract on an asset that neither receives benefits
nor incurs carrying costs during the term of the contract, the forward price is equal
to the:
A. spot price.
B. future value of the spot price.
C. present value of the spot price.

29. If the net cost of carry of an asset is positive, then the price of a forward contract
on that asset is most likely:
A. lower than if the net cost of carry was zero.
B. the same as if the net cost of carry was zero.
C. higher than if the net cost of carry was zero.
30. If the present value of storage costs exceeds the present value of its convenience
yield, then the commodity's forward price is most likely:
A. less than the spot price compounded at the risk-free rate.
B. the same as the spot price compounded at the risk-free rate.
C. higher than the spot price compounded at the risk-free rate.

31. Which of the following factors most likely explains why the spot price of a
commodity in short supply can be greater than its forward price?
A. Opportunity cost
B. Lack of dividends
C. Convenience yield

32. When interest rates are constant, futures prices are most likely:
A. less than forward prices.
B. equal to forward prices.
C. greater than forward prices.

33 In contrast to a forward contract, a futures contract:

A. trades over-the-counter.
B. is initiated at a zero value.
C. is marked-to-market daily.

34. To the holder of a long position, it is more desirable to own a forward contract
than a futures contract when interest rates and futures prices are:
A. negatively correlated.
B. uncorrelated.
C. positively correlated.

35. The value of a swap typically:

A. is non-zero at initiation.
B. is obtained through replication.
C. does not fluctuate over the life of the contract.

36. The price of a swap typically:

A. is zero at initiation.
B. fluctuates over the life of the contract.
C. is obtained through a process of replication.
37. The value of a swap is equal to the present value of the:
A. fixed payments from the swap.
B. net cash flow payments from the swap.
C. underlying at the end of the contract.

38. A European call option and a European put option are written on the same
underlying, and both options have the same expiration date and exercise price. At
expiration, it is possible that both options will have:
A. negative values.
B. the same value.
C. positive values.

39. At expiration, a European put option will be valuable if the exercise price is:
A. less than the underlying price.
B. equal to the underlying price.
C. greater than the underlying price.

40. The value of a European call option at expiration is the greater of zero or the:
A. value of the underlying.
B. value of the underlying minus the exercise price.
C. exercise price minus the value of the underlying.

41. For a European call option with two months until expiration, if the spot price is
below the exercise price, the call option will most likely have
A. zero time value.
B. positive time value.
C. positive exercise value.

42. Prior to expiration, the lowest value of a European put option is the greater of
zero or the:
A. exercise price minus the value of the underlying.
B. present value of the exercise price minus the value of the underlying.
C. value of the underlying minus the present value of the exercise price.

43. Which of the following transactions is the equivalent of a synthetic long call
position?
A. Long asset, long put, short call
B. Long asset, long put, short bond
C. Short asset, long call, long bond