CFA 57: Derivative Markets and Instruments

An interest rate swap is a derivative contract in which: two parties agree to exchange a series of cash flows. the credit seller provides protection to the credit buyer. the buyer has the right to purchase the underlying from the seller.

A is correct. An interest rate swap is defined as a derivative in which two parties agree to exchange a series of cash flows: One set of cash flows is variable, and the other set can be variable or fixed. B is incorrect because a credit derivative is a derivative contract in which the credit protection seller provides protection to the credit protection buyer. C is incorrect because a call option gives the buyer the right to purchase the underlying from the seller.

Arbitrage opportunities exist when: two identical assets or derivatives sell for different prices. combinations of the underlying asset and a derivative earn the risk-free rate. arbitrageurs simultaneously buy takeover targets and sell takeover acquirers.

A is correct. Arbitrage opportunities exist when the same asset or two equivalent combinations of assets that produce the same results sell for different prices. When this situation occurs, market participants would buy the asset in the cheaper market and simultaneously sell it in the more expensive market, thus earning a riskless arbitrage profit without committing any capital. B is incorrect because it is not the definition of an arbitrage opportunity. C is incorrect because it is not the definition of an arbitrage opportunity.

Compared with the underlying spot market, derivative markets are more likely to have: greater liquidity. higher transaction costs. higher capital requirements.

A is correct. Derivative markets typically have greater liquidity than the underlying spot market as a result of the lower capital required to trade derivatives compared with the underlying. Derivatives also have lower transaction costs and lower capital requirements than the underlying. B is incorrect because transaction costs for derivatives are lower than the underlying spot market. C is incorrect because derivatives markets have lower capital requirements than the underlying spot market.

Which of the following derivatives provide payoffs that are non-linearly related to the payoffs of the underlying? Options Forwards Interest-rate swaps

A is correct. Options are classified as a contingent claim which provides payoffs that are non-linearly related to the performance of the underlying. B is incorrect because forwards are classified as a forward commitment, which provides payoffs that are linearly related to the performance of the underlying. C is incorrect because interest-rate swaps are classified as a forward commitment, which provides payoffs that are linearly related to the performance of the underlying.

Which of the following is most likely to be a destabilizing consequence of speculation using derivatives? Increased defaults by speculators and creditors Market price swings resulting from arbitrage activities The creation of trading strategies that result in asymmetric performance

A is correct. The benefits of derivatives, such as low transaction costs, low capital requirements, use of leverage, and the ease in which participants can go short, also can result in excessive speculative trading. These activities can lead to defaults on the part of speculators and creditors. B is incorrect because arbitrage activities tend to bring about a convergence of prices to intrinsic value. C is incorrect because asymmetric performance is not itself destabilizing.

A credit derivative is a derivative contract in which the: clearinghouse provides a credit guarantee to both the buyer and the seller. seller provides protection to the buyer against the credit risk of a third party. the buyer and seller provide a performance bond at initiation of the contract.

B is correct. A credit derivative is a derivative contract in which the credit protection seller provides protection to the credit protection buyer against the credit risk of a third party. A is incorrect because the clearinghouse provides a credit guarantee to both the buyer and the seller of a futures contract, whereas a credit derivative is between two parties, in which the credit protection seller provides a credit guarantee to the credit protection buyer. C is incorrect because futures contracts require that both the buyer and the seller of the futures contract provide a cash deposit for a portion of the futures transaction into a margin account, often referred to as a performance bond or good faith deposit.

In contrast to contingent claims, forward commitments provide the: right to buy or sell the underlying asset in the future. obligation to buy or sell the underlying asset in the future. promise to provide credit protection in the event of default.

B is correct. Forward commitments represent an obligation to buy or sell the underlying asset at an agreed upon price at a future date. A is incorrect because the right to buy or sell the underlying asset is a characteristic of contingent claims, not forward commitments. C is incorrect because a credit default swap provides a promise to provide credit protection to the credit protection buyer in the event of a credit event such as a default or credit downgrade and is classified as a contingent claim.

Which of the following characteristics is least likely to be a benefit associated with using derivatives? More effective management of risk Payoffs similar to those associated with the underlying Greater opportunities to go short compared with the spot market

B is correct. One of the benefits of derivative markets is that derivatives create trading strategies not otherwise possible in the underlying spot market, thus providing opportunities for more effective risk management than simply replicating the payoff of the underlying. A is incorrect because effective risk management is one of the primary purposes associated with derivative markets. C is incorrect because one of the operational advantages associated with derivatives is that it is easier to go short compared to the underlying spot market.

Compared with exchange-traded derivatives, over-the-counter derivatives would most likely be described as: standardized. less transparent. more transparent.

B is correct. Over-the counter-derivatives markets are customized and mostly unregulated. As a result, over-the-counter markets are less transparent in comparison with the high degree of transparency and standardization associated with exchange-traded derivative markets. A is incorrect because exchange-traded derivatives are standardized, whereas over-the counter derivatives are customized. C is incorrect because exchange-traded derivatives are characterized by a high degree of transparency because all transactions are disclosed to exchanges and regulatory agencies, whereas over-the-counter derivatives are relatively opaque.

Which of the following derivatives is least likely to have a value of zero at initiation of the contract? Futures Options Forwards

B is correct. The buyer of the option pays the option premium to the seller of the option at the initiation of the contract. The option premium represents the value of the option, whereas futures and forwards have a value of zero at the initiation of the contract. A is incorrect because no money changes hands between parties at the initiation of the futures contract, thus the value of the futures contract is zero at initiation. C is incorrect because no money changes hands between parties at the initiation of the forward contract, thus the value of the forward contract is zero at initiation.

Which of the following derivatives is classified as a contingent claim? Futures contracts Interest rate swaps Credit default swaps

C is correct. A credit default swap (CDS) is a derivative in which the credit protection seller provides protection to the credit protection buyer against the credit risk of a separate party. CDS are classified as a contingent claim. A is incorrect because futures contracts are classified as forward commitments. B is incorrect because interest rate swaps are classified as forward commitments.

A derivative is best described as a financial instrument that derives its performance by: passing through the returns of the underlying. replicating the performance of the underlying. transforming the performance of the underlying.

C is correct. A derivative is a financial instrument that transforms the performance of the underlying. The transformation of performance function of derivatives is what distinguishes it from mutual funds and exchange traded funds that pass through the returns of the underlying. A is incorrect because derivatives, in contrast to mutual funds and exchange traded funds, do not simply pass through the returns of the underlying at payout. B is incorrect because a derivative transforms rather than replicates the performance of the underlying.

Exchange-traded derivatives are: largely unregulated. traded through an informal network. guaranteed by a clearinghouse against default.

C is correct. Exchanged-traded derivatives are guaranteed by a clearinghouse against default. A is incorrect because traded derivatives are characterized by a relatively high degree of regulation. B is incorrect because the terms of exchange-traded derivatives terms are specified by the exchange.

Forward commitments subject to default are: forwards and futures. futures and interest rate swaps. interest rate swaps and forwards.

C is correct. Interest rate swaps and forwards are over-the-counter contracts that are privately negotiated and are both subject to default. Futures contracts are traded on an exchange, which provides a credit guarantee and protection against default. A is incorrect because futures are exchange-traded contracts which provide daily settlement of gains and losses and a credit guarantee by the exchange through its clearinghouse. B is incorrect because futures are exchange-traded contracts which provide daily settlement of gains and losses and a credit guarantee by the exchange through its clearinghouse.

The law of one price is best described as: the true fundamental value of an asset. earning a risk-free profit without committing any capital. two assets that will produce the same cash flows in the future must sell for equivalent prices.

C is correct. The law of one price occurs when market participants engage in arbitrage activities so that identical assets sell for the same price in different markets. A is incorrect because the law of one price refers to identical assets. B is incorrect because it refer to arbitrage not the law of one price.