4. Derivatives Questions

A disadvantage of futures contracts is that they: A. cannot be customized. B. have high counterparty risk. C. cannot be used by speculators.

A. cannot be customized. C - Futures are used by hedgers and speculators.

Q. A primary difference between a futures contract on an asset and an option contract on the same asset is that the futures contract: A. represents the right to trade the asset. B. is marked to market at the end of each trading day. C. cannot be easily cancelled or closed out at any time before expiration.

B. A futures contract is a standardized instrument that is marked to market at the end of each trading day—that is, profits and losses are settled at the end of the day. The same is not true for an option contract. A - A futures contract on an asset represents the obligation to trade the asset (buy or sell). C - A futures contract can be cancelled or offset prior to expiration by entering into an opposite position on the same contract. For example, if you are long you can offset or cancel the long with a short position in the same contract.

Q. An investor in an option on a stock who must purchase the stock when the option is exercised is: A. buying a put option. B. selling a put option. C. selling a call option.

B. selling a put option. When the buyer of the put option exercises the option, the seller of the put option must purchase the stock from the buyer at the exercise price.

Q. One feature of a swap contract is that: A. it trades on an organised exchange. B. the value of the swap changes over time. C. it has an initial net positive value to one party.

B. the value of the swap changes over time. The value of a swap contract changes with the passage of time. Swaps trade in the OTC market and have an initial net value of zero.

Q. In contrast to an interest rate swap, a credit default swap (CDS) is a: A. bilateral contract. B. unilateral contract. C. multilateral contract.

B. unilateral contract. A CDS is a unilateral contract because only one party to the contract has a future commitment. Interest rate swaps are bilateral contracts because both parties have a commitment to fulfil the contract provisions.

A key distinction between forward contracts and futures contracts is that forward contracts: A. are only settled with cash. B. have lower transactions costs. C. have no cash flows except at maturity.

C. Forward contracts have no cash flows except at maturity, whereas futures contracts are marked to market daily. Transactions costs for futures contracts are lower than forward contracts because futures are standardized.

Which of the following parties to an option contract on a company's shares is obligated to buy shares at the option strike price if the option is exercised? A. Put seller B. Put buyer C. Call buyer

A. Put seller

Q. Which of the following options would be described as being in the money? A. A put option in which the underlying's price is lower than the exercise price. B. A call option in which the underlying's price is lower than the exercise price. C. A put option in which the underlying's price is higher than the exercise price.

A is correct. A put option is in the money when the underlying's price is lower than the exercise price.

Which of the following options would be described as being in the money? A. A put option in which the underlying's price is lower than the exercise price. B. A call option in which the underlying's price is lower than the exercise price. C. A put option in which the underlying's price is higher than the exercise price.

A. The put buyer has the right to sell the underlying at the exercise price, which is higher than the current market price of the underlying.

Q. An investor can use derivatives contracts to manage the volatility of the future price of raw material, but relative to investing directly in the underlying raw material, the investor commits: A. less capital and incurs lower transaction costs. B. more capital and incurs lower transaction costs. C. more capital and incurs higher transaction costs.

A. Relative to directly investing in raw materials, an investor using derivatives to manage future risks related to raw material prices commits less capital and incurs lower costs.

For futures contracts, marking to market most likely reduces counterparty risk through the process of: A. cash settlement of profits and losses at the end of each day. B. increasing initial margins for underlying assets with higher price volatility. C. increasing maintenance margins for underlying assets with higher price volatility.

A. Counterparty risk is reduced through marking to market, which refers to the process whereby profits and losses on futures contracts are settled at the end of each day.

Q. Compared with investing directly in an asset, derivatives allow an investor a way to gain exposure to the asset by committing: A. less capital and incurring lower transaction costs. B. more capital and incurring higher transaction costs. C. less capital and incurring higher transactions costs.

A. Relative to investing directly in an asset, derivatives allow an investor to gain exposure to an asset by committing less capital and incurring lower transaction costs.

Q. A derivative contract where two parties exchange cash flow or other financial instruments periodically over a specified period of time for the mutual benefit of both parties is a(n): A. swap contract. B. futures contract. C. options contract.

A. A swap contract is a derivatives contract in which two parties exchange (or swap) cash flows or financial instruments periodically over multiple periods for the mutual benefit of both parties.

In contrast to forward contracts, futures contracts: A. trade on organized exchanges. B. have negotiable expiration dates. C. have contract sizes tailored to investor needs.

A. Futures contracts trade on organized exchanges, whereas forward contracts trade in the OTC market.

Q. Which of the following parties to an option contract on a company's shares is obligated to buy shares at the option strike price if the option is exercised? A. Put seller B. Put buyer C. Call seller

A. Put seller

Q. With regard to the underlying asset, derivative contracts are used: A. as a hedge against risk. B. to guarantee a specific rate of return. C. to stabilise the price of the underlying asset.

A. as a hedge against risk. Derivative contracts can be used to hedge risk, that is to reduce risk exposure to the underlying. B - the use of derivative contracts does not guarantee a specific rate of return. However, the counterparty in the derivative contract that is the true speculator takes on additional risk in the hope of earning returns because of expected increase in the price of the underlying asset. The second counterparty is the hedger who uses the derivative contract to reduce risk exposure to the underlying. C - Derivatives are not used to stabilize prices of the underlying asset.

Q. A disadvantage of futures contracts is that they: A. cannot be customized. B. have high counterparty risk. C. cannot be used by speculators.

A. cannot be customized. Futures contracts are standardised contracts that trade on exchanges and cannot be customised to meet the requirements of individual users. C - Futures are used by hedgers and speculators.

The expiration date of a derivatives contract is the date when the: A. contract expires. B. option premium is paid. C. contract must be settled.

A. contract expires The expiration date for a derivate contract refers to the date when the contract expires. B - The option premium is paid at the time of purchase. C - A derivate may be settled at or before expiration date.

Q. If the price of the underlying stock increases, then holding other factors constant, the value of the call option and the value of the put option on the stock, respectively, will most likely: A. increase and decrease. B. decrease and increase. C. increase and increase.

A. increase and decrease. When the price of the underlying stock increases, holding other factors constant, the value of the call option on the stock will increase, whereas the value of the put option on the stock will decrease.

Q. The value of a call option, relative to other comparable call options, will be higher if the time to maturity and price volatility of the underlying asset, respectively, are: A. longer; higher B. shorter; lower C. shorter; higher

A. longer; higher The longer the time to maturity for an option, the greater the probability that the price of the underlying asset will move in a manner that is favourable to the value of the option. Similarly, if the price of the underlying asset is more volatile, the price of the related call option will increase.

The value of a derivatives contract is most likely to be directly affected by the: A. price of the underlying. B. supply of the underlying. C. demand for the underlying.

A. price of the underlying. Derivatives are contracts that derive their value from the performance, such as price, of an underlying. B & C - The supply of and demand for the underlying will affect the price of the underlying so they indirectly, not directly, affect the value of the derivative.

Q. For an exporter exposed to currency risk, the use of currency derivatives will most likely: A. reduce currency risk. B. increase currency risk. C. leave currency risk unchanged.

A. reduce currency risk. An exporter can use a currency derivative to reduce or eliminate currency risk. It is the counterparty who is exposed to currency risk.

Q. The buyer of a put option on a stock has the: A. right to sell the stock at the exercise price. B. obligation to sell the stock at the exercise price. C. obligation to purchase the stock at the exercise price.

A. right to sell the stock at the exercise price. The buyer of a put option on a stock has the right to sell or deliver the stock at the exercise price.

Q. A farmer will harvest his corn crop in six months but wants to lock in a price today. The farmer will most likely: A. buy a corn futures contract. B. sell a corn futures contract. C. buy a corn forward contract.

B. sell a corn futures contract. The seller of a forward or futures contract is obligated to make delivery of the underlying. By selling a corn futures contract, the farmer is agreeing to sell corn in six months at the contract price locked in today.

Forwards and futures are similar in that for both types of contracts: A. terms are customized. B. buyers and sellers are obliged to fulfil the contract. C. positions can be closed by entering an opposite position.

B. For forward and futures contracts, both buyers and sellers are obliged to fulfil the terms of the contract. A - Forwards can be customized, whereas futures have standardized terms. C - Futures can be closed only by entering an opposite position.

The value of a derivatives contract is most likely determined by: A. the exchange the contract trades on. B. the performance of an underlying asset. C. the negotiation between the parties involved in the derivatives trade.

B. The value of a derivatives contract is based on the performance of an underlying asset. A - the exchange on which the contract trades may decide on the features of the contract, but it does not set the value of the derivatives contract. C - the parties involves in the derivatives trade do not determine the value of the derivatives contract.

Q. A benefit of futures contracts is that they offer investors the advantage of: A. customising contract terms. B. access to high-risk investors. C. no initial margin requirement.

B. Access to high-risk investors. High-risk buyers and sellers cannot use forward contracts, but they can access futures markets by posting collateral. A - Futures contracts do not allow investors to customize the terms of the contract. C - For futures contracts, initial margin is required, it is the collateral posted.

Q. Compared with a forward contract, in the case of a futures contract: A. counterparty risk is higher. B. it is easier to exit a position before maturity. C. only the buyer has an obligation to fulfil the contract.

B. It is easier to exit a futures contract prior to maturity or the settlement date. In the case of a futures contract, a position can be effectively closed by taking an opposite position, for example, a short futures position if you already have a long position. A - Counterparty risk is higher for forward contract and limited for futures contracts. C - In forward and futures contracts, both the buyer and the seller are obliged to fulfill their side of the contract. "bilateral"

In contract to forward contracts, option contracts are: A. bilateral contracts. B. unilateral contracts. C. multilateral contracts.

B. Unilateral Contracts. Options contracts are unilateral contracts because only one part to the contract has a future commitment.

A benefit of futures contracts is that they offer investors the advantage of: A. customizing contract terms. B. access to high-risk investors. C. no initial margin requirement.

B. access to high-risk investors. High-risk buyers and sellers cannot use forward contracts, but they can access futures markets by posting collateral. C - Initial margin is requires for futures contracts. It is the collateral posted.

Q. The seller of a credit default swap (CDS): A. receives protection from the buyer in the event of a default. B. agrees to protect the buyer from losses in the event of a default. C. exchanges principal with the counterparty when the swap is initiated.

B. agrees to protect the buyer from losses in the event of a default. The seller of a CDS receives a periodic premium from the buyer and in exchange agrees to cover losses to the buyer in the event of a default on the reference debt instrument.

Q. The buyer of a call option on a stock has the right under the contract, up until the expiration date, to: A. sell the stock at the market price. B. buy the stock at the exercise price. C. sell the stock at the exercise price.

B. buy the stock at the exercise price. The buyer of a call option has the right to purchase the stock at the exercise price at any time up until the expiration date of the option contract.

Q. Which of the following statements accurately describes a difference between forward contracts and futures contracts? Compared with futures contracts: A. it is easier to exit a forward contract. B. counterparty risk is higher for forward contracts. C. forward contracts are only available on a limited number of underlying assets.

B. counterparty risk is higher for forward contracts. Futures exchanges require initial and maintenance margin and daily marking to market to reduce counterparty risk of futures contracts. A - It easier to exit a futures contract by taking an opposite position in the same futures contract. The same is not true for a forward contract. C - Both forward and futures contract exist on a wide range of underling assets.

Counterparty risk is most likely lowest for: A. swap contracts B. futures contracts C. forwards contracts

B. futures contracts Futures are exchange traded. Margin requirements and daily marking to market reduce counterparty risk for investors in futures contracts. Swaps and Forwards are traded in private, over-the-country markets. Consequently, counterparty risk is higher in forward contracts and swap contracts than futures contracts.

Q. Swap contracts: A. are mostly traded on exchanges. B. have an initial net value of zero. C. are not susceptible to counterparty risk.

B. have an initial net value of zero. The initial net value of a swap contract is zero. Over time, the swap changes in value as the underlying changes in value. One side of the swap contract loses while the other side gains.

A primary difference between a futures contract on an asset and an option contract on the same asset is that the futures contract: A. represents the right to trade the asset. B. is marked to moarket at the end of each trading day. C. cannot be easily cancelled or closed out at any time before expiration.

B. is market to market at the end of each day. A - A futures contract on an asset represents the OBLIGATION (not the right) to trade the asset (buy or sell).

Compared with a forward contract, in the case of a futures contract: A. counterparty risk is higher. B. it is easier to exit a position before maturity. C. only the buyer has an obligation to fulfil the contract.

B. it is easier to exit a position before maturity. In the case of a futures contract, a position can be effectively closed by taking an opposite position, for example, a short futures position if you already have a long position.

Q. Consider a put option whereby the market price of the underlying stock is greater than the exercise price. At maturity, the profit for the holder of the put option is most likely: A. equal to zero. B. less than zero. C. greater than zero.

B. less than zero. If the market price of the underlying stock exceeds the exercise price, the put option at maturity is worthless. Because the buyer has paid a premium, the profit is less than zero.

Forward contracts and futures contracts, with otherwise identical terms, are similar with respect to: A. counterparty risk B. payoffs at maturity C. customization of contracts

B. payoffs at maturity If a forward contract and futures contract with identical terms are held to maturity, the final outcome is the same. For a forward contract, the entire effect of changing prices is taken into account at maturity, whereas for a futures contract, the effect of changing prices is taken into account on an ongoing basis.

Q. An investor who purchases a call option on a stock has the: A. right to sell the stock at the current price at a future date. B. right to buy the stock at the exercise price until the expiration date. C. obligation to purchase the stock at the strike price when the option expires.

B. right to buy the stock at the exercise price until the expiration date. The purchase of a call option on a stock gives the investor the right—not the obligation—to buy the stock at a fixed price (called the strike or exercise price) on or before the expiration date of the contract.

Q. For option contracts, buyers and sellers (writers) of the option, respectively, have the: A. obligation to trade underlying asset; right to trade underlying asset B. right to trade underlying asset; obligation to trade underlying asset C. obligation to trade underlying asset; obligation to trade underlying asset

B. right to trade underlying asset; obligation to trade underlying asset. The buyer of an option has the right but not the obligation to trade the underlying asset. The seller (writer) of the option has the obligation to trade the underlying asset if the buyer chooses to exercise the option.

Q. Which of the following parties to an option contract on a company's shares has the right to buy shares at the exercise price? A. Put seller B. Call seller C. Call buyer

C. Call buyer The buyer of a call option has the right to buy shares at the exercise price. A - the seller of a put option has an obligation to buy shares at the exercise price. B - the seller of a call option has an obligation to sell shares at the exercise price if the call buyer exercises the option.

Q. A contract in which one party directly enters into a customised agreement with a party to take delivery of a quantity of corn, at a specified price, at some future date, is called a: A. spot contract. B. futures contract. C. forward contract.

C. Forward contract. In a forward contract, one party directly enters into an agreement with another party to deliver a commodity, such as corn, at a specified price at some future date. A - In the spot market the contract is for immediate delivery of the commodity at the spot price. B - A futures contract is a standardized agreement whereas a forward contract is a customized agreement.

Derivatives contracts are constructed such that the underlying may be based on: A. only an outcome B only a tangible asset C. a tangible asset or an outcome

C. a tangible asset or outcome The underlying asset in a derivative contract may be a tangible asset, such as corn or wheat, or an outcome, such as the weather.

Q. The parties in a currency swap exchange: A. interest payments only. B. principal payments only. C. both principal and interest payments.

C. both principal and interest payments. In a currency swap, there is an exchange of principal at the beginning and end of the swap contract. There is also an exchange of interest payments, in different currencies, during the life of the swap.

Which of the following parties to an option contract on a company's shares has the right to buy shares at the exercise price? A. put seller B. call seller C. call buyer

C. call buyer The buyer of a call option has the RIGHT to BUY shares at the exercise prices. A - the seller of a put option has an OBLIGATION to BUY shares at the exercise price. B - the seller of a call option has an OBLIGATION to SELL shares at the exercise price if the call buyer exercises the option.

Q. In the case of a forward contract, the risk that one party to the contract will not fulfil the terms of the contract is referred to as: A. collateral risk. B. performance risk. C. counterparty risk.

C. counterparty risk In a forward contract, the risk that one party to the contract will not fulfil its contractual obligations is referred to as counterparty risk, not performance risk or collateral risk. Counterparty risk can be managed through the use of a performance bond or by pledging collateral.

In the case of a forward contract, the risk that one party to the contract will not fulfil the terms of the contract is referred to as: A. collateral risk. B. performance risk. C. counterparty risk.

C. counterparty risk.

In a derivatives contract, the exercise price most likely refers to the: A. current sale price of the underlying asset. B. spot price of the underlying asset. C. future purchase or sale price of the underlying asset.

C. future purchase or sale price of the underlying asset. In a derivatives contract, the exercise or strike price is the price specified in the contract for future delivery of the underlying asset. That is, the exercise price specifies the future sale or purchase price of hte underlying asset - not the current or spot price.

In contrast to futures contracts, in the case of forward contracts: A. counterparty risk is very low. B. the range of underlyings is very limited. C. it is possible to precisely hedge a position.

C. is correct. Because forward contracts trade in the over-the-counter market, the terms are tailored to meet the needs of the contracting parties. As a consequence, when using forward contracts, it is possible to precisely hedge a position.

Q. In contrast to futures contracts, in the case of forward contracts: A. counterparty risk is very low. B. the range of underlyings is very limited. C. it is possible to precisely hedge a position.

C. it is possible to precisely hedge a position. Because forward contracts trade in the over-the-counter market, the terms are tailored to meet the needs of the contracting parties. As a consequence, when using forward contracts, it is possible to precisely hedge a position.

In a contractual agreement to purchase or sell an asset in the future, in which the value of the contract is tied to the performance of the asset, that asset may be described as the: A. hedge B. derivative C. underlying

C. underlying A contractual agreement to purchase or sell an asset in the future, in which the value of the contract is tied to the performance of the asset is a derivative. The asset in question is referred to as the underlying. The contractual agreement is the "derivative". The asset is the "underlying".

Q. A put option on shares of Company B has an exercise price of £40. The option is out of the money when the share price of Company B is: A. £35. B. £40. C. £45.

C. £45. A put option contract is out of the money when the underlying's price is higher than the exercise price.