CH. 9: DERIVATIVES -- FUTURES, OPTIONS, SWAPS
Describe the condition that would have a call option in the money. Now describe the condition that has a put option out of the money.
A call option will be in the money when the strike price is below the spot or current market price. The option holder has the right to call the asset away from the option writer at a price below what the asset could be sold for on the spot market. A put option is out of the money when the strike price is below the spot or market price. Here the option holder has the right to put (sell) the asset to the option writer at a predetermined (strike) price. If the strike price is below the market price the option holder would be better off selling the asset on the spot market versus selling it to the option writer.
Explain why a forward contract may actually carry more risk than a futures contract.
A forward contract is a private agreement between two parties that is customized for the two parties. As a result, the high degree of customization makes them very difficult if not impossible to resell. Futures contracts on the other hand are highly standardized. The high level of standardization allows them to be bought and sold on organized exchanges, which increases their liquidity and reduces risk. In addition, forward contracts are private agreements and thus carry greater default risk. Futures contracts are usually settled through clearing corporations where procedures such as mark to market greatly reduce default risk.
Assume we have a stock currently worth $50. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $50. If the stock can rise or fall by $10 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A. $5 B. $10 C. $50 D. $40
A. $5
If a futures contract for U.S. Treasury bonds decreases by "17" in the financial page listings, the price of the contract decreased by: A. $531.25. B. $170.00. C. $340.00. D. $1700.00.
A. $531.25.
A price of a futures contract for U.S. Treasury bonds listed as "111-15" is measured in: A. 32nds. B. 12ths. C. 4ths. D. dollars; it stands for $111.15 but a dash is used instead of a period.
A. 32nds.
The key difference between a forward and a futures contract is: A. a forward contract is customized where a futures contract is not. B. a forward contract is bought and sold on organized exchanges. C. only the forward contracts have settlement dates. D. the amount of time involved.
A. a forward contract is customized where a futures contract is not.
The short position in a futures contract is the party that will: A. deliver a commodity or financial instrument to the buyer at a future date. B. suffer the loss. C. accept the risk. D. benefit from increases in price of the underlying asset.
A. deliver a commodity or financial instrument to the buyer at a future date.
There's a call option written for 100 shares of GM stock for $85.00 a share, prior to the third Friday of October 2017: The option writer: A. has the requirement to sell 100 shares of GM for $85 a share on or before the third Friday of October 2017 if the option holder wants to exercise the option. B. has the option to sell 100 shares of GM for $85 a share on or before the third Friday of October 2017. C. can cancel the option before the third Friday of October 2017. D. does not have to post margin while the option holder does.
A. has the requirement to sell 100 shares of GM for $85 a share on or before the third Friday of October 2017 if the option holder wants to exercise the option.
An investor who purchases a call option is: A. highly leveraged for a gain but is limited in losses. B. limited in his or her gain but is highly leveraged in losses. C. highly leveraged for both gains and losses. D. limited in both gains and losses.
A. highly leveraged for a gain but is limited in losses.
The process of marking to market: A. is done by the clearing corporation to reduce risk in futures contracts. B. involves the margin accounts of only the buyers of future contracts. C. involves the margin accounts of only the sellers of future contracts. D. usually requires margin accounts to be adjusted weekly by the clearing corporation.
A. is done by the clearing corporation to reduce risk in futures contracts.
Sue sells a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is lower than Sue expected. Sue will have: A. lost money on her short position. B. gained money on her long position. C. gained money on her short position. D. lost money on her long position.
A. lost money on her short position.
If the price of an underlying asset has a standard deviation of zero: A. options for this asset would likely not exist. B. option for this asset would be highly valued. C. the intrinsic value of options for this asset would equal the asset's price. D. options for this asset would have a time value of the option equal to the price of the asset.
A. options for this asset would likely not exist.
An individual who neither uses nor produces a commodity but sells a futures contract for the asset is: A. speculating that the price of the commodity is going to fall. B. speculating that the price of the commodity is going to increase. C. hedging trying to transfer risk. D. using arbitrage to earn profits without taking a risk.
A. speculating that the price of the commodity is going to fall.
Considering interest-rate swaps, the swap rate is: A. the benchmark rate plus a premium. B. the rate being offered on U.S. Treasury securities of similar maturities. C. another name for the swap spread. D. a measure of overall risk in the economy.
A. the benchmark rate plus a premium.
There is a futures contract for the purchase of 1000 bushels of corn at $3.00 per bushel. At the end of the day when the market price of corn falls to $2.50: A. the buyer (long position) needs to transfer $500 to the seller (short position). B. the seller (long position) needs to transfer $500 to the buyer (short position). C. nothing happens since marked to market adjustments only occur if the market price rises above the contract price. D. nothing happened since no funds are transferred until the settlement date.
A. the buyer (long position) needs to transfer $500 to the seller (short position).
Considering a call option, if the price of the underlying asset decreases: A. the intrinsic value of the option decreases if it is above zero. B. the intrinsic value of the option increases if it is above zero. C. the strike price decreases. D. the value of the option increases.
A. the intrinsic value of the option decreases if it is above zero.
We have a stock selling for $90.00. There is a put option for this stock with a strike price of $85 and an option price of $1.20: A. the intrinsic value of this option is $0.00 and the time value of the option is $1.20. B. the intrinsic value of this option is $90.00 and the time value of the option is $1.20. C. the intrinsic value of this option is -$5.00 and the time value of the option is $1.20. D. you cannot determine the intrinsic value or time value of the option since the strike price is less than the underlying asset price.
A. the intrinsic value of this option is $0.00 and the time value of the option is $1.20.
As an option approaches its expiration date, the value of the option approaches: A. the intrinsic value. B. the price of the underlying asset. C. zero. D. infinity.
A. the intrinsic value.
The option writer is: A. the seller of an option. B. the buyer of an option. C. the underlying asset of the option. D. the individual who obtains the rights.
A. the seller of an option.
A put option described as out of the money would find: A. the strike price is below the market price of the stock. B. the market price of the stock and the strike price are equal. C. the market price of the stock is below the strike price. D. the option has expired.
A. the strike price is below the market price of the stock.
Explain how an interest rate futures contract differs from an outright purchase of a bond.
An investor who purchases a bond does so with the thought that the price of a bond is going to rise. There really is no way to profit from a price decline when you actually purchase the bond. On the other hand, an investor can profit from price declines in bonds by using an interest rate futures contract. With such a contract, two individuals agree that they will make payments to the counterparty based on interest rate movements over some specified time period. Another key difference is that with the futures contract (derivative) one person's loss is the counterparty's gain. The amount on the table never changes, it just moves between the counterparties. Yet another difference is that a futures contract is equivalent to a low-cost, leveraged exposure to fluctuations in the bond price.
How can we link the lack of futures markets in poor countries to the fact that farmers in poor countries are likely to remain poor?
As discussed in the chapter, the access to and use of futures markets allows individuals to transfer risk to those most willing to bear it. For example, a wheat farmer in the U.S. does not need to worry about the price of wheat falling when the crop comes in, because the farmer can sell a futures contract at a specified price. As a result of transferring this risk, the farmer will plant a larger crop and have a higher income. But as we also saw in the chapter, the use of futures requires the posting of margins. This is something that poor farmers would find very difficult to do. As a result, many poor farmers do not have access to the futures market, cannot transfer risk, and as a result plant smaller crops and have lower incomes.
The main difference between European and American options is: A. holders of European options have more options than holders of American options. B. American option holders have more options than European option holders. C. European option holders can exercise the option prior to expiration. D. European options cannot be resold.
B. American option holders have more options than European option holders.
For a given call option price, which of the following statements is correct? A. The closer the strike price is to the current price of the underlying asset, the smaller the time value of the option. B. The closer the strike price is to the current price of the underlying asset, the larger the time value of the option. C. As the strike price approaches the price of the underlying asset, the time value of the option approaches zero. D. As the strike price approaches the price of the underlying asset, the intrinsic value of the option increases and the time value of the option decreases.
B. The closer the strike price is to the current price of the underlying asset, the larger the time value of the option.
Comparing an option to a futures contract it would be correct to say: A. the risk involved in each is equal. B. a futures contract carries more risk than the option contract. C. an option contract carries more risk than the futures contract. D. neither involves risk; they are tools to eliminate risk.
B. a futures contract carries more risk than the option contract.
The clearing corporation's main role in the futures market is to: A. set the market price of the contract. B. act as the counterparty to both sides of the transaction, thereby guaranteeing payment. C. provide the underlying assets so the contracts can be created. D. all of the above.
B. act as the counterparty to both sides of the transaction, thereby guaranteeing payment.
Interest-rate swaps are: A. exchanges of equity securities for debt securities. B. agreements between two parties to exchange periodic interest-rate payments over some future period. C. agreements involving swapping of option contracts. D. agreements that allow both parties to convert floating interest rates to fixed interest rates.
B. agreements between two parties to exchange periodic interest-rate payments over some future period.
A call option is: A. any option written more than sixty days into the future. B. an option giving the holder the right to buy a given quantity of an asset at a specific price on or before a specified date. C. an option giving the seller the right to sell a given quantity of an asset at a specific price on or before a specified date. D. an option where all rights are granted to the seller of the option.
B. an option giving the holder the right to buy a given quantity of an asset at a specific price on or before a specified date.
Considering a put option, an increase in the strike price: A. causes the intrinsic value of the option to decrease if it is above zero. B. causes the intrinsic value of the option to increase if it is above zero. C. causes the value of the option to decrease. D. makes the option worthless.
B. causes the intrinsic value of the option to increase if it is above zero.
5. Forward contracts are: A. an agreement between more than two parties. B. contracts usually involving the exchange of a commodity or financial instrument. C. always standardized. D. easily resold.
B. contracts usually involving the exchange of a commodity or financial instrument.
Marking to market is a process that: A. involves a transfer of risk. B. ensures that the buyers and sellers receive what the contract promises. C. always requires the sellers of contracts to transfer funds to the buyers of contracts. D. buyers and sellers can request for an additional fee when the contract is created.
B. ensures that the buyers and sellers receive what the contract promises.
A U.S. Treasury bond dealer with a large portfolio who sells a futures contract for U.S. Treasury bonds is: A. taking on additional risk in hopes of getting a larger return. B. ensuring the sales price of the bond through hedging. C. not likely to find a buyer for this transaction. D. should see the value of the futures contract increase as bond prices rise.
B. ensuring the sales price of the bond through hedging.
Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is lower than Tom expected. Tom will have: A. lost money on his long position. B. gained money on his long position. C. lost money on his short position. D. gained money on his short position.
B. gained money on his long position.
With a call option, the option holder: A. has the right to sell the asset. B. has the right to buy the asset. C. can buy or sell, it is their option. D. can buy the asset but only after the date specified.
B. has the right to buy the asset.
Speculators differ from hedgers in the sense that: A. speculators do not like risk. B. hedgers seek to transfer risk. C. speculators seek to transfer risk. D. speculators are hedgers, there isn't any difference.
B. hedgers seek to transfer risk.
The time value of the option should: A. decrease the longer the time to expiration. B. increase the longer the time to expiration. C. not change with time to expiration. D. approach infinity at expiration.
B. increase the longer the time to expiration.
Futures markets and derivatives contribute to economic growth by: A. decreasing speculation. B. increasing the risk-taking capacity of the economy. C. deterring the transfer of risk. D. forcing people to accept the risk their decisions create.
B. increasing the risk-taking capacity of the economy.
The intrinsic value of an option: A. is the amount the investor believes the option will be worth on the expiration date. B. is the amount the option is worth if it is exercised immediately. C. is equal to price of the underlying asset. D. cannot be determined without knowing the future price of the underlying asset.
B. is the amount the option is worth if it is exercised immediately.
Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is higher than Tom expected. Tom will have: A. gained money on his short position. B. lost money on his long position. C. gained money on his long position. D. lost money on his short position.
B. lost money on his long position.
With a futures contract: A. payment is made when the contract is created. B. no payment is made until the settlement date. C. the short position agrees to purchase the underlying asset. D. the risk is eliminated for both parties.
B. no payment is made until the settlement date.
The seller of a put option is transferring the risk: A. of a price decrease of the stock to the buyer of the option. B. of a price increase of the stock to the buyer of the option. C. this statement is incorrect since options do not transfer risk. D. this statement is incorrect since only sellers of call options are transferring risk.
B. of a price increase of the stock to the buyer of the option.
The primary risk in swaps is that: A. interest rates will not change. B. one of the parties will default. C. they are highly liquid and the market price will change. D. high U.S. government deficits will limit the availability of swaps.
B. one of the parties will default.
An individual who neither uses nor produces a commodity but buys a futures contract for the asset is: A. speculating that the price of the commodity is going to fall. B. speculating that the price of the commodity is going to increase. C. is using arbitrage to earn profits without taking a risk. D. is hedging and transferring risk.
B. speculating that the price of the commodity is going to increase.
The user of a commodity who is trying to insure against the price of the commodity rising would: A. take the short position in a futures contract. B. take the long position in a futures contract. C. be better off speculating on price movements and earning higher profits. D. want to hedge by selling a futures contract.
B. take the long position in a futures contract.
If market participants believe next year's corn crop is likely to be unusually large: A. the current spot market price of corn is likely to be below the futures price of corn. B. the current spot market price of corn is likely to be above the futures price of corn. C. it would be impossible to find someone to take the short position in a futures contract. D. it will be impossible to find someone to take the long position in a futures contract.
B. the current spot market price of corn is likely to be above the futures price of corn.
Considering interest-rate swaps, the swap spread is: A. another name for the swap rate. B. the difference between the benchmark rate and the swap rate. C. the benchmark rate plus the swap rate. D. a measure of the time value of the swap.
B. the difference between the benchmark rate and the swap rate.
There is a futures contract for the purchase of 100 bushels of wheat at $2.50 per bushel. At the end of the day when the market price of wheat increases to $3.00 per bushel: A. the buyer (long position) needs to transfer $50 to the seller (short position). B. the seller (short position) needs to transfer $50 to the buyer (long position). C. nothing happens since with a futures contract all payments are made at the settlement date. D. nothing happens since marked to market adjustments only take place when the market price falls below the contract price.
B. the seller (short position) needs to transfer $50 to the buyer (long position).
A put option that is described as in the money would find: A. the market price of the stock above the strike price. B. the strike price is above the market price of the stock. C. the market and strike prices are the same. D. the option has been exercised.
B. the strike price is above the market price of the stock.
Derivatives are financial instruments that: A. present high levels of risk and should only be used by the wealthy. B. when used correctly can actually lower risk. C. should only be used by people seeking high returns from low risk. D. represent the outright purchase of a bond.
B. when used correctly can actually lower risk.
Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $20 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A. $20 B. $0 C. $10 D. $100
C. $10
31. If a futures contract for U.S. Treasury bonds increases by "12" in the financial page listings, the value of the contract increased by: A. $120.00. B. $1200.00. C. $375.00. D. $240.00.
C. $375.00.
An option's value will never be less than zero because: A. the intrinsic value is always less than zero. B. the option seller is required to make up any shortfall faced by the option buyer. C. an option holder will never make an additional payment to exercise the option. D. the time value of the option is always less than zero.
C. an option holder will never make an additional payment to exercise the option.
The long position in a futures contract is the party that will: A. benefit from decreases in the price of the underlying asset. B. agree to make delivery of a commodity or financial instrument at a future date. C. benefit from increases in the price of the underlying asset. D. accept the greater share of the risk.
C. benefit from increases in the price of the underlying asset.
The right to buy a given quantity of an underlying asset at a predetermined price on or before a specific date is called a(n): A. put option. B. option writer. C. call option. D. arbitrage contract.
C. call option.
With a put option, the option holder: A. has the right to buy the asset. B. can buy or sell the asset, it is their option. C. has the right to sell the asset. D. can buy the asset but only on the date specified.
C. has the right to sell the asset.
One key difference between options contracts and futures contracts is: A. in a futures contract, one part has more rights than the other. B. with an options contract both parties have equal rights. C. in an options contract, the rights belong to one party. D. in a futures contract all rights are held by just one party.
C. in an options contract, the rights belong to one party.
As the volatility of the stock price increases, the time value of the option: A. decreases. B. is zero. C. increases. D. doesn't change.
C. increases.
The intrinsic value of a call option: A. is the difference between the option price and the interest rate. B. must be less than or equal to zero. C. is the greater of zero or the difference between the price of the underlying asset and the strike price. D. will be negative if the time value of the option is negative.
C. is the greater of zero or the difference between the price of the underlying asset and the strike price.
At expiration, the time value of an option: A. is equal to the intrinsic value. B. is greater than the intrinsic value. C. is zero. D. is less than the intrinsic value.
C. is zero.
Sue buys a futures contract for U.S. Treasury bonds and on the settlement date the interest rate on U.S. Treasury bonds is higher than Sue expected. Sue will have: A. gained money on her short position. B. gained money on her long position. C. lost money on her long position. D. lost money on her short position.
C. lost money on her long position.
A key use of interest-rate swaps is to: A. eliminate risk for both parties involved in the transaction. B. earn the fees for constructing the swaps. C. provide a hedge against interest-rate risk. D. manage government revenues.
C. provide a hedge against interest-rate risk.
The option holder is: A. the seller of an option. B. another name for the clearinghouse used in futures contracts. C. the buyer of an option. D. always a spectator.
C. the buyer of an option.
On the settlement date of a futures contract: A. the future's price is always above the price of the underlying asset. B. the future's price is always below the price of the underlying asset. C. the future's price is equal to the price of the underlying asset. D. the future's price may be above or below the price of the underlying asset but not equal to it.
C. the future's price is equal to the price of the underlying asset.
The two parts that make up an option's price are: A. extrinsic value and the time value of the option. B. the commission and the time value of the option. C. the intrinsic value and the time value of the option. D. the price of the underlying asset and the time value of the option.
C. the intrinsic value and the time value of the option.
If we have a stock selling for $95.00 and a call option for this stock has a strike price of $82.00 and an option price of $13.60: A. the intrinsic value of the option is $0.60 and the time value of the option is $13.00. B. the intrinsic value is $82.00 and the time value of the option is $13.60. C. the intrinsic value of the option is $13.00 and the time value of the option is $0.60. D. the intrinsic value is $0 since the option is out of the money.
C. the intrinsic value of the option is $13.00 and the time value of the option is $0.60.
With a call option that is described as in the money: A. the market price of the stock is below the strike price. B. the market price of the stock equals the strike price. C. the market price of the stock is above the strike price. D. the option has been exercised.
C. the market price of the stock is above the strike price.
The strike price of an option is: A. the market price at the time the option is written. B. the market price at the time the option is exercised. C. the price at which the option holder has the right to buy or sell. D. always above the market price.
C. the price at which the option holder has the right to buy or sell.
Considering a put option; if the price of the underlying asset increases: A. the value of the put option also increases. B. the intrinsic value of the option increases. C. the value of the option decreases. D. the time value of the option decreases.
C. the value of the option decreases.
The value of a derivative is determined by: A. the Federal Reserve. B. SEC regulation. C. the value of the underlying asset. D. the risk-free rate.
C. the value of the underlying asset.
Options are popular because of all of the following EXCEPT: A. stock prices are volatile. B. they offer a tool to transfer risk. C. they present a tool to limit losses but also limit gains. D. they offer opportunities for high leverage.
C. they present a tool to limit losses but also limit gains.
In a derivative transaction: A. the dollar amount of the transaction increases as the contract date approaches. B. the risk is less than if actually purchasing the underlying asset. C. what one person gains is what the other person loses. D. there is always a futures contract.
C. what one person gains is what the other person loses.
A pension fund manager who plans on purchasing bonds in the future: A. wants to insure against the price of bonds falling. B. can offset the risk of bond prices rising by selling a futures contract. C. will take the long position in a futures contract. D. will take the short position in a futures contract.
C. will take the long position in a futures contract.
A wheat farmer who must purchase his inputs now but will sell his wheat at a market price at a future date: A. faces a market risk that cannot be offset. B. is a good example of what the chapter refers to as a speculator. C. would hedge by taking the short position in a wheat futures contract. D. would hedge by taking the long position in a wheat futures contract.
C. would hedge by taking the short position in a wheat futures contract.
Which of the following statements is true? A. Call options can be sold prior to expiration but put options cannot. B. Put options can be sold prior to expiration but call options cannot. C. No option can be sold prior to expiration. D. Both American and European options can be sold prior to expiration.
D. Both American and European options can be sold prior to expiration.
A baker of bread has a long-term fixed-price contract to supply bread. Which of the following would NOT reduce her risk? A. Taking the long position in wheat futures contract B. Hedging this risk in the wheat futures market C. Finding a wheat farmer who will take the short position in a wheat futures contract D. Finding a wheat farmer who will take the long position in a wheat futures contract
D. Finding a wheat farmer who will take the long position in a wheat futures contract.
Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $5 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A. $10 B. $5 C. $0 D. None of the answers is correct.
D. None of the answers is correct.
Which of the following would tend to decrease the size of the time value of the option? A. The price volatility of the underlying asset is high. B. The time to expiration of the contract is far away. C. The underlying price of the asset approaches the strike price. D. The time to expiration of the options contract is near.
D. The time to expiration of the options contract is near.
Users of commodities are: A. usually not participants in futures contracts. B. speculators preferring to get the large returns which result from large risk. C. likely to take the short position in a futures contract. D. buyers of futures.
D. buyers of futures.
At expiration, the value of an option: A. is greater than the intrinsic value. B. is less than the intrinsic value. C. is equal to the time value of the option. D. is equal to the intrinsic value.
D. is equal to the intrinsic value.
The principal in an interest rate swap is: A. always transferred from the originator to the counterparty of the swap. B. is usually held by a clearinghouse to guarantee payment. C. usually borrowed from a third party. D. is not borrowed, lent, or exchanged. It just serves as the basis for the calculation of cash flows.
D. is not borrowed, lent, or exchanged. It just serves as the basis for the calculation of cash flows.
There's a call option written for 100 shares of GM stock for $85.00 a share, prior to the third Friday of October 2017: The option writer: A. has the option but not the requirement of selling 100 shares of GM for $85.00. B. will sell 100 shares of GM for $85.00 on the third Friday of October 2017. C. has the option to back out of this contract prior to the third Friday of October 2017. D. is required to post margin.
D. is required to post margin.
Standardization of derivative contracts: A. results in increased risk for the parties involved. B. makes them more difficult to understand and therefore leads to increased misuse. C. makes the premiums involved with these contracts increase. D. leads to greater liquidity and lower risk.
D. leads to greater liquidity and lower risk.
One key difference between swaps and option contracts is: A. swaps are derivative agreements and options are not. B. swaps do not involve any risk and options do. C. options transfer risk, swaps create risk. D. options trade on organized exchanges and swaps do not.
D. options trade on organized exchanges and swaps do not.
One argument why farmers in poor countries remain poor is: A. they know very little about farming techniques needed for the crop they are growing. B. they are poor assessors of the risks they face. C. risk taking is a deterrent to growth. D. poor farmers in many countries lack access to commodity futures markets.
D. poor farmers in many countries lack access to commodity futures markets.
An arbitrageur is someone who: A. always takes the long position in a futures contract. B. always takes the short position in a futures contract. C. seeks the high returns that come from the high risk inherent in futures markets. D. simultaneously buys and sells financial instruments to benefit from temporary price differences.
D. simultaneously buys and sells financial instruments to benefit from temporary price differences.
The time value of the option can best be defined as (excluding its intrinsic value): A. the commission earned by a broker. B. the fee earned for the potential benefits from buying the option. C. the service fee charged by the SEC for regulating the option market. D. the fee paid for the potential benefits from buying an option.
D. the fee paid for the potential benefits from buying an option.
A call option described as at the money would find: A. the market price of the stock is above the strike price. B. the market price of the stock is below the strike price. C. the option has been exercised. D. the market price of the stock equals the strike price.
D. the market price of the stock equals the strike price.
As the time of settlement gets closer: A. the price of the futures contract will diverge from the price of the underlying asset. B. the price of the futures contract will always be above the price of the underlying asset. C. the price of the underlying asset and the future's price will show no correlation at all. D. the price of the futures contract will move in lockstep with the price of the underlying asset.
D. the price of the futures contract will move in lockstep with the price of the underlying asset.
Someone who purchases a call option is really buying insurance to protect against: A. the stock not being available when they want to purchase it. B. the price of the stock falling. C. a seller not being able to deliver the stock. D. the price of the stock rising.
D. the price of the stock rising.
A call option described as out of the money would find: A. the market price of the stock is above the strike price. B. the option has been exercised. C. the option has expired. D. the strike price is above the market price of the stock.
D. the strike price is above the market price of the stock.
The purpose of derivatives is to: A. increase the risk so the return is larger. B. eliminate risk for both parties in the transaction. C. postpone the risk for both parties in the transaction. D. transfer the risk from one person to another.
D. transfer the risk from one person to another.
What are the three main ways to categorize derivatives?
Derivatives can be categorized as: forwards and futures, options, and swaps.
Consider a call option; in terms of the option writer and option holder, who is the buyer? Who is the seller? Finally, who has the option? Explain.
In the case of a call option, the option writer is the seller. Here the option writer is stating the underlying asset, strike price, and expiration or delivery date. The option holder is the buyer of the option. The option holder buys the right to have the option of actually purchasing the underlying asset on or before the expiration date for the strike price. The option holder has the option, because she could let the option expire and not "call away" the underlying asset, just foregoing the price paid for the option.
We have a futures contract for the purchase of 10,000 bushels of wheat at $3.00 per bushel. If the price of wheat were to increase to $3.50, explain what happens to the parties involved in the contract in terms of marking to market. Be sure to identify who is long and short and specifically how much is transferred.
The buyer of the contract, the long position, will pay $30,000 for 10,000 bushels of wheat. The seller of the contract, the short position, delivers 10,000 bushels of wheat and receives $30,000. If before expiration the market price of wheat increases to $3.50 the seller, (short) will have to give the buyer, (long) $5000 so that the buyer will still only have to pay $30,000 for the wheat. So the buyer's margin account will be marked to market (credited) with $5,000, which comes from the seller's margin account which is marked to market (debited) for the $5,000.
Explain how the clearing corporation reduces the risk it faces in the futures market through the use of margin accounts and marking-to-market.
The clearing corporation requires each party to a futures contract to place a deposit with the corporation. This practice is called posting margin in a margin account. The margin account serves as a guarantee that when the contract comes due the parties can meet their obligations. Minimum deposits must be maintained in these accounts or the contracts are sold. The daily process of marking to market has the corporation posting gains and losses to each party's account. Again, this guarantees that obligations are met. If an individual's margin account falls below the minimum required the contract will be sold.
A lender obtains funds from depositors by offering short-term interest rates on savings accounts. The lender uses these funds to make longer-term installment loans. Explain how the lender might make use of the futures market to hedge the risk taken.
The lender faces the risk that short-term interest rates will increase. The lender can hedge this risk by selling futures contracts for U.S. Treasury bills that are also short term. If interest rates increase, the lender will profit from the futures contracts.
With a put option, what specifically does the option holder receive for the price paid for the option?
The option holder (buyer) receives the right but not the obligation, to sell the underlying asset at a specific (strike) price on or before the expiration date of the option. If the strike price is above the spot or current market price the option holder will profit from exercising the option. If the strike price is below the spot price of the underlying asset, the option holder will let the option simply expire.
What is the process that makes sure the market price of an underlying asset equals the price of a futures contract at the settlement date? Provide an example.
The process that makes sure the price of the underlying asset and the price of the futures contract are the same at the settlement date is arbitrage. Arbitrage is the process where an individual earns a profit without incurring any risk. For example, let's say one year before the settlement date the futures price for delivery of a 5 percent 10-year coupon bond is $1100. Currently the spot market price of the bond is $1000 and the investor can borrow at 5 percent. An investor could borrow $1000, purchase the 10-year bond, and sell a bond future for $1100 promising delivery of the bond in one year. The investor can use the interest payment on the bond to pay the interest on the loan and deliver the bond to the buyer of the futures contract on the delivery date. This transaction is riskless and nets the investor a profit of $100 without putting up any funds.
As the chapter points out, there have been many cases where derivatives have led to a lot of abuse. If this is the case, why do derivatives exist?
When used properly, derivatives are very helpful financial instruments. They allow people to transfer risk to those most willing to bear it and as a result they can take profitable but risky projects that they otherwise wouldn't. The economy, as a result, performs more efficiently.
Explain why the two parties in a futures contract technically do not make a bilateral agreement with each other.
With a futures contract, the high degree of standardization allows for the use of a clearing corporation. Of the many roles the clearing corporation performs, one is to be the actual counterparty. The two parties to a futures contract make an agreement with the clearing corporation which acts like an insurance company, guaranteeing that both parties will meet their obligations. This increases the efficiency and use of futures contracts.
