FIN3244 - Derivatives Quiz

Describe two useful purposes served by speculators in derivatives markets.

#1. Hedgers transfer risk to speculators #2. Studies show speculators provide essential liquidity according to the book.

Suppose that Acme Widget is currently selling for $100 per share and you own a call option to buy Acme Widget at $75 per share. The intrinsic value of your option is A.) $25. B.) $100. C.) not possible to determine in the absence of information on values of the share price of Acme Widget between now and the expiration date of the call option. D.) $75.

A.) $25.

How does hedging affect the flow of funds in the financial system? A.) It increases it because it reduces risk thus encouraging more people to make financial investments. B.) It reduces it since it is a sign that investors do not like risk. C.) It increases it by encouraging more speculation. D.) It reduces it because it increases risk by encouraging speculation.

A.) It increases it because it reduces risk thus encouraging more people to make financial investments.

Which of the following factors would tend to increase the size of the premium on an options contract? A.) The option is far away from its expiration date. B.) The option is near its expiration date. C.) The price volatility of the underlying asset is low. D.) The current default-risk-free interest rate is high.

A.) The option is far away from its expiration date.

Which of the following is NOT a regulation applying to swap dealers as a result of the Dodd-Frank Act? A.) The value of swap contracts are limited to no more than $8 billion. B.) Swaps must be traded through a clearinghouse. C.) Data on trades must be publicly available. D.) Dealers are required to deposit a fraction of the value of the contract with the clearinghouse.

A.) The value of swap contracts are limited to no more than $8 billion.

Which of the following referred to derivatives as "financial weapons of mass destruction"? A.) Warren Buffett B.) Ben Bernanke C.) Barack Obama D.) Michael Lewis

A.) Warren Buffett

Derivative instruments are A.) assets which derive their value from underlying assets. B.) assets whose rates of returns must be derived from information published in financial tables. C.) computers which display real-time financial information. D.) assets such as bonds or common stock that derive their value from the value of the companies which issue them.

A.) assets which derive their value from underlying assets.

An options contract A.) confers the rights to buy or sell an underlying asset at a predetermined price by a predetermined time. B.) is another name for a futures contract. C.) may be written for debt instruments, but not for equities. D.) may be written for equities, but not for debt instruments.

A.) confers the rights to buy or sell an underlying asset at a predetermined price by a predetermined time.

Which of the following is NOT a benefit of derivatives? A.) guaranteed minimum profit B.) information services C.) risk sharing D.) liquidity

A.) guaranteed minimum profit

Forward transactions A.) have information problems. B.) are very liquid. C.) provide little risk sharing. D.) are widely used by sellers of commodities, but rarely used by buyers of commodities.

A.) have information problems.

An order from an exchange for a seller to add enough funds to meet the minimum balance in a margin account is called a A.) margin call. B.) maintenance margin. C.) margin put. D.) margin option.

A.) margin call

An interest rate swap involving the exchange of floating-rate obligations for fixed-rate obligations is known as A.) plain vanilla. B.) forward swaps. C.) a swap option. D.) a swaption.

A.) plain vanilla.

In a put options contract, the A.) seller has the obligation to receive the instrument at a specified time. B.) seller has the obligation to deliver the instrument at a specified time. C.) buyer has the obligation to deliver the instrument at a specified time. D.) buyer has the obligation to receive the instrument at a specified time.

A.) seller has the obligation to receive the instrument at a specified time.

A put option is said to be "in the money" if A.) the price of the underlying asset is currently less than the strike price. B.) the price of the underlying asset is currently less than the strike price plus the option premium. C.) it is written on a Treasury bill or other money-market asset. D.) it has increased in price since it was first written.

A.) the price of the underlying asset is currently less than the strike price.

Which best describes a credit default swap? A.) It is designed to reduce interest-rate risk. B.) The issuer receives payments from the buyer in return for agreeing to make payments to the buyer if the security goes into default. C.) Issuers are taking out insurance in case of default. D.) It represents a way for the issuer to establish its creditworthiness.

B.) The issuer receives payments from the buyer in return for agreeing to make payments to the buyer if the security goes into default.

Forward transactions would be useful to A.) a household wanting to reduce its future tax liability. B.) a business wanting to know the cost of its funds on future loans. C.) a business wanting to expand its operations in overseas markets. D.) a government wanting to know the size of its future debt.

B.) a business wanting to know the cost of its funds on future loans.

Speculators in derivatives markets A.) reduce the efficiency of these markets. B.) accept risk transferred to them by hedgers. C.) reduce the liquidity of these markets. D.) are acting contrary to U.S. securities laws.

B.) accept risk transferred to them by hedgers.

A swap is A.) the name for the replacement of a futures contract by an options contract. B.) an agreement between two or more counterparties to exchange sets of cash flows over some future period. C.) another name for a put option. D.) another name for a call option.

B.) an agreement between two or more counterparties to exchange sets of cash flows over some future period.

Using forward transactions allows A.) holders of common stock to lock in future dividend payments. B.) both buyers and sellers to reduce risks associated with price fluctuations. C.) the federal government to stabilize fluctuations in tax receipts. D.) corporations to reduce problems arising from future fluctuations in their dividend payments.

B.) both buyers and sellers to reduce risks associated with price fluctuations.

All of the following are steps involved in basic currency swaps EXCEPT A.) the parties exchange the principal amount at the end of the agreement. B.) counterparties exchange the net interest at the end of the swap. C.) the parties exchange periodic interest payments over the life of the agreement. D.) the parties exchange principals in two currencies.

B.) counterparties exchange the net interest at the end of the swap.

The person on the other side of a transaction is referred to as the A.) speculator. B.) counterparty. C.) hedger. D.) derivator.

B.) counterparty.

Spot transactions A.) are relatively unimportant in financial markets. B.) involve immediate settlement. C.) may only take place in face-to-face trading. D.) take place on-the-spot, rather than on an organized exchange.

B.) involve immediate settlement.

As an option nears its expiration date, the size of the premium approaches A.) an amount which varies, depending on prevailing market interest rates on the expiration date. B.) its intrinsic value. C.) zero. D.) infinity.

B.) its intrinsic value.

A shortcoming of swaps that has led to the domination of the swaps market by large firms and financial institutions is the A.) desire for more flexibility. B.) need to assess creditworthiness. C.) limited size of the market. D.) lack of privacy.

B.) need to assess creditworthiness.

A lender who is worried that its cost of funds might rise during the term of a loan it has made can hedge against this rise by A.) buying futures contracts on Treasury bills. B.) selling futures contracts on Treasury bills. C.) increasing the amount of money which it lends. D.) buying call options on Treasury bills.

B.) selling futures contracts on Treasury bills.

When you borrow stock from a broker and sell it now with plans to buy it back after it drops in price, you are engaging in a(n) A.) European option. B.) short sale. C.) margin call. D.) American option.

B.) short sale.

Futures trading has traditionally been conducted by A.) the London Stock Exchange. B.) the Chicago Board of Trade and the New York Mercantile Exchange. C.) the Omaha Grain Exchange. D.) the New York Stock Exchange.

B.) the Chicago Board of Trade and the New York Mercantile Exchange.

Marking to market refers to A.) the settlement of gains and losses on forward contracts each day. B.) the settlement of gains and losses on futures contracts each day. C.) the determination of the prices of options contracts by the interaction of demand and supply. D.) the determination of the prices of futures contracts by the interaction of demand and supply.

B.) the settlement of gains and losses on futures contracts each day.

A key reason that firms and financial institutions might participate in an interest rate swap is A.) the favorable tax implications of swaps compared with other derivative contracts. B.) to transfer interest rate risk to parties that are more willing to bear it. C.) the low information costs of swaps compared with other derivative contracts. D.) the greater liquidity of swaps compared with other derivative contracts.

B.) to transfer interest rate risk to parties that are more willing to bear it.

Which of the following financial futures contracts are traded in the United States? A.) interest rates B.) stock indexes C.) All of these D.) currencies

C.) All of these

AIG almost went bankrupt in 2008 because A.) the value of the securities underlying its credit default swaps declined significantly. B.) prices of securities underlying their credit default swaps were hard to determine since they were no longer actively traded. C.) All of these. C.) it lacked the collateral required by buyers of its credit default swaps.

C.) All of these.

A speculator who believes strongly that interest rates will rise would be likely to A.) increase now the amount of money which he lends. B.) buy Treasury bonds in the spot market. C.) buy futures contracts on Treasury bills. D.) sell futures contracts on Treasury bills.

C.) buy futures contracts on Treasury bills.

One benefit of a swap compared to futures and options is that they A.) promote liquidity. B.) can involve financial instruments and not just commodities. C.) can be better tailored to meet the needs of market participants. D.) reduce the risk for both the buyer and seller.

C.) can be better tailored to meet the needs of market participants.

Profits from speculation arise because of A.) the high information costs in markets for derivative instruments. B.) the spread between the bid and ask prices on bonds. C.) disagreements among traders about future prices of a commodity or financial instrument. D.) the illiquidity of markets for derivative instruments.

C.) disagreements among traders about future prices of a commodity or financial instrument.

Standardization of derivative contracts A.) has been proposed many times by financial analysts, but has not yet been carried out by the SEC. B.) is the rule with respect to contracts whose underlying asset is a commodity, but not for contracts whose underlying asset is a financial asset. C.) increases their liquidity. D.) is the rule with respect to contracts whose underlying asset is a financial security, but not for contracts whose underlying asset is a commodity.

C.) increases their liquidity.

The existence of counterparty risk A.) is disallowed under current government regulations. B.) reduces the risk introduced by forward contracts. C.) results in information costs for buyers and sellers when analyzing the potential creditworthiness of potential trading partners. D.) has no effect on the contracting parties.

C.) results in information costs for buyers and sellers when analyzing the potential creditworthiness of potential trading partners.

Warren Buffet argued that ________ contributed significantly to the financial crisis. A.) only derivatives that are exchange traded B.) virtually no derivatives C.) some derivatives that are not exchange traded D.) all derivatives

C.) some derivatives that are not exchange traded

A call option is said to be "in the money" if A.) the price of the underlying asset is currently greater than the strike price plus the option premium. B.) it has increased in price since it was first written. C.) the price of the underlying asset is currently greater than the strike price. D.) it is written on a Treasury bill or other money-market asset.

C.) the price of the underlying asset is currently greater than the strike price.

Forward contracts A.) entail small information costs. B.) are highly liquid. C.) provide little risk sharing. D.) are subject to default risk.

D.) are subject to default risk.

In derivative markets, trade takes place in A.) assets whose rates of returns must be derived from information published in financial tables. B.) assets which are not allowed to be traded on organized exchanges. C.) assets such as bonds or common stock that derive their value from the value of the companies which issue them. D.) assets that derive their value from underlying assets.

D.) assets that derive their value from underlying assets.

Speculators are primarily interested in A.) reducing the spread between bid and ask prices on bonds. B.) reducing their exposure to the risk of price fluctuations. C.) increasing market liquidity. D.) betting on anticipated changes in prices.

D.) betting on anticipated changes in prices.

An investor who is considering hedging by selling Treasury futures can also hedge by A.) selling Treasury put options. B.) buying Treasury call options. C.) buying European Treasury options. D.) buying Treasury put options.

D.) buying Treasury put options.

Marking to market involves A.) changing the futures price to the spot price each day. B.) engaging in arbitrage so as to reduce the risk involved with futures contracts. C.) updating the futures price after the market closes each day. D.) crediting or debiting the margin account based on the net change in the value of the futures contract.

D.) crediting or debiting the margin account based on the net change in the value of the futures contract.

One difference between futures and options contracts is A.) in the case of futures, funds only change hands when they are exercised. B.) futures are designed to reduce risk while options are not. C.) funds change hands daily in the case of options but not with futures. D.) funds change hands daily in the case of futures, but not with options.

D.) funds change hands daily in the case of futures, but not with options.

Which of the following is NOT a result of the ability of investors to hedge? A.) slower economic growth B.) investors are more willing to invest C.) increased access to funds by firms and households D.) increased risk aversion

D.) increased risk aversion

The intrinsic value of an option A.) is impossible to determine in the absence of information on the future prices of the underlying asset. B.) is the amount the option is expected to be worth on its expiration date. C.) is equal to the option premium. D.) is the amount the option actually is worth if it is immediately exercised.

D.) is the amount the option actually is worth if it is immediately exercised.

The initial deposit required by a buyer or seller of a futures contract is known as A.) debit. B.) credit. C.) marking. D.) margin requirement.

D.) margin requirement.

Hedgers are primarily interested in A.) betting on anticipated changes in prices. B.) increasing market liquidity. C.) reducing the spread between bid and ask prices on bonds. D.) reducing their exposure to the risk of price fluctuations.

D.) reducing their exposure to the risk of price fluctuations.

How can a bond investor hedge against a possible bear market in bonds? A.) going long in the spot market B.) buy futures contracts on Treasury notes C.) going short in the spot market D.) sell futures contracts on Treasury notes

D.) sell futures contracts on Treasury notes

In a call options contract, the A.) seller may choose whether or not to deliver the instrument at a specified time. B.) buyer will choose to exercise his option only if the value of the underlying security falls. C.) buyer has the obligation to receive the instrument at a specified time. D.) seller has the obligation to deliver the instrument at a specified time.

D.) seller has the obligation to deliver the instrument at a specified time.

Investors who buy and sell oil derivatives with the hope of profiting from price changes in crude oil are known as A.) profiteers. B.) wildcatters. C.) arbitrageurs. D.) speculators.

D.) speculators.

Futures trading practices in the United States are regulated by A.) the Board of Futures Trading. B.) the Chicago Mercantile Exchange. C.) the Chicago Board of Trade. D.) the Commodities Futures Trading Commission.

D.) the Commodities Futures Trading Commission.

As the time of delivery in a futures contract gets closer A.) the futures and spot prices remain the same as they were when the contract was first created. B.) the futures price generally rises further above the spot price. C.) the futures price generally falls further below the spot price. D.) the futures price gets closer to the spot price.

D.) the futures price gets closer to the spot price.

When reading an options listing for a company like General Motors, the further away the expiration date A.) the higher the price of the call option and the lower the price of the put option. B.) the lower the price of both the call option and the put option. C.) the lower the price of the call option and the higher the price of the put option. D.) the higher the price of both the call option and the put option.

D.) the higher the price of both the call option and the put option.

Forward contracts are often illiquid because A.) government regulation has not provided for a secondary market in them. B.) the brokerage fees involved in buying and selling them are very high. C.) any capital gains on them are heavily taxed, making investors reluctant to sell them. D.) they generally contain terms specific to the particular buyer and seller.

D.) they generally contain terms specific to the particular buyer and seller.

All of the following are cited by Warren Buffet as problems with derivatives not traded on exchanges EXCEPT A.) firms do not set aside reserves against potential losses. B.) they involve substantial counterparty risk. C.) they are thinly traded which makes it difficult to determine their value. D.) they were not flexible enough due to lack of standardization.

D.) they were not flexible enough due to lack of standardization.

Why may some investors prefer forward contracts to futures?

Forward contracts are more flexible than futures contracts.

Why are forward contracts typically illiquid?

Forward contracts are often illiquid because they generally contain terms specific to the particular buyer and seller.

Why are forward contracts typically illiquid?

Forward contracts are very standard with a specific contract about the financial instrument stating both the buyer and seller positions. Most if not all forward contracts contain terms regarding the certain buyer and seller who are involved in a transaction, selling the contract is almost impossible if the buyer is unwilling or unable to accept the same terms.

In what ways do futures contracts differ from forward contracts?

Futures contracts are traded on exchanges, making them standardized contracts. Forward contracts are private agreements between two parties to buy and sell an asset at a specified price in the future. There's always the chance one party in a forward contract may default. Futures contracts have clearing houses that guarantee the transactions. Forward contracts are settled on one date at the end of the contract. Futures contracts are marked-to-market daily, which means their value is determined day-by-day until the contract ends. Futures contracts can settle over a range of dates.

The interest rate at which international banks loan to each other is called the federal funds rate. LIBOR. international bank lending rate. prime rate.

LIBOR.

What are the steps involved in using options for a short sale of a stock?

Options transfer risk from buyer to seller. A call option ensures that the cost of buying an asset will not rise. A put option ensures that the price at which the asset can be sold will not go down.

What does it mean to "cover a short"?

Short covering involves purchasing a security to cover an open short position. To close out a short position, traders and investors purchase the same amount of shares in the security they sold short.

Short covering is when you buy shares of stock in order to close out an existing short position.

Short covering is when you buy shares of stock in order to close out an existing short position.

Southwest Airlines relies on jet fuel to operate its planes. If it chooses to hedge against future changes in fuel prices, what positions (long or short) will it take in the spot and futures markets?

Southwest will take a short position in the spot market and long position in the futures markets.

Explain the difference between a credit swap and a credit default swap.

Swaps allow traders to transfer risk. The book talks about Interest rate swaps and Credit default swaps. An Interest rate swap allows one swap party to alter the stream of payments it makes or receives for a fee. A credit default swap are a form of insurance that allows a buyer to own a bond or mortgage without bearing its default risk.

Which of the following statements about the presence of speculators in futures markets is correct? They make it difficult for hedgers to find someone to take the opposite side of their positions. Once a futures market participant is known to be a speculator, he or she is no longer allowed to participate in the market. They aid hedgers by increasing the liquidity in futures markets. Their main objective is to reduce their exposure to risk.

They aid hedgers by increasing the liquidity in futures markets.

If you look at the financial page listings for futures contracts and find that futures prices on Treasury bonds are falling over a particular time period, futures market investors must expect that futures prices will rise again at the end of the period. Treasury bond yields will be higher in the future. Treasury bond prices will be higher in the future. Treasury bond yields will be lower in the future.

Treasury bond yields will be higher in the future.

What are the information costs associated with forward contracts?

You are unable to predict the future and the value of the asset you have agreed to sell. The value could increase or decrease in value between the time of the contracts inception and the asset exchange.

Suppose you are a manager for a company that produces grape jelly. Which of the following is the best way for you to reduce your risk? A.) sell a derivative that increases in value if grape jelly prices increase B.) acquire a derivative that increases in value if grape prices increase C.) acquire a derivative that increases in value if grape jelly prices increase D.) sell a derivative that increases in value if grape prices increase

acquire a derivative that increases in value if grape prices increase

Forward transactions originated in the market for government bonds. agricultural and other commodities. common stock. corporate bonds.

agricultural and other commodities.

The period over which a call or put option exists is determined by its delivery date. determined by its expiration date. indeterminate; options contracts continue in existence until either the buyer or the seller desires to discontinue it. determined by whether the contract is written for a commodity or for a financial instrument.

determined by its expiration date.

In an options contract, another name for the strike price is the exercise price. fixed price. market price. equilibrium price.

exercise price.

The most important derivative instruments are corporate bonds. common and preferred stocks. futures, options, and swaps. government bonds.

futures, options, and swaps.

Options traded on exchanges are known as call options. put options. listed options. exchange traded options.

listed options.

If insurance is available on an activity more of that activity will occur. investors will be less likely to hedge. less of that activity will occur. it increases the risk of engaging in that activity.

more of that activity will occur.

Forward transactions provide reduced tax payments. provide risk sharing. provide substantial liquidity. entail small information costs.

provide risk sharing.

During the financial crisis of 2007-2009, the VIX fell to zero. reached a level of 80. remained relatively stable. recorded negative values for the first time in history.

reached a level of 80.

When talking about forward contracts, the date on which the contracted delivery must take place is called the counterparty date. forward date. settlement date. spot date.

settlement date.

The price at which an option may be exercised is called the market price. fixed price. equilibrium price. strike price.

strike price.

Why do investors hedge using futures contracts? they are more flexible than forward contracts in order to provide a counterparty to speculators they are willing to pay for a reduction in risk they are seeking to increase liquidity

they are willing to pay for a reduction in risk