Derivatives and Risk Management Test Preparation
Course Introduction
This course provides an in-depth exploration of financial derivatives and their role in modern risk management strategies. Students will learn about the characteristics, valuation, and applications of various derivative instruments such as forwards, futures, options, and swaps. Key topics include hedging techniques, pricing models (including Black-Scholes and binomial models), and the regulatory and market environments in which these instruments operate. Emphasis is placed on how businesses and financial institutions use derivatives to manage exposures to interest rates, exchange rates, commodity prices, and other market risks. Through theoretical understanding and practical case studies, students will gain the skills necessary to analyze, construct, and implement effective risk management solutions using derivative products.
Recommended Textbook
Introduction to Derivatives and Risk Management 8th Edition by Don M. Chance
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Chapter 1: Introduction
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Sample Questions
Q1) A transaction in which an investor holds a position in the spot market and sells a futures contract or writes a call is
A)a gamble
B)a speculative position
C)a hedge
D)a risk-free transaction
E)none of the above
Answer: C
Q2) A forward contract has which of the following characteristics?
A)has a buyer and a seller
B)trades on an organized exchange
C)has a daily settlement
D)gives the right but not the obligation to buy
E)all of the above
Answer: A
Q3) Options,forwards,swaps,and futures are financial assets.
A)True
B)False
Answer: False
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Page 3
Chapter 2: Structure of Options Markets
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Sample Questions
Q1) Which one of the following is not a type of transaction cost in options trading?
A)the bid-ask spread
B)the commission
C)clearing fees
D)the cost of obtaining a quote
E)all of the above
Answer: D
Q2) The Put and Call Brokers and Dealers Association created the first organized options exchange.
A)True
B)False
Answer: False
Q3) Which of the following are long-term options?
A)Bond options
B)LEAPS
C)currency options
D)Nikkei put warrants
E)none of the above
Answer: B
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Page 4
Chapter 3: Principles of Option Pricing
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Sample Questions
Q1) High volatility is bad for option holders because it increases the probability that the option will expire out-of-the-money.
A)True
B)False
Answer: False
Q2) Suppose you use put-call parity to compute a European call price from the European put price,the stock price,and the risk-free rate.You find the market price of the call to be less than the price given by put-call parity.Ignoring transaction costs,what trades should you do?
A)buy the call and the risk-free bonds and sell the put and the stock
B)buy the stock and the risk-free bonds and sell the put and the call
C)buy the put and the stock and sell the risk-free bonds and the call
D)buy the put and the call and sell the risk-free bonds and the stock
E)none of the above
Answer: A
Q3) The lower the exercise price,the more valuable the call option.
A)True
B)False
Answer: True
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Page 5
Chapter 4: Option Pricing Models: the Binomial Model
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Sample Questions
Q1) In a two-period binomial world,a mispriced call will lead to an arbitrage profit if
A)the proper hedge ratio is maintained over the two periods
B)the hedge portfolio is terminated after one period
C)the option goes from over- to underpriced or vice versa
D)the option remains mispriced over both periods
E)none of the above
Q2) The binomial option pricing formula is based on the weighted average of the next two possible values,discounted back to the present.
A)True
B)False
Q3) If the stock price adjusted for dividends at a continuous rate follows the up and down parameters,the binomial tree will recombine.
A)True
B)False
Q4) When the hedge ratio is adjusted in the binomial model,the transactions must be done in the option.
A)True
B)False
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6
Chapter 5: Option Pricing Models: the
Black-Scholes-Merton Model
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Sample Questions
Q1) When the risk-free rate is zero,the Black-Scholes formula converges to the intrinsic value.
A)True
B)False
Q2) Which of the following statements about the Black-Scholes-Merton model is not true?
A)decreasing the volatility lowers the call price
B)the expected stock price plays a role in the model
C)the risk-free rate is continuously compounded
D)the model is consistent with put-call parity
E)none of the above
Q3) An approximate implied volatility for an at-the-money call can be solved directly.
A)True
B)False
Q4) The binomial model always gives the same option price as the Black-Scholes-Merton model.
A)True
B)False
Page 7
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Chapter 6: Basic Option Strategies
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Sample Questions
Q1) Suppose the investor constructed a covered call.At expiration the stock price is $27.What is the investor's profit?
A)$589
B)$289
C)$2,989
D)$2,711
E)none of the above
Q2) The breakeven for a protective put is the same as that for a covered call.
A)True
B)False
Q3) A covered call provides protection for a stock price at expiration down to the current stock price minus the premium.
A)True
B)False
Q4) As long as puts are available for trading,there is little justification for constructing synthetic puts.
A)True
B)False
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Chapter 7: Advanced Option Strategies
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Sample Questions
Q1) A box spread is a combination of a call bull spread and a put bear spread.
A)True
B)False
Q2) What is the profit if the position is held for 90 days and the stock price is $55?
A)-$971
B)-$58
C)-$109
D)-$471
E)none of the above
Q3) Which of the following is the best strategy for an expected fall in the market?
A)long strip (2 puts and 1 call)
B)put bull spread
C)calendar spread
D)butterfly spread
E)none of the above
Q4) There are three breakeven stock prices in a butterfly spread.
A)True
B)False
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Chapter 8: The Structure of Forward and Futures Markets
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Sample Questions
Q1) Firms that solicit futures trading business from the public are called Futures Commission Merchants.
A)True
B)False
Q2) Most futures contracts are closed by A)delivery
B)offset
C)exercise
D)default
E)none of the above
Q3) One of the first automated trading systems that matched bids and offers implemented at the CME is called
A)COMEX
B)GLOBEX
C)LIFFE
D)CFTC
E)none of the above
Q4) A limit move is when a futures price reaches its all time high or low price.
A)True
B)False
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Chapter 9: Principles of Pricing Forwards, Futures, and Options on Futures
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Sample Questions
Q1) Interest rate parity is essentially the same as A)the cross-rate relationship
B)the cost of carry relationship
C)the Garman-Kohlhagen model
D)all of the above
E)none of the above
Q2) The Black-Scholes-Merton formula can be used in place of the Black formula if you use the futures price for the stock price and a risk-free rate of zero.
A)True
B)False
Q3) A convenience yield is an explanation for a negative cost of carry. A)True
B)False
Q4) The Black formula prices an option on an instrument with a positive cost of carry. A)True
B)False
Q5) The daily settlement brings the value of a futures contract back to zero.
A)True
B)False
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Chapter 10: Futures Arbitrage Strategies
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Sample Questions
Q1) It is important to identify the cheapest bond to deliver because it is the one the futures contract is priced off of.
A)True
B)False
Q2) Stock index arbitrage will earn,at no risk,the difference between the futures price and the theoretical futures price.
A)True
B)False
Q3) The implied repo rate is similar to the
A)internal rate of return
B)cost of hedging
C)yield on the futures contract
D)all of the above
E)none of the above
Q4) If a stock index futures is at 455 and the pricing model says it should be at 458,an arbitrageur should buy the futures and sell short the stock.
A)True
B)False
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Chapter 11: Forward and Futures Hedging, Spread, and Target Strategies
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Sample Questions
Q1) Although a hedge might not be perfect,it should be partially effective if the spot and futures prices move in opposite directions.
A)True
B)False
Q2) Though a cross hedge has somewhat higher risk than an ordinary hedge,it will reduce risk if which of the following occurs?
A)futures prices are more volatile than spot prices
B)the spot and futures contracts are correctly priced at the onset
C)spot and futures prices are positively correlated
D)futures prices are less volatile than spot prices
E)none of the above
Q3) Since it states that systematic risk cannot be eliminated,modern portfolio theory does not allow for stock index futures contracts.
A)True
B)False
Q4) The price sensitivity hedge ratio uses the durations of the spot and futures positions. A)True
B)False
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Chapter 12: Swaps
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Sample Questions
Q1) Swap payments are always either fixed or floating but never both.
A)True
B)False
Q2) The settlement period in a swap refers to the full life of the swap.
A)True
B)False
Q3) Equity swaps can be used for all of the following except:
A)to synthetically buy stock
B)to synthetically sell stock
C)to convert dividends into capital gains
D)to synthetically re-align an equity portfolio
E)none of the above
Q4) The notional principal is never exchanged in an interest rate swap.
A)True
B)False
Q5) In an interest rate swap,the upcoming floating payment will not be determined until the end of the current settlement period.
A)True
B)False
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Chapter 13: Interest Rate Forwards and Options
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Sample Questions
Q1) The Black model's accuracy in pricing interest rate options is greatest when the options have short maturities.
A)True
B)False
Q2) Find the approximate market value of a long position in an FRA at a fixed rate of 5 percent in which the contract expires in 20 days,the underlying is 180-day LIBOR,the notional principal is $25 million,the 20-day rate is 7 percent,and the 200-day rate is 8.5 percent.
A)$433,658
B)-$454,954
C)$322,819
D)-$322,819
E)$454,954
Q3) If interest rates increase,the holder of a long FRA benefits.
A)True
B)False
Q4) Pricing an interest rate cap is done by pricing the component caplets and adding up their values.
A)True
B)False
15
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Chapter 14: Advanced Derivatives and Strategies
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Sample Questions
Q1) Modified lookback options fix the exercise price and replace the expiration price of the asset with the maximum or minimum price.
A)True
B)False
Q2) What is the minimum value of the insured portfolio?
A)$16,672,344
B)$12,500,000
C)$12,091,709
D)$12,244,898
E)$13,375,000
Q3) Which of the following is not a type of structured note?
A)range floater
B)inverse floater
C)diff floater
D)reverse floater
E)none of the above
Q4) Portfolio insurance using stock and T-bills is less expensive than using stock and puts.
A)True
B)False
Page 16
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Chapter 15: Financial Risk Management Techniques and Applications
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Sample Questions
Q1) Which of the following best describes the delta normal method?
A)a method of managing a delta hedge to assure a low gamma
B)the historical method when the distribution is normal
C)the Monte Carlo method when price changes are normally distributed
D)the analytical method applied to options
E)a method of measuring changes in an option's delta
Q2) The risk that errors can occur in inputs to a pricing model is called
A)input risk
B)model risk
C)pricing risk
D)valuation risk
E)none of the above
Q3) In option terms,the limited liability of corporate stockholders is
A)a forward contract
B)a call option
C)a put option
D)a protective put
E)a fiduciary call
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Chapter 16: Managing Risk in an Organization
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Sample Questions
Q1) The purpose of IAS 39 is to prescribe standards for derivatives accounting for foreign currency transactions.
A)True
B)False
Q2) By speculating in derivatives,Procter and Gamble used its treasury department as a profit center.
A)True
B)False
Q3) What is the primary activity of a firm's front office?
A)risk management
B)trading
C)pricing derivative products
D)auditing
E)none of the above
Q4) End users typically invest more resources in their derivatives operations than do dealers.
A)True
B)False
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Page 18