Derivatives Markets
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Course Introduction
This course offers an in-depth exploration of derivatives markets, focusing on the structure, functioning, and key instruments such as options, futures, forwards, and swaps. Students will learn about the pricing, trading, and risk management strategies associated with derivative products, including their roles in hedging and speculation. Topics include valuation models, regulatory frameworks, market participants, and the impact of derivatives on financial stability. The course combines theoretical foundations with practical applications, equipping students with the analytical tools necessary to navigate contemporary financial markets and utilize derivatives effectively in various investment and risk management scenarios.
Recommended Textbook Fundamentals of Futures and Options Markets 9th Edition by John C. Hull
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Chapter 1: Introduction
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Q1) Which of the following best describes a central counterparty
A) It is a trader that works for an exchange
B) It stands between two parties in the over-the-counter market
C) It is a trader that works for a bank
D) It helps facilitate futures trades
Answer: B
Q2) Which of the following is approximately true when size is measured in terms of the underlying principal amounts or value of the underlying assets
A) The exchange-traded market is twice as big as the over-the-counter market.
B) The over-the-counter market is twice as big as the exchange-traded market.
C) The exchange-traded market is ten times as big as the over-the-counter market.
D) The over-the-counter market is ten times as big as the exchange-traded market.
Answer: D
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3
Chapter 2: Futures Markets and Central Counterparties
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Q1) Which of the following are cash settled
A) All futures contracts
B) All option contracts
C) Futures on commodities
D) Futures on stock indices
Answer: D
Q2) A haircut of 20% means that
A) A bond with a market value of $100 is considered to be worth $80 when used to satisfy a collateral request
B) A bond with a face value of $100 is considered to be worth $80 when used to satisfy a collateral request
C) A bond with a market value of $100 is considered to be worth $83.3 when used to satisfy a collateral request
D) A bond with a face value of $100 is considered to be worth $83.3 when used to satisfy a collateral request
Answer: A
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4
Chapter 3: Hedging Strategies Using Futures
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Q1) Which of the following describes tailing the hedge?
A) A strategy where the hedge position is increased at the end of the life of the hedge
B) A strategy where the hedge position is increased at the end of the life of the futures contract
C) A more exact calculation of the hedge ratio when forward contracts are used for hedging
D) None of the above
Answer: D
Q2) A company will buy 1000 units of a certain commodity in one year. It decides to hedge 80% of its exposure using futures contracts. Spot price and futures price are currently $100 and $90. The one year futures price of the commodity is $90. If the spot price and the futures price in one year turn out to be $112 and $110, respectively. What is the average price paid for the commodity?
A) $92
B) $96
C) $102
D) $106
Answer: B
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5
Chapter 4: Interest Rates
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Q1) Which of the following is true?
A) When interest rates in the economy increase, all bond prices increase
B) As its coupon increases, a bond's price decreases
C) Longer maturity bonds are always worth more that shorter maturity bonds when the coupon rates are the same
D) None of the above
Q2) Which of following describes forward rates?
A) Interest rates implied by current zero rates for future periods of time
B) Interest rate earned on an investment that starts today and last for n-years in the future without coupons
C) The coupon rate that causes a bond price to equal its par (or principal) value
D) A single discount rate that gives the value of a bond equal to its market price when applied to all cash flows
Q3) At what interest rate does a government borrow in its own currency?
A) Treasury rate
B) LIBOR
C) LIBID
D) Repo rate
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Chapter 5: Determination of Forward and Futures Prices
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Q1) Which of the following is true?
A) The convenience yield is always positive or zero.
B) The convenience yield is always positive for an investment asset.
C) The convenience yield is always negative for a consumption asset.
D) The convenience yield measures the average return earned by holding futures contracts.
Q2) As inventories of a commodity decline, which of the following is true?
A) The one-year futures price as a percentage of the spot price increases
B) The one-year futures price as a percentage of the spot price decreases
C) The one-year futures price as a percentage of the spot price stays the same
D) Any of the above can happen
Q3) Which of the following describes contango?
A) The futures price is below the expected future spot price
B) The futures price is below today's spot price
C) The futures price is a declining function of the time to maturity
D) The futures price is above the expected future spot price
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Chapter 6: Interest Rate Futures
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Q1) Which of following is applicable to corporate bonds in the United States?
A) Actual/360
B) Actual/Actual
C) 30/360
D) Actual/365
Q2) In the U.S. what is the longest maturity for 3-month Eurodollar futures contracts?
A)2 years
B)5 years
C)10 years
D)20 years
Q3) Which of the following is NOT an option open to the party with a short position in the Treasury bond futures contract?
A) The ability to deliver any of a number of different bonds
B) The wild card play
C) The fact that delivery can be made any time during the delivery month
D) The interest rate used in the calculation of the conversion factor
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8
Chapter 7: Swaps
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Q1) A floating-for-fixed currency swap is equivalent to A) Two interest rate swaps, one in each currency
B) A fixed-for-fixed currency swap and one interest rate swap
C) A fixed-for-fixed currency swap and two interest rate swaps, one in each currency
D) None of the above
Q2) Which of the following describes the way a LIBOR-in-arrears swap differs from a plain vanilla interest rate swap?
A) Interest is paid at the beginning of the accrual period in a LIBOR-in-arrears swap
B) Interest is paid at the end of the accrual period in a LIBOR-in-arrears swap
C) No floating interest is paid until the end of the life of the swap in a LIBOR-in-arrears swap, but fixed payments are made throughout the life of the swap
D) Neither floating nor fixed payments are made until the end of the life of the swap
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Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) What are teaser rates
A) Interest rates that appear lower than they are
B) Interest rates that depend on LIBOR
C) Interest rates on mortgages with a very long amortization period
D) Interest rates that apply only for the first two or three years
Q2) Which of the following were introduced before the credit crisis that started in 2007
A) Basel II
B) Dodd-Frank
C) Basel III
D) Requirements for living wills
Q3) Which of the following is true as the correlation between mortgage defaults increases?
A) Equity tranches are almost certain to incur losses
B) Senior tranches become more likely to incur losses
C) The expected number of defaults increases
D) Equity tranches are unaffected
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10
Chapter 9: Mechanics of Options Markets
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Q1) An investor has exchange-traded put options to sell 100 shares for $20. There is a $1 cash dividend. Which of the following is then the position of the investor?
A) The investor has put options to sell 100 shares for $20
B) The investor has put options to sell 100 shares for $19
C) The investor has put options to sell 105 shares for $19
D) The investor has put options to sell 105 shares for $19.05
Q2) The price of a stock is $67. A trader sells 5 put option contracts on the stock with a strike price of $70 when the option price is $4. The options are exercised when the stock price is $69. What is the trader's net profit or loss?
A) Loss of $1,500
B) Loss of $500
C) Gain of $1,500
D) Loss of $1,000
Q3) Which of the following is true?
A) A long call is the same as a short put
B) A short call is the same as a long put
C) A call on a stock plus a stock the same as a put
D) None of the above
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11
Chapter 10: Properties of Stock Options
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Q1) Which of the following is the put-call parity result for a non-dividend-paying stock?
A) The European put price plus the European call price must equal the stock price plus the present value of the strike price
B) The European put price plus the present value of the strike price must equal the European call price plus the stock price
C) The European put price plus the stock price must equal the European call price plus the strike price
D) The European put price plus the stock price must equal the European call price plus the present value of the strike price
Q2) Which of the following is true?
A) An American call option on a stock should never be exercised early
B) An American call option on a stock should never be exercised early when no dividends are expected
C) There is always some chance that an American call option on a stock will be exercised early
D) There is always some chance that an American call option on a stock will be exercised early when no dividends are expected
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Page 12
Chapter 11: Trading Strategies Involving Options
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Q1) Which of the following is correct?
A) A calendar spread can be created by buying a call and selling a put when the strike prices are the same and the times to maturity are different
B) A calendar spread can be created by buying a put and selling a call when the strike prices are the same and the times to maturity are different
C) A calendar spread can be created by buying a call and selling a call when the strike prices are different and the times to maturity are different
D) A calendar spread can be created by buying a call and selling a call when the strike prices are the same and the times to maturity are different
Q2) Six-month call options with strike prices of $35 and $40 cost $6 and $4, respectively. What is the maximum gain when a bull spread is created by trading a total of 200 options?
A) $100
B) $200
C) $300
D) $400
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13
Chapter 12: Introduction to Binomial Trees
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Q1) A stock is expected to return 10% when the risk-free rate is 4%. What is the correct discount rate to use for the expected payoff on an option in the real world?
A) 4%
B) 10%
C) More than 10%
D) It could be more or less than 10%
Q2) If the volatility of a stock is 20% per annum and a risk-free rate is 5% per annum, which of the following is closest to the Cox, Ross, Rubinstein parameter u for a tree with a three-month time step?
A) 1.05
B) 1.07
C) 1.09
D) 1.11
Q3) Which of the following is NOT true in a risk-neutral world?
A) The expected return on a call option is independent of its strike price
B) Investors expect higher returns to compensate for higher risk
C) The expected return on a stock is the risk-free rate
D) The discount rate used for the expected payoff on an option is the risk-free rate
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Chapter 13: Valuing Stock Options: the Bsm Model
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Q1) What does N(x) denote?
A) The area under a normal distribution from zero to x
B) The area under a normal distribution up to x
C) The area under a normal distribution beyond x
D) The area under the normal distribution between -x and x
Q2) When the non-dividend paying stock price is $20, the strike price is $20, the risk-free rate is 5%, the volatility is 20% and the time to maturity is 3 months which of the following is the price of a European put option on the stock
A) 19.7N(-0.1)-20N(-0.2)
B) 20N(-0.1)-20N(-0.2)
C) 19.7N(-0.2)-20N(-0.1)
D) 20N(-0.2)-20N(-0.1)
Q3) What is the number of trading days in a year usually assumed for equities?
A) 365
B) 252
C) 262
D) 272
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Chapter 14: Employee Stock Options
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Q1) What term is used to describe losses shareholders experience because the interests of managers are not aligned with their own?
A) Agency costs
B) Backdating scandals
C) Dilution
D) Income statement expense
Q2) When an employee stock option is exercised, which of the following is usually true?
A) The employee pays the market price for the shares and the company refunds the difference between the market price and the strike price
B) The company or the company's agent buys stock in the market for the employee
C) The company issues more shares and sells them to the employee for the strike price
D) The employee cannot immediately sell the shares
Q3) Employee stock options are particularly popular with start ups because
A) They encourage employees to work hard
B) The start up cannot afford to pay high salaries
C) The risk associated with the company's success is shared with employees.
D) All of the above
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Chapter 15: Options on Stock Indices and Currencies
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Q1) A portfolio manager in charge of a portfolio worth $10 million is concerned that stock prices might decline rapidly during the next six months and would like to use options on an index to provide protection against the portfolio falling below $9.5 million. The index is currently standing at 500 and each contract is on 100 times the index. What position is required if the portfolio has a beta of 1?
A) Short 200 contracts
B) Long 200 contracts
C) Short 100 contracts
D) Long 100 contracts
Q2) Index put options are used to provide protection against the value of the portfolio falling below a certain level. Which of the following is true as the beta of the portfolio increases?
A) The cost of hedging increases
B) The options require a lower strike price
C) The number of options required increases
D) All of the above
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Chapter 16: Futures Options and Blacks Model
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Q1) Which of the following is true about a futures option and a spot option on the same underlying asset with an identical strike price and expiration date?
A) A European call spot option and an American call futures option are equivalent
B) An American call spot option and a European call futures option are equivalent
C) A European put spot option and European put futures option are equivalent
D) An American put spot option and American put futures option are equivalent
Q2) Which of the following is acquired (in addition to a cash payoff) when the holder of a call futures exercises?
A) A long position in a futures contract
B) A short position in a futures contract
C) A long position in the underlying asset
D) A short position in the underlying asset
Q3) Which of the following is true?
A) A futures option is settled daily
B) A futures-style option is settled daily
C) Both a futures option and a futures-style option are settled daily
D) Neither a futures option nor a futures-style option is settled daily
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18
Chapter 17: The Greek Letters
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Q1) A call option on a stock has a delta of 0.3. A trader has sold 1,000 options. What position should the trader take to hedge the position?
A) Sell 300 shares
B) Buy 300 shares
C) Sell 700 shares
D) Buy 700 shares
Q2) Which of the following is NOT a letter in the Greek alphabet?
A) delta
B) rho
C) vega
D) gamma
Q3) What does rho measure?
A) The rate of change of delta with the asset price
B) The rate of change of the portfolio value with the passage of time
C) The sensitivity of a portfolio value to interest rate changes
D) None of the above
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Chapter 18: Binomial Trees in Practice
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Q1) Which of the following can be valued without using a numerical procedure such as a binomial tree?
A) American put options on a non-dividend paying stock
B) American call options on a non-dividend paying tock
C) American call options on a currency
D) American put options on futures
Q2) When we move from assuming no dividends to assuming a constant dividend yield, which of the following is true for a Cox, Ross, Rubinstein tree?
A) The parameters u and p change
B) p changes but u does not
C) u changes but p does not
D) Neither p nor u changes
Q3) How many different paths are there through a Cox-Ross-Rubinstein tree with four-steps?
A) 5
B) 9
C) 12
D) 16
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Chapter 19: Volatility Smiles
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Q1) Which of the following causes a volatility smile that is a ``frown``?
A) There is a small probability of a large stock price decrease in one week
B) There is a small probability of a large stock price increase in one week
C) The outcome of a lawsuit (roughly equal chance of being favorable or unfavorable) will create a large movement up or down in one week
D) None of the above
Q2) The implied volatilities for strike prices of 1.1 and 1.2 when the time to maturity is 6 months are 20% and 22%. The implied volatilities for strike prices of 1.1 and 1.2 when the time to maturity is 1 year are 18.8% and 20.2%. Using linear interpolation, what is the implied volatility for a strike price of 1.12 and a time to maturity of 10 months?
A) 19.24%
B) 19.52%
C) 20.48%
D) 19.96%
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Chapter 20: Value at Risk and Expected Shortfall
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Q1) Which of the following is true when lambda equals 0.95?
A) The weight given to the most recent observation is 0.95
B) The weight given to the observation one day ago is 95% of the weight given to the observation two days ago
C) The weights given to observations add up to 0.95
D) The weights given to the observation two days ago is 95% of the weight given to the observation one day ago
Q2) At the end of Thursday, the estimated volatility of asset A is 2% per day. During Friday asset A produces a return of 3%. An EWMA model with lambda equal to 0.9 is used. What is an estimate of the volatility of asset A at the end of Friday?
A) 2.08%
B) 2.10%
C) 2.12%
D) 2.14%
Q3) Which of the following describes stressed VaR?
A) It is based on movements in market variables in stressed market conditions
B) It is VaR with a very high confidence level
C) It is VaR multiplied by a factor of 3
D) None of the above
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Page 22
Chapter 21: Interest Rate Options
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Q1) The price of a December put futures option is quoted as 5-52. Each Treasury bond futures contract is for delivery of $100,000 in Treasury bonds. What is the cost of one contract?
A) $5,520.00
B) $5,812.50
C) $6,625.00
D) $8,250.00
Q2) Which of the following is true?
A) A callable bond allows the lender to ask for the principal to be repaid early
B) A callable bond allows the borrower to repay the principal early
C) A callable bond is a bond with an embedded stock option
D) None of the above
Q3) Which of the following is true?
A) A puttable bond allows the lender to ask for the principal to be repaid early
B) A puttable bond allows the borrower to repay the principal early
C) A puttable bond is a bond with an embedded stock option
D) None of the above
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Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) A PO is a "principal only" MBS and an IO is an "interest only" MBS. As prepayments increase which of the following happens.
A) Both the PO and IO become more valuable
B) The PO becomes more valuable and the IO becomes less valuable
C) The PO becomes less valuable and the IO becomes more valuable
D) Both the PO and IO become less valuable
Q2) In a shout call option the strike price is $30. The holder shouts when the asset price is $40. What is the payoff from the option if the final asset price is $35?
A) $0
B) $5
C) $10
D) $15
Q3) A binary option pays of $100 if a stock price is greater than its current value in three months. The risk-free rate is 3% and the volatility is 40%. Which of the following is its value?
A) 99.25N(-0.1375)
B) 99.25N(0.1375)
C) 99.25N(-0.0625)
D) 99.25N(0.0625)
Page 24
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Chapter 23: Credit Derivatives
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Q1) In a CDS with a notional principal of $100 million the reference entity defaults. What is the payoff to the buyer of protection when the recovery rate is 30%?
A) $100 million
B) $30 million
C) $130 million
D) $70 million
Q2) Which of the following is the most popular life for a credit default swap?
A) 1 year
B) 3 years
C) 5 years
D) 10 years
Q3) A hazard rate is 1% per annum. What is the probability of a default during the first two years?
A) 2.00%
B) 2.02%
C) 1.98%
D) 1.96%
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Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Where are oil, gas, and electricity derivatives traded?
A) On exchanges and the OTC market
B) On exchanges, but not on the OTC market
C) On the OTC market , but not on exchanges
D) Oil is traded in both markets, but the other two are traded only in the OTC market
Q2) On a certain day the highest temperature is 77 degrees and the lowest temperature is 61 degrees. What is the day's CDD?
A) 5
B) 12
C) 4
D) 0
Q3) Which of the following is a common use of weather derivatives?
A) Hedge the volume of electricity that will be demanded by customers in the summer
B) Hedge the price of oil that must be purchased in the winter
C) Hedge the price of electricity that must be purchased in the summer
D) Hedge the price and volume of gas that must be purchased for heating in the winter
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