Derivatives Markets
Test Bank
Course Introduction
Derivatives Markets explores the fundamental principles and mechanics of derivative instruments, including forwards, futures, options, and swaps. The course examines the roles these financial products play in risk management, speculation, and arbitrage, as well as the functioning of major global derivatives exchanges. Students will learn pricing models, hedging strategies, and the impact of market variables on derivative valuation. Emphasis is placed on real-world applications, regulatory frameworks, and the systemic significance of derivatives in contemporary financial markets.
Recommended Textbook Fundamentals of Futures and Options Markets 8th Edition by John C. Hull
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Page 2
Chapter 1: Introduction
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Q1) An investor sells a futures contract an asset when the futures price is $1,500. Each contract is on 100 units of the asset. The contract is closed out when the futures price is $1,540. Which of the following is true?
A) The investor has made a gain of $4,000
B) The investor has made a loss of $4,000
C) The investor has made a gain of $2,000
D) The investor has made a loss of $2,000
Answer: B
Q2) A speculator can choose between buying 100 shares of a stock for $40 per share and buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For second alternative to give a better outcome at the option maturity, the stock price must be above
A) $45
B) $46
C) $55
D) $50
Answer: D
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3
Chapter 2: Mechanics of Futures Markets
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Q1) For a futures contract trading in April 2012, the open interest for a June 2012 contract, when compared to the open interest for Sept 2012 contracts, is usually
A) Higher
B) Lower
C) The same
D) Equally likely to be higher or lower
Answer: A
Q2) A speculator takes a long position in a futures contract on a commodity on November 1, 2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31, 2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on March 1, 2013. What gain is recognized in the accounting year January 1 to December 31, 2013? Each contract is on 1000 units of the commodity.
A) $0
B) $1,000
C) $3,000
D) $4,000
Answer: C
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Chapter 3: Hedging Strategies Using Futures
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Q1) Which of the following best describes the capital asset pricing model?
A) Determines the amount of capital that is needed in particular situations
B) Is used to determine the price of futures contracts
C) Relates the return on an asset to the return on a stock index
D) Is used to determine the volatility of a stock index
Answer: C
Q2) Which of the following is true?
A) Hedging can always be done more easily by a company's shareholders than by the company itself
B) If all companies in an industry hedge, a company in the industry can sometimes reduce its risk by choosing not to hedge
C) If all companies in an industry do not hedge, a company in the industry can reduce its risk by hedging
D) If all companies in an industry do not hedge, a company is liable increase its risk by hedging
Answer: D
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Chapter 4: Interest Rates
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Q1) Prior to the credit crisis that started in 2007 which of the following was the proxy used by derivatives traders for the risk-free rate?
A) The Treasury rate
B) The LIBOR rate
C) The repo rate
D) The overnight indexed swap rate
Q2) The six month and one-year rates are 3% and 4% per annum with semiannual compounding. Which of the following is closest to the one-year par yield expressed with semiannual compounding?
A) 3.99%
B) 3.98%
C) 3.97%
D) 3.96%
Q3) A repo rate is
A) An uncollateralized rate
B) A rate where the credit risk is relatively high
C) The rate implicit in a transaction where securities are sold and bought back at a higher price
D) None of the above
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Page 6
Chapter 5: Determination of Forward and Futures Prices
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Q1) Which of the following describes the way the futures price of a foreign currency is quoted?
A) The number of U.S. dollars per unit of the foreign currency
B) The number of the foreign currency per U.S. dollar
C) Some futures prices are always quoted as the number of U.S. dollars per unit of the foreign currency and some are always quoted the other way round
D) There are no quotation conventions for futures prices
Q2) A short forward contract that was negotiated some time ago will expire in three months and has a delivery price of $40. The current forward price for three-month forward contract is $42. The three month risk-free interest rate (with continuous compounding) is 8%. What is the value of the short forward contract?
A) +$2.00
B) -$2.00
C) +$1.96
D) -$1.96
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Chapter 6: Interest Rate Futures
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Q1) The modified duration of a bond portfolio worth $1 million is 5 years. By approximately how much does the value of the portfolio change if all yields increase by 5 basis points?
A) Increase of $2,500
B) Decrease of $2,500
C) Increase of $25,000
D) Decrease of $25,000
Q2) Which of the following is applicable to corporate bonds in the United States?
A) Actual/360
B) Actual/Actual
C) 30/360
D) Actual/365
Q3) A company invests $1,000 in a five-year zero-coupon bond and $4,000 in a ten-year zero-coupon bond. What is the duration of the portfolio?
A) 6 years
B) 7 years
C) 8 years
D) 9 years
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8
Chapter 7: Swaps
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Q1) Which of the following is true for the party paying fixed in an interest rate swap?
A) There is more credit risk when the yield curve is upward sloping than when it is downward sloping
B) There is more credit risk when the yield curve is downward sloping than when it is upward sloping
C) The credit exposure increases when interest rates decline
D) There is no credit exposure providing a financial institution is used as the intermediary
Q2) Which of the following describes the five-year swap rate?
A) The fixed rate of interest which a swap market maker is prepared to pay in exchange for LIBOR on a 5-year swap
B) The fixed rate of interest which a swap market maker is prepared to receive in exchange for LIBOR on a 5-year swap
C) The average of A and B
D) The higher of A and B
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9
Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) Which of the following is true of a non-recourse mortgage?
A) The house buyer, if unable to make payments, can lose all possessions
B) The house buyer has an American style put option on the house
C) The house buyer has a European style put option on the house
D) The lender is less likely to lose money on the mortgage
Q2) Which of the following would be described by the term "liar loan"?
A) A situation where the lender concealed information from the borrower
B) A situation where the lender lied to the borrower about the interest rate
C) A situation where the borrower lied about his or her income
D) None of the above
Q3) AIG lost money because
A) It bought tranches created from mortgages
B) It invested heavily in real estate
C) It invested heavily in the stock market
D) It insured AAA tranches of ABS CDOs
Q4) Which of the following describes the S&P/Case-Shiller index?
A) A stock market index
B) An index of interest rates on mortgages
C) An index of house prices
D) An index showing the dollar amount of mortgages granted each month
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Chapter 9: Mechanics of Options Markets
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Q1) In which of the following cases is an asset NOT considered constructively sold?
A) The owner shorts the asset
B) The owner buys an in-the-money put option on the asset
C) The owner shorts a forward contract on the asset
D) The owner shorts a futures contract on the stock
Q2) An investor has exchange-traded put options to sell 100 shares for $20. There is 25% stock dividend. Which of the following is the position of the investor after the stock dividend?
A) Put options to sell 100 shares for $20
B) Put options to sell 75 shares for $25
C) Put options to sell 125 shares for $15
D) Put options to sell 125 shares for $16
Q3) 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
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11
Chapter 10: Properties of Stock Options
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Q1) Which of the following is true for American options?
A) Put-call parity provides an upper and lower bound for the difference between call and put prices
B) Put call parity provides an upper bound but no lower bound for the difference between call and put prices
C) Put call parity provides an lower bound but no upper bound for the difference between call and put prices
D) There are no put-call parity results
Q2) Which of the following is true when dividends are expected?
A) Put-call parity does not hold
B) The basic put-call parity formula can be adjusted by subtracting the present value of expected dividends from the stock price
C) The basic put-call parity formula can be adjusted by adding the present value of expected dividends to the stock price
D) The basic put-call parity formula can be adjusted by subtracting the dividend yield from the interest rate
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Chapter 11: Trading Strategies Involving Options
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Q1) Which of the following creates a bull spread?
A) Buy a low strike price put and sell a high strike price put
B) Buy a high strike price put and sell a low strike price put
C) Buy a high strike price call and sell a low strike price put
D) Buy a high strike price put and sell a low strike price call
Q2) A trader creates a long butterfly spread from options with strike prices $60, $65, and $70 by trading a total of 400 options. The options are worth $11, $14, and $18. What is the maximum net gain (after the cost of the options is taken into account)?
A) $100
B) $200
C) $300
D) $400
Q3) How can a strap trading strategy be created?
A) Buy one call and one put with the same strike price and same expiration date
B) Buy one call and one put with different strike prices and same expiration date
C) Buy one call and two puts with the same strike price and expiration date
D) Buy two calls and one put with the same strike price and expiration date
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Page 13
Chapter 12: Introduction to Binomial Trees
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Q1) Which of the following are NOT true?
A) Risk-neutral valuation and no-arbitrage arguments give the same option prices
B) Risk-neutral valuation involves assuming that the expected return is the risk-free rate and then discounting expected payoffs at the risk-free rate
C) A hedge set up to value an option does not need to be changed
D) All of the above
Q2) A tree is constructed to value an option on an index which is currently worth 100 and has a volatility of 25%. The index provides a dividend yield of 2%. Another tree is constructed to value an option on a non-dividend-paying stock which is currently worth 100 and has a volatility of 25%.
A) The parameters p and u are the same for both trees
B) The parameter p is the same for both trees but u is not
C) The parameter u is the same for both trees but p is not
D) None of the above
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14
Chapter 13: Valuing Stock Options: the Bsm Model
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Q1) The volatility of a stock is 18% per year. What is the volatility per month?
A) 1.5%
B) 3.0%
C) 5.2%
D) None of the above
Q2) A stock price is $100. Volatility is estimated to be 20% per year. What is an estimate of the standard deviation of the change in the stock price in one week?
A) $0.38
B) $2.77
C) $3.02
D) $0.76
Q3) Which of the following is a definition of volatility?
A) The standard deviation of the return, measured with continuous compounding, in one year
B) The variance of the return, measured with continuous compounding, in one year
C) The standard deviation of the stock price in one year
D) The variance of the stock price in one year
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Chapter 14: Employee Stock Options
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Q1) Which of the following strategies makes no sense?
A) An employee exercises stock options early and sells the stock. No dividends are expected
B) An employee exercises stock options early and keeps the stock. No dividends are expected
C) An employee exercises stock options early and sells the stock. Dividends are expected
D) An employee exercises stock options early and keeps the stock. Dividends are expected
Q2) Which of the following is NOT usually true about employee stock options?
A) There is a vesting period
B) They can be sold to other employees
C) They are often at-the-money when issued
D) Their value is currently a charge to the income statement
Q3) When a CEO has employee stock options, he or she is in theory motivated to do which of the following?
A) Take more risk
B) Take less risk
C) Buy some of the company's stock
D) None of the above
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Page 16
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 the market 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 0.5?
A) Short 200 contracts
B) Long 200 contracts
C) Short 100 contracts
D) Long 100 contracts
Q2) A portfolio manager in charge of a portfolio worth $10 million is concerned that the market 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 should the strike price of options on the index be the portfolio has a beta of 1?
A) 425
B) 450
C) 475
D) 500
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Chapter 16: Futures Options
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Q1) 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
Q2) Which of the following is acquired (in addition to a cash payoff) when the holder of a put 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 are true?
A) Futures options are usually European
B) Futures options are usually American
C) Both American and European futures options trade actively are exchanges
D) Both American and European futures options trade actively in the OTC market
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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) Maintaining a delta-neutral portfolio is an example of which of the following?
A) Stop-loss strategy
B) Dynamic hedging
C) Hedge and forget strategy
D) Static hedging
Q3) Vega tends to be high for which of the following?
A) At-the money options
B) Out-of-the money options
C) In-the-money options
D) Options with a short time to maturity
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Chapter 18: Binomial Trees in Practice
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Q1) Which of the following cannot be estimated from a single binomial tree?
A) delta
B) gamma
C) theta
D) vega
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) What is the difference between valuing an American and a European option using a tree?
A) The value of u is higher for American options
B) The value of u is lower for American options
C) The time steps for American options are not equal
D) It is necessary to do two calculations at nodes where the option is in the money
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Chapter 19: Volatility Smiles
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Q1) Which of the following is NOT true?
A) A volatility surface provides more information than a single volatility smile
B) A volatility surface is used to determine the implied volatility of an option that does not trade actively
C) A volatility surface can be determined from a single volatility smile using interpolation
D) A volatility surface incorporates information about options with different maturity dates
Q2) What does the shape of the volatility smile reveal about put options on equity?
A) Options close-to-the-money have the lowest implied volatility
B) Options deep-in-the-money have a relatively high implied volatility
C) Options deep-out-of-the-money have a relatively high implied volatility
D) All of the above
Q3) Which of the following is true when the tails of a future stock price distribution are compared with those of a lognormal distribution with the same mean and standard deviation?
A) The left tail and right tail are thinner
B) The left tail is thinner and the right tail is fatter
C) The right tail is thinner and the left tail is fatter
D) Both tails are fatter
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Page 21
Chapter 20: Value at Risk
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Q1) Which of the following is true when delta, but not gamma, is used in calculating VaR for option positions?
A) VaR for a long call is too low and VaR for a long put is too low
B) VaR for a long call is too low and VaR for a long put is too high
C) VaR for a long call is too high and VaR for a long put is too low
D) VaR for a long call is too high and VaR for a long put is too high
Q2) The gain from a project is equally likely to have any value between -$0.15 million and +$0.85 million. What is the 99% value at risk?
A) $0.145 million
B) $0.14 million
C) $0.13 million
D) $0.10 million
Q3) What is the method of testing how often a VaR with a certain confidence level was exceeded in the past called?
A) Stress testing
B) Backtesting
C) EWMA
D) The model-building approach
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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) What is exchanged when a put option on an interest rate futures is exercised?
A) A long position in a futures contract for the holder of the option and a short position in a futures contract for the option writer
B) A short position in a futures contract for the holder of the option and a long position in a futures contract for the option writer
C) Cash payoff, a long position in a futures contract for the holder of the option, and a short position in a futures contract for the option writer
D) Cash payoff, a short position in a futures contract for the holder of the option, and a long position in a futures contract for the option writer
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23
Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) A fixed lookback put option pays off which of the following?
A) The amount by which the final stock price exceeds the minimum stock price
B) The amount by which the maximum stock price exceeds the final stock price
C) The amount by which the strike price exceeds the minimum stock price
D) The amount by which the maximum stock price exceeds the strike price
Q2) Which of the following is equivalent to a short position in a European put option?
A) A short position in a cash-or-nothing put option plus a long position in an asset-or-nothing put option
B) A long position in an asset-or-nothing put option plus a long position in a cash-or-nothing put option
C) A long position in an asset-or-nothing call option plus a long position in a cash-or-nothing call option
D) A long position in an asset-or-nothing call option plus a short position in a cash-or-nothing call option
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24
Chapter 23: Credit Derivatives
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Q1) 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
Q2) 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
Q3) If the CDS-bond basis is X minus Y, what are X and Y?
A) X is the CDS spread and Y is the excess of the bond yield over the swap rate
B) X is the excess of the bond yield over the swap rate and Y is the CDS spread
C) X is the CDS spread and Y is the excess of the bond yield over the Treasury rate
D) X is the excess of the bond yield over the Treasury rate and Y is the CDS spread
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Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Which of the following are least likely to use weather derivatives?
A) Energy producers
B) Food and drink manufacturers
C) Companies in the leisure industry
D) Automobile manufacturers
Q2) Which of the following is NOT true about electricity?
A) Supply and demand for electricity are matched within 140 control areas in the US, then excess power sold to other control areas
B) The ability to sell excess power is constrained by transmission capacity
C) Electricity is a commodity that can be easily stored
D) Air conditioning is a big use of electricity
Q3) How can an energy producer hedge its risks?
A) Use weather derivatives for price risk and energy derivatives for volume risk
B) Use energy derivatives for price and volume risk
C) Use energy derivatives for price risk and weather derivatives for volume risk
D) Use weather derivatives for price and volume risk
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