Financial Derivatives
Exam Materials
Course Introduction
Financial Derivatives explores the fundamental concepts, pricing, and strategic uses of derivative instruments such as forwards, futures, options, and swaps. The course covers the underlying mechanics of derivative markets, risk management techniques, and valuation models including the Black-Scholes formula and binomial trees. Students analyze real-world applications in hedging, speculation, and arbitrage, while considering regulatory, ethical, and market risk issues. By the end of the course, students develop analytical skills necessary to understand derivative securities and their role in modern financial markets.
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) The price of a stock on February 1 is $48. A trader sells 200 put options on the stock with a strike price of $40 when the option price is $2. The options are exercised when the stock price is $39. The trader's net profit or loss is
A) Loss of $800
B) Loss of $200
C) Gain of $200
D) Loss of $900
Answer: C
Q2) 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
Q3) Which of the following describes European options?
A) Sold in Europe
B) Priced in Euros
C) Exercisable only at maturity
D) Calls (there are no puts)
Answer: C
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Chapter 2: Futures Markets and Central Counterparties
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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) In the corn futures contract a number of different types of corn can be delivered (with price adjustments specified by the exchange) and there are a number of different delivery locations. Which of the following is true
A) This flexibility tends increase the futures price.
B) This flexibility tends decrease the futures price.
C) This flexibility may increase and may decrease the futures price.
D) This flexibility has no effect on the futures price
Answer: B
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4
Chapter 3: Hedging Strategies Using Futures
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Q1) A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to reduce beta to 0.9?
A) Long 192 contracts
B) Short 192 contracts
C) Long 48 contracts
D) Short 48 contracts
Answer: D
Q2) A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to increase beta to 1.8?
A) Long 192 contracts
B) Short 192 contracts
C) Long 96 contracts
D) Short 96 contracts
Answer: C
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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) At what interest rate does a government borrow in its own currency?
A) Treasury rate
B) LIBOR
C) LIBID
D) Repo rate
Q3) A repo rate is
A) An uncollateralized rate
B) A rate where the credit risk is relative 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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Chapter 5: Determination of Forward and Futures Prices
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Q1) The spot price of an investment asset that provides no income is $30 and the risk-free rate for all maturities (with continuous compounding) is 10%. What is the three-year forward price?
A) $40.50
B) $22.22
C) $33.00
D) $33.16
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) The spot price of an asset is positively correlated with the market. Which of the following would you expect to be true?
A) The forward price equals the expected future spot price.
B) The forward price is greater than the expected future spot price.
C) The forward price is less than the expected future spot price.
D) The forward price is sometimes greater and sometimes less than the expected future spot price.
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Page 7
Chapter 6: Interest Rate Futures
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Q1) The conversion factor for a bond is approximately
A) The price it would have if all cash flows were discounted at 6% per annum
B) The price it would have if it paid coupons at 6% per annum
C) The price it would have if all cash flows were discounted at 8% per annum
D) The price it would have if it paid coupons at 8% per annum
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 day count conventions applies to a US Treasury bond?
A) Actual/360
B) Actual/Actual (in period)
C) 30/360
D) Actual/365
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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) A floating for floating 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
Q3) Which of the following is a typical bid-offer spread on the swap rate for a plain vanilla interest rate swap?
A) 3 basis points
B) 8 basis points
C) 13 basis points
D) 18 basis points
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9
Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) Which of the following is NOT true
A) The bonus structure at banks can lead to short-term horizons for decision making
B) Securitization involves the transfer of risk
C) The term "agency costs" describes the situation where the incentives of two parties in a business relationship are not perfectly aligned
D) Correlations decrease in stressed market conditions
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 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
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Chapter 9: Mechanics of Options Markets
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Q1) Which of the following is NOT traded by the CBOE?
A) Weeklys
B) Monthlys
C) Binary options
D) DOOM options
Q2) Which of the following describes a call option?
A) The right to buy an asset for a certain price
B) The obligation to buy an asset for a certain price
C) The right to sell an asset for a certain price
D) The obligation to sell an asset for a certain price
Q3) Which of the following describes a long position in an option?
A) A position where there is more than one year to maturity
B) A position where there is more than five years to maturity
C) A position where an option has been purchased
D) A position that has been held for a long time
Q4) Which of the following must post margin?
A) The seller of an option
B) The buyer of an option
C) The seller and the buyer of an option
D) Neither the seller nor the buyer of an option
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Chapter 10: Properties of Stock Options
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Q1) Which of the following describes a situation where an American put option on a stock becomes more likely to be exercised early?
A) Expected dividends increase
B) Interest rates decrease
C) The stock price volatility decreases
D) All of the above
Q2) Which of the following can be used to create a long position in a European put option on a stock?
A) Buy a call option on the stock and buy the stock
B) Buy a call on the stock and short the stock
C) Sell a call option on the stock and buy the stock
D) Sell a call option on the stock and sell the stock
Q3) When the stock price increases with all else remaining the same, which of the following is true?
A) Both calls and puts increase in value
B) Both calls and puts decrease in value
C) Calls increase in value while puts decrease in value
D) Puts increase in value while calls decrease in value
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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) When the interest rate is 5% per annum with continuous compounding, which of the following creates a $1000 principal protected note?
A) A one-year zero-coupon bond plus a one-year call option worth about $59
B) A one-year zero-coupon bond plus a one-year call option worth about $49
C) A one-year zero-coupon bond plus a one-year call option worth about $39
D) A one-year zero-coupon bond plus a one-year call option worth about $29
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Chapter 12: Introduction to Binomial Trees
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Q1) The current price of a non-dividend-paying stock is $30. Over the next six months it is expected to rise to $36 or fall to $26. Assume the risk-free rate is zero. What is the risk-neutral probability of that the stock price will be $36?
A) 0.6
B) 0.5
C) 0.4
D) 0.3
Q2) 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%
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14
Chapter 13: Valuing Stock Options: the Bsm Model
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Q1) A stock price is 20, 22, 19, 21, 24, and 24 on six successive Fridays. Which of the following is closest to the volatility per annum estimated from this data?
A) 50%
B) 60%
C) 70%
D) 80%
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 measured by the VIX index
A) Implied volatilities for stock options trading on the CBOE
B) Historical volatilities for stock options trading on CBOE
C) Implied volatilities for options trading on the S&P 500 index
D) Historical volatilities for options trading on the S&P 500 index
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15
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) Which of the following is true about the practice of backdating a stock options grant?
A) It is illegal
B) It is illegal in the majority of states in the U.S., but not all states
C) It is illegal in roughly half the states in the U.S.
D) It is unethical, but not illegal
Q3) When an employee leaves the company which of the following is usually true?
A) All outstanding employee stock options are forfeited
B) Out-of the money employee stock options are forfeited
C) All options which have vested are forfeited
D) All options are retained
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Chapter 15: Options on Stock Indices and Currencies
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Q1) A European at-the-money call option on a currency has four years until maturity. The exchange rate volatility is 10%, the domestic risk-free rate is 2% and the foreign risk-free rate is 5%. The current exchange rate is 1.2000. What is the value of the option?
A) 1.11N(0.7)-0.98N(0.5)
B) 1.11N(-0.7)-0.98N(-0.5)
C) 1.11N(0.7)-0.98N(0.4)
D) 1.11N(-0.06)-0.98N(-0.10)
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 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
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Chapter 16: Futures Options and Blacks Model
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Q1) Consider a European one-year call futures option and a European one-year put futures options when the futures price equals the strike price. Which of the following is true?
A) The call futures option is worth more than the put futures option
B) The put futures option is worth more than the call futures option
C) The call futures option is sometimes worth more and sometimes worth less than the put futures option
D) The call futures option is worth the same as the put futures option
Q2) What is the cash settlement if a put futures option on 50 units of the underlying asset is exercised?
A) (Current Futures Price - Strike Price) times 50
B) (Strike Price - Current Futures Price) times 50
C) (Most Recent Futures Settlement Price - Strike Price) times 50
D) (Strike Price - Most Recent Futures Settlement Price) times 50
Q3) Which of the following is true for a September futures option?
A) The expiration month of option is September
B) The option was first traded in September
C) The delivery month of the underlying futures contract is September
D) September is the first month when the option can be exercised
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Page 18
Chapter 17: The Greek Letters
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Q1) What does gamma 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
Q2) Which of the following is true for a call option on a non-dividend-paying stock?
A) If the option is at the money (stock price equals strike price) it must have a delta of 0.5
B) If the strike price equals the forward price of the stock, it must have a delta of 0.5
C) If the option has a delta of 0.5, it must be out of the money
D) If the option has a delta of 0.5, it must be in of the money
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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19
Chapter 18: Binomial Trees in Practice
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Q1) Which of the following is possible in a modified Cox, Ross, Rubinstein binomial tree?
A) The interest rate and volatility can both be functions of time
B) The interest rate or the volatility can be a function of time, but not both
C) The interest rate can be a function of time but the volatility cannot
D) The interest rate and volatility must be constant
Q2) The values of a stock price at the end of the second time step are $80, $100, $125. The corresponding values of an option are $0, $5, and $20 respectively. What is an estimate of gamma?
A) 0.136
B) 0.146
C) 0.156
D) 0.166
Q3) 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
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Chapter 19: Volatility Smiles
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Q1) 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
Q2) 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
Q3) Which of the following is true as time to maturity increases?
A) The volatility smile for currency options tends to become more pronounced
B) The volatility smile for currency options tends to become less pronounced
C) The volatility smile for currency options first becomes less pronounced and then becomes more pronounced
D) The volatility smile for currency options remains approximately the same
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Page 21
Chapter 20: Value at Risk and Expected Shortfall
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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) Which of the following is true?
A) The quadratic model approximates daily changes in using delta and gamma
B) The quadratic model approximates daily changes using delta, but not gamma
C) The quadratic model approximates daily changes using gamma, but not delta
D) None of the above
Q3) If the volatility for a portfolio is 20% per year, what is the volatility per quarter?
A) 20%
B) 10%
C) 5%
D) 2%
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Chapter 21: Interest Rate Options
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Q1) 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
Q2) A Eurodollar futures option contract has a strike price of 97 and the Eurodollar interest rate is 2.50%. What is the intrinsic value of the contract if the option is a call?
A) $0
B) $1,250
C) $1,750
D) $2,500
Q3) In put-call parity for caps and floors, which of the following is true?
A) Long cap plus long floor equals swap
B) Long cap plus swap equals short floor
C) Long cap equals long floor plus swap
D) Long cap minus long floor equals swaption
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23
Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) There are two types of regular options (calls and puts). How many types of compound options are there?
A) Two
B) Four
C) Six
D) Eight
Q2) Which of the following is a five-year interest rate swap that can be canceled at the two year point?
A) The difference between two plain vanilla interest rate swaps
B) The difference between a plain vanilla interest rate swap and a forward start swap
C) A regular interest rate swap plus a European swap option
D) A regular interest rate swap plus a Bermudan swap option
Q3) A floating 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
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Page 24
Chapter 23: Credit Derivatives
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Q1) Which of the following best describes a total return swap?
A) It exchanges the realized return on an asset, including both income and capital gains/losses, for a return, equal to LIBOR plus a spread on the initial value of the asset
B) It exchanges the promised return on an asset, including both income and capital gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset
C) It exchanges the realized return on an asset, including income but not capital gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset
D) It exchanges the promised return on an asset, including income but not capital gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset
Q2) Which of the following is true about a CDS?
A) Restructuring is never a credit event
B) Restructuring is always a credit event
C) Certain types of restructuring qualify as credit events but others do not
D) Sometimes a CDS is defined so that restructuring is a credit event and sometimes it is not
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25
Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Which of the following is NOT seasonal?
A) Spot electricity
B) Spot natural gas
C) Electricity futures prices
D) Spot price of corn
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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