Financial Markets and Institutions
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Course Introduction
This course offers a comprehensive overview of financial markets and institutions, exploring their crucial roles within the modern economy. Students will analyze the structure and functioning of major financial markets including money, bond, equity, and derivative markets and examine the interests and behaviors of key participants such as banks, insurance companies, investment firms, and regulatory bodies. Through an integration of theoretical concepts and real-world examples, the course delves into the mechanisms of risk management, the determination of interest rates, the impact of monetary policy, and the process of financial innovation, preparing students to make informed decisions in a dynamic financial environment.
Recommended Textbook Fundamentals of Futures and Options Markets Global Edition 8th Edition by John Hull
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Chapter 1: Introduction
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Q1) Which of the following is NOT true?
A)When a CBOE call option on IBM is exercised.IBM issues more stock
B)An American option can be exercised at any time during its life
C)An call option will always be exercised at maturity if the underlying asset price is greater than the strike price
D)A put option will always be exercised at maturity if the strike price is greater than the underlying asset price
Answer: A
Q2) Which of the following is NOT true?
A)A call option gives the holder the right to buy an asset by a certain date for a certain price
B)A put option gives the holder the right to sell an asset by a certain date for a certain price
C)The holder of a call or put option must exercise the right to sell or buy an asset
D)The holder of a forward contract is obligated to buy or sell an asset
Answer: C
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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) Which entity in the United States takes primary responsibility for regulating futures market?
A)Federal Reserve Board
B)Commodities Futures Trading Commission (CFTC)
C)Security and Exchange Commission (SEC)
D)US Treasury
Answer: B
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Page 4
Chapter 3: Hedging Strategies Using Futures
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Q1) Which of the following does NOT describe beta?
A)A measure of the sensitivity of the return on an asset to the return on an index
B)The slope of the best fit line when the return on an asset is regressed against the return on the market
C)The hedge ratio necessary to remove market risk from a portfolio
D)Measures correlation between futures prices and spot prices
Answer: D
Q2) Which of the following is necessary for tailing a hedge?
A)Comparing the size in units of the position being hedged with the size in units of the futures contract
B)Comparing the value of the position being hedged with the value of one futures contract
C)Comparing the futures price of the asset being hedged to its forward price
D)None of the above
Answer: B
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Chapter 4: Interest Rates
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Q1) An interest rate is 6% per annum with annual compounding.What is the equivalent rate with continuous compounding?
A)5.79%
B)6.21%
C)5.83%
D)6.18%
Q2) Given a choice between 5-year and 1-year instruments most people would choose 5-year instruments when borrowing and 1-year instruments when lending.Which of the following is a theory consistent with this observation?
A)Expectations theory
B)Market segmentation theory
C)Liquidity preference theory
D)Maturity preference theory
Q3) Under liquidity preference theory,which of the following is always true?
A)The forward rate is higher than the spot rate when both have the same maturity
B)Forward rates are unbiased predictors of expected future spot rates
C)The spot rate for a certain maturity is higher than the par yield for that maturity
D)Forward rates are higher than expected future spot rates
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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) 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
Q3) Which of the following is a consumption asset?
A)The S&P 500 index
B)The Canadian dollar
C)Copper
D)IBM stock
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Page 7
Chapter 6: Interest Rate Futures
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Q1) The most recent settlement bond futures price is 103.5.Which of the following four bonds is cheapest to deliver?
A)Quoted bond price = 110;conversion factor = 1.0400
B)Quoted bond price = 160;conversion factor = 1.5200
C)Quoted bond price = 131;conversion factor = 1.2500
D)Quoted bond price = 143;conversion factor = 1.3500
Q2) Which of the following is closest to the duration of a 2-year bond that pays a coupon of 8% per annum semiannually? The yield on the bond is 10% per annum with continuous compounding.
A)1.82
B)1.85
C)1.88
D)1.92
Q3) What is the quoted discount rate on a money market instrument?
A)The interest rate earned as a percentage of the final face value of a bond
B)The interest rate earned as a percentage of the initial price of a bond
C)The interest rate earned as a percentage of the average price of a bond
D)The risk-free rate used to calculate the present value of future cash flows from a bond
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Chapter 7: Swaps
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Q1) A company can invest funds for five years at LIBOR minus 30 basis points.The five-year swap rate is 3%.What fixed rate of interest can the company earn by using the swap?
A)2.4%
B)2.7%
C)3.0%
D)3.3%
Q2) An interest rate swap has three years of remaining life.Payments are exchanged annually.Interest at 3% is paid and 12-month LIBOR is received.A exchange of payments has just taken place.The one-year,two-year and three-year LIBOR/swap zero rates are 2%,3% and 4%.All rates an annually compounded.What is the value of the swap as a percentage of the principal when LIBOR discounting is used?
A)0.00
B)2.66
C)2.06
D)1.06
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9
Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) What,as a percent of tranche principal,are losses on the mezzanine tranche of the ABS CDO?
A)50%
B)60%
C)80%
D)100%
Q2) 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
Q3) 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
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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 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
Q3) Which of the following describes LEAPS?
A)Options which are partly American and partly European
B)Options where the strike price changes through time
C)Exchange-traded stock options with longer lives than regular exchange-traded stock options
D)Options on the average stock price during a period of time
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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 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
Q3) Which of the following best describes the intrinsic value of an option?
A)The value it would have if the owner were forced to exercise immediately
B)The Black-Scholes-Merton price of the option
C)The lower bound for the option's price
D)The amount paid for the option
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Page 12
Chapter 11: Trading Strategies Involving Options
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Q1) 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 loss (after the cost of the options is taken into account)?
A)$100
B)$200
C)$300
D)$400
Q2) Which of the following creates a bull spread?
A)Buy a low strike price call and sell a high strike price call
B)Buy a high strike price call and sell a low strike price call
C)Buy a low strike price call and sell a high strike price put
D)Buy a low strike price put and sell a high strike price call
Q3) How can a straddle 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) An investor sells call options with a strike price of $32. Which of the following hedges the position?
A)Buy 0.6 shares for each call option sold
B)Buy 0.4 shares for each call option sold
C)Short 0.6 shares for each call option sold
D)Short 0.4 shares for each call option sold
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 p for a tree with a three-month time step?
A)0.50
B)0.54
C)0.58
D)0.62
Q3) In a binomial tree created to value an option on a stock,the expected return on stock is
A)Zero
B)The return required by the market
C)The risk-free rate
D)It is impossible to know without more information
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Page 14
Chapter 13: Valuing Stock Options: The BSM Model
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Q1) A stock provides an expected return of 10% per year and has a volatility of 20% per year.What is the continuously compounded expected return in one year?
A)6%
B)8%
C)10%
D)12%
Q2) 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
Q3) 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)
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Chapter 14: Employee Stock Options
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Q1) 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
Q2) 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
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16
Chapter 15: Options on Stock Indices and Currencies
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Q1) For a European put option on an index,the index level is 1,000,the strike price is 1050,the time to maturity is six months,the risk-free rate is 4% per annum,and the dividend yield on the index is 2% per annum.How low can the option price be without there being an arbitrage opportunity?
A)$50.00
B)$43.11
C)$29.21
D)$39.16
Q2) 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)
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17
Chapter 16: Futures Options
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Q1) What is the growth rate of an index futures price in the risk-neutral world?
A)The excess of the risk-free rate over the dividend yield
B)The risk-free rate
C)The dividend yield on the index
D)Zero
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) What is the value of a European call futures option where the futures price is 50,the strike price is 50,the risk-free rate is 5%,the volatility is 20% and the time to maturity is three months?
A)49.38N(0.05)-49.38N(-0.05)
B)50N(0.05)-50N(-0.05)
C)49.38N(0.1)-49.38N(-0.1)
D)50N(0.1)-49.38N(-0.1)
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Chapter 17: The Greek Letters
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Q1) The delta of a call option on a non-dividend-paying stock is 0.4.What is the delta of the corresponding put option?
A)-0.4
B)0.4
C)-0.6
D)0.6
Q2) Which of the following could NOT be a delta-neutral portfolio?
A)A long position in call options plus a short position in the underlying stock
B)A short position in call options plus a short position in the underlying stock
C)A long position in put options and a long position in the underlying stock
D)A long position in a put option and a long position in a call option
Q3) Gamma 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 long time to maturity
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19
Chapter 18: Binomial Trees in Practice
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Q1) A binomial tree prices an American option at $3.12 and the corresponding European option at $3.04.The Black-Scholes price of the European option is $2.98.What is the control variate price of the American option?
A)$3.06
B)$3.18
C)$2.90
D)$3.08
Q2) When the volatility of an option increases from 30% to 32% the value of the option increases from $2.00 to $2.40.What is the vega of the option?
A)0.20 dollars per %
B)0.50 dollars per %
C)0.80 dollars per %
D)2.00 dollars per %
Q3) What is the recommended way of making interest rates a function of time in a Cox,Ross,Rubinstein tree?
A)Make u a function of time
B)Make p a function of time
C)Make u and p a function of time
D)Make the lengths of the time steps unequal
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Page 20
Chapter 19: Volatility Smiles
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Q1) Which of the following could cause the volatility smile typically seen for foreign currency options?
A)Currencies are traded in different countries at different times of the day
B)Currencies tend to have low volatilities
C)The activities of central banks causes occasional jumps in the exchange rate
D)Interest rates may be different in the two countries
Q2) Which of the following is true for European call and put options?
A)If they have the same strike price.they have the same implied volatility
B)If they have the same time to maturity.they have the same implied volatility
C)If they have the same strike price and time to maturity.they have the same implied volatility
D)None of the above
Q3) What does the shape of the volatility smile reveal about call options on a currency?
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
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Chapter 20: Value at Risk
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Q1) 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%
Q2) An investor has $2,000 invested in stock A and $5,000 in stock B.The daily volatilities of A and B are 1.5% and 1% respectively and the coefficient of correlation is 0.8.What is the one day 99% VaR? (Note that N(-2.33)=0.01)
A)$177
B)$135
C)$215
D)$331
Q3) What is the 99% value at risk?
A)$0.145 million
B)$0.14 million
C)$0.13 million
D)$0.10 million
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Page 22
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 floating-rate borrower wants to use a collar as a hedge.Which of the following is appropriate?
A)Buy a cap and sell a floor
B)Buy a cap and buy a floor
C)Sell a cap and sell a floor
D)Sell a cap and buy a floor
Q3) A five-year cap is reset annually period.The cap rate is 3% and the notional principal is $100 million.The 12-month LIBOR interest rate for the third year proves to be 5%.Which of the following is approximately true?
A)The resulting payoff is $2 million at the beginning of the third year
B)The resulting payoff is $2 million at the end of the fifth year
C)The resulting payoff is $2 million at the end of the third year
D)The resulting payoff is $2 million half way through the third year
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Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) When can Bermudan options be exercised?
A)Any time during the life of the options
B)Any time after a certain date up to the end of the life
C)Any time before a certain date or at the end of the option's life
D)On dates specified at the start of the option
Q2) An employer has promised that it will grant employees three year options in one year's time and that the options will be at the money at the time they are granted.What describes these options?
A)Chooser options
B)Forward start options
C)Compound options
D)Shout options
Q3) In a LIBOR-in-arrears swap,which of the following is true?
A)The floating payment made on a date is the LIBOR rate on the previous payment date
B)The floating payment on a date is the LIBOR rate two payment dates ago
C)The floating payment on a date is the LIBOR rate on that date
D)The floating payment on a date is the LIBOR rate on that date only when it is higher than the LIBOR rate on the previous payment date
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Chapter 23: Credit Derivatives
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Q1) What is the number of companies underlying the CDX NA IG index?
A)50
B)75
C)100
D)125
Q2) Which of the following is true of a synthetic CDO?
A)It is created from portfolios of bonds
B)It is created from portfolios of CDSs
C)It references a standard portfolio of bonds
D)None of the above
Q3) What is the rating of the companies underlying the iTraxx index?
A)A or above
B)BBB or above
C)BB or below
D)BBB or below
Q4) What is the number of companies underlying the iTraxx index?
A)50
B)75
C)100
D)125
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Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Which of the following describes a typical reinsurance contract?
A)Covers a percentage of all losses by an insurance company
B)Covers all losses of the insurance company up to a certain amount
C)Covers all losses of the insurance company above a certain amount
D)Covers all losses of the insurance company between two amounts
Q2) 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
Q3) Which of the following is the average of CDD and HDD for a day?
A)The highest temperature during the day
B)The lowest temperature during the day
C)The average temperature during the day
D)None of the above
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