Financial Markets and Institutions
Test Preparation
Course Introduction
This course provides a comprehensive overview of the structure, functions, and operations of financial markets and institutions. Students will explore the roles played by various financial intermediaries, including banks, insurance companies, mutual funds, and investment firms, in facilitating the flow of funds within the economy. Key topics include the determination of interest rates, the process of financial intermediation, risk management principles, and regulatory frameworks governing the industry. Through case studies and practical applications, the course emphasizes the impact of global economic events on financial systems and equips students with analytical tools to evaluate the performance and stability of financial institutions and markets.
Recommended Textbook
Derivatives Markets 3rd Edition by Robert L. McDonald
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546 Verified Questions
546 Flashcards
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Chapter 1: Introduction to Derivatives
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Sample Questions
Q1) Describe the concept of a bid-ask spread and how that impacts the cash flows of an investor.
Answer: In some markets,especially OTC,dealers complete transactions.Buyers of stock pay the higher of the spread and sellers receive the lower price in the spread.The difference is the dealer's profit.
Q2) Assume that you purchase 100 shares of Jiffy,Inc.common stock at the bid-ask prices of $32.00 - $32.50.When you sell,the bid-ask prices are $32.50 - $33.00.If you pay a commission rate of 0.5%,what is your profit or loss?
A) $0
B) $16.25 loss
C) $32.50 gain
D) $32.50 loss
Answer: D
Q3) What would cause the spread between the market rate of interest and the repo rate to be small?
Answer: If there is a low demand to short sell a security or a large supply of the security repo rates will be higher due to lack of demand for short instruments.
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Page 3
Chapter 2: An Introduction to Forwards and Options
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Sample Questions
Q1) An investor has a long call option on the market index at a strike price of $930.At expiration the index price is $920.Explain the profit and loss.
Answer: The long call investor has the right,not the obligation,to exercise.Thus,she will elect to let the option expire unexercised and realize no profit or loss.
Q2) The spot price of the market index is $900.A 3-month forward contract on this index is priced at $930.What is the profit or loss to a short position if the spot price of the market index rises to $920 by the expiration date?
A) $20 gain
B) $20 loss
C) $10 gain
D) $10 loss
Answer: C
Q3) The spot price of the market index is $900.A 3-month forward contract on this index is priced at $930.Draw the payoff graph for the short position in the forward contract. Answer: 11ea50b5_7ce8_1b15_9d47_e7f146bd882b_TB4904_00
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Chapter 3: Insurance, collars, and Other Strategies
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Sample Questions
Q1) What are the similarities and differences between bear and bull spreads?
Answer: Both have floors and ceilings.The bear position has a ceiling where prices are falling and a floor where prices rise.A bull spread has the opposite floor and ceiling.
Q2) A strategy consists of buying a market index product at $830 and longing a put on the index with a strike of $830.If the put premium is $18.00 and interest rates are 0.5% per month,what is the estimated price of a call option with an exercise price of $830?
A) $42.47
B) $45.26
C) $47.67
D) $49.55
Answer: A
Q3) Explain how a long stock and long put strategy equals the cash flow from a long call strategy.
Answer: The net effect of the long put and long stock creates a cash flow identical to the long call,provided you include the cost of funds.
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Chapter 4: Introduction to Risk Management
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Sample Questions
Q1) Why are managerial controls over option and forward trading departments vital to proper risk control?
Q2) Farmer Jayne bought a $1.70 strike put option for $0.11 and sold a $1.75 strike call option for a premium of $0.14.Her total costs are $1.65 per bushel and interest rates are 4.0% over this period.What is the floor in her strategy assuming a 20,000-bushel crop?
A) $624
B) $1,624
C) $2,624
D) $3,624
Q3) Engage the class in a discussion of why firms hedge risks.Steer them towards an understanding that firms manufacture products,they do not speculate in commodity markets.Now,turn the tables and ask why manufacturers do not employ pure hedge strategies with forward contracts.Try to get the class to arrive at the conclusion that since firms are experts in their respective industries,their knowledge may benefit them by implementing creative strategies,while still hedging losses.
Q4) Why are synthetics created and/or calculated when the actual derivative is available?
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Chapter 5: Financial Forwards and Futures
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Sample Questions
Q1) Consider an investment in five S&P 500 Index futures contracts at a price of $924.80.The initial margin requirement is 15.0% and the maintenance margin is 10.0%.If the continuously compounded interest rate is 5.0% what will the futures price need to be for a margin call to occur 10 days from now? Assume no settlement within the 10 days.
A) $852.64
B) $872.79
C) $898.63
D) $905.25
Q2) The annualized dividend yield on the S&P 500 Index is 1.40%.The continuously compounded interest rate is 6.4%.If the 9-month forward price is $925.28 and the index is priced at $950.46,what is the profit/loss from a cash-and-carry strategy?
A) $25.18 loss
B) $25.18 gain
C) $61.50 loss
D) $61.50 gain
Q3) What is the process involved in creating a cash-and-carry strategy?
Q4) Name some advantages that futures contracts have over forward contracts.
Q5) What are some uses for index futures contracts?
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Chapter 6: Commodity Forwards and Futures
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Sample Questions
Q1) When is it possible for the lease rate to fall below zero?
Q2) The spot price of corn is $5.82 per bushel.The opportunity cost of capital for an investor is 0.6% per month.If storage costs of $0.03 per bushel per month are factored in,all else being equal,what is the future value of storage costs over a 6-month period?
A) $0.1534
B) $0.1684
C) $0.1772
D) $0.1827
Q3) Nine-month gold futures are trading for $1565 per ounce.The spot price is $1509 per ounce.LIBOR during each of the upcoming 4 quarters is listed as 1.04%,1.22%,1.30%,and 1.35%,respectively.Calculate the 9-month lease rate on the futures contract.
A) 2.4%
B) 2.1%
C) 1.3%
D) 0.0%
Q4) Explain how a negative correlation between agricultural production and commodity prices creates a natural hedge.
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8
Chapter 7: Interest Rate Forwards and Futures
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Sample Questions
Q1) Two months from today you plan to borrow $3 million for 6 months at LIBOR.You hedge your interest rate risk with a euro dollar futures contract priced at 93.6.If settled in arrears,what is your payment if the 6-month LIBOR is 2.5% in two months?
A) $8,500
B) $10,500
C) $13,500
D) $15,500
Q2) The annual coupon rate on a 1-year treasury bond is 5.5%.The coupon on a 2-year treasury bond is 5.8%.What is the continuously compounded yield on a 2-year zero coupon bond?
A) 5.55%
B) 5.65%
C) 5.75%
D) 5.85%
Q3) Explain the expectations hypothesis and its ability to accurately forecast interest rates.
Q4) What is the pure yield curve and why is it common to present coupon-based yield curves in practice?
Q5) Explain the process of creating a synthetic Forward Rate Agreement.
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Chapter 8: Swaps
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Sample Questions
Q1) Assume oat forward prices over the next 3 years are $2.25,$2.35,and $2.28,respectively.Effective annual interest rates over the same period are 5.2%,5.5%,and 5.8%.What is the ?2-year swap price on a hypothetical "forward swap" that begins at the end of year 1?
A) $2.14
B) $2.32
C) $2.41
D) $2.53
Q2) How does the existence of swaptions add to the possibilities in risk management techniques? While option strategies have not yet been discussed,students should be able to draw conclusions from prior chapters.Lead the class in a discussion of how options lead to an infinite range of possible strategies for swap investors.
Q3) Describe briefly the nature of a swap and its primary component.
Q4) Under what circumstances would a multinational company elect to enter into a currency swap agreement?
Q5) How would a market-maker hedge a swap involving variable price and quantity?
Q6) Why do arbitrage profits rarely exist in interest rate swap pricing?
Q7) Explain a "diff swap" as it relates to currency swaps.
Page 10
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Chapter 9: Parity and Other Option Relationships
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Sample Questions
Q1) Rankin Corp.common stock is priced at $74.20 per share.The company just paid its $1.10 quarterly dividend.Interest rates are 6.0%.A $70.00 strike European call,maturing in 6 months,sells for $6.50.How much arbitrage profit/loss is made by shorting the European call,which is priced at $2.50?
A) $0.12 loss
B) $0.12 gain
C) $0.36 loss
D) $0.36 gain
Q2) The necessary condition for early exercise is that we prefer to receive something sooner rather than later.With a dividend paying call and a non-dividend paying put,what do we receive?
Q3) The spot exchange rate in dollars per euro is $1.31.Dollar denominated interest rates are 4.0% and euro denominated interest rates are 3.0%.What is the difference in call and put option prices given a 2-year option and a $1.34 strike price?
A) -$0.1041
B) -$0.0652
C) $0.1233
D) $0.1546
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11
Chapter 10: Binomial Option Pricing: Basic Concepts
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Sample Questions
Q1) Explain the impact a constant dividend yield would have on the price of a call option.
Q2) Draw the binomial tree listing only the option prices at each node.Assume the following data on a 6-month put option,using 3-month intervals as the time period.K = $40.00,S = $37.90,r = 5.0%, = 0.35
Q3) A stock is selling for $53.20.Interest rates are 6.0% and the returns on the stock have a standard deviation of 24.0%.What is the forecasted up movement in the stock over a 6-month interval?
A) $64.96
B) $69.69
C) $73.48
D) $76.96
Q4) A stock is currently selling for $22.00 per share.Ignoring interest,determine the intrinsic value of a call option should there exist equally probable stock prices of $25.00 and $23.00.
A) $0.00
B) $1.00
C) $2.00
D) $3.00
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Page 12
Chapter 11: Binomial Option Pricing: Selected Topics
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Sample Questions
Q1) What economic concept is central to proving that risk neutral pricing functions in the establishing of option prices?
A) Consumption possibilities
B) Factor analysis
C) Marginal average cost
D) Declining marginal utility
Q2) When developing a binomial tree model where stocks pay discrete dividends,what problem may occur?
Q3) Consider a one-period binomial model of 12 months.Assume the stock price is $54.00, = 0.25,r = 0.04 and the exercise price of a call option is $55.What is the forecasted price of the stock given a downward movement during the year?
A) $43.77
B) $ 45.28
C) $48.98
D) $51.84
Q4) Under what circumstances should an option be exercised early?
Q5) What is the primary potential for error when using the Cox-Ross-Rubenstein binomial tree?
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Chapter 12: The Black-Scholes Formula
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Sample Questions
Q1) Assume that a $60 strike call has a 2.0% continuous dividend,r = 0.05,and the stock price is $61.00.What is the theta of the option as the expiration time declines from 60 to 50 days?
A) -0.52
B) -0.42
C) -0.32
D) -0.22
Q2) Which Greek is also called time decay and why?
Q3) Assume that a $75 strike call has a 1.0% continuous dividend,90 days until expiration and stock price of $72.00.What is the rho of the option as the interest rate changes from 6.0% to 5.0%?
A) 0.07
B) 0.12
C) 0.16
D) 0.20
Q4) Why do we care about Greeks? Use this as an opportunity to introduce students to option strategies.Ask students to create simple strategies such as covered calls.Introduce Greeks and show how "not all covered calls are created equal." Encourage the class to explain how the Greeks tell us which options are better to use than others.
Page 14
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Chapter 13: Market-Making and Delta-Hedging
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Sample Questions
Q1) The equation used by Black and Scholes to characterize the behavior of an option,expressed with Greeks,holds true for American options as well as European options with one exception.What is the exception?
Q2) Which of the following is NOT a source of cash while maintaining a delta neutral hedge?
A) Borrowing
B) Purchase or sale of shares
C) Interest
D) Self financing
Q3) Assume S = $62.50, = 0.20,r = 0.03,div = 0.0,on a $60 strike call and 81 days until expiration.Given a delta = 0.7092,gamma = 0.0582,and theta = -0.0158,what is the PREDICTED call price,using the delta,gamma,theta approach,after 1 day,assuming a $0.50 rise in the stock price?
A) $4.364
B) $4.376
C) $4.390
D) $4.392
Q4) What actions are required to both delta-hedge and gamma-hedge a written option position?
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Chapter 14: Exotic Options: I
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Sample Questions
Q1) Assume S = $42,K = 45,div = 0,r = 0.04, = 0.48,and 80 days until expiration.What is the premium on a knock-out put option with a down-and-out barrier of $44?
A) $2.13
B) $3.13
C) $3.47
D) $4.07
Q2) Assume S = $31.75,div = 0,r = 0.03,and = 0.20,and 90 days until the expiration of a standard call option.A put on call compound option with an exercise price of $2.00 has 180 days until expiration.What is the premium of the put on call option?
A) $0.42
B) $0.48
C) $0.85
D) $1.11
Q3) When hedging a foreign currency position,what makes a down-and-out put unattractive?
Q4) For a long put position,what benefit is provided by a gap option should prices rise?
Q5) What is the primary difference between a standard option and an exchange option?
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Page 16
Chapter 15: Financial Engineering and Security Design
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Sample Questions
Q1) Wayne,Inc.stock is $40.00 per share.The company's quarterly dividend is forecasted as $0.45 per share,indefinitely.A coupon equity-linked bond,promising to pay one share of Wayne,Inc.in 3 years pays a quarterly coupon of $0.50.If annual interest rates are 4.0%,what is the price of the bond?
A) $40.56
B) $42.60
C) $44.56
D) $46.60
Q2) Assume the spot price of gold is $745 per ounce and the 2-year forward price is $773.Annualized 1-year and 2-year forward interest rates are 5.0% and 5.2%,respectively.For a commodity-linked note to sell at par,what is the annual coupon?
A) $23.09
B) $24.09
C) $25.09
D) $26.09
Q3) What possible tax advantage exists in equity-linked notes?
Q4) How does a coupon bond differ from an equity-linked bond?
Q5) What is the primary difference between an equity-linked bond and a currency-linked bond?
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Chapter 16: Corporate Applications
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Sample Questions
Q1) In the case of an acquisition,with which of the following offer structures does the acquired firm bear the most risk between the time the offer is accepted and the time it is consummated?
A) Fixed stock offer
B) Floating stock offer
C) Fixed collar offer
D) Floating collar offer
Q2) We will assume that Nathans,Inc.has 3-year zero-coupon debt outstanding,which will pay $200 at maturity.The assets are valued at $175, = 0.20,r = 0.04,and the company does not pay a dividend.Using a Black-Scholes model,what is the value of the equity?
A) $23.05
B) $43.05
C) $63.05
D) $83.05
Q3) Why should or should not a company expense compensation options? Divide the class into two groups and assign each a different opinion.Have each prepare arguments to support their case.After brief group meetings,have each group present their conclusions.
Q4) Why does a company sell a put when issuing compensation options?
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Chapter 17: Real Options
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Sample Questions
Q1) Why is the perpetual call formula used to price commodity extraction options?
Q2) Use Cox-Ross-Rubenstein to construct a 2-year binomial tree for the evolution of cash flows with a binomial period of 1.Assume the initial cash flow is (CF )= $62 million, = 0.20,r<sub><sup>p</sup></sub> = 0.14,and g = 0.03.What is the highest possible value of the project?
A) $222 million
B) $314 million
C) $622 million
D) $841 million
Q3) The current price of silver is $32.00 per ounce.The effective lease rate and risk free rate are 3.0% and 4.0%,respectively.If the cost to mine one ounce of silver is a constant $25.00,what is the trigger price per ounce at which the silver will be mined?
A) $33.17
B) $35.17
C) $37.17
D) $39.17
Q4) What is the main difference in pricing R & D options versus most other real options?
Q5) What two components go into valuing an infinite commodity reserve?
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Chapter 18: The Lognormal Distribution
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Sample Questions
Q1) A stock is valued at $55.00.The annual expected return is 12.0% and the standard deviation of annualized returns is 22.0%.If the stock is lognormally distributed,what is the expected median stock price after 3 years?
A) $57.67
B) $67.67
C) $77.67
D) $87.67
Q2) What is the probability that a number drawn from the standard normal distribution will NOT be between -1 and 1?
A) 0.22
B) 0.32
C) 0.42
D) 0.52
Q3) Given a mean of -7.8 and a standard deviation of 16 from a normally distributed sample,what is the probability of an observation being below 12.0?
A) 0.51
B) 0.61
C) 0.71
D) 0.81
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Chapter 19: Monte Carlo Valuation
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Sample Questions
Q1) Given X = N (0,1)and X = N (0.5,8),what is the mean of e ²?
A) 69.97
B) 79.97
C) 89.97
D) 99.97
Q2) A stock owned by a portfolio has a bankruptcy probability of 1% per year.Using a Poisson distribution,what is the probability that this firm will not declare bankruptcy over the upcoming 10 years?
A) 60%
B) 70%
C) 80%
D) 90%
Q3) When valuing options using true probabilities,the discount rate is computed as follows:
A) Once using the risk-free rate
B) At the final period
C) For each node
D) For each path
Q4) What advantage does a variance reduction technique offer?
Q5) How does the number of draws impact the validity of a Monte Carlo simulation?
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Chapter 20: Brownian Motion and Itos Lemma
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Sample Questions
Q1) Assume a stock price of S(0)= $62.00,r = 0.05, = 0.30,and dividend = 0.What is the price of a claim that pays \( \sqrt{S} \) ? Use formula 20.29.
A) $7.59
B) $8.59
C) $9.59
D) $10.59
Q2) When considering drift and noise,how would you explain price movements over smaller and smaller time intervals?
Q3) Assume the following: LN(S)and LN(Q)have a correlation coefficient of -0.20,S(0)= 45,S(Q)= 55,r = 0.03, s = 0.18 Q = 0.28,and no dividends.Using formula 20.39,what is the price of a claim that pays 1/ \(\sqrt{Q S}\) ?
A) $3.02
B) $2.02
C) $1.02
D) $0.02
Q4) What are two important implications of assuming that prices follow a geometric Brownian motion?
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Page 22
Chapter 21: The Black-Scholes-Merton Equation
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Sample Questions
Q1) What is the boundary condition for a European put option?
A) Max [0,S(T)-K]
B) Max [0,K-S(T)]
C) Min [0,S(T)-K]
D) Min [0,K-S(T)]
Q2) Explain the relationship between strike prices and implied volatilities under a price jump scenario.
Q3) Assume S = $48.35,K = 45, = 0.23,r = 0.04,T - t = 60 days,div = 0,and a jump probability = 0.005.What is the increase in the value of a call over a no-jump call?
A) $0.04
B) $0.03
C) $0.02
D) $0.01
Q4) What is the boundary condition for a European call option?
A) Max [0,S(T)-K]
B) Max [0,K-S(T)]
C) Min [0,S(T)-K]
D) Min [0,K-S(T)]
Q5) Give an example of currency translation that is a change in numeraire.
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Chapter 22: Risk-Neutral and Martingale Pricing
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Q1) How do asset values differ between using a traditional DCF approach and a stochastic discount factor approach?
Q2) When defining a change in measure,a redefining of the units in which a payoff is measured is called:
A) Brownian motion
B) Change of numeraire
C) Stochastic discount factor
D) Utility function
Q3) The primary link between Brownian motion and Girsanov's theorem relates to which variable?
A) Drift
B) Numeraire
C) Returns
D) Standard deviation
Q4) What aspect of risk-neutral pricing valuation links it to portfolio selection?
Q5) In the first-order condition for portfolio selection,explain the meaning of equilibrium.
Q6) What does Girsanov's theorem tell us about drift and Brownian motion?
Q7) How do probabilities change with a change of measure?
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Chapter 23: Exotic Options: 2
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Q1) How does a quanto hedge the currency risk a U.S.investor encounters when investing in foreign indexes?
Q2) Suppose S = $52.50,K = $50, = 0.25,r = 0.04 and div = 0.01.What is the price of a gap option with 156 days until expiration and K = $32.00?
A) $14.00
B) $15.00
C) $16.00
D) $17.00
Q3) Eugene holds a collect-on-delivery call with S = $36.50,K = $35, = 0.22,r = 0.04,div = 0 and 270 days until expiration.What is the value of the European COD call?
A) $5.90
B) $6.90
C) $7.90
D) $8.90
Q4) What purpose do currency linked options serve?
Q5) Donald Trump offers to give you a partnership share in his casinos if the price of his shares drops below a certain level.He charges a nominal fee for this right.What is he offering you and is he wise?
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Chapter 24: Volatility
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Sample Questions
Q1) Explain the pattern of implied volatility that is often referred to as a smirk.(Use a call as your example.)
Q2) Ask students to provide a definition of forecasted volatility and market efficiency.Begin a discussion of the consistency or inconsistency that may exist between these two concepts.Is it possible that markets are inefficient if volatility can be forecasted? If so,how can someone take advantage of this inefficiency to make excess returns?
Q3) A stock has a historical volatility of 39%.The data shows significantly increased volatility in recent data and significantly lower volatility in older data.The implied estimate of the unconditional volatility using the GARCH model is most likely to be which of the following?
A) 12%
B) 25%
C) 45%
D) 85%
Q4) What is the primary difference between ARCH models and GARCH models?
Q5) Why would an exponentially weighted moving average be a more accurate means of calculating volatility than a simple sampling of historical data?
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Chapter 25: Interest Rate and Bond Derivatives
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Sample Questions
Q1) How does the node configuration in interest rates and bonds differ from stocks?
Q2) Bonds maturing in 1,2,and 3 years have prices of 0.9600,0.9153 and 0.8620,respectively.A 0.9300 strike call on a 1-year bond matures in 1 year with = 0.20.What is the price of an 8.0% interest rate caplet that expires in 1 year?
A) $0.66
B) $0.76
C) $0.86
D) $0.96
Q3) The price of a bond that matures in 1 year is 103.34,using base 100 pricing.The price of a bond that matures in two years is 101.90,using base 100 pricing.What is the 1-year bond forward price in year 1?
A) 98.56
B) 98.61
C) 101.90
D) 103.34
Q4) What is the transaction that results within an interest rate cap to make the holder's rate "capped"?
Q5) Describe the effectiveness of duration as a tool in hedging bonds.
Q6) What is calibration?
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Chapter 26: Value at Risk
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21 Verified Questions
21 Flashcards
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Sample Questions
Q1) Use VaR techniques to determine the cost of insurance on a risky investment.The investment asset has a value of $80 and pays no dividend.The historical standard deviation of the asset is 15% and the expected return on the asset is 8%.At the 95% confidence level,what is the price of a put option that insures the asset over the next year?
A) $2.56
B) $1.25
C) $0.86
D) $0.15
Q2) A stock has a price of $42.63 and pays no dividend.The historical standard deviation of the stock is 18% and the expected return on the stock is 11%.At the 95% confidence level,what is the Tail VaR over the next 270 days?
A) $2.13
B) $6.56
C) $9.71
D) $40.50
Q3) Why is VaR an important tool in measuring risk? What are some of its shortcomings? Ask the class to explain the rationale for a company to rely heavily on VaR in the absence of other measurement tools.
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Chapter 27: Credit Risk
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18 Verified Questions
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Sample Questions
Q1) What is the recovery rate?
Q2) The chance that a counter party may fail to meet a contractual obligation on a debt instrument is referred to as:
A) Credit risk
B) Credit spread
C) Loss given default
D) Recovery rate
Q3) What are the two ways that the payoff conditional on default can be expressed?
Q4) A firm has a single issue of a zero coupon debt that promises to pay $90 in 4 years,and the A = $100,r = 4%, = 25%,and = 0.If the asset has a 2% chance of total default,what is the value of the debt?
A) $67.10
B) $75.19
C) $85.62
D) $90.00
Q5) What is a credit default swap and what function does it serve?
Q6) What is meant by the phrase "tranche" when referring to collateralized debt obligations?
Q7) What does a transition matrix indicate about a bond's future credit risk?
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