Futures and Options
Pre-Test Questions
Course Introduction
This course provides a comprehensive introduction to the concepts, principles, and practical applications of futures and options markets. Students will explore the structure and function of derivative instruments, including pricing, hedging, arbitrage, and risk management strategies. Emphasis is placed on the valuation of contracts, market mechanisms, margin requirements, and the roles that futures and options play in contemporary financial markets. Real-world examples and case studies will help students understand the use of derivatives for speculation and risk mitigation across various asset classes, preparing them for careers in finance, investment, or related fields.
Recommended Textbook Fundamentals of Futures and Options Markets 8th Edition by John C. Hull
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Chapter 1: Introduction
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Q1) Which of the following is NOT true about call and put options?
A) An American option can be exercised at any time during its life
B) A European option can only be exercised only on the maturity date
C) Investors must pay an upfront price (the option premium) for an option contract
D) The price of a call option increases as the strike price increases
Answer: D
Q2) 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
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Chapter 2: Mechanics of Futures Markets
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Q1) With bilateral clearing, the number of agreements between four dealers, who trade with each other, is
A) 12
B) 1
C) 6
D) 2
Answer: C
Q2) The frequency with which margin accounts are adjusted for gains and losses is
A) Daily
B) Weekly
C) Monthly
D) Quarterly
Answer: A
Q3) Margin accounts have the effect of
A) Reducing the risk of one party regretting the deal and backing out
B) Ensuring funds are available to pay traders when they make a profit
C) Reducing systemic risk due to collapse of futures markets
D) All of the above
Answer: D
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Page 4
Chapter 3: Hedging Strategies Using Futures
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Q1) Which of the following increases basis risk?
A) A large difference between the futures prices when the hedge is put in place and when it is closed out
B) Dissimilarity between the underlying asset of the futures contract and the hedger's exposure
C) A reduction in the time between the date when the futures contract is closed and its delivery month
D) None of the above
Answer: B
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) The zero curve is downward sloping. Define X as the 1-year par yield, Y as the 1-year zero rate and Z as the forward rate for the period between 1 and 1.5 year. Which of the following is true?
A) X is less than Y which is less than Z
B) Y is less than X which is less than Z
C) X is less than Z which is less than Y
D) Z is less than Y which is less than X
Q2) The compounding frequency for an interest rate defines
A) The frequency with which interest is paid
B) A unit of measurement for the interest rate
C) The relationship between the annual interest rate and the monthly interest rate
D) None of the above
Q3) The zero curve is upward sloping. Define X as the 1-year par yield, Y as the 1-year zero rate and Z as the forward rate for the period between 1 and 1.5 year. Which of the following is true?
A) X is less than Y which is less than Z
B) Y is less than X which is less than Z
C) X is less than Z which is less than Y
D) Z is less than Y which is less than X
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Page 6
Chapter 5: Determination of Forward and Futures Prices
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Q1) Which of the following is true?
A) The convenience yield is always positive or zero
B) The convenience yield is always positive for an investment asset
C) The convenience yield is always negative for a consumption asset
D) The convenience yield measures the average return earned by holding futures contracts
Q2) Which of the following is NOT true?
A) Gold and silver are investment assets
B) Investment assets are held by significant numbers of investors for investment purposes
C) Investment assets are never held for consumption
D) The forward price of an investment asset can be obtained from the spot price, interest rates and the income paid on the asset
Q3) Which of the following describes a known dividend yield on a stock?
A) The size of the dividend payments each year is known
B) Dividends per year as a percentage of today's stock price are known
C) Dividends per year as a percentage of the stock price at the time when dividends are paid are known
D) Dividends will yield a certain return to a person buying the stock today
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Page 7
Chapter 6: Interest Rate Futures
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Q1) A portfolio is worth $24,000,000. The futures price for a Treasury note futures contract is 110 and each contract is for the delivery of bonds with a face value of $100,000. On the delivery date the duration of the bond that is expected to be cheapest to deliver is 6 years and the duration of the portfolio will be 5.5 years. How many contracts are necessary for hedging the portfolio?
A) 100
B) 200
C) 300
D) 400
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
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8
Chapter 7: Swaps
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Q1) A floating-for-fixed currency swap is equivalent to
A) Two interest rate swaps, one in each currency
B) A fixed-for-fixed currency swap and one interest rate swap
C) A fixed-for-fixed currency swap and two interest rate swaps, one in each currency
D) None of the above
Q2) Which of the following describes the five-year swap rate?
A) The rate on a five-year loan to a AA-rated company
B) The rate on a five-year loan to an A-rated company
C) The rate that can be earned over five years from a series of short-term loans to AA-rated companies
D) The rate that can be earned over five years from a series of short-term loans to A-rated companies
Q3) Which of the following is true for an interest rate swap?
A) A swap is usually worth close to zero when it is first negotiated
B) Each forward rate agreement underlying a swap is worth close to zero when the swap is first entered into
C) Comparative advantage is a valid reason for entering into the swap
D) None of the above
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Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%, mezzanine 10%, and equity 5%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. How high can losses on the mortgages be before the mezzanine tranche of the ABD CDO bears losses?
A) 5.0%
B) 5.5%
C) 6.0%
D) 6.5%
Q2) Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 85%, mezzanine 10%, and equity 5%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. How high can losses on the mortgages be before the senior tranche of the ABS CDO bears losses?
A) 5.5%
B) 6.0%
C) 6.5%
D) 7.0%
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Chapter 9: Mechanics of Options Markets
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Q1) Which of the following describes a short position in an option?
A) A position in an option lasting less than one month
B) A position in an option lasting less than three months
C) A position in an option lasting less than six months
D) A position where an option has been sold
Q2) Which of the following is an example of an option series?
A) All calls on a certain stock
B) All calls with a particular strike price on a certain stock
C) All calls with a particular time to maturity on a certain stock
D) All calls with a particular time to maturity and strike price on a certain stock
Q3) Which of the following is true?
A) A long call is the same as a short put
B) A short call is the same as a long put
C) A call on a stock plus a stock the same as a put
D) None of the above
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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) When volatility 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
Q3) When the strike 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 diagonal 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 diagonal 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 diagonal 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 diagonal 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) How can a strangle 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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Chapter 12: Introduction to Binomial Trees
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Q1) The current price of a non-dividend-paying stock is $40. Over the next year it is expected to rise to $42 or fall to $37. An investor buys put options with a strike price of $41. What is the value of each option? The risk-free interest rate is 2% per annum with continuous compounding.
A) $3.93
B) $2.93
C) $1.93
D) $0.93
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) 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
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) When there are two dividends on a stock, Black's approximation sets the value of an American call option equal to which of the following?
A) The value of a European option maturing just before the first dividend
B) The value of a European option maturing just before the second (final) dividend
C) The greater of the values in A and B
D) The greater of the value in B and the value assuming no early exercise
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Chapter 14: Employee Stock Options
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Q1) Which of the following was true about employee stock options between 1996 and 2004?
A) The options never had any affect on a company's financial statements
B) The value of options which were at-the-money when issued had to be expensed on the income statement
C) The value of options which were at-the-money when issued had to be reported in the notes to the financial statements
D) Options which were at-the-money when issued did not affect a company's financial statements
Q2) Which of the following is true about employee stock options after they have been issued?
A) They have to be revalued every year
B) They have to be revalued every quarter
C) They have to be revalued every day like other derivatives
D) They never have to be revalued
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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 stock prices might decline rapidly during the next six months and would like to use options on an index to provide protection against the portfolio falling below $9.5 million. The index is currently standing at 500 and each contract is on 100 times the index. What position is required if the portfolio has a beta of 1?
A) Short 200 contracts
B) Long 200 contracts
C) Short 100 contracts
D) Long 100 contracts
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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) A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34 cents in the next six months. The risk-free interest rate is 6%. What is the probability of an up movement in a risk-neutral world?
A) 0.4
B) 0.5
C) 0.72
D) 0.6
Q3) 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
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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) A trader uses a stop-loss strategy to hedge a short position in a three-month call option with a strike price of 0.7000 on an exchange rate. The current exchange rate is 0.6950 and value of the option is 0.1. The trader covers the option when the exchange rate reaches 0.7005 and uncovers (i.e., assumes a naked position) if the exchange rate falls to 0.6995. Which of the following is NOT true?
A) The exchange rate trading might cost nothing so that the trader gains 0.1 for each option sold
B) The exchange rate trading might cost considerably more than 0.1 for each option sold so that the trader loses money
C) The present value of the gain or loss from the exchange rate trading should be about 0.1 on average for each option sold
D) The hedge works reasonably well
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Chapter 18: Binomial Trees in Practice
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Q1) A European option on a stock with known dollar dividend is valued by setting the stock price variable equal to the stock price minus the present value of the dividend in the Black-Scholes-Merton formula. A second price can be obtained using the tree building procedure in the chapter. Which of the following is true when a very large number of time steps are used in the tree?
A) The first price is higher than the second price
B) The first price is lower than the second price
C) The first price is sometimes higher and sometimes lower than the second price
D) The two prices are almost exactly the same
Q2) Which of the following can be valued without using a numerical procedure such as a binomial tree?
A) American put options on a non-dividend paying stock
B) American call options on a non-dividend paying stock
C) American call options on a currency
D) American put options on futures
Q3) Which of the following is true for u in a Cox-Ross-Rubinstein binomial tree?
A) It depends on the interest rate and the volatility
B) It depends on the volatility but not the interest rate
C) It depends on the interest rate but not the volatility
D) It depends on neither the interest rate nor the volatility
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Chapter 19: Volatility Smiles
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Q1) The daily percentage change in an exchange rate is compared to a normal distribution with the same mean and standard deviation. Which of the following is true?
A) Both small and large exchange rate moves are more likely than with the normal distribution
B) Small exchange rate moves are less likely and large exchange rate moves are more likely than with the normal distribution
C) Large exchange rate moves are less likely and small exchange rate moves are more likely than with the normal distribution
D) Both small and large exchange rate moves are less likely than with the normal distribution
Q2) 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
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Chapter 20: Value at Risk
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Q1) 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
Q2) Which was the minimum capital requirement for market risk in the 1996 BIS Amendment?
A) At least 3 times the 10-day VaR with a 99% confidence level
B) At least 3 times 7-day VaR with a 97% confidence level
C) At least 2 times 5-day VaR with a 95% confidence level
D) 1-day VaR with a 99% confidence level
Q3) 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
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Page 22
Chapter 21: Interest Rate Options
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Q1) Which of the following is true?
A) A swaption that gives the holder the right to pay fixed is equivalent to a call option on a bond
B) A swaption that gives the holder the right to pay fixed is equivalent to a put option on a bond
C) A swaption that gives the holder the right to pay fixed is equivalent to a put option on one bond combined with a call option on another bond
D) None of the above
Q2) Which of the following is true?
A) A cap is a portfolio of put options on interest rates
B) A cap is a put option on a coupon-bearing bond
C) A cap is a call option on a coupon-bearing bond
D) None of the above
Q3) 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
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23
Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) 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
Q2) A PO is a "principal only" MBS and an IO is an "interest only" MBS. As prepayments increase which of the following happens?
A) Both the PO and IO become more valuable
B) The PO becomes more valuable and the IO becomes less valuable
C) The PO becomes less valuable and the IO becomes more valuable
D) Both the PO and IO become less valuable
Q3) Which of the following would be referred to as an equity swap?
A) An exchange of the return from an equity index for a fixed rate of interest
B) An exchange of a long position in one stock for a long position in another stock
C) An exchange of a short position in one stock for a short position in another stock
D) None of the above
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Chapter 23: Credit Derivatives
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Q1) 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
Q2) Which of the following is the most popular life for a credit default swap?
A) 1 year
B) 3 years
C) 5 years
D) 10 years
Q3) If the CDS spread for a regular 5-year CDS is 120 basis points, what is the CDS spread for a 5-year binary CDS on the same underlying reference entity? Assume a recovery rate of 40%.
A) 48 basis points
B) 72 basis points
C) 200 basis points
D) 300 basis points
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25
Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Which of the following might we expect to be the result of global warming?
A) An decrease in observed CDDs
B) An increase in observed CDDs
C) An increase in observed HDDs
D) None of the above
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) When a reinsurer covers the layer of hurricane losses for an insurance company between $20 million and $30 million, which of the following describes the insurance company's losses?
A) A bull spread on total hurricane losses
B) A bear spread on total hurricane losses
C) A long call option on total hurricane losses
D) A short put option on total hurricane losses
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