Chapter 9

Demystifying Derivatives
D1Factual
1. Which of the following is not a derivative? A) Treasury bond futures B) Common stock C) wa!s ") #!tions Answer$ B

D1Factual
%. A&n) '''''''''''''''''' is a contractual agreement that calls for the delivery of a s!ecific underlying commodity or security at some future date at a currently agreed(u!on !rice. A) o!tion contract B) swa! C) futures contract ") bond Answer$ C

D1Interpretive
). *inancial institutions use futures contracts as a means of A) risk management. B) e+!anding ca!ital. C) minimi,ing ta+es. ") increasing assets. Answer$ A

D1Factual
-. Which of the following is a derivative financial asset? A) A mortgage B) Commercial !a!er C) A Treasury bill ") An o!tion contract Answer$ "

100

101.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D2Factual
3. Which of the following futures contracts is available on the various commodity e+changes in the 0nited tates? A) Treasury bond futures B) 4nvestment(grade bonds C) #ver(the(counter stocks ") 0. . savings bonds Answer$ A

D2Factual
5. Which of the following futures contracts is available on the Chicago Board of Trade? A) 6ew 7ork tock 2+change Com!osite 4nde+ futures B) *oreign currency futures C) 0. . Treasury bonds ") 8alue 9ine :arket 4nde+ futures Answer$ C

D2Factual
;. *utures contracts are least likely to be traded on which of the following e+changes? A) 6ew 7ork tock 2+change B) Chicago Board of Trade C) Chicago :ercantile 2+change ") All of the above are e<ually likely to trade futures contracts. Answer$ A

D1Factual
=. The !recise terms of each futures contract are A) negotiated by the long and the short. B) set by the short. C) set by the long. ") established by the e+change on which the trade takes !lace. Answer$ "

D2Interpretive
>. The !rice of a Treasury bond futures contract is set A) by the federal government. B) by the Chicago Board of Trade. C) by the *ederal .eserve. ") as a result of bidding and offering by market !artici!ants. Answer$ "

D2Applied
1?. 4f !erson A sells a %??) Treasury bond futures contract to !erson B1 in market terminology1 A) A is the long and B is the short. B) A is the short and B is the long. C) A is the short and B is the broker. ") A is the long and B is the dealer. Answer$ B

Cha!ter >"emystifying "erivatives 102

D2Interpretive
11. The Chicago Board of Trade !romotes li<uidity in the futures market by A) setting !rices. B) establishing a !rice floor. C) allowing the short or the long to renegotiate contract terms. ") standardi,ing contract terms. Answer$ "

D2Interpretive
1%. '''''''''''''''''' trading volume !romotes '''''''''''''''''' bid(asked s!reads. A) 9arge@ wide B) 9arge@ narrow C) mall@ narrow ") 6one of the above Answer B

D2Factual
1). The clearing cor!oration associated with the Chicago Board of Trade consists of A) government regulatory bodies. B) maAor commercial banks. C) members of the e+change. ") maAor cor!orations. Answer$ C

D2Factual
1-. *or the settlement of futures contracts1 the clearing cor!oration re<uires that a margin be !laced with the cor!oration by A) the short only. B) the long only. C) the short and the long in all contracts. ") the short and the long only in e+traordinary circumstances. Answer$ C

D1Factual
13. *utures contracts are marked(to(market A) every day. B) every week. C) every month. ") every <uarter. Answer$ A

D2Factual
15. .ather than acce!t delivery1 most traders in futures markets choose A) to make margin !ayments. B) settlement by offset. C) to mark(to(market. ") to make arbitrage !ayments. Answer$ B

103.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D2Factual
1;. 4n the financial futures <uotations1 the total number of long !ositions outstanding is called A) settlements. B) market activity. C) o!en interest. ") arbitrage. Answer$ C

D1Factual
1=. '''''''''''''''''' buy or sell futures contracts to reduce their e+!osure to the risk of future !rice movements in the underlying asset. A) Bedgers B) !eculators C) Arbitrageurs ") 6one of the above Answer$ A

D2Factual
1>. Which of the following futures contracts would not have an interest rate com!onent? A) Treasury bonds B) Treasury notes C) :unici!al Bond 4nde+ ") tandard and CoorDs 3?? tock 4nde+ Answer$ "

D2Interpretive
%?. 4n order to reduce market risk associated with bonds held in inventory1 a dealer can A) take a long !osition in bond futures. B) take a short !osition in bond futures. C) !urchase bonds at the mark(to(market settlement !rice. ") use settlement by offset !rocedures. Answer$ B

D2Interpretive
%1. The relationshi! between the !rice in the cash market and the !rice in the futures market is A) none+istent. B) negative. C) !ositive. ") 6one of the above Answer$ C

D2Interpretive
%%. !eculators absorb additional risk in futures markets as a result of the actions taken by A) longs. B) hedgers. C) brokers. ") shorts. Answer$ B

Cha!ter >"emystifying "erivatives 104

D2Interpretive
%). 4n the futures market1 the difference between the !rice of the futures and the underlying asset is eliminated by A) s!eculators. B) hedgers. C) arbitrageurs. ") longs. Answer$ C

D3Interpretive
%-. Assume that the !rice of a futures contract is higher than the !rice of the underlying security during the delivery !eriod. Arbitrageurs would A) buy the futures1 simultaneously sell the underlying asset1 and !ocket the !rice difference. B) sell the futures1 simultaneously buy the underlying asset1 and !ocket the !rice difference. C) sell the futures1 simultaneously sell the underlying asset1 and !ocket the !rice difference. ") buy the futures1 simultaneously buy the underlying asset1 and !ocket the !rice difference. Answer$ B

D2Interpretive
%3. "uring the delivery !eriod1 A) the futures !rice e+ceeds the !rice in the cash market. B) the !rice in the cash market e+ceeds the futures !rice. C) the futures !rice and the !rice in the cash market are e<ual. ") there is no discernible relationshi! between the futures !rice and the !rice in the cash market. Answer$ C

D1Factual
%5. Cuts and calls are the choices available to !artici!ants in the A) o!tions market. B) futures market. C) swa! market. ") stock market. Answer$ A

D1Factual
%;. #!tions on individual stocks are not listed on the A) 6ew 7ork tock 2+change. B) American tock 2+change. C) 6asda<. ") Cacific tock 2+change. Answer$ C

105.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D2Factual
%=. 4n the o!tions market1 the right to buy an underlying asset rests with A) call buyers. B) !ut buyers. C) call sellers. ") !ut sellers. Answer$ A

D2Factual
%>. The seller of a call o!tion has the A) right to buy shares at a s!ecified !rice. B) obligation to buy shares at a s!ecified !rice if the o!tion is e+ercised. C) right to sell shares at a s!ecified !rice. ") obligation to sell shares at a s!ecified !rice if the o!tion is e+ercised. Answer$ "

D2Factual
)?. The !rice !aid for an o!tion is called the A) settlement !rice. B) mark(to(market !rice. C) o!tion !remium. ") call !rice. Answer$ C

D2Factual
)1. An o!tion !remium is A) !aid by the short to the long as soon as the o!tion is !urchased. B) !aid by the long to the short as soon as the o!tion is !urchased. C) !aid by the long to the short when the o!tion is e+ercised. ") !aid by the short to the long when the o!tion is e+ercised. Answer$ B

D2Interpretive
)%. Which of the following statements is correct? A) #!tion buyers have rights@ o!tion sellers have obligations. B) #!tion sellers have rights@ o!tion buyers have obligations. C) #!tion buyers and sellers have obligations but not rights. ") #!tions buyers and sellers each have both rights and obligations. Answer$ A

D3Applied
)). The buyer of a !ut o!tion on Boeing with a strike !rice of E;3 and an e+!iration date in 6ovember %??) has the A) right to buy 1?? shares of Boeing at E;3 on or before 6ovember 1>>>. B) right to sell 1?? shares of Boeing at E;3 on or before 6ovember 1>>>. C) right to buy 1?? shares of Boeing at E;3 on or after 6ovember 1>>>. ") right to sell 1?? shares of Boeing at E;3 on or after 6ovember 1>>>. Answer$ B

Cha!ter >"emystifying "erivatives 106

D3Interpretive
)-. A long !ut !osition A) has a value of ,ero if the stock !rice is below the e+ercise !rice. B) has a value e<ual to the stock !rice minus the e+ercise !rice if the stock !rice is above the e+ercise !rice. C) has a value of ,ero if the stock !rice at the time of !urchase e+ceeds the e+!ected stock !rice at o!tion e+!iration. ") has a value e<ual to the e+ercise !rice minus the stock !rice if the stock !rice is below the e+ercise !rice. Answer$ "

D2Applied
)3. A call o!tion has a strike !rice of E=?. 4f the underlying stock is selling for E=) on the e+!iration date1 the intrinsic value of the call o!tion is '''''''''''''''''' !er share. A) E15) B) E=) C) E) ") E? Answer$ C

D2Applied
)5. A call o!tion has a strike !rice of E-=. 4f the underlying stock is selling for E-3 on the e+!iration date1 the intrinsic value of the call o!tion is '''''''''''''''''' !er share. A) E>) B) E-3 C) E) ") E? Answer$ "

D2Factual
);. The '''''''''''''''''' is e<ual to the current stock !rice minus the o!tion e+ercise !rice. A) settlement !rice B) discount !rice C) intrinsic value ") mark(to(market settlement Answer$ C

D2Factual
)=. The o!en interest on calls '''''''''''''''''' the o!en interest on !uts. A) is always e<ual B) is always larger C) is always smaller ") has no direct relationshi! with Answer$ "

107.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D2Factual
)>. Which of the following !ieces of information on individual stocks cannot be found in the o!tions section of the financial news? A) The closing !rice of the stock B) #!en interest C) #!tion trading volume ") Bid !rice Answer$ A

D2Interpretive
-?. *or the buyer of a call o!tion1 the downside risk A) is unlimited1 but u!side !otential is limited. B) is limited1 but u!side !otential is unlimited. C) and u!side !otential are unlimited. ") and u!side !otential are limited. Answer$ B

D2Interpretive
-1. To the o!tions buyer1 the !remium !aid for the contract re!resents the A) ma+imum return. B) largest !otential loss. C) yield. ") transaction cost. Answer$ B

D2Interpretive
-%. The value of the !ut o!tion rises when the underlying asset A) e+!eriences !rice increases. B) e+!eriences !rice declines. C) e+!eriences reduced volatility. ") has a relatively short maturity. Answer$ B

D1Factual
-). Which of the following is not a determinant of o!tion !remiums? A) The volatility of the underlying stock B) The !rice of the underlying stock C) The time to e+!iration of the o!tion ") All of the above are determinants of o!tion !remiums. Answer$ "

Cha!ter >"emystifying "erivatives 108

D2Interpretive
--. The '''''''''''''''''' the !rice of the underlying stock1 the '''''''''''''''''' the call o!tion !remium will be. A) higher@ lower B) lower@ higher C) lower@ lower ") 6one of the above Answer$ C

D2Interpretive
-3. A s!eculator becomes the fi+ed(rate !ayer in an interest rate swa!. Be e+!ects that A) long rates rise. B) long rates fall. C) short rates rise. ") short rates fall. Answer$ C

D2Interpretive
-5. A s!eculator becomes the floating(rate !ayer in an interest(rate swa!. he ho!es that A) long rates rise. B) long rates fall. C) short rates rise. ") short rates fall. Answer$ "

D1Factual
-;. The !arties to a swa! are formally called the A) counter!arties. B) o!tioners. C) short and long !ositions. ") bond( and billholders. Answer$ A

D1Factual
-=. The most !o!ular floating rate in swa!s is A) 94B#. B) the Treasury note rate C) the !rime rate ") the si+(month Treasury bill rate Answer$ A

109.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D2Factual
->. wa!s are '''''''''''''''''' agreements involving the e+change of interest !ayments . A) standardi,ed@ against a bundle of Treasury securities B) standardi,ed@ on a stated notional !rinci!al amount C) customi,ed@ against a bundle of Treasury securities ") customi,ed@ on a stated notional !rinci!al amount Answer$ "

D2Factual
3?. The fi+ed rate in a swa! contract is A) a certain short rate in the market when the contract is signed. B) a certain long rate in the market when the contract is signed. C) negotiated by the !arties in the contract. ") the difference between stated long and short rates when the contract is signed. Answer$ C

D2Interpretive
31. A rise in si+(month 94B#. is good news to '''''''''''''''''' in a swa! contract. A) the fi+ed(rate !ayer B) the floating(rate !ayer C) both !ayers ") neither !ayer Answer$ A

D2Interpretive
3%. A dro! in si+(month 94B#. is good news to '''''''''''''''''' in a swa! contract. A) the fi+ed(rate !ayer B) the floating(rate !ayer C) both !ayers ") neither !ayer Answer$ B

D2Factual
3). The fi+ed(rate !ayer in a swa! contract !ays a A) current ca!ital market rate. B) ca!ital market rate minus one !ercentage !oint. C) ca!ital market rate !lus one !ercentage !oint. ") ca!ital market rate !lus a !remium based on creditworthiness. Answer$ "

Cha!ter >"emystifying "erivatives 110

D2Factual
3-. A swa! designed to com!ensate for mismatched securities is a ty!e of '''''''''''''''''' called a '''''''''''''''''' swa!. A) s!eculation@ 9ondon B) s!eculation@ !lain vanilla C) hedging@ 9ondon ") hedging@ !lain vanilla Answer$ "

D2Factual
33. A swa! contract '''''''''''''''''' be resold1 which is !articularly im!ortant for the '''''''''''''''''' in swa!s. A) can@ s!eculator B) can@ hedger C) cannot@ s!eculator ") cannot@ hedger Answer$ A

D2Interpretive
35. A s!eculator who feels strongly that short rates will be falling over the ne+t few years might want to be a '''''''''''''''''' !ayer in a swa! contract@ if he is wrong there is '''''''''''''''''' downside risk. A) fi+ed(rate@ no B) fi+ed(rate@ considerable C) floating(rate@ no ") floating(rate@ considerable Answer$ "

D2Interpretive
3;. A s!eculator who feels strongly that short rates will be rising over the ne+t few years might want to be a '''''''''''''''''' !ayer in a swa! contract@ if she is wrong there is '''''''''''''''''' downside risk. A) fi+ed(rate@ no B) fi+ed(rate@ considerable C) floating(rate@ no ") floating(rate@ considerable Answer$ B

D1Factual
3=. An asset that derives its value from some other underlying asset is a A) stock B) bond C) derivative ") C" Answer$ C

111.itter/ ilber/0dell Money, Banking, and Financial Markets 1 2leventh 2dition

D1Factual
3>. *utures contract !rices are established A) through an auction !rocess in the F!itG on the e+change floor. B) through brokers. C) through an over(the(counter network of futures dealers. ") through s!ecialists on the stock and bond e+changes. Answer$ A

D2Factual
5?. Traders in futures markets settle gains and losses each day A) by making margin !ayments. B) by using settlement(by(offset. C) in a !rocess called mark(to(market settlement. ") by making arbitrage !ayments. Answer$ C

D3Applied
51. The strike !rice of a !ut o!tion for a !articular stock is E-=. 4f the stock is selling for E-3 on the e+!iration date1 a !ut o!tion on this stock has an intrinsic value of '''''''''''''''''' !er share. A) E-= B) E-3 C) E) ") E? Answer$ C

D2Interpretive
5%. A s!eculator may choose to buy a call o!tion because A) the !ossible gain is greater than with a futures contract. B) the !otential loss on the call is limited to the !remium1 while the !otential loss is unlimited with a futures contract. C) the !ossible gain with the o!tion is great than the !ossible gain from buying the underlying stock itself. ") calls eliminate the risk of loss so a s!eculator can lose nothing or Aust make a gain. Answer$ B