CHAPTER 1: INTRODUCTION

1. The market value of the derivatives contracts worldwide totals

a. less than a trillion dollars
b. in the hundreds of trillion dollars
c. over a trillion dollars but less than a hundred trillion
d. over quadrillion dollars
e. none of the above

2. Cash markets are also known as

a. speculative markets
b. spot markets
c. derivative markets
d. dollar markets
e. none of the above

3. A call option gives the holder

a. the right to buy something
b. the right to sell something
c. the obligation to buy something
d. the obligation to sell something
e. none of the above

4. Which of the following instruments are contracts but are not securities
a. stocks
b. options
c. swaps
d. a and b
e. b and c

5. The positive relationship between risk and return is called

a. expected return
b. market efficiency
c. the law of one price
d. arbitrage
e. none of the above

6. A transaction in which an investor holds a position in the spot market and sells
a futures contract or writes a call is
a. a gamble
b. a speculative position
c. a hedge
d. a risk-free transaction
e. none of the above

7. Which of the following are advantages of derivatives?

a. lower transaction costs than securities and commodities
b. reveal information about expected prices and volatility
c. help control risk
d. make spot prices stay closer to their true values
e. all of the above

8. A forward contract has which of the following characteristics?

a. has a buyer and a seller
b. trades on an organized exchange
c. has a daily settlement
d. gives the right but not the obligation to buy
e. all of the above

9. Options on futures are also known as

a. spot options
b. commodity options
c. exchange options
d. security options
e. none of the above

10. A market in which the price equals the true economic value
a. is risk-free
b. has high expected returns
c. is organized
d. is efficient
e. all of the above

11. Which of the following trades on organized exchanges?

a. caps
b. forwards
c. options
d. swaps
e. none of the above
12. Which of the following markets is/are said to provide price discovery?
a. futures
b. forwards
c. options
d. a and b
e. b and c

13. Investors who do not consider risk in their decisions are said to be
a. speculating
b. short selling
c. risk neutral
d. traders
e. none of the above

14. Which of the following statements is not true about the law of one price
a. investors prefer more wealth to less
b. investments that offer the same return in all states must pay the risk-free rate
c. if two investment opportunities offer equivalent outcomes, they must have the
same price
d. investors are risk neutral
e. none of the above

15. Which of the following contracts obligates a buyer to buy or sell something at a
later date?
a. call
b. futures
c. cap
d. put
e. swaption

16. The process of creating new financial products is sometimes referred to as

a. financial frontiering
b. financial engineering
c. financial modeling
d. financial innovation
e. none of the above

17. The process of selling borrowed assets with the intention of buying them back
at a later date and lower price is referred to as
a. longing an asset
b. asset flipping
c. shorting
d. anticipated price fall arbitrage
e. none of the above

18. In which one of the following types of contract between a seller and a buyer
does the seller agree to sell a specified asset to the buyer today and then buy it back at
a specified time in the future at an agreed future price.
a. repurchase agreement
b. short selling
c. swap
d. call
e. none of the above

19. The expected return minus the risk-free rate is called

a. the risk premium
b. the percentage return
c. the asset’s beta
d. the return premium
e. none of the above

20. When the law of one price is violated in that the same good is selling for two
different prices, an opportunity for what type of transaction is created?
a. return-to-equilibrium transaction
b. risk-assuming transaction
c. speculative transaction
d. arbitrage transaction
e. none of the above
 CHAPTER 2: STRUCTURE OF OPTIONS MARKETS

1. Identify the true statement regarding the largest derivatives exchanges.

a. CME Group is one of the top five largest derivatives exchange, based on
volume
b. Intercontinental Exchange is one of the top five largest derivatives exchange,
based on volume
c. The volume of trading exceeded one billion on each of the top five derivatives
exchanges
d. Among the top 20 derivatives exchanges, several different continents are
represented
e. all of the above

2. A call option priced at $2 with a stock price of $30 and an exercise price of $35
allows the holder to buy the stock at
a. $2
b. $32
c. $33
d. $35
e. none of the above

3. A put option in which the stock price is $60 and the exercise price is $65 is said
to be
a. in-the-money
b. out-of-the-money
c. at-the-money
d. exercisable
e. none of the above

4. Organized options markets are different from over-the-counter options markets

for all of the following reasons except
a. exercise terms
b. physical trading floor
c. regulation
d. standardized contracts
e. credit risk
5. The number of options acquired when one contract is purchased on an
exchange is
a. 1
b. 5
c. 100
d. 500
e. 8,000

6. The advantages of the over-the-counter options market include all of the

following except
a. customized contracts
b. privately executed
c. freedom from government regulation
d. lower prices
e. none of the above

7. Which one of the following is not a type of transaction cost in options trading?
a. the bid-ask spread
b. the commission
c. clearing fees
d. the cost of obtaining a quote
e. all of the above

8. If the market maker will buy at 4 and sell at 4.50, the bid-ask spread is
a. 8.50
b. 4.25
c. 0.50
d. 4.00
e. none of the above

9. Which of the following is a legitimate type of option order on the exchange?

a. purchase order
b. limit order
c. execution order
d. floor order
e. all of the above
10. The exercise price can be set at any desired level on each of the following types
of options except
a. FLEX options
b. equity options
c. over-the-counter options
d. all of the above
e. none of the above

11. An investor who owns a call option can close out the position by any of the
following types of transactions except
a. exercise
b. offset
c. expiring out-of-the-money
d. buying a put
e. none of the above

12. Which of the following is not the task of market makers?

a. provide liquidity
b. offer to buy and sell
c. provide price transparency
d. work as a sole specialist
e. none of the above

13. The option price is also referred to as the

a. strike
b. spread
c. premium
d. fee
e. none of the above

14. Which of the following contract terms is not set by the futures exchange?
a. the dates on which delivery can occur
b. the expiration months
c. the price
d. the deliverable commodities
e. the size of the contract
15. If an investor exercises a cash settled derivative,
a. the transaction entails only a bookkeeping entry
b. must purchase the underlying instrument from the writer
c. immediately buy a put option to offset the call option
d. immediately write another call option to offset
e. none of the above

16. Which of the following organizations has the ultimate regulatory authority in
the futures industry?
a. National Futures Association
b. Commodity Futures Trading Commission
c. Commodity Exchange Authority
d. Securities and Exchange Commission
e. none of the above

17. The derivatives exchange with the largest trading volume is the
a. Moscow Exchange
b. Nasdaq OMX
c. CME Group
d. Pacific Stock Exchange
e. National Stock Exchange of India

18. A writer selected to exercise an option is said to be

a. marginal
b. assigned
c. restricted
d. designated
e. none of the above

19. All of the following are forms of options except

a. convertible bonds
b. callable bonds
c. puttable bonds
d. mutual funds
e. none of the above

20. If the initial margin is $5,000, the maintenance margin is $3,500 and your
balance is $4,000, how much must you deposit?
a. nothing
b. $6,000
 c. $1,500
d. $9,000
e. none of the above

21. In which city did organized option markets originate?

a. New York
b. Chicago
c. Philadelphia
d. San Francisco
e. none of the above

22. If the initial margin is $5,000, the maintenance margin is $3,500 and your
balance is $3,100, how much must you deposit?
a. $1,500
b. $400
c. 0
d. $1,900
e. none of the above

22. An order that specifies a maximum price to pay if buying is a

a. stop order
b. market order
c. limit order
d. all or none order
e. none of the above

23. What amount must a call writer pay if a cash–settled index call is exercised?
a. difference between the index level and the exercise price
b. exercise price
c. difference between the exercise price and the index level
d. index level
e. none of the above

24. Option traders incur which of the following types of costs?

a. margin requirements
b. taxes
c. stock trading commissions
d. a and b
e. a, b and c
25. The total number of long option contracts outstanding at any given time is
called the
a. market cap
b. sum options outstanding (SOO)
c. option wealth outstanding (OWO)
d. open interest
e. none of the above

26. The number of long or short futures positions outstanding is called the
a. reportable position
b. open interest
c. minimum volume
d. spread position
e. none of the above

26. This individual maintains and attempts to fill public option orders but does not
disclose them to others.
a. liquidity provider
b. board broker
c. order book official
d. registered option trader
e. none of the above

27. What intermediary guarantees an option writer’s performance?

a. credit worthiness rating company
b. brokerage
c. good-till-canceled order
d. clearinghouse
e. none of the above

28. Suppose you hold a call option. The stock price has recently been
increasing-making your call option more valuable. Through what process might you
take advantage of the liquid nature of the options market?
a. offsetting order
b. contract reconciliation
c. mark to market order
d. settling up
e. none of the above
29. Where did the U.S. futures market originate?
a. Kansas
b. New York
c. Minneapolis
d. Chicago
e. none of the above

30. Variation margin is which of the following?

a. margin deposited as a result of marking-to-market
b. the difference in margin between hedger and speculator
c. margin differences according to trading style
d. margin set by the variability of a futures price
e. none of the above

31. Which of the following duties is not performed by the clearinghouse?

a. holding margin deposits
b. guaranteeing performance of buyer and writer
c. maintaining records of transactions
d. lending money to meet margin requirements
e. none of the above

32. What are circuit breakers?

a. rules that stop trading when futures are about to expire
b. a system that shuts down the exchange computer during periods of
abnormal volume
c. limits on the number of contracts that can be traded on high volume
days
d. rules that limit the number of contracts a speculator can hold
e. none of the above

33. A futures contract covers 5000 pounds with a minimum price change of $0.01
is sold for $31.60 per pound. If the initial margin is $2,525 and the maintenance
margin is $1,000, at what price would there be a margin call?
a. 31.91
b. 32.11
c. 31.29
d. 31.09
e. 31.80
34. One of the advantages of forward markets is
a. performance is guaranteed by the G-30
b. trading is conducted in the evening over computers
c. the contracts are private and customized
d. trading is less costly and governed by more rules
e. none of the above

35. Individuals engaging in this type of trading strategy are characterized by their
attempt to profit from guessing the direction of the market
a. hedgers
b. spreaders
c. speculators
d. arbitraguers
e. none of the above

36. Despite the fact that forward contracts carry more credit risk than futures
contracts, forward contracts offer what primary advantage over futures contracts?
a. the over-the-counter forward market is a highly regulated market
b. forward contracts prevent the writer from assuming the credit risk of the buyer
c. terms and conditions are tailored to the specific needs of the two parties
involved
d. transaction information between the two parties involved in the forward
contract is readily available to the public
e. conditions of the forward contract, such as delivery date and location, cannot
be altered

37. Which of the following correctly orders the process of daily settlement?
a. clearinghouse officials establish a settlement price; each account is marked to
market; accounts of those holding long/short positions are credited/debited
appropriately; differences between today’s settlement price and the previous days
settlement price are determined
b. clearinghouse officials establish a settlement price; each account is marked to
market; differences between today’s settlement price and the previous day’s settlement
price are determined; accounts of those holding long/short positions are
credited/debited appropriately
c. differences between today’s settlement price and the previous day’s settlement
price are determined; accounts are marked to market; clearinghouse officials establish
a settlement price; accounts of those holding long/short positions are credited/debited
appropriately
d. clearinghouse officials establish a settlement price; differences between today’s
settlement price and the previous days settlement price are determined; accounts of
those holding long/short positions are credited/debited appropriately; each account is
marked to market
e. differences between today’s settlement price and the previous day’s settlement
price are determined; accounts are marked to market; clearinghouse officials establish
a settlement price; accounts of those holding long/short positions are credited/debited
appropriately
 CHAPTER 3: PRINCIPLES OF OPTION PRICING

1. Consider a portfolio consisting of a long call with an exercise price of X, a

short position in a non-dividend paying stock at an initial price of S0, and the purchase
of riskless bonds with a face value of X and maturing when the call expires. What
should such a portfolio be worth?
a. C + P – X(1 + r)-T
b. C – S0
c. P–X
d. P + S0 – X(1 + r)-T
e. none of the above

2. What is the lowest possible value of a European put?

a. Max(0, X – S0)
b. X(1 + r)-T
c. Max[0, S0 – X(1 + r)-T]
d. Max[0, X(1 + r)-T – S0)]
e. none of the above

3. Another expression for intrinsic value is

a. parity
b. parity value
c. exercise value
d. all of the above
e. none of the above

4. On March 2, a Treasury bill expiring on April 20 had a bid discount of 5.86,

and an ask discount of 5.80. What is the best estimate of the risk-free rate as given in
the text?
a. 5.86 %
b. 5.83 %
c. 6.11 %
d. 6.14 %
e. none of the above

5. Suppose you use put-call parity to compute a European call price from the
European put price, the stock price, and the risk-free rate. You find the market price of
the call to be less than the price given by put-call parity. Ignoring transaction costs,
what trades should you do?
a. buy the call and the risk-free bonds and sell the put and the stock
b. buy the stock and the risk-free bonds and sell the put and the call
c. buy the put and the stock and sell the risk-free bonds and the call
d. buy the put and the call and sell the risk-free bonds and the stock
e. none of the above

6. If there are no dividends on a stock, which of the following statements is

correct?
a. An American call will sell for more than a European call
b. A European call will sell for more than an American call
c. An American call will be immediately exercised
d. An American call and an American put will sell for the same price
e. none of the above

The following quotes were observed for options on a given stock on November 1 of a
given year. These are American calls except where indicated. Use the information to
answer questions 7 through 20.

The stock price was 113.25. The risk-free rates were 7.30 percent (November), 7.50
percent (December) and 7.62 percent (January). The times to expiration were 0.0384
(November), 0.1342 (December), and 0.211 (January). Assume no dividends unless
indicated.

7. What is the intrinsic value of the December 115 put?

a. 1.75
b. 0.00
c. 3.90
d. 3.00
e. none of the above

8. What is the intrinsic value of the November 105 put?

a. 0.30
b. 8.25
c. 8.50
d. 0.00
e. none of the above

9. What is the intrinsic value of the January 110 call?

a. 0.00
b. 8.30
c. 3.75
d. 5.00
e. none of the above

10. What is the intrinsic value of the November 115 call?

a. 1.50
b. 0.00
c. 2.80
d. 1.75
e. none of the above

11. What is the time value of the December 105 put?

a. 1.30
b. 8.30
c. 0.00
d. 7.00
e. none of the above

12. What is the time value of the November 115 put?

a. 1.75
b. 2.80
c. 1.10
d. 0.00
e. none of the above(1.05)

13. What is the time value of the November 110 call?

a. 0.00
b. 4.40
c. 1.15
d. 3.25
e. none of the above

14. What is the time value of the January 115 call?

a. 5.30
b. 0.00
c. 3.50
d. 1.70
e. none of the above

15. What is the European lower bound of the December 105 call?
a. 9.86
b. 0.00
c. 8.25
d. 9.26
e. none of the above

16. What is the European lower bound of the November 115 call?
a. 1.44
b. 0.00
c. 1.75
d. 2.06
e. none of the above

17. From American put-call parity, what are the minimum and maximum values
that the sum of the stock price and December 110 put price can be?
a. 101.81 and 102.87
b. 2.50 and 113.25
c. 116.038 and 117.10
d. 7.125 and 110
e. none of the above

18. The maximum difference between the January 105 and 110 calls is which of
the following?
a. 11.50
b. 4.92
c. 5.00
d. 4.0
e. none of the above

19. Suppose you knew that the January 115 options were correctly priced but
suspected that the stock was mispriced. Using put-call parity, what would you expect
the stock price to be? For this problem, treat the options as if they were European.
a. 113.73
b. 123.23
c. 121.23
d. 112.77
e. none of the above

20. Suppose the stock is about to go ex-dividend in one day. The dividend will be
$4.00. Which of the following calls will you consider for exercise?
a. November 115
b. November 110
c. December 115
d. all of the above
e. none of the above

21. The time value of an option is also referred to as the

a. synthetic value
b. strike value
c. speculative value
d. parity value
e. none of the above

22. Which of the following is the lowest possible value of an American call on a
stock with no dividends?
a. Max[0, S0 – X(1 + r)-T]
b. S0
c. Max(0, S0 – X)
d. Max[0, S0 (1 + r)-T – X]
e. none of the above

23. Which of the following is the lowest possible value of an American put on a
stock with no dividends?
a. X(1 + r)-T
b. X
c. Max[0, X(1 + r)-T – S0]
d. Max(0, X – S0)
e. none of the above

24. The difference between a Treasury bill's face value and its price is called the
a. time value
b. discount
c. coupon rate
d. bid
e. none of the above
25. Which of the following statements about an American call is not true?
a. Its time value decreases as expiration approaches
b. Its maximum value is the stock price
c. It can be exercised prior to expiration
d. It pays dividends
e. none of the above

26. Given a longer-lived American call and a shorter-lived American call with the
same terms, the longer-lived call must always be worth
a. at most the value of the shorter-lived call
b. at least as much as the shorter-lived call
c. exactly the same as the shorter-lived call
d. the shorter-lived call discounted to the length of the longer-lived call
e. none of the above

27. Which of the following inequalities correctly states the relationship between
the difference in the prices of two European calls that differ only by exercise price
a. (X2¬ – X1)(1 + r)-T ≥ Ce(S0,T,X1) – Ce(S0,T,X2)
b. (X2¬ – X1) ≥ Ce(S0,T,X2) – Ce(S0,T,X1)
c. (X2 – X1)(1 + r)-T ≥ Ce(S0,T,X1) + Ce(S0,T,X2)
d. (X2¬ – X1) ≥ Ce(S0,T,X1) – Ce(S0,T,X2)
e. none of the above

28. Suppose that you observe a European option on a currency with an exchange
rate of S0 and a foreign risk-free rate of . Which of the following inequalities correctly
expresses the lower bound of the call?
a. Ce(S0,T,X) ≥ Max[0,S0(1 + )-T + X(1 + r)-T]
b. Ce(S0,T,X) ≥ Max[0,S0 – X(1 + )-T]
c. Ce(S0,T,X) ≥ Max[0,S0(1 + )-T – X]
d. Ce(S0,T,X) ≥ Max[0,S0(1 + )-T – X(1 + r)-T]
e. none of the above

29. A situation in which early exercise of an American put can be justified is

a. bankruptcy
b. merger
c. if X exceeds S0 by greater than any transaction costs.
d. both a and b
e. both a and b and c
30. The effect of volatility on a call/put’s price is
a. decreased price due to decreased possible losses
b. nominal volatility will not noticeably effect a call/put’s price
c. increased price due to increased possible gains
d. decreased price due to increased possible losses
e. none of the above
 CHAPTER 4: OPTION PRICING MODELS: THE BINOMIAL MODEL

1. A portfolio that combines the underlying stock and a short position in an option
is called
a. a risk arbitrage portfolio
b. a hedge portfolio
c. a ratio portfolio
d. a two-state portfolio
e. none of the above

2. In a binomial model, if the call price in the market is higher than the call price
given by the model, you should
a. sell the call and sell short the stock
b. buy the call and sell short the stock
c. buy the stock and sell the call
d. buy the call and buy the stock
e. none of the above

3. In a two-period binomial world, a mispriced call will lead to an arbitrage profit

if
a. the proper hedge ratio is maintained over the two periods
b. the hedge portfolio is terminated after one period
c. the option goes from over- to underpriced or vice versa
d. the option remains mispriced over both periods
e. none of the above

4. The values of u and d are which of the following?

a. the return on the stock if it goes up and down, respectively
b. the inverse of the ratio of the up and down probabilities, respectively, and the
risk-free rate
c. the normal probabilities of up and down movements, respectively
d. one plus the return on the stock if it goes up and down, respectively
e. none of the above

5. If the stock pays a specific dollar dividend and the stock price, to include the
dividend, follows the binomial up and down factors, which of the following will
happen?
a. the binomial tree will recombine
b. the binomial tree will not recombine
c. the option will be mispriced
d. an arbitrage profit will not be possible
e. none of the above

6. When puts are priced with the binomial model, which of the following is true?
a. the puts must be American
b. the puts cannot be properly hedged
c. the puts will violate put-call parity
d. the hedge ratio is one throughout the tree
e. none of the above

7. If the binomial model is extended to multiple periods for a fixed option life,
which of the following adjustments must be made?
a. the up and down factors must be increased
b. the risk-free rate must be increased
c. the up and down factors and the risk-free rate must be decreased
d. the initial stock price must be proportionately reduced
e. none of the above

8. Which of the following are not path-dependent options when the stock pays a
constant dividend yield?
a. European calls and European puts
b. European calls and American puts
c. American puts and European puts
d. American puts and European calls
e. none of the above

9. In a non-recombining tree, the number of paths that will occur after three
periods is
a. three
b. four
c. ten
d. eight
e. six

10. When the number of time periods in a binomial model is large, a European call
option value does what?
a. fluctuates around its intrinsic value
b. converges to a specific value
c. increases without limit
d. converges to the European lower bound
e. none of the above

11. When the number of time periods in a binomial model is large, what happens to
the binomial probability of an up move?
a. it approaches 1.0
b. it approaches zero
c. it fluctuates without pattern
d. it converges to 0.5
e. none of the above

Consider a binomial world in which the current stock price of 80 can either go up by
10 percent or down by 8 percent. The risk-free rate is 4 percent. Assume a one-period
world. Answer questions 12 through 15 about a call with an exercise price of 80.

12. What would be the call's price if the stock goes up?
a. 3.60
b. 8.00
c. 5.71
d. 4.39
e. none of the above

13. What would be the call's price if the stock goes down?
a. 8.00
b. 3.60
c. 0.00
d. 9.00
e. none of the above

14. What is the hedge ratio?

a. 0.429
b. 0.714
c. 0.571
d. 0.823
e. none of the above

15. What is the theoretical value of the call?

a. 8.00
b. 4.39
c. 5.15
d. 5.36
e. none of the above

Now extend the one-period binomial model to a two-period world. Answer questions
16 through 18.

16. What is the value of the call if the stock goes up, then down?
a. 0.96
b. 16.80
c. 8.00
d. 0.00
e. none of the above

17. What is the hedge ratio if the stock goes down one period?
a. 0.00
b. 0.0725
c. 1.00
d. 0.73
e. none of the above

18. What is the current value of the call?

a. 8.00
b. 7.30
c. 11.13
d. 0.619
e. none of the above

19. In the binomial model, if an option has no chance of expiring

out-of-the-money, the hedge ratio will be
a. 0.5
b. infinite
c. 1
d. 0
e. none of the above

20. Suppose S = 70, X = 65, r = 0.05, p = 0.6, Cu = 7.17, Cd = 1.22 and there is
one period left in an American call's life. What will the option be worth?
a. 6.83
b. 0.00
c. 4.56
d. 5.00
e. none of the above

21. In a one-period binomial model with Su = 49.5, Sd = 40.5, p = 0.8, r = 0.06, S

= 45 and X = 50, what is a European put worth?
a. 2.17
b. 0.50
c. 9.50
d. 5.00
e. none of the above

22. Which of the following statements about the binomial model is incorrect?
a. it converges to the Black-Scholes-Merton model
b. it can accommodate early exercise
c. it allows only two stock prices at expiration
d. it can be extended to a large number of time periods
e. none of the above

23. A stock priced at 50 can go up or down by 10 percent over two periods. The
risk-free rate is 4 percent. Which of the following is the correct price of an American
put with an exercise price of 55?
a. 7.88
b. 3.38
c. 4.00
d. 5.00
e. 1.65

24. Determine the value of u for a three period binomial problem when the option’s
life is one-half a year and the volatility is 0.48. Use the model for u that does not
require the risk-free rate.
a. 1.22
b. 1.48
c. 1.40
d. 1.32
e. none of the above

25. Which of the following statements about the binomial option pricing model is
not always true?
a. it can capture the effect of early exercise
b. it can accommodate a large number of possible stock prices at expiration
c. it reflects the effects of the stock price, exercise price, risk-free rate, volatility
and time to expiration
d. it gives the price at which the option will trade in the market.
e. none of the above

26. All of the following are variables used to determine a call option’s price except
a. the risk-free rate
b. the probability of stock price movement
c. the exercise price
d. the possible future stock prices at expiration
e. none of the above

27. Pricing a put with the binomial model is the same procedure as pricing with a
call, except that the
a. underlying stock must not pay dividends
b. binomial model cannot account for expiration payoffs
c. value of the underlying must be discounted back to the current time period
d. expiration payoffs reflect the fact that the option is the right to sell the
underlying stock
e. none of the above

28. All of the following are practical applications of the binomial model except
a. choices regarding real options
b. options regarding executive incentive plans
c. models in which the stock price can go up, down, or remain constant in the
next period
d. embedded options within debt securities
e. none of the above

29. Determine the value of d for a four period binomial model when the option’s
life is one-fourth of a year and the volatility is 0.64. Use the model for u and d that
does not require the risk-free rate.
a. 0.85
b. 1.17
c. 2.56
d. 0.90
e. none of the above
30. The binomial option pricing model will converge to what value as the number
of periods increases?
a. a random value
b. the Black-Scholes-Merton value of the option
c. the intrinsic volatility of the option
d. the true value of the underlying
e. none of the above
 CHAPTER 5: OPTION PRICING MODELS: THE
BLACK-SCHOLES-MERTON MODEL

The following information is given about options on the stock of a certain company.

S0 = 23 X = 20
rc = 0.09 T = 0.5
2 = 0.15

No dividends are expected.

Use this information to answer questions 1 through 8.

1. What value does the Black-Scholes-Merton model predict for the call? (Due to
differences in rounding your calculations may be slightly different. “none of the
above” should be selected only if your answer is different by more than 10 cents.)
a. 5.35
b. 1.10
c. 4.73
d. 6.50
e. none of the above

2. Suppose you feel that the call is overpriced. What strategy should you use to
exploit the apparent mis-valuation? (Due to differences in rounding your calculations
may be slightly different. “none of the above” should be selected only if your answer
is different by more than 10 shares.)
a. buy 791 shares, sell 1,000 calls
b. buy 705 shares, sell 1,000 calls
c. sell short 791 shares, buy 1,000 calls
d. sell short 705 shares, buy 1,000 calls
e. none of the above

3. The price of a put on the stock is: (Due to differences in rounding your
calculations may be slightly different. “none of the above” should be selected only if
your answer is different by more than 10 cents.)
a. 0.85
b. 8.64
c. 2.35
d. 4.88
e. none of the above

4. To construct a riskless hedge, the number of puts per 100 shares purchased is:
(Due to differences in rounding your calculations may be slightly different. “none of
the above” should be selected only if your answer is different by more than 0.01.)
a. 0.7580
b. 0.2420
c. –0.2480
d. –0.6628
e. none of the above

5. The call's vega is: (Due to differences in rounding your calculations may be
slightly different. “none of the above” should be selected only if your answer is
different by more than 0.05.)
a. –3.02
b. 0.046
c. –0.792
d. 4.67
e. none of the above

6. If the actual call price is 3.79, the implied standard deviation is

a. 0.25
b. greater than 0.25
c. less than 0.25
d. infinite
e. none of the above

7. If we now assume that the stock pays a dividend at a known constant rate of 3.5
percent, what stock price should we use in the model? (Due to differences in rounding
your calculations may be slightly different. “none of the above” should be selected
only if your answer is different by more than 10 cents.)
a. 22.60
b. 19.65
c. 23.00
d. 21.99
e. none of the above

8. If we now assume that the stock pays a single dividend of 2.25 in three months,
what stock price should we use in the model? (Due to differences in rounding your
calculations may be slightly different. “none of the above” should be selected only if
your answer is different by more than 10 cents.)
a. 17.75
b. 20.75
c. 20.00
d. 20.80
e. none of the above

9. If the simple return on a Treasury bill is 8.5 percent, the risk-free rate in the
Black-Scholes-Merton model is
a. 8.77 percent
b. 8.93 percent
c. 8.55 percent
d. 8.20 percent
e. none of the above

10. Which of the following variables in the Black-Scholes-Merton option pricing

model is the most difficult to obtain?
a. the volatility
b. the risk-free rate
c. the stock price
d. the time to expiration
e. the exercise price

11. The binomial price will theoretically equal the Black-Scholes-Merton price
under which of the following conditions?
a. when the number of time periods is large
b. when the option is at-the-money
c. when the option is in-the-money
d. when the option is out-of-the-money
e. none of the above

12. If the stock price is 44, the exercise price is 40, the put price is 1.54, and the
Black-Scholes-Merton price using 0.28 as the volatility is 1.11, the implied volatility
will be
a. higher than 0.28
b. lower than 0.28
c. 0.28
d. lower than the risk-free rate
e. none of the above
13. Which of the following statements about the Black-Scholes-Merton model is
not true?
a. decreasing the volatility lowers the call price
b. the expected stock price plays a role in the model
c. the risk-free rate is continuously compounded
d. the model is consistent with put-call parity
e. none of the above

14. Which of the following characteristics of the Black-Scholes-Merton model is

not correct?
a. it is a discrete time model
b. it is the limit of the binomial model
c. it is a continuous time model
d. it gives the price of a European option
e. none of the above

15. Which of the following assumptions of the Black-Scholes-Merton model is not

correct?
a. the stock volatility is constant
b. the stock return follows a normal distribution
c. there are no transaction costs
d. there are no taxes
e. none of the above

16. Which of the following statements about the delta is not true?
a. it ranges from zero to one
b. it converges to zero or one at expiration
c. it is given by N(d1) in the Black-Scholes-Merton model
d. it changes slowly near expiration if the option is at-the-money
e. none of the above

17. Which of the following “Greeks” is not a measure of the option’s sensitivity to
a change in one of its input values?
a. delta
b. gamma
c. rho
d. theta
e. sigma
18. Which of the following statements is true about the relationship between the
option price and the risk-free rate?
a. a call price is nearly linear with respect to the risk-free rate
b. a call price is highly sensitive to the risk-free rate
c. the risk-free rate affects a call but not a put
d. the risk-free rate does not affect a call price
e. none of the above

19. The relationship between the volatility and the time to expiration is called the
a. volatility smile
b. volatility skew
c. term structure of volatility
d. theta
e. none of the above

20. What is the reason for executing a gamma hedge?

a. the volatility can change
b. the stock price can make a large move
c. the stock price moves are too small for a delta hedge to work
d. there is no true risk-free rate
e. none of the above

21. Which of the following statements about the volatility is not true?
a. the implied volatility often differs across options with different exercise prices
b. the implied volatility equals the historical volatility if the option is correctly
priced
c. the implied volatility is determined by trial and error
d. the implied volatility is nearly linearly related to the option price
e. none of the above

22. The relationship between the option price and the exercise price is called
a. the gamma
b. the vega
c. the omega
d. the zeta
e. none of the above

23. What happens when the volatility is zero in the Black-Scholes-Merton model?
a. the option price converges to either zero or the lower bound
b. the option price converges to the intrinsic value
c. the option automatically expires out of the money
d. the gamma and delta converge
e. none of the above

24. Which of the following is not correct about a call’s gamma?

a. it is the same as a put’s gamma
b. it is large when the call is at-the-money
c. it can be viewed as a measure of the risk of the delta
d. it is a source of risk that can be hedged only by using another option
e. none of the above

25. Which of the following statements is incorrect about the historical volatility?
a. if used in the Black-Scholes-Merton model, it gives the current market price
b. it is based on the volatility of the log return on the stock
c. it requires a sample of recent returns
d. it should be converted to an annualized volatility
e. none of the above

26. A hedge portfolio is established and maintained by constantly adjusting the

relative proportions of stock and options, a process referred to as
a. actively managing
b. continuous reconciliation
c. marking to market
d. dynamic trading
e. none of the above

27. The standard normal random variable used in the calculation of cumulative
normal probabilities within the Black-Scholes-Merton option pricing model is
a. the lognormal distribution
b. the d1 and d2 statistic
c. the z statistic
d. the f distribution
e. none of the above

28. The pattern of volatility across exercise prices is often called

a. the price-fluctuation graph
b. the volatility smile
c. the term structure of implied volatility
d. the skew
e. none of the above
29. The Black-Scholes-Merton model for European puts, obtained by applying
put-call parity to the Black-Scholes-Merton model for European calls, is customarily
expressed by which of the following:

30. The implied volatility is obtained by finding the standard deviation that, when
used in the Black-Scholes-Merton model, makes the
a. model price expire at zero
b. model price equal the market price of the option
c. model price such that it exceeds currently traded market option values
d. model price equal the intrinsic value of the underlying stock
e. none of the above
 CHAPTER 6: BASIC OPTION STRATEGIES

Consider a stock priced at $30 with a standard deviation of 0.3. The risk-free rate is
0.05. There are put and call options available at exercise prices of 30 and a time to
expiration of six months. The calls are priced at $2.89 and the puts cost $2.15. There
are no dividends on the stock and the options are European. Assume that all
transactions consist of 100 shares or one contract (100 options). Use this information
to answer questions 1 through 10.

1. What is your profit if you buy a call, hold it to expiration and the stock price at
expiration is $37?
a. $700
b. –$289
c. $2,711
d. $411
e. none of the above

2. What is the breakeven stock price at expiration on the transaction described in

problem 1?
a. $32.89
b. $30.00
c. $27.11
d. $32.15
e. there is no breakeven

3. What is the maximum profit on the transaction described in problem 1?

a. $2,711
b. infinity
c. zero
d. $3,289
e. $3,000

4. What is the maximum profit that the writer of a call can make?
a. $2,711
b. $289
c. $3,000
d. $3,289
e. none of the above
5. Suppose the buyer of the call in problem 1 sold the call two months before
expiration when the stock price was $33. How much profit would the buyer make?
a. $32.89
b. $30.11
c. $78.00
d. $11.00
e. none of the above

6. Suppose the investor constructed a covered call. At expiration the stock price is
$27. What is the investor's profit?
a. $589
b. $289
c. $2,989
d. $2,711
e. none of the above

7. What is the breakeven stock price at expiration for the transaction described in
problem 6?
a. $27.11
b. $30.00
c. $32.89
d $29.89
e. none of the above

8. If the transaction described in problem 6 is closed out when the option has
three months to go and the stock price is at $36, what is the investor's profit?
a. $600
b. $311
c. $889
d. $229
e. none of the above

9. What is the maximum profit from the transaction described in Question 6 if the
position is held to expiration?
a. $3,289
b. $289
c. infinity
d. $2,711
e. none of the above
10. What is the minimum profit from the transaction described in Question 6 if the
position is held to expiration?
a. –$2,711
b. –$3,289
c. –$3,000
d. negative infinity
e. none of the above

11. Consider two put options differing only by exercise price. The one with the
higher exercise price has
a. the lower breakeven and lower profit potential
b. the lower breakeven and greater profit potential
c. the higher breakeven and greater profit potential
d. the higher breakeven and lower profit potential
e. the greater premium and lower profit potential

12. Which of the following statements is true about closing a long call position
prior to expiration relative to holding it to expiration?
a. the profit is greater at all stock prices
b. the profit is greater only at low stock prices
c. the profit is greater only at high stock prices
d. the range of possible profits is greater
e. none of the above are true

13. Which of the following transactions does not profit in a strong bull market.
a. a short put
b. a covered call
c. a protective put
d. a synthetic call
e. none of the above

14. Which of the following is equivalent to a synthetic call?

a. a long stock and a short put position
b. a long put and a long stock position
c. a long put and a short risk-free bond position
d. a long stock and a short risk-free bond position
e. none of the above
15. Early exercise imposes a risk to all but one of the following transactions.
a. a short call
b. a short put
c. a protective put
d. an uncovered call
e. none of the above

16. Each of the following is a bullish strategy except

a. a long call
b. a short put
c. a short stock
d. a protective put
e. none of the above

17. Which of the following strategies has the greatest potential loss?
a. an uncovered call
b. a long put
c. a covered call
d. a long position in the stock
e. it is impossible to tell

18. Which of the following strategies has essentially the same profit diagram as a
covered call?
a. a long put
b. a short put
c. a protective put
d. a long call
e. none of the above

19. Which of the following statements is true about the purchase of a protective put
at a higher exercise price relative to a lower exercise price?
a. the breakeven is lower
b. the maximum loss is greater
c. the insurance is less costly
d. the insurance is more costly
e. none of the above

20. What is the disadvantage of a strategy of rolling over a covered call to avoid
exercise?
a. the call premium is essentially thrown away
 b. transaction costs tend to be high
c. the stock will incur losses
d. the call is more expensive when rolled over
e. none of the above

21. Which of the following is the breakeven for a protective put?

a. X + S0 – P
b. P + S0
c. X – ST
d. X – S0 – P
e. none of the above

22. Which of the following statements about a covered call writing strategy is true?
a. the losses are limited
b. return and risk are greater than that of simply holding the stock
c. it is a cheaper form of insurance than a protective put
d. it generally makes a large number of small profits
e. none of the above

23. The difference in profit from an actual put and a synthetic put is
a. X
b. ST – X
c. X – ST
d. ST + X(1 + r)-T
e. none of the above

24. A covered call writer who prefers even less risk should
a. get rid of the call
b. switch to a call with a lower exercise price
c. get rid of the stock
d. switch to a call with a higher exercise price
e. none of the above

25. Which of the following investors may be obligated to buy stock?

a. covered call writer
b. call buyer
c. put writer
d. protective put buyer
e. none of the above
26. Identify the correct statement related to the choice of exercise price for buying
a call.
a. the higher the exercise price the higher the call premium
b. the lower the exercise price the more likely the call option will expire
out-of-the-money
c. A higher strike price results in smaller gains on the upside but smaller
losses on the downside
d. the higher the exercise price the more dividends contribute to the overall
profit
e. none of the above are correct statements related to the choice of exercise
price for buying a call

27. Consider the following statement related to writing a naked call option. For a
given stock price, the ____________ the position is held, the more time value it loses
and the ___________ the profit. Identify the correct words for these two blanks.
a. longer, lower
b. longer, higher
c. shorter, lower
d. shorter, higher
e. longer, flatter

28. Consider the following statement related to buying a put option. For a given
stock price, the ____________ the position is held, the more time value it loses and
the ___________ the profit; however, an exception can occur when the stock price is
___________. Identify the correct words for these two blanks.
a. longer, lower, low
b. longer, higher, high
c. shorter, lower, low
d. shorter, higher, high
e. longer, flatter, low

29. A synthetic long call position can be created with which of the following sets
of transactions.
a. borrow the present value of the strike price, sell stock, sell put
b. lend the present value of the strike price, sell stock, buy put
c. sell put, buy stock, lend the present value of the strike price
d. buy stock, buy put, borrow the present value of the strike price
e. none of the above creates a synthetic long call position
30. A synthetic short put position can be created with which of the following sets
of transactions.
a. borrow the present value of the strike price, sell stock, sell call
b. lend the present value of the strike price, sell stock, buy call
c. sell call, buy stock, lend the present value of the strike price
d. buy stock, buy call, borrow the present value of the strike price
e. none of the above creates a synthetic long call position
 CHAPTER 7: ADVANCED OPTION STRATEGIES

The following prices are available for call and put options on a stock priced at $50.
The risk-free rate is 6 percent and the volatility is 0.35. The March options have 90
days remaining and the June options have 180 days remaining. The Black-Scholes
model was used to obtain the prices.

Calls Puts
Strike March June March June
45 6.84 8.41 1.18 2.09
50 3.82 5.58 3.08 4.13
55 1.89 3.54 6.08 6.93

Use this information to answer questions 1 through 20. Assume that each transaction
consists of one contract (for 100 shares) unless otherwise indicated.

For questions 1 through 6, consider a bull money spread using the March 45/50 calls.

1. How much will the spread cost?

a. $986
b. $302
c. $283
d. $193
e. none of the above

2. What is the maximum profit on the spread?

a. $500
b. $802
c. $198
d. $302
e. none of the above

3. What is the maximum loss on the spread?

a. $500
b. $698
c. $198
d. $802
e. none of the above
4. What is the profit if the stock price at expiration is $47?
a. -$102
b. $398
c. -$302
d. $500
e. none of the above

5. What is the breakeven point?

a. $48.02
b. $41.98
c. $55.66
d. $50.00
e. none of the above

6. Suppose you closed the spread 60 days later. What will be the profit if the stock
price is still at $50?
a. $41
b. $198
c. $302
d. $102
e. none of the above

For questions 7 and 8, suppose an investor expects the stock price to remain at about
$50 and decides to execute a butterfly spread using the June calls.

7. What will be the cost of the butterfly spread?

a. $1,195
b. $637
c. $79
d. $1,045
e. none of the above

8. What will be the profit if the stock price at expiration is $52.50?

a. $171
b. $1,421
c. $1.037
d. $421
e. none of the above
9. Suppose you wish to construct a ratio spread using the March and June 50
calls. You want to buy 100 June 50 call contracts. How many March 50 calls would
you sell?
a. 105
b. 95
c. 100
d. 57
e. none of the above

Answer questions 10 and 11 about a calendar spread based on the assumption that
stock prices are expected to remain fairly constant. Use the June/March 50 call spread.
Assume one contract of each.

10. What will the spread cost?

a. -$176
b. $176
c. $558
d. $105
e. none of the above

11. What will be the profit if the spread is held 90 days and the stock price is $45?
a. $36
b. $20
c. $558
d. -$20
e. none of the above

Answer questions 12 through 17 about a long straddle constructed using the June 50
options.

12. What will the straddle cost?

a. $145
b. $690
c. $971
d. $413
e. none of the above

13. What are the two breakeven stock prices at expiration?

a. $55.58 and $45.87
b. $54.13 and $45.87
 c. $55.58 and $44.42
d. $59.71 and $40.29
e. none of the above

14. What is the profit if the stock price at expiration is at $64.75?

a. -$971
b. $1,475
c. -$3,525
d. $500
e. none of the above

15. What is the profit if the position is held for 90 days and the stock price is $55?
a. -$971
b. -$58
c. -$109
d. -$471
e. none of the above

16. Suppose the investor adds a call to the long straddle, a transaction known as a
strap. What will this do to the breakeven stock prices?
a. lower both the upside and downside breakevens
b. raise both the upside and downside breakevens
c. raise the upside and lower the downside breakevens
d. lower the upside and raise the downside breakevens
e. none of the above

17. Suppose a put is added to a straddle. This overall transaction is called a strip.
Determine the profit at expiration on a strip if the stock price at expiration is $36.
a. -$129
b. $1,416
c. $429
d. $1,384
e. none of the above

Answer questions 18 through 20 about a long box spread using the June 50 and 55
options.

18. What is the cost of the box spread?

a. $500
b. $2,018
 c. $76
d. $484
e. none of the above

19. What is the profit if the stock price at expiration is $52.50?

a. $16
b. $500
c. –$234
d. $250
e. none of the above

20. What is the net present value of the box spread?

a. $9.84
b. $5.00
c. $16.00
d. $1.84
e. none of the above

21. Which of the following strategies does not profit in a rising market?
a. put bull spread
b. long straddle
c. collar
d. call bull spread
e. none of the above

22. Which of the following transactions can have an unlimited loss?

a. long straddle
b. calendar spread
c. butterfly spread
d. reverse box spread
e. none of the above

23. Which of the following is the best strategy for an expected fall in the market?
a. long strip (2 puts and 1 call)
b. put bull spread
c. calendar spread
d. butterfly spread
e. none of the above
24. Early exercise is a disadvantage in which of the following transactions?
a. short box spread
b. put bear spread
c. long strip (2 puts and 1 call)
d. long strap (2 calls and 1 put)
e. none of the above

25. Which of the following have similar profit graphs?

a. call bull spread and long box spread
b. put bear spread and short box spread
c. butterfly spread and ratio spread
d. calendar spread and call bear spread
e. none of the above

26. The purchase of one option and the sale of another is known as
a. box
b. bear strategy
c. bull strategy
d. collar
e. spread

27. The option strategy where the holder of a long position in a stock buys a put
with an exercise price lower than the current stock price and sells a call with an
exercise price higher than the current stock price is known as
a. box
b. bear strategy
c. bull strategy
d. collar
e. spread

28. The profit from a put bear spread strategy when both options are out of the
money is
a. –X1 + ST + P1 + X2 – ST – P2
b. –X1 + ST + P1 – P2
c. X1 – ST – P1 – X2 + ST + P2
d. P1 + X2 – ST – P2
e. P1 – P2
29. “Like the butterfly spread, the calendar spread is one in which the underlying
instrument’s ___________ is the major factor in its performance.” The best word for
the blank is which of the following?
a. volatility
b. expected rate of return
c. beta
d. correlation with the benchmark index
e. skewness

30. Which of the following statements best describes the nature of option time
value decay?
a. time value decays more rapidly as the stock price approaches being
at-the-money
b. time value decays more rapidly as expiration approaches
c. time value decays more rapidly for put option than call options
d. time value decay does not occur for collar option strategies
e. time value decay is detrimental for a trader who is short call options
 CHAPTER 8: PRINCIPLES OF PRICING FORWARDS, FUTURES AND
OPTIONS ON FUTURES

1. What is the lower bound of a European call option on a futures contract where
f0 is the futures price and X is the exercise price? Assume f0 is greater than X.
a. the difference between f0 and X
b. zero
c. the present value of the difference between f0 and X
d. the ratio of f0 to X
e. none of the above

2. Which of the following best describes normal contango?

a. the spot price is less than the futures price
b. the futures price is less than the spot price
c. the expected spot price is less than the futures price
d. the cost of carry is negative
e. none of the above

3. Which of the following can explain a contango?

a. the interest rate exceeds the dividend yield
b. the cost of carry is negative
c. futures prices exceed forward prices
d. the market is at less than full carry
e. none of the above

4. Determine the appropriate price of a European put on a futures if the call is

worth $6.55, the continuously compounded risk-free rate is 5.6 percent, the futures
price is $80, the exercise price is $75, and the expiration is in three months.
a. $12.56
b. $0.54
c. $11.48
d. $1.62
e. none of the above

5. Suppose you buy a one-year forward contract at $65. At expiration, the spot
price is $73. The risk-free rate is 10 percent. What is the value of the contract at
expiration?
a. $8.00
b. –$8.00
 c. $0.00
d. $7.27
e. none of the above

6. Suppose you sell a three-month forward contract at $35. One month later, new
forward contracts with similar terms are trading for $30. The continuously
compounded risk-free rate is 10 percent. What is the value of your forward contract?
a. $4.96
b. $5.00
c. $4.92
d. $4.55
e. none of the above

7. Suppose you buy a futures contract at $150. If the futures price changes to
$147, what is its value an instant before it is marked-to-market?
a. 0
b. $3
c. –$3
d. it is impossible to tell
e. none of the above

8. Find the price of a European call on a futures contract if the futures price is
$106, the exercise price is $100, the continuously compounded risk-free rate is 7.2
percent, the volatility is 0.41 and the call expires in six months.
a. $14.57
b. $17.04
c. $6.00
d. $19.78
e. none of the above

9. A deep in-the-money call option on futures is exercised early because

a. the intrinsic value is maximized
b. it behaves like a futures but ties up funds
c. the futures price is not likely to rise any further
d. all of the above
e. none of the above
10. Find the value of a European put option on futures if the futures price is 72, the
exercise price is 70, the continuously compounded risk-free rate is 8.5 percent, the
volatility is 0.38 and the time to expiration is three months.
a. 6.30
b. 12.90
c. 4.34
d. 2.00
e. none of the above

11. Futures prices differ from spot prices by which one of the following factors?
a. the systematic risk
b. the cost of carry
c. the spread
d. the risk premium
e. none of the above

12. Find the forward rate of foreign currency Y if the spot rate is $4.50, the
domestic interest rate is 6 percent, the foreign interest rate is 7 percent, and the
forward contract is for nine months. (The interest rates are continuously
compounded.)
a. $4.458
b. $5.104
c. $4.468
d. $4.532
e. none of the above

13. A contango market is consistent with

a. a negative basis
b. futures prices exceeding spot prices
c. a positive cost of carry
d. all of the above
e. none of the above

14. What is the lower bound of a European foreign currency call if the spot rate is
$2.25, the domestic interest rate is 5.5 percent, the foreign interest rate is 6.2 percent,
the option expires in three months, and the exercise price is $2.20? (The interest rates
are continuously compounded.)
a. $0.0457
b. $0.05
c. $0.0793
 d. $0.0529
e. none of the above

15. Suppose there is a risk premium of $0.50. The spot price is $20 and the futures
price is $22. What is the expected spot price at expiration?
a. $21.50
b. $22.50
c. $20.50
d. $24.50
e. none of the above

16. Find the value of a European foreign currency call if the spot rate is $5.25, the
exercise price is $5.40, the domestic interest rate is 6.1 percent, the foreign interest
rate is 5.5 percent, the call expires in one month, and the volatility is 0.32. (The
interest rates are continuously compounded.)
a. $0.167
b. $0.15
c. $0.140
d. $0.131
e. none of the above

17. What would be the spot price if a stock index futures price were $75, the
risk-free rate were 10 percent, the continuously compounded dividend yield is 3
percent, and the futures contract expires in three months?
a. $73.70
b. $77.48
c. $72.60
d. $76.32
e. none of the above

18. Find the lower bound of a European foreign currency put if the spot rate is
$3.50, the domestic interest rate is 8 percent, the foreign interest rate is 7 percent, the
option expires in six months, and the exercise price is $3.75. (The interest rates are
continuously compounded.)
a. zero
b. $0.250
c. $0.366
d. $0.108
e. none of the above
19. Suppose it is currently July. The September futures price is $60 and the
December futures price is $68. What does the spread of $8 represent?
a. the cost of carry from July to September
b. the expected risk premium from July to September
c. the cost of carry from September to December
d. the expected risk premium from September to December
e. none of the above

20. Why is the initial value of a futures contract zero?

a. the futures is immediately marked-to-market
b. you do not pay anything for it
c. the basis will converge to zero
d. the expected profit is zero
e. none of the above

21. The spot price plus the cost of carry equals

a. the convenience yield
b. the expected future spot price
c. the risk premium
d. the futures price
e. none of the above

22. Determine the value of a European foreign currency put if the call is at $0.05,
the spot rate is $0.5702, the exercise price is $0.59, the domestic interest rate is 5.75
percent, the foreign interest rate is 4.95 percent and the options expire in 45 days. (The
interest rates are continuously compounded.)
a. $0.069
b. $0.031
c. $0.050
d. $0.517
e. none of the above

23. Interest rate parity is essentially the same as

a. the cross-rate relationship
b. the cost of carry relationship
c. the Garman-Kohlhagen model
d. all of the above
e. none of the above
24. A transaction that exploits differences in the theoretical and actual values of a
foreign currency forward or futures contract is called
a. covered interest arbitrage
b. triangular arbitrage
c. a conversion
d. interest-rate parity
e. none of the above

25. The cost of carry consists of all the following except

a. the risk–free rate
b. the cost of storage
c. insurance on the asset
d. the risk premium
e. none of the above

26. The value of a long position in a forward contract at expiration is

a. the spot price plus the original forward price
b. the spot price minus the original forward price
c. the original forward price discounted to expiration
d. the spot price minus the original forward price discounted to expiration
e. none of the above

27. The value of a futures contract immediately after being marked to market is
a. numerically equal to the daily settlement amount
b. the spot price plus the original forward price
c. equal to the amount by which the price changed since the contract was opened
d. simply zero
e. none of the above

28. Under uncertainty and risk aversion, today’s spot price equals
a. the expected future spot price, minus the storage costs, minus the interest
forgone, minus the risk premium
b. the expected future spot price, minus the storage costs, minus the interest
forgone, plus the risk premium
c. the expected future spot price, minus the storage costs, minus the risk premium
d. the future spot price minus the cost of storage
e. none of the above
29. The additional return earned by holding a commodity that is in short supply or
a nonpecuniary gain from an asset is referred to as
a. the negative cost of carry
b. the convenience yield
c. cash-flow free gains
d. gains on the underlying
e. none of the above

30. Put-call-futures parity is the relationship between the prices of puts, calls, and
futures on an asset. Assuming a constant risk-free rate and European options, which of
the following correctly expresses the relationship of put-call-futures parity?
a. Pe(S0,T) = Ce(S0,T) + (X – f0(T))(1 + r)-T
b. Pe(S0,T,X) = Ce(S0,T) – (X – f0(T))(1 + r)-T
c. Pe(S0,T,X) = Ce(S0,T,X) + (X – f0(T))(1 + r)-T
d. Pe(S0,T,X) = Ce(S0,T,X)(X – f0(T))(1 + r)-T
e. none of the above
 CHAPTER 9: FUTURES ARBITRAGE STRATEGIES

1. The transaction designed to exploit mispricing in the relationship between

futures and spot prices is called
a. a repurchase agreement
b. a hedge
c. speculation
d. carry arbitrage
e. none of the above

2. The implied repo rate is similar to the

a. internal rate of return
b. cost of hedging
c. yield on the futures contract
d. all of the above
e. none of the above

3. On the basis of liquidity, the best futures contract for hedging short-term
interest rates is
a. Treasury bills
b. the prime rate
c. commercial paper
d. Eurodollars
e. none of the above

4. Which one of the following options is not associated with the Treasury bond
futures contract?
a. end-of-the-month
b. spread option
c. wild card option
d. quality option
e. none of the above

5. The transaction in which a Treasury bond futures spread is combined with a

Fed funds futures transaction is called a
a. Bond-bill spread
b. MOB spread
c. designated order turnaround
d. turtle trade
 e. none of the above

6. The opportunity to lock in the invoice price and purchase the deliverable
Treasury bond later is called
a. bond insurance
b. program trading
c. the wild card
d. delivery arbitrage
e. none of the above

7. If the futures price at 3:00 p.m. is 122, the spot price is 142.5 and the CF is
1.1575, by how much must the spot price fall by 5:00 p.m. to justify delivery?
a. 1.285
b. 1.1102
c. 20.50
d. 17.71
e. 42.94

8. How is the cost of a delivery option paid?

a. the long pays the short with a cash settlement
b. the short pays the long with a cash settlement
c. a higher closing futures price
d. a lower closing futures price
e. none of the above

9. Find the annualized implied repo rate on a T-bond arbitrage if the spot price is
112.25, the accrued interest is 1.35, the futures price is 114.75, the CF is 1.0125, the
accrued interest at delivery is 0.95, and the holding period is three months.
a. 1.85 percent
b. 0.77 percent
c. 14.77 percent
d. 13.04 percent
e. 2.23 percent

10. If a firm is planning to borrow money in the future, the rate it is trying to lock
in is
a. the current forward rate
b. the current spot rate
c. the difference between the spot rate and the forward rate
d. the forward rate at the termination of the hedge
e. none of the above
f.
11. Determine the annualized implied repo rate on a Treasury bond spread in which
the March is bought at 98.7 and the June is sold at 99.5. The March CF is 1.225 and
the June CF is 1.24. The accrued interest as of March 1 is 0.75 and the accrued interest
as of June 1 is 1.22.
a. 5.21 percent
b. 10.03 percent
c. 1.28 percent
d. 2.42 percent
e. 0.81 percent

12. Determine the amount by which a stock index futures is mispriced if the stock
index is at 200, the futures is at 202.5, the risk-free rate is 6.45 percent, the dividend
yield is 2.75 percent, and the contract expires in three months.
a. underpriced by 0.64
b. overpriced by 2.5
c. overpriced by 9.76
d. overpriced by 0.64
e. underpriced by 2.5

13. Which of the following is not a risk of program trading?

a. the stocks cannot be simultaneously sold at expiration
b. fractional contracts cannot be purchased or sold
c. the dividends are not certain
d. the stocks cannot be purchased simultaneously
e. none of the above

14. What reason might be given for not wanting to hedge the future issuance of a
liability if interest rates are unusually high?
a. the margin cost will be expensive
b. you are locking in a high rate
c. transaction costs are higher
d. futures prices are lower
e. none of the above

15. If the stock index is at 148, the three-month futures price is 151, the dividend
yield is 5 percent and the interest rate is 8 percent, determine the profit from an index
arbitrage if the stock ends up at 144 at expiration. (Ignore transaction costs.)
a. 1.89
 b. 4.00
c. 7.00
d. 5.11
e. –7.00

16. The transaction in which money is borrowed by selling a security and

promising to buy it back in several weeks is called a
a. term repo
b. overnight repo
c. term arbitrage
d. MOB spread
e. none of the above

17. The end-of-the-month option is

a. the right to exercise an option on the last day of the month
b. an option expiring on the last day of the month
c. the right to deliver during the last seven business days of the month
d. an option that trades only at the end of the month
e. none of the above

18. If you buy both a 30-day Eurodollar CD paying 6.7 percent and a 90-day
futures on a 90-day Eurodollar CD with a price implying a yield of 7.2 percent, what
is your total annualized return? (Both yields are based on 360-day years.)
a. 7.25 percent
b. 7.07 percent
c. 10.15 percent
d. 7.75 percent
e. 6.95 percent

19. A deliverable Treasury bond has accrued interest of 3.42 per $100, a coupon of
9.5 percent, a price of 135 and a conversion factor of 1.195. The futures price is
112.25. What is the invoice amount?
a. 137.56
b. 143.64
c. 161.33
d. 134.14
e. none of the above

20. Determine the conversion factor for delivery of the 7 1/4’s off May 15, 2026 on
the March 2010 T–bond futures contract.
a. 1.225
b. 0.932
c. 1.083
d. 1.127
e. 1.509

21. Which of the following is not needed when calculating the implied repo rate for
stock index futures?
a. futures price
b. conversion factor
c. time–to–expiration
d. spot price
e. none of the above

Use the following information to answer questions 22 through 24. On October 1, the
one-month LIBOR rate is 4.50 percent and the two month LIBOR rate is 5.00 percent.
The November Fed funds futures is quoted at 94.50. The contract size is $5,000,000.

22. The dollar value of a one basis point rise in the Fed funds futures price is
a. –$25.00
b. $41.67
c. $5,000
d. $25.00
e. none of the above

23. All of the following are limitations to Fed funds futures arbitrage, except
a. Fed funds rates are determined by Federal Reserve Bank policy
b. basis risk between Fed funds and LIBOR
c. repo rate is variable for the trading horizon
d. settlement is based on average in delivery month
e. transaction costs

24. Compute the dollar profit or loss from borrowing the present value of
$5,000,000 at one month LIBOR and lending the same amount at two month LIBOR
while simultaneously selling one November Fed funds futures contract. Assume that
rates on November 1 were 7 percent, there is no basis risk, and the position is
unwound on November 1. Select the closest answer.
a. –$3,150
b. $0
c. $3,150
 d. $940
e. –$940

25. Which of the following is a form of program trading?

a. index arbitrage
b. wild card arbitrage
c. triangular arbitrage
d. timing arbitrage
e. none of the above

26. Suppose you observe the spot S&P 500 index at 1,210 and the three month
S&P 500 index futures at 1,205. Based on carry arbitrage, you conclude
a. this futures market is inefficient because the futures price is below the
spot price
b. this futures market is indicating that the spot price is expected to fall
c. the spot price is too high relative to the observed futures price
d. the dividend yield is higher than the risk-free interest rate
e. none of the above

27. Suppose you observe the spot euro at $1.38/€ and the three month euro futures
at $1.379/€. Based on carry arbitrage, you conclude
a. this futures market is inefficient because the futures price is below the
spot price
b. this futures market is indicating that the spot price is expected to fall
c. the spot price is too high relative to the observed futures price
d. the risk-free rate in Europe is higher than the risk-free rate in the U. S.
e. none of the above

28. Suppose you observe the spot euro at $1.38/€, the U. S. risk-free interest rate of
0.25% (continuously compounded), and the European risk-free interest rate of 0.75%
(continuously compounded). Identify the theoretical value of a six month foreign
exchange futures contract (select the closest answer).
a. $1.3815/€
b. $1.3765/€
c. $1.3785/€
d. $1.3825/€
e. $1.3755/€
29. Suppose you observe the spot euro at $1.50/€, the U. S. risk-free interest rate of
3.25% (continuously compounded), and the six month futures price of $1.50/€.
Identify the correct implied European risk-free interest rate (select the closest answer).
a. –3.25%
b. –1.0%
c. 0.0%
d. 1.0%
e. 3.25%

30. Covered interest arbitrage from a U. S. dollar perspective when the euro futures
price (expressed in $/€) is too high involves
a. buying foreign exchange futures contracts
b. selling interest rate futures contracts
c. lending funds in risk-free euro investment
d. selling euros
e. buying euro stock index ETFs
 CHAPTER 10: FORWARD AND FUTURES HEDGING, SPREAD, AND
TARGET STRATEGIES

1. A short hedge is one in which

a. the margin requirement is waived
b. the hedger is short futures
c. the hedger is short in the spot market
d. the futures price is lower than the spot price
e. none of the above

2. An anticipatory hedge is one in which

a. the basis is expected to fall
b. the hedger expects to make a profit on the futures
c. the spot position will be taken in the future
d. all of the above
e. none of the above

3. A strengthening of the basis means

a. the spot price rises more than the futures price
b. the futures price falls more than the spot price
c. a short hedger benefits
d. all of the above
e. none of the above

4. A hedge in which the asset underlying the futures is not the asset being hedged
is
a. a cross hedge
b. an optimal hedge
c. a basis hedge
d. a minimum variance hedge
e. none of the above

5. When the futures expires before the hedge is terminated and the hedger moves
into the next futures expiration, it is called
a. spreading the hedge
b. rolling the hedge forward
c. optimally weighting the hedge
 d. all of the above
e. none of the above

6. The duration of the futures contract used in the price sensitivity hedge ratio is
a. the duration of the spot bond being hedged using the futures price
instead of the spot price
b. the duration of the deliverable bond using the spot price
c. the duration of the deliverable bond using the futures price
d. the duration of the overall bond portfolio
e. none of the above

7. Which technique can be used to compute the minimum variance hedge ratio?
a. duration analysis
b. present value
c. regression
d. all of the above
e. none of the above

8. Which of the following measures is used in the price sensitivity hedge ratio for
bond futures?
a. beta
b. duration
c. correlation
d. variance
e. none of the above

9. Suppose you buy an asset at $50 and sell a futures contract at $53. What is your
profit at expiration if the asset price goes to $49? (Ignore carrying costs)
a. –$1
b. –$4
c. $3
d. $4
e. none of the above

10. Suppose you buy an asset at $70 and sell a futures contract at $72. What is your
profit if, prior to expiration, you sell the asset at $75 and the futures price is $78?
a. –$1
b. $2
c. $1
d. –$6
 e. none of the above

11. Which of the following is not a reason for firms to hedge?

a. Firms can hedge less expensively than can their shareholders
b. Shareholders cannot tolerate mark-to-market losses
c. Hedging by corporations can have tax advantages
d. Shareholders are not always aware of their firms' risks
e. none of the above

12. Find the profit if the investor buys a July futures at 75, sells an October futures
at 78 and then reverses the July futures at 72 and the October futures at 77.
a. –3
b. –2
c. 2
d. 1
e. none of the above

13. Determine the optimal hedge ratio for Treasury bonds worth $1,000,000 with a
modified duration of 12.45 if the futures contract has a price of $90,000 and a
modified duration of 8.5 years.
a. 16.27
b. 15.93
c. 7.42
d. 11.11
e. none of the above

14. What is the profit on a hedge if bonds are purchased at $150,000, two futures
contracts are sold at $72,500 each, then the bonds are sold at $147,500 and the futures
are repurchased at $74,000 each?
a. –$2,500
b. –$5,500
c. –$500
d. –$3,000
e. none of the above

15. Find the optimal stock index futures hedge ratio if the portfolio is worth
$1,200,000, the beta is 1.15 and the S&P 500 futures price is 450.70 with a multiplier
of 250.
a. 10.65
b. 12.25
 c. 6123.80
d. 5325.05
e. none of the above

16. In which of the following situations would you use a short hedge?
a. the planned purchase of a stock
b. the planned purchase of commercial paper
c. the planned issuance of bonds
d. the planned repurchase of stock to cover a short position
e. none of the above

17. You hold a stock portfolio worth $15 million with a beta of 1.05. You would
like to lower the beta to 0.90 using S&P 500 futures, which have a price of 460.20 and
a multiplier of 250. What transaction should you do? Round off to the nearest whole
contract.
a. sell 130 contracts
b. sell 9,778 contracts
c. sell 20 contracts
d. buy 50,000 contracts
e. sell 50,000 contracts

18. You hold a bond portfolio worth $10 million and a modified duration of 8.5.
What futures transaction would you do to raise the duration to 10 if the futures price is
$93,000 and its implied modified duration is 9.25? Round up to the nearest whole
contract.
a. buy 109 contracts
b. buy 17 contracts
c. buy 669 contracts
d. sell 100 contracts
e. sell 669 contracts

19. Which of the following statements about the use of futures in tactical asset
allocation is correct?
a. Implementing tactical asset allocation using futures is a form of market
timing.
b. Futures can be used to synthetically buy or sell stocks but you cannot
simultaneously adjust the beta or duration
c. A difference between the portfolio held and the index on which the futures is
based will generate a gain for the investor.
d. The use of futures in tactical asset allocation will generate cash from the
synthetic sale, which is then used in the synthetic purchase.
e. None of the above

20. Though a cross hedge has somewhat higher risk than an ordinary hedge, it will
reduce risk if which of the following occurs?
a. futures prices are more volatile than spot prices
b. the spot and futures contracts are correctly priced at the onset
c. spot and futures prices are positively correlated
d. futures prices are less volatile than spot prices
e. none of the above

21. Which of the following correctly expresses the profit on a hedge?

a. the basis when the hedge is closed
b. the change in the basis
c. the spot profit minus the futures profit
d. the futures profit minus the spot profit
e. none of the above

22. What happens to the basis through the contract's life?

a. it initially decreases, then increases
b. it initially increases, then decreases
c. it remains relatively steady
d. it moves toward zero
e. none of the above

23. Find the profit if the investor enters an intramarket spread transaction by selling
a September futures at $4.5, buys an December futures at $7.5 and then reverses the
September futures at $5.5 and the December futures at $9.5.
a. –3
b. –2
c. 2
d. 1
e. none of the above

24. Quantity risk is

a. the difficulty in measuring the volatility
b. the uncertainty about the size of the spot position
c. the risk of mismatching the futures maturity to the spot maturity
d. the possibility of regression error
 e. none of the above

25. The relationship between the spot yield and the yield implied by the futures
price is called
a. the yield beta
b. the price sensitivity
c. the tail
d. the hedge ratio
e. none of the above

26. All of the following are futures contract choice decisions related to hedging,
except
a. which future underlying asset
b. which strike price
c. which futures contract expiration
d. whether to go long or short
e. all of the above are futures contract choice decisions

27. Hedging with futures contracts entails all of the following risks, except
a. marking to market may require large cash outflows
b. changes in margin requirements
c. basis risk
d. quantity risk
e. all of the above are potential risks

28. Based on the minimum variance hedge ratio approach, what is the optimal
number of futures contracts to deploy, given the following information. The
correlation coefficient between changes in the underlying instrument’s price and
changes in the futures contract price is 0.95, the standard deviation of the changes in
the underlying position’s value is 300%, and the standard deviation of the changes in
the futures contract’s price is 11.4%.
a. long 35 futures contracts
b. long 25 futures contracts
c. long 15 futures contracts
d. short 25 futures contracts
e. short 15 futures contracts

29. Based on the minimum variance hedge ratio approach what is the hedging
effectiveness, given the following information. The correlation coefficient between
changes in the underlying instrument’s price and changes in the futures contract price
is 0.70, the standard deviation of the changes in the underlying position’s value is
40%, and the standard deviation of the changes in the futures contract’s price is 50%.
(Select the closest answer.)
a. 50%
b. 45%
c. 40%
d. 35%
e. 30%

30. Based on the price sensitivity hedge ratio approach, what is the optimal number
of futures contracts to deploy, given the following information. The yield beta is 0.65,
the present value of a basis point change for the underlying bond portfolio is $33,000,
and the present value of a basis point change for the bond futures contract is $325.
(Select the closest answer.)
a. long 100 futures contracts
b. long 55 futures contracts
c. short 66 futures contracts
d. short 22 futures contracts
e. short 11 futures contracts
 CHAPTER 11: SWAPS

1. The difference between the swap rate and the rate on a Treasury security of the
same maturity is called the
a. swap spread
b. risk premium
c. swap basis
d. settlement spread
e. LIBOR

2. Interest rate swap payments are made

a. on the last day of the quarter
b. on the first day of each month
c. at whatever dates are agreed upon by the counterparties
d. on the 15th of the agreed-upon months
e. on the last day of the month

3. To determine the fixed rate on a swap, you would

a. use put-call parity
b. price it as the issuance of a fixed rate bond and purchase of a floating
rate bond or vice versa
c. use the same fixed rate as that of a zero coupon bond of equivalent
maturity
d. use the continuously compounded rate for the shortest maturity bond
e. none of the above

4. Which of the following is not a type of swap?

a. settlement swaps
b. commodity swaps
c. interest rate swaps
d. equity swaps
e. currency swaps

5. The underlying amount of money on which the swap payments are made is
called
a. settlement value
b. market value
c. notional amount
d. base value
 e. equity value

6. The most basic and common type of swap is called

a. basis swap
b. plain vanilla swap
c. plain paper swap
d. commercial swap
e. bond swap

7. An interest rate swap with both sides paying a floating rate is called a
a. plain vanilla swap
b. two-way swap
c. floating swap
d. spread swap
e. basis swap

8. Consider a swap to pay currency A floating and receive currency B floating.

What type of swap would be combined with this swap to produce a swap to produce a
plain vanilla swap in currency B.
a. pay currency B floating, receive currency A fixed
b. pay currency B fixed, receive currency A floating
c. pay currency B fixed, receive currency A fixed
d. pay currency B floating, receive currency A floating
e. none of the above

9. For a currency swap with $10 million notional amount, the notional amount in
British pounds if the exchange rate is $1.55 is (approximately)
a. ₤11.55 million
b. ₤15.5 million
c. ₤10 million
d. ₤6.45 million
e. none of the above

10. A currency swap without the exchange of notional amount is most likely to be
used in what situation?
a. a company issuing a bond
b. a company generating cash flows in a foreign currency
c. a company arranging a loan
d. a dealer trying to hedge a currency option
e. none of the above
11. Which of the following distinguishes equity swaps from currency swaps?
a. equity swap payments are always hedged
b. equity swap payments are made on the first day of the month
c. equity swap payments can be negative
d. equity swap payments have more credit risk
e. none of the above

12. Find the upcoming net payment in a plain vanilla interest rate swap in which
the fixed party pays 10 percent and the floating rate for the upcoming payment is 9.5
percent. The notional amount is $20 million and payments are based on the
assumption of 180 days in the payment period and 360 days in a year.
a. fixed payer pays $1,950,000
b. fixed payer pays $950,000
c. floating payer pays $1 million
d. floating payer pays $50,000
e. fixed payer pays $50,000

13. Find the upcoming payment interest payments in a currency swap in which
party A pays U. S. dollars at a fixed rate of 5 percent on notional amount of $50
million and party B pays Swiss francs at a fixed rate of 4 percent on notional amount
of SF35 million. Payments are annual under the assumption of 360 days in a year, and
there is no netting.
a. party A pays $2,500,000, and party B pays SF1,400,000
b. party A pays SF1,400,000, and party B pays $2,500,000
c. party A pays SF1,750,000, and party B pays SF1,400,000
d. party A pays $2,500,000, and party B pays $2,000,000
e. party A pays $50 million, and party B pays SF35 million

14. Find the net payment on an equity swap in which party A pays the return on a
stock index and party B pays a fixed rate of 6 percent. The notional amount is $10
million. The stock index starts off at 1,000 and is at 1,055.15 at the end of the period.
The interest payment is calculated based on 180 days in the period and 360 days in the
year.
a. party B pays $851,500
b. parry B pays $48,500
c. party B pays $251,500
d. party A pays $251,500
e. party A pays $851,500
15. Find the approximate upcoming net payment on an equity swap in which party
A pays the return on stock index 1 and party B pays the return on stock index 2. The
notional amount is $25 million. Stock index 1 starts the period at 1500 and goes up to
1600 at the end of the period. Stock index 2 starts the period at 3500 and goes up to
3300 at the end of the period.
a. The party paying index 1 pays about $238,000
b. The party paying index 2 pays about $238,000
c. The party paying index 2 pays about $3.095 million
d. The party paying index 1 pays about $25 million
e. The party paying index 1 pays about $3.095 million

16. Find the fixed rate on a plain vanilla interest rate swap with payments every
180 days (assume a 360-day year) for one year. The prices of Eurodollar zero coupon
bonds are 0.9756 (180 days) and 0.9434 (360 days).
a. 5.9 percent
b. 5 percent
c. 6 percent
d. 5.5 percent
e. 2.95 percent

17. Use the information in problem 16 to find the fixed rate on an equity swap in
which the stock index is at 2,000.
a. 5.9 percent
b. 5 percent
c. 6 percent
d. 2.95 percent
e. 3.5 percent

18. Find the market value of a plain vanilla swap from the perspective of the fixed
rate payer in which the upcoming payment is in 30 days, and there is one more
payment 180 days after that. The fixed rate is 7 percent and the upcoming floating
payment is at 6.5 percent. The notional amount is $15 million. Assume 360 days in a
year. The prices of Eurodollar zero coupon bonds are 0.9934 (30 days) and 0.9528
(210 days).
a. the fixed payer pays $31,763.75
b. the fixed payer pays $71,527.50
c. the floating payer pays $49,500
d. the floating payer pays $194,228
e. none of the above
19. Which of the following statements about constant maturity swaps is not true?
a. the CMT rate is linked to a U. S. treasury security of equivalent maturity
b. the typical maturity is 2 to 5 years
c. the maturity is constant
d. one rate is based on a security of a longer rate than the settlement period
e. the swap is a type of interest rate swap

20. Which of the following is not a way to terminate a swap:

a. the two counterparties cash settle the market value
b. enter into an opposite swap with another counterparty
c. hold the swap to its maturity date
d. use a forward contract or option on the swap to enter into an offsetting
swap
e. borrow the notional amount and pay off the counterparty

21. An equity swap with fixed interest payments has two payments remaining. The
first occurs in 30 days and the second occurs in 210 days. The discount factors are
0.9934 (30 days) and 0.9528 (210 days). The upcoming fixed payment is at 4 percent
and is based 180 days in a 360-day year. The equity index was at 1150 at the
beginning of the period and is now at 1152.75. The notional amount is $60 million.
Find the approximate value of the equity swap from the perspective of the party
making the equity payment and receiving the fixed payment.
a. $143,478
b. $642,000
c. -$143,478
d. -$642,000
e. -$496,560

22. The present value of the series of dollar payments in a currency swap per $1
notional amount is $0.03. The present value of the series of euro payments in the same
currency swap per €1 is €0.0225. The current exchange rate is $1.05 per euro. If the
swap has a notional amount of $100 million and €105 million, find the market value
of the swap from the perspective of the party paying euros and receiving dollars.
a. $519,375
b. –$2,480,625
c. $3,000,000
d. –$3,000,000
e. –$519,375
23. Equity swaps can be used for all of the following except:
a. to synthetically buy stock
b. to synthetically sell stock
c. to convert dividends into capital gains
d. to synthetically re-align an equity portfolio
e. none of the above

24. Which of the following statements about diff swaps is true?

a. they involve interest payments in separate currencies
b. they are based on the difference between interest rates in two countries
c. they are based on the difference between interest rates of different
maturities
d. the notional amount reduces throughout the life of the swap
e. the notional amount increases throughout the life of the swap

25. Interest rate swaps can be used for all of the following purposes except:
a. to borrow at the prime rate
b. to convert a fixed-rate loan into a floating-rate loan
c. to convert a floating-rate loan into a fixed-rate loan
d. to speculate on interest rates
e. to hedge interest rate risk

26. The value of a pay-fixed, receive floating interest rate swap is found as the
value of a
a. floating-rate bond times the value of a fixed-rate bond.
b. floating-rate bond plus the value of a fixed-rate bond.
c. floating-rate bond minus the value of another floating-rate bond.
d. fixed-rate bond minus the value of another fixed-rate bond.
e. floating-rate bond minus the value of a fixed-rate bond.

27. A basis swap is priced by adding a spread to the higher rate or subtracting a
spread from the lower rate. This spread is found as
a. the difference between the floating rate on a plain vanilla swap based on
one of the rates and the fixed rate on a plain vanilla swap based on the other rate.
b. the addition of the fixed rate on a plain vanilla swap based on one of the
rates and the fixed rate on a plain vanilla swap based on the other rate.
c. the difference between the fixed rate on a plain vanilla swap based on
one of the rates and the fixed rate on a plain vanilla swap based on the other rate.
d. the difference between the floating rate on a plain vanilla swap based on
one of the rates and the floating rate on a plain vanilla swap based on the other rate.
 e. none of the above correctly explain how this spread is found

28. The value of a pay-fixed, receive-floating interest rate swap is found as the
value of a
a. floating-rate bond minus the value of a fixed-rate bond.
b. fixed-rate bond minus the value of a floating-rate bond.
c. floating-rate bond minus the value of another floating-rate bond.
d. fixed-rate bond minus the value of another fixed-rate bond.
e. none of the above correctly identify how this value is found.

29. Swap payments typically involve adjusting for the fraction of the year in some
fashion. This adjustment is known as
a. the compounding convention
b. the accrual period
c. the fraction convention
d. the money market convention
e. the payment period

30. The combination of a pay euro fixed and receive dollar fixed swap with a pay
dollar floating and receive euro fixed results in
a. a currency swap
b. a currency swap, receive euro fixed and pay euro floating
c. an interest rate swap, pay dollar fixed and receive dollar floating
d. an interest rate swap, receive euro fixed and pay euro floating
e. an interest rate swap, pay dollar floating and receive dollar fixed
 CHAPTER 12: INTEREST RATE FORWARDS AND OPTIONS

1. Which of the following is a 1 x 4 FRA?

a. The FRA expires in one month, and the underlying Eurodollar expires in
three months.
b. The FRA expires in four months, and the underlying Eurodollar expires
in one month.
c. The FRA expires in one month, and the underlying Eurodollar expires in
four months.
d. The FRA expires in three months, and the underlying Eurodollar expires
in four months.
e. The FRA expires in one month, and the underlying Eurodollar expires in
five months.

2. Determine the value of an interest rate call option at the maturity of a loan if
the call has a strike of 12 percent, a face value of $50 million, the loan matures 90
days after the call is exercised, the call expires in 60 days, the call premium is
$200,000, and LIBOR ends up at 13 percent.
a. $125,000
b. $83,333
c. $208,000
d. –$75,000
e. none of the above

3. A bank makes a $5 million 180-day pure discount loan at LIBOR of 9 percent.

At the same time, however, it exercises an interest rate put that has a strike of 11
percent. Find the annualized rate of return on the loan. Ignore the cost of the put.
a. 9.34 percent
b. 11.47 percent
c. 9 percent
d. 11 percent
e. none of the above

4. Which of the following best describes an interest rate cap?

a. a cash-and-carry hedge
b. a series of forward contracts
c. a series of interest rate calls
d. a call option spread
e. none of the above
5. A bank buys an interest rate floor in conjunction with a loan it holds that will
make four semiannual payments starting six months from now. The floor has a strike
of 9 percent. LIBOR at the beginning of the four payment periods is 10, 11, 8, and 8.6
percent. On which dates will the floor writer make a payment to the bank?
a. now and in 24 months
b. in 18 and 24 months
c. in 12 and 18 months
d. in 6, 12, 18 and 24 months
e. none of the above

6. The advantage of a collar over a cap is

a. it lowers the out-of-pocket cost
b. it offers the possibility of greater returns
c. it eliminates the risk
d. it has lower transaction costs
e. none of the above

7. An FRA is most like which of the following transactions

a. an interest rate cap
b. an interest rate floor
c. an interest rate collar
d. a forward contract
e. none of the above

8. The payoff to the holder of a long FRA on 90-day LIBOR with a fixed rate of
8.75 percent, a notional amount of $20 million if the underlying is 9 percent at
expiration is
a. $12,500
b. –$12,500
c. –$12,225
d. $12,225
e. –$48,900

9. The fixed rate on an FRA expiring in 30 days on 180-day LIBOR with the
30-day rate being 5 percent and the 210 day rate being 6 percent is
a. 6 percent
b. 6.14 percent
c. 5 percent
d. 5.5 percent
 e. 5.15 percent

10. Swaptions are like forward swaps in which of the following ways
a. Both are free of credit risk
b. Both require the execution of a swap at expiration
c. They have the same price
d. Both are traded on swaption exchanges
e. none of the above

11. Find the premium of a correctly priced interest rate call on 30-day LIBOR if
the current forward rate is 7 percent, the strike is 7 percent, the continuously
compounded risk-free rate is 6.2 percent, the volatility is 12 percent and the option
expires in one year. The notional amount is $30 million.
a. $.0031
b. $93,000
c. $7,817
d. $0.0012
e. $36,000

12. Which of the following is a limitation of using the Black model to price interest
rate options?
a. the risk-free rate is not constant
b. the volatility is not constant
c. interest rates are not lognormally distributed
d. all of the above
e. none of the above

13. An FRA differs from an interest rate swap in which of the following ways?
a. An FRA has more credit risk
b. FRAs are federally regulated
c. Traditionally the payment in an FRA is delayed
d. FRAs are used only by banks and swaps are used only by corporations
e. none of the above

14. Which of the following is not required to determine a swaption payoff at

expiration?
a. the exercise rate
b. the term structure of zero coupon rates at the swaption expiration
c. the maturity of the underlying swap
d. the yield on a bond of equivalent maturity as the swap
 e. none of the above

15. Find the payoff of an interest rate call option on the annual rate with an
exercise rate of 10 percent if the one-period rate at expiration is 11 percent. (No
days/360 adjustment is necessary and assume a $1 notional amount.)
a. 0.12
b. zero
c. 0.01
d. 0.0090
e. none of the above

16. Find the approximate market value of a long position in an FRA at a fixed rate
of 5 percent in which the contract expires in 20 days, the underlying is 180-day
LIBOR, the notional amount is $25 million, the 20-day rate is 7 percent, and the
200-day rate is 8.5 percent.
a. $433,658
b. –$454,954
c. $322,819
d. –$322,819
e. $454,954

17. Find the rate on a pure discount loan hedged with a long FRA if the loan is for
$10 million and matures in 30 days, the FRA is 30-day LIBOR, the fixed rate on the
FRA is 4 percent, and LIBOR at the time the loan is taken out is 5 percent.
a. 4.87 percent
b. 0.25 percent
c. 5.18 percent
d. 4.13 percent
e. 2.04 percent

18. A long position in an interest rate call would be appropriate for which of the
following situations:
a. a bond trader expects falling interest rates
b. a borrower expects rising interest rates
c. a lender expects rising interest rates
d. a derivatives dealer is exposed to the risk of falling interest rates
e. a party holding a short position in Eurodollar futures is concerned about losing
money
19. A payer swaption is equivalent to which of the following instruments.
a. a call option on a bond
b. a long Treasury bond futures option
c. a long Eurodollar futures
d. an interest rate cap
e. a put option on a bond

20. Which of the following strategies replicates a long position in an FRA?

a. long a long term Eurodollar time deposit and short a short-term Eurodollar time
deposit
b. long a Eurodollar futures and short a Eurodollar option
c. long a Eurodollar option on a futures
d. short a long-term Treasury bond futures and short a short-term Treasury bond
futures
e. long a receiver swaption

21. An FRA in which the rate is not set according to rates in the market is called
a. a short FRA
b. a long FRA
c. an off-market FRA
d. a hedged FRA
e. an FRA spread

22. If a lender uses a collar, the transactions would be

a. buy a floor at one exercise price, sell a floor at another exercise price
b. buy a floor, sell a cap
c. sell a floor, buy a cap
d. buy a cap at one exercise price, sell a floor at another exercise price
e. buy a cap and sell a floor at the same exercise price

23. A payer swaption is expiring. The underlying swap has a two year maturity. Th
e present value factors are 0.9259 (one year) and 0.8651 (two years). The strike rate is
7 percent. What is the value of the swaption per $1 notional amount.
a. 0.0000, since it is out-of-the-money
b. 1.0000
c. 0.0753
d. 0.0095
e. none of the above
24. Find the fixed rate on a forward swap expiring in 90 days in which the
underlying swap has a maturity of 180 days and makes payments every 90 days. The
prices of zero coupon bonds are 0.9877 (90 days), 0.9732 (180 days), and 0.9597 (270
days).
a. 5.97 percent
b. 5.6 percent
c. 5.5 percent
d. 5.78 percent
e. 5 percent

25. All of the following are uses of swaptions except

a. to speculate on interest rates
b. to give a firm flexibility in future borrowings
c. to borrow money
d. to create callable from non-callable bonds
e. none of the above

26. Suppose your firm issued a callable bond two years ago and it has three more
years to go before the first call date. If interest rates have fallen over the past two
years and you believe rates will not stay this low and that it would be in the firm’s best
interest to lengthen the duration of the liabilities, which of the following is one
potential strategy to accomplish the objective of lengthening the duration while also
securing the lowering interest rate.
a. buy a payer swaption
b. sell a payer swaption
c. buy a receiver swaption
d. sell a receiver swaption
e. buy an interest rate floor

27. Suppose your firm invested in a callable bond recently when interest rates were
high and the bond has three more years to go before the first call date. If interest rates
are expected to fall over the next three years, which of the following is one potential
strategy would take advantage of this view.
a. buy a payer swaption
b. sell a payer swaption
c. buy a receiver swaption
d. sell a receiver swaption
e. buy an interest rate floor
28. Which of the following best describes a zero cost collar within the context of
interest rate derivatives?
a. A zero cost collar is a long (short) position in an interest rate cap and a
short (long) position in an interest rate floor where the cost of the cap (floor) exactly
offsets the revenue from the floor (cap).
b. A zero cost collar is a long (short) position in an interest rate cap and a
short (long) position in an interest rate floor where the cost of the cap (floor) is less
than the revenue from the floor (cap).
c. A zero cost collar is a long (short) position in an interest rate cap and a
short (long) position in an interest rate floor where the cost of the cap (floor) is greater
than the revenue from the floor (cap).
d. A zero cost collar is an option that pays off only if interest rates remain
within a designated range.
e. A zero cost collar is an option that pays off only if interest rates fall
outside of a designated range.

29. Suppose you have a floating rate loan tied to 90-day LIBOR and have hedged
the interest rate risk with an interest rate cap. The effective annual rate actually paid
on the loan with the cap is found using a methodology equivalent to
a. computing the Black-Scholes-Merton option call price
b. computing the net present value
c. computing the internal rate of return
d. computing the Black commodity option call price
e. computing the WACC

30. When valuing an interest rate call option, one approach is to use the Black call
option price adjusted for the present value
a. over the m days of the underlying option using the continuously
compounded forward rate.
b. over the m days of the underlying rate using the continuously
compounded spot rate.
c. over the days remaining of the option using the continuously
compounded forward rate.
d. over the days remaining of the option using the continuously
compounded spot rate.
e. over the m days of the underlying rate using the continuously
compounded forward rate.
 CHAPTER 13: ADVANCED DERIVATIVES AND STRATEGIES

Answer questions 1 through 6 about insuring a portfolio identical to the S&P 500
worth $12,500,000 with a three-month horizon. The risk-free rate is 7 percent.
Three-month T-bills are available at a price of $98.64 per $100 face value. The S&P
500 is at 385. Puts with an exercise price of 390 are available at a price of 13. Calls
with an exercise price of 390 are available at a price of 13.125. Round off your
answers to the nearest integer.

1. What is the minimum value of the insured portfolio?

a. $16,672,344
b. $12,500,000
c. $12,091,709
d. $12,244,898
e. $13,375,000

2. How many puts should be used to insure this portfolio?

a. 122,584
b. 31,397
c. 62,814
d. 961,538
e. 32,468

3. If the S&P 500 ends up at 401, determine the upside capture.

a. 96.7 percent
b. 96 percent
c. 99.3 percent
d. 94 percent
e. 100 percent

4. If the insured portfolio consisted entirely of calls and T-bills, how many would
be used?
a. 19,143 calls and 124,176 T-bills
b. 31,397 calls and 122,449 T-bills
c. 933,238 calls and 2,547 T-bills
d. 31,407 calls and 119,997 T-bills
e. 32,468 calls and 32,468 T-bills
5. If the insured portfolio were dynamically hedged with stock index futures, how
many futures would be used? The call delta is 0.52 and the continuous risk-free rate is
5.48 percent. Each futures has a multiplier of 250 and a price of 777.30.
a. 60
b. 64
c. 30
d. 32
e. none of the above

6. If the insured portfolio were dynamically hedged with T-bills, how many
T-bills would be used?
a. 16,332
b. 63,002
c. 126,723
d. 61,672
e. 32,468

7. Suppose a firm offers an equity-linked security. The face value is $1 million

and its payoff is based on any appreciation in an equity index currently at 855.50. It
has determined that of the $1 million raised, it can structure the option component so
that its value is $135,000. Currently an at-the-money call option is worth $125. What
percentage of the gain in the index can it offer?
a. 92 percent
b. 100 percent
c. 50 percent
d. 8.23 percent
e. none of the above

8. Weather derivative payoffs can be based on each of the following variables

except
a. temperature above a given level
b. inches of snowfall
c. total value of insurance claims
d. temperature below a given level
e. sunshine

9. Which of the following statements about mortgage-backed security strips is

true?
a. both interest-only and principal-only strips are subject to pre-payment risk
b. only principal-only strips are subject to prepayment risk
c. only interest-only strips are subject to prepayment risk
d. the prepayment risk of interest-only and principal-only strips is precisely
offsetting
e. none of the above

10. A chooser option is similar to what other type of option strategy

a. put-call parity
b. a covered call
c. a protective put
d. a combination bull and bear spread
e. none of the above

11. The number of possible final average prices in an Asian option for a four
period binomial model is
a. 8
b. 4
c. 16
d. 32
e. none of the above

12. A lookback call option provides the right

a. to change the stock on which the option is written
b. to buy the stock at its lowest price over the option's life
c. to insure a stock against loss
d. to change your mind about the exercise price
e. none of the above

13. If the stock price is currently 36, the exercise price is 35 and the stock ends up
at 44, the value of an asset-or-nothing option at expiration is
a. 35
b. 8
c. 9
d. 44
e. none of the above

14. The primary problem in pricing electricity derivatives is that

a. the volatility cannot be measured
b. the underlying asset cannot be stored
c. electricity is a homogeneous product
d. the demand for electricity is unpredictable
 e. the electricity market is unregulated

15. An equity forward contract is

a. a forward contract on LIBOR secured by a stock as collateral
b. a futures contract on a stock index that is not marked-to-market
c. a call option on a stock with greater downside risk than an ordinary call
d. a forward contract whose payoff is determined by a stock or index
e. none of the above

16. A security that pays off the return from a combination of mortgages is called a
a. homeowners’ equity claim
b. mortgage portfolio
c. mortgage option
d. mortgage-backed security
e. none of the above

17. Asian options are also called

a. average price options
b. Pacific options
c. installment options
d. no-regrets options
e. none of the above

18. Which of the following statements is correct about cash-or-nothing options

a. they are subject to no credit risk
b. they must be priced by the binomial model
c. they have lower upside gains and lower downside losses than ordinary
options
d. they are equivalent to short positions in asset-or-nothing options
e. none of the above

19. A constant maturity swap has which of the following characteristics

a. the swap maturity is held constant at a fixed number of years
b. the floating payment is usually based on the rate on a Treasury note
c. the swap calls for all payments to be made at its maturity
d. the floating payment and the maturity are both constant
e. none of the above
20. A range floater is a security with which of the following characteristics
a. the payments range from a given maximum to a given minimum
b. the maturity is limited to a fixed range
c. its payments are based on whether the rate stays within a range
d. all of the above
e. none of the above

21. A security that is sub-divided into securities called tranches is called a

a. principal-only strip
b. asian lookback option
c. range mortgage strip
d. collateralized mortgage obligation
e. none of the above

22. Which of the following is a path-independent option

a. a fixed strike Asian call option
b. a standard European call option
c. an up-and-out call option
d. an American put option
f. none of the above

23. In a weather derivative, the number of days times the average temperature
above 65 degrees Fahrenheit is called
a. temperature day count
b. day-temps
c. cooling degree days
d. temp-days
e. heating degree days

24. A contingent-pay option is replicated by which of the following combinations?

a. long an ordinary call and long an ordinary put
b. long an ordinary call and short a cash-or-nothing call
c. long an ordinary call and short an asset-or-nothing call
d. long an ordinary call and long an equity forward
e. long an ordinary call and long a risk-free bond

25. Which of the following is not a type of structured note?

a. range floater
b. inverse floater
c. diff floater
d. reverse floater
e. none of the above

26. When pursuing portfolio insurance of a stock position, the minimum value of
the portfolio is equal to
a. zero
b. strike price times the number of shares of stocks and puts held
c. strike price divided by the number of shares of stocks and puts held
d. stock price times the number of shares of stocks held
e. strike price times the initial value of the portfolio divided by the stock
price minus the put price

27. Upside capture is defined as the

a. dollar value of the uninsured portfolio value minus the insured portfolio
value
b. percentage of the insured portfolio value that is represented by the
uninsured portfolio value
c. dollar value of the insured portfolio value minus the uninsured portfolio
value
d. percentage of the uninsured portfolio value that is represented by the
insured portfolio value
e. put premium as a percentage of the original portfolio value

28. Identify the false statement related to break forward contracts.

a. It is a combination of spot and derivative positions that replicates an
ordinary call option.
b. The initial positions are structured so that the overall position costs
nothing up front.
c. Penalizes the investor if the option ends up out-of-the-money.
d. Break denotes the ability of the purchaser to void the contract.
e. All of the above statements are true related to break forward contracts.

29. Digital options can be used to synthetically create a position in an underlying

instrument by
a. purchasing a cash-or-nothing digital put and selling an asset-or-nothing
digital call
b. purchasing both a cash-or-nothing digital call and a cash-or-nothing
digital put
c. purchasing both an asset-or-nothing digital call and an asset-or-nothing
digital put
 d. purchasing a cash-or-nothing digital call and selling a cash-or-nothing
digital put
e. purchasing an asset-or-nothing digital call and selling an
asset-or-nothing digital put

30. Digital options can be used to synthetically create a position in a zero coupon
bond by
a. purchasing a cash-or-nothing digital put and selling an asset-or-nothing
digital call
b. purchasing both a cash-or-nothing digital call and a cash-or-nothing
digital put
c. purchasing both an asset-or-nothing digital call and an asset-or-nothing
digital put
d. purchasing a cash-or-nothing digital call and selling a cash-or-nothing
digital put
e. purchasing an asset-or-nothing digital call and selling an
asset-or-nothing digital put
 CHAPTER 14: FINANCIAL RISK MANAGEMENT TECHNIQUES AND
APPPLICATIONS

1. Risk management encompasses all of the following except

a. determining a firm’s actual level of risk
b. determining a firm’s desired level of risk
c. setting policies and procedures
d. monitoring your position after-the-fact
e. none of the above

2. Market risk is which of the following

a. the risk associated with failing to properly record market transactions
b. the risk that a dealer will lose market share to a competing dealer
c. the risk associated with movements in such factors as interest rates and
exchange rates
d. the risk of the government declaring a transaction illegal
e. none of the above

3. What is the reason for undertaking a gamma hedge?

a. government regulation
b. the possibility of counterparty default
c. changes in volatility
d. large movements in the underlying
e. none of the above

4. Which of the following is the interpretation of a VAR of $5 million for one year
at 5 percent probability.
a. the probability is 5 percent that the firm will lose at least $5 million in one year
b. the probability is at least 5 percent that the firm will lose $5 million in one year
c. the probability is 5 percent that the firm will lose $5 million in one year
d. the probability is less than 5 percent that the firm will lose $5 million in one
year
e. none of the above

5. Which of the following are not methods of determining the VAR?

a. simulation method
b. historical method
c. estimation method
d. analytical method
e. none of the above
6. Which of the following methods is not used to reduce credit risk?
a. delta-gamma-vega hedging
b. collateral
c. marking to market
d. limiting the amount of business you do with a party
e. none of the above

7. Which of the following are types of risks faced by a derivatives dealer?

a. tax risk
b. operational risk
c. accounting risk
d. legal risk
e. none of the above

8. Netting permits a firm to?

a. subtract losses from price increases from losses from price decreases
b. net its transactions with a given counterparty against each other
c. net all of its gains against all of its losses
d. all of the above
e. none of the above

9. Systemic risk is
a. the risk of a failure of the entire financial system
b. the risk associated with broad market movements
c. the risk of a failure of a firm’s financial risk management system
d. the risk of large price movements throughout the financial system
e. none of the above

10. Which of the following is the primary impetus for the growth in the practice of
risk management?
a. faster computers
b. better pricing models
c. improved knowledge of risk management
d. tighter government regulation
e. concern over volatility

11. Each of the following is a benefit of practicing risk management by companies

except
a. companies can manage risk better than their shareholders
 b. risk management can avoid bankruptcy costs
c. risk management can lower taxes
d. risk management can increase employment opportunities
e. risk management can help prevent companies from passing up valuable
investment opportunities

12. Find the number of Eurodollar futures each having a delta of –$25 that would
delta-hedge a portfolio of a long position in swaps with a delta of $5,000 and a short
position in a put option with a delta of –$2,300.
a. long 292 contracts
b. short 108 contracts
c. short 292 contracts
d. long 200 contracts
e. long 108 contracts

13. A total return swap is best described as

a. A swap in which the payments include only capital gains
b. a swap in which the total return on a stock index is swapped for the total return
on a bond
c. a swap in which the return on one bond is swapped for some other payment
d. a swap designed to substitute for a basis swap
e. none of the above

14. Which of the following best describes a credit default swap?

a. it is protected against default
b. it has a higher rate to compensate for the possibility of one party defaulting
c. it carries a higher credit rating than most other swaps
d. it off if another party external to the swap defaults
e. none of the above

15. Which of the following statements is not true about a credit spread option?
a. it is an option on the spread of a bond over a reference bond
b. its value would change with changes in investors’ perceptions of a party’s
credit quality
c. it requires payment of a premium up front
d. it requires that the underlying bond be relatively liquid
e. none of the above

16. Which of the following forms of hedging requires the use of options?
a. delta hedging
 b. vega hedging
c. gamma hedging
d. credit risk hedging
e. none of the above

17. If a firm engages in risk management to capture arbitrage profits, what is it

easy to overlook?
a. the additional credit risk it assumes
b. the cost is greater than the benefit
c. the market risk is high
d. all of the above
e. none of the above

18. Which of the following best describes the delta normal method?
a. a method of managing a delta hedge to assure a low gamma
b. the historical method when the distribution is normal
c. the Monte Carlo method when price changes are normally distributed
d. the analytical method applied to options
e. a method of measuring changes in an option’s delta

19. The risk that errors can occur in inputs to a pricing model is called
a. input risk
b. model risk
c. pricing risk
d. valuation risk
e. none of the above

20. Which of the following techniques is a more appropriate risk management tool
for a company in which asset value is not easily measurable?
a. stress risk
b. credit value at risk
c. market risk
d. delta at risk
e. cash flow at risk

21. In option terms, the limited liability of corporate stockholders is

a. a forward contract
b. a call option
c. a put option
d. a protective put
 e. a fiduciary call

22. The risk that a party will not pay while the counterparty is sending payment is
called
a. wire transfer risk
b. payment risk
c. settlement risk
d. cross-border risk
e. none of the above

23. A bond subject to default is equivalent to

a. a payer swaption
b. a call and a default-free bond
c. a put and a call
d. a default-free bond and a short put
e. none of the above

24. Which of the following instruments could be used to execute a delta, gamma
and vega hedge?
a. a swap
b. an option
c. a futures
d. an FRA
e. none of the above

25. Which of the following is approximately the Value at Risk at 5 percent of a

portfolio of $10 million of asset A, whose expected return is 15 percent and volatility
is 35 percent, and $15 million of asset B, whose expected return is 21 percent and
volatility is 30 percent, where the correlation between the two assets is 0.2.
a. $5.6 million
b. $10 million
c. $15 million
d. $1.25 million
e. none of the above

26. A delta-hedged position is one in which the

a. combined spot and derivatives positions have a delta of one.
b. spot position has a delta of zero.
c. derivatives position has a delta of zero.
d. combined spot and derivatives positions have a delta of zero.
 e. combined spot and derivatives positions have a gamma of zero.

27. A delta and gamma hedge is

a. one in which the combined spot and derivatives positions have a delta of
zero and a gamma of zero.
b. one that is not guaranteed to be free of all risks
c. effective only for small changes in the underlying instrument.
d. all of the above statements are true
e. none of the above statements are true

28. Which of the following positions has a negative vega?

a. Receive fixed and pay floating LIBOR-based interest rate swap contract
b. Short cattle futures contract
c. Receive floating, pay fixed LIBOR-based forward rate agreement
d. Long Apple, Inc. put option
e. Short S&P 500 index call option

29. Delta, gamma, and vega hedging is rather complex. Identify the false
statement.
a. Requires the use of four hedging instruments
b. At least one of the instruments has to be an option
c. Involves designing a portfolio where delta, gamma, and vega are set
equal to zero
d. Typically involves the solution to three simultaneous equations
e. All of the above statements are true

30. Which of the following is not a method for computing Value at Risk?
a. Analytical method
b. Variance-covariance method
c. Comprehensive method
d. Historical method
e. Delta normal method

31. The present value of the payments made to convert a bond subject to default to
a default-free bond is called the
a. Insurance cost
b. Credit default swap premium
c. Annuity risk factor
d. Present value of the default volatility
e. None of the above
 CHAPTER 15: MANAGING RISK IN AN ORGANIZATION

1. Derivatives activities in end users are primarily conducted by

a. the human resources group
b. the sales staff
c. the chief financial officer
d. the board of directors
e. the treasury group

2. Which of the following best describes a company that practices enterprise risk
management?
a. interest rate risk and currency risk would be managed in unison
b. a single department to manage risk
c. it would manage insurance-related risks along with financial risk
d. credit risk would be managed the same way as market risk
e. operational risk would be managed

3. The front office refers to

a. the compliance office
b. the traders who engage in derivatives transactions
c. legal counsel
d. the risk management function
e. senior management

4. FAS 133 defines effective hedging as

a. a hedge with no basis risk
b. a correctly priced hedge
c. a perfect hedge
d. a hedge that reduces 80 to 125 percent of the risk
e. none of the above

5. In which of the following activities is hedge accounting prohibited?

a. hedging an overall portfolio as opposed to an individual transaction
b. using short calls to protect a long asset
c. using long puts to protect an asset
d. hedging a long position with a short futures
e. hedging a swap with a swaption
6. Which of the following organizations recommends best practices for the
investment management industry?
a. PRMIA
b. Risk Standards Working Group
c. GARP
d. G-30
e. Financial Accounting Standards Board

7. Which of the following activities does senior management not do?

a. ensure that personnel are qualified
b. ensure that controls are in place
c. execute hedge transactions
d. establish policies
e. define roles and responsibilities

8. The primary distinction between FAS 133 and IAS 39 is

a. IAS 39 does not permit hedge accounting
b. IAS 39 was adopted earlier than FAS 133
c. IAS 39 applies only to publicly traded corporations
d. IAS 39 applies to all financial assets and liabilities, not just derivatives
e. none of the above

9. Metalgesellschaft lost about $1.3 billion doing what?

a. hedging short-term commitments with long-term options
b. using crude oil futures options to hedge crude oil futures
c. trading futures spreads on crude oil
d. hedging fixed rate oil price commitments with swaptions
e. none of the above

10. “Independent risk management” means which of the following?

a. that risk management of a firm is independent of its overall corporate policy
decisions
b. that the risk management function is provided by an outside consulting firm
c. that the risk manager cannot be influenced by the traders
d. that the risk manager is independent of the firm’s senior managers
e. none of the above

11. End users are all of the following types of organizations except?
a. investment funds
b. non-financial corporations
 c. governments
d. financial institutions
e. none of the above

12. What is the primary activity of a firm’s front office?

a. risk management
b. trading
c. pricing derivative products
d. auditing
e. none of the above

13. Orange County lost $1.6 billion doing what?

a. betting that interest rates would remain stable
b. buying Treasury bond futures
c. selling Eurodollar futures
d. buying short- and intermediate-term bonds on margin
e. trading money market options

14. Risk managers should report to

a. the chief trader
b. legal counsel
c. the executive in charge of the front office
d. the executive in charge of the back office
e. none of the above

15. Prior to FAS 133, where on the financial statements were derivatives reported?
a. as contingent liabilities
b. as goodwill
c. as intangible assets
d nowhere because they were off-balance sheet items
e. in Other Comprehensive Income

16. Which of the following methods is not acceptable for disclosure under the
SEC’s rules?
a. the CEO’s letter to the shareholders
b. tabular information
c. sensitivity analysis
d VAR
e. none of the above
17. Ultimate authority for risk management lies with
a. legal counsel
b. the head trader
c. senior management
d. the internal auditors
e. the external auditors

18. Derivatives dealers primarily conduct derivatives transactions for which of the
following reasons?
a. to enhance the returns on their other investment transactions
b. to profit off of their ability to execute trades at the right time
c. to profit off of their market making services
d. to provide services to enhance the overall attractiveness of their product line
a. none of the above

19. Which of the following methods is not permitted to satisfy the SEC’s
requirements for disclosure of derivatives activity?
a. an explanation in the chairman’s letter
b. a Value-at-Risk figure
c. a sensitivity analysis
d. a table of market values and related terms
e. none of the above

20. Hedge accounting is which of the following?

a. describing all hedges in footnotes to accounting statements
b. deferring all recording of hedge profits and losses until the hedge is over
c. associating the derivative profit or loss with the instrument being hedged
d. all of the above
e. none of the above

21. Which of the following statements is not true about fair value hedges?
a. it requires a method of determining the fair value of the derivative
b. it defers recognition of all profits and losses until the hedge is terminated
c. it will cause earnings to fluctuate if hedges are not effective
d. it requires proper documentation
e. none of the above

22. Which of the following statements is not true about fair value hedges?
a. it requires identification of the effective and ineffective parts
b. derivatives profits and losses are temporarily carried in an equity account
c. it requires proper documentation
d. only dealer firms are eligible to use it
e. none of the above

23. Barings lost $1.2 billion because of what?

a. a failure of risk controls in one of its foreign offices
b. model risk in their VAR models
c. fraudulent transactions
d. regulators shut it down because of poor risk management
e. speculating on German interest rates

24. Which of the following would not be included among typical derivatives end
users in the U. S.?
a. pension funds
b. corporations
c. state and local governments
d. the federal government
e. hedge funds

25. Procter and Gamble lost $157 million doing what?

a. speculating on a worldwide recession
b. failure to hedge their borrowing cost on a bond issue
c. speculating on foreign interest and exchange rates
d. speculating on a decrease in the federal budget deficit
e. mismanagement of a hedge fund in their pension fund

26. All of the following make up the financial derivatives risk management
industry, except
a. end users
b. dealers
c. consultants
d. specialized software companies
e. GRAP professionals

27. Enterprise risk management includes all of the following except

a. a process in which a firm seeks to controls all of its risks in a
centralized, integrated manner
b. seeks to manage traditional financial risks, such as interest rate and
foreign currency risks
c. seeks to manage risk of product obsolescence risk
 d. seeks also to manage nontraditional financial risks, such as insurable
risks
e. all of the above

28. Hedge accounting, based on FAS 133, addresses all of the following except
a. fair value hedges
b. unfair value hedges
c. cash flow hedges
d. foreign investment hedges
e. speculation

29. Responsibilities of senior management include all of the following except

a. establish written policies
b. define roles and responsibilities
c. identify acceptable strategies
d. ensure that control systems are in place
e. all of the above

30. Hedge accounting is a method of accounting for which the

a. gains and losses from a hedge are deferred until the hedge is completed.
b. debits and credits are managed to keep the cash account stable
c. derivatives revenues and expenses are recorded so as to exactly balance
d. gains and losses on derivatives are shown before the hedge is terminated
e. none of the above
 MIDTERM

1. In which of the following situations would you use a short hedge?

a. The planned repurchase of stock to cover a short position
b. The planned purchase of a stock
c. The planned purchase of commercial paper
d. The planned issuance of bonds

2. The relationship between the volatility and the time to expiration is called the
theta
A. term structure of volatility
B. volatility skew
C. volatility smile
D. none are correct

3. Which of the following is the interpretation of a VAR of $5 million for one year at
5% probability?

A. The probability is 5 percent that the firm will lose at least $5 million in one
year
B. The probability is at least 5 percent that the firm will lose $5 million in one
year
C. The probability is 5 percent that the firm will lose $5 million in one year
D. The probability is less than 5 percent that the firm will lose $5 million in one
year

4. Which of the following strategies can lead to an obligation to buy stock?

A. Buying a call
B. Buying a protective put
C. Writing a put
D. Writing a covered call

5. The “limited liability” of stockholders is similar to:

A. a stock
B. a bond
C. a put
D. a call
6. In October, MaxCorp decided to buy 100 thousand shares of Z Company, with the
purchase taking place in November. Z Company's stock has a beta of 1.60 and
currently worth $32.50. MaxCorp would like to hedge this transaction using
December S&P 500 futures, whose current price is 2938.50 and a multiplier of $250.
Assume the S&P 500 futures contract has a beta of 1. The number of S&P 500 futures
required is:

A. 7
B. 9.
C. 10
D. 5

7. Which of the following pairs of currency swaps can be combined to create a plain
vanilla interest rate swap to pay USD fixed and receive USD floating?

a.Pay EUR floating/Receive USD floating + Pay USD fixed/Receive EUR floating
b.Pay EUR fixed/Receive USD fixed + Pay USD floating/Receive EUR fixed
c.Pay EUR floating/Receive USD fixed + Pay USD fixed/Receive EUR fixed
d.Pay EUR fixed/Receive USD floating + Pay USD floating/Receive EUR floating

8. The underlying's ______ is the major factor in the calendar spread's performance.

A. expected rate of return

B. beta
C. correlation with the benchmark index
D. volatility

9. Suppose you buy an asset at $70 and sell a futures contract at $72. What is your
profit if, prior to expiration, you sell the asset at $75 and the futures price is $78?
A. $2
B. -$1
C. -$6
D. $5

10. In order to construct a covered call, we _____ for every share owned.
A. write a call
B. write a put
C. buy a put
D. buy a call
11. What is the breakeven for a protective put?
Select one:
A. S0 + P
B. S0 – C
C. S0 – X
D. S0 + X