45 & 46: Derivatives

Question 1

Either the long or short in the forward contract will make a cash payment at contract expiration and the asset is not delivered

Answer 1

Cash settlement
Can be used for futures (exchanged traded forward contracts)

Question 2

The standardized terms of a future (exchanged traded) give it far more flexibility to traders, giving rise to a strong secondary market and greater:

Answer 2

liquidity; uniformity of the contract terms broadens the market for the futures by appealing to a greater number of traders.

Question 3

For a futures contract, once the account margin (based on the daily settlement price) falls below the maintenance margin level, it must be returned to the:

Answer 3

Initial margin level

To avoid closing out a futures position

Question 4

when a combination of two securities will produce a certain payoff in the future that produces a return that is greater than the risk-free rate of interest

Answer 4

arbitrage opportunity

Question 5

The reason there may be a difference in price between a forward contract and an identical futures contract is that a futures position has:

Answer 5

daily settlement;

makes or requires cash flows during its life

Question 6

Price of derivatives is established at:

Answer 6

established at contract initiation, so that the price at initiation is 0

Question 7

The value of futures and swaps, throughout the life of the contract:

Answer 7

may vary; due to daily cash settlement & floating rate changes

Changes during the life of the contract, with opposite gains & losses to the long & short

Question 8

How do benefits & costs impact the no-arbitrage froward price at initiation?

Answer 8

• Benefits, decrease the price (F < Spot)
• Costs, increase the price (F > Spot)

Question 9

used to hedge the interest rate exposure of a floating-rate loan

Answer 9

forward rate agreements

Question 10

Differences may exist between forward and futures prices for otherwise identical contracts if futures prices are correlated with:

Answer 10

interest rates

Question 11

When interest rates and futures prices are uncorrelated the prices of forward and futures on the same asset will be:.

Answer 11

equal

Question 12

Short FRA position gains when:

Answer 12

Short (Seller) of FRA gains when floating rates decline

Obligation to make payment in the event that the reference interest rate increases above the contract prices

Question 13

Used to lock in an interest rate for future borrowing or lending

Answer 13

FRA

Question 14

Long position in FRA gains when:

Answer 14

Long (Buyer) position of FRA gains when interest rates increase

Buyer exchanges fixed rate agreement for floating rate agreement

Question 15

The underlying instrument in a FRA:

Answer 15

interest rate

Question 16

Financial instrument that transforms the underlying asset’s performance

Answer 16

Derivative

Question 17

The price used to determine the daily gains and losses in the margin account:

Answer 17

Settlement Price

Question 18

In using a one-period binomial model to value an option the expected payoff at the end of one period is discounted at the:

Answer 18

Risk-free rate

Question 19

A bank borrows for 360 days and simultaneously lends the proceeds for 90 days. This transaction creates a synthetic forward rate agreement (FRA) closest to:

Answer 19

long position in a 90-day FRA on 270-day LIBOR.

Question 20

A hedger could replicate a 90-day long FRA position on 120 day LIBOR by:

Answer 20

Lending at 90 day LIBOR & borrowing at 210 day LIBOR

(borrow for full time, lend for first portion)

Question 21

Profit of a forward or futures contract at expiration=

Answer 21

Profit @ expiration= Value of option - Option premium

Expiration= Spot price- contract price

Question 22

Intrinsic value (exercise value) =

Answer 22

The amount the option is in the money

Question 23

Option Premium=

(price of the option)

Answer 23

Option premium = Intrinsic value + Time value

Intrinsic value/exercise value = amount in the money
If out of the money: option premium= time value
Time value > 0, before expiration

Question 24

Greater volatility in the price of the underlying asset will have what effect on the value of a call option and the value of a put option?

Answer 24

Values of call and put options will both increase

An option’s value can fall no lower than zero (it will expire out of the money), volatility will increase an option’s upside potential

Question 25

Law of one price: two assets with identical cash flows, regardless of future events, should:

Answer 25

Have the same price

Question 26

Interest rate swaps are:

Answer 26

Forward commitements

Question 27

Interest rate swap in which the parties exchange one floating rate obligation for another:

Answer 27

Basis Swap

Question 28

Can be replicated by a series of off-market FRAs with a non-zero value at initiation, but present values that sum to zero at swap initiation

Answer 28

Interest Rate Swap

Each FRA has a forward rate = fixed rate in in the intere rate swap

Question 29

Buying the right, but not the obligation to exercise the call and buy at a specified price

Answer 29

Buyer of call option

Long asset exposure

Question 30

Has the obligation to sell a specified asset to the buyer, at a specific price, if the buyer of the call option exercises before expiration

Answer 30

Writer (seller) of call option

Short asset exposure

Question 31

Has the right but not the obligation to sell at a specifed price, in the future

Answer 31

Buyer of put option

Short asset exposure

Investor beleives the stock price will drop below the exercise price, before expiration

Question 32

Has the obligation to buy the asset from the buyer, at a specified price, if the buyer exercises before expiration

Answer 32

Seller of put option

long asset exposure

(think of insurance company- buys the costs to repair a car for a premium… profits off the volume of put option premiums sold)
Long asset exposure: the amount invested in the long position > amout invested in the short position

Question 33

Allows the owner to exercise the option any time before expiration

Answer 33

American option

American option value > = European option value
Except for:
Call options on dividend paying stocks
in the money put options

Question 34

Options can only be exercised at expiration

Answer 34

European

Question 35

Investor believes that the stock price will drop below the exercise price, before expiration:

Answer 35

Buyer of put option

If the stock price drops below the exercise price, the buyer will be able to sell at a higher price & make a profit

Question 36

Measures the sensitivity of a derivatives value to the price of the underlying asset:

Answer 36

Delta

Question 37

A put buyer and call buyer can experience a maximuim loss of:

Answer 37

Option premium