Derivatives

Question 1

contingent claim

Answer 1

is a derivative in which with a right, but not an obligation, to make a final payment contingent on the performance of the underlying.

Question 2

option

Answer 2

is a derivative contract in which one party, the buyer, pays a
sum of money to the other party, the seller or writer, and receives the right
to either buy or sell an underlying asset at a fixed price either on a specific
expiration date or at any time prior to the expiration date.

Question 3

Call Option with physical delivery

Answer 3

a call option with physical delivery,
upon exercise the underlying asset is delivered to the call buyer, who pays the call
seller the exercise price.

Question 4

put option with physical delivery

Answer 4

put buyer delivers the underlying asset to the put seller and receives the strike price.

Question 5

Exercise Price

Answer 5

The fixed price at which the underlying asset can be purchased is called the exercise price (also called the “strike price,” the “strike,” or the “striking price”). This price
is somewhat analogous to the forward price because it represents the price at which
the underlying will be purchased or sold if the option is exercised.

Question 6

Option Premium

Answer 6

it is the present value of the cash flows that are expected to be received by the
holder of the option during the life of the option.

Question 7

In the money

Answer 7

if the underlying value exceeds the exercise price (ST > X), then the option
value is positive and equal to ST – X

Question 8

Out of the money

Answer 8

When the

underlying value is less than the exercise price,

Question 9

At the money

Answer 9

When ST = X,

Question 10

Equity Swaps

Answer 10

permit investors to pay the return on one stock index and receive the return on
another index or a fixed rate

Question 11

Notional Principal

Answer 11

The notional principal of a swap is not exchanged in the case of an interest rate swap

Question 12

Price Limits

Answer 12

Price limits are important in helping the clearinghouse manage its
credit exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from parties losing money

Question 13

Forward Contract

Answer 13

In a forward contract, either party could default, whereas in a contingent claim, default is possible only from the short to the long.

Question 14

Value of a forward contract

Answer 14

the spot price of the underlying asset

minus the present value of the forward price.

Question 15

The forward price of an asset with benefits and/or costs

Answer 15

the spot price
compounded at the risk- free rate over the life of the contract minus the
future value of those benefits and costs.

Question 16

The forward price

Answer 16

the spot price compounded at the risk- free rate over

the life of the contract.

Question 17

Value of Forward at t=0

Answer 17

Because neither the long nor the short pays anything to the other at the
initiation date of a forward contract, the value of a forward contract when
initiated is zero.

Question 18

The value of a forward contract at expiration

Answer 18

the spot price of the underlying minus the forward price agreed to in the contract.

Question 19

value of a futures contract

Answer 19

accumulated gain since the previous settlement, which resets to zero
upon settlement.

Question 20

off- market forward

Answer 20

A forward transaction that starts with a nonzero value

Question 21

Lower Exercise price of call option benefits

Answer 21

One is that there are more
values of the underlying at expiration that are above the exercise price, meaning that
there are more outcomes in which the call expires in- the- money. The other benefit
is that assuming the call expires in- the- money, for any value of the underlying, the
option value is greater the lower the exercise price

Question 22

When to exploit arbitrage oportunities

Answer 22

only worth exploiting if the transaction costs are low

Question 23

Derivative Pricing Models

Answer 23

all derivative pricing models discount the expected payoff of the derivative at the risk- free rate.

Question 24

Assets Forward Price

Answer 24

An asset’s forward price is increased by the future value of any
costs and decreased by the future value of any benefits: F0(T) = S0(1 + r)
T – (γ
– θ)(1 + r)
T. If the net cost of carry (benefits less costs) is positive, the forward
price is lower than if the net cost of carry was zero.

Question 25

Commodity Convenience Yield

Answer 25

When a commodity’s storage costs exceed its convenience yield
benefits, the net cost of carry (benefits less costs) is negative.

Question 26

Forward and Futures Prices

Answer 26

When interest rates are constant, forwards and futures will likely
have the same prices. The price differential will vary with the volatility of interest rates.

Question 27

Negative Correlation Futures and Forward

Answer 27

If futures prices and interest rates are negatively correlated, forwards are more desirable to holders of long positions than are futures.

Question 28

Valuation of the swap

Answer 28

appeals to replication and
the principle of arbitrage. Valuation consists of reproducing the remaining
payments on the swap with other transactions.

Question 29

The value of a European call option at expiration

Answer 29

the greater of

zero or the value of the underlying minus the exercise price.

Question 30

The value of a European call option

Answer 30

is inversely related to the exercise price. A lower exercise price means there are more potential outcomes at
which the call expires in- the- money.

Question 31

the lowest value of a European put

Answer 31

is the

greater of zero or the present value of the exercise price minus the value of the underlying.

Question 32

Payments, such as dividends,

Answer 32

reduce the value of the underlying

which increases the value of a European put option

Question 33

A long bond can be synthetically

Answer 33

created by combining a long

asset, a long put, and a short call.

Question 34

A fiduciary call

Answer 34

a long call with a risk free bond.

Question 35

A protective put

Answer 35

is created by combining a long asset with a long put

Question 36

the volatility of the underlying decreases

Answer 36

the value of the
option also decreases, meaning that the upper payoff value of the hedge portfolio combining them declines. However, the lower payoff value remains at zero

Question 37

If an option is trading above the value predicted by the binomial model

Answer 37

investors can engage in arbitrage by selling a call, buying shares of the
underlying, and funding the transaction by borrowing at the risk- free rate. This
will earn a return in excess of the risk- free rate

Question 38

At expiration, the values of American and European call options

Answer 38

are effectively the same; both are worth the greater of zero and the exercise value.

Question 39

When a dividend is declared

Answer 39

an American call option will have
a higher value than a European call option because an American call option
holder can exercise early to capture the value of the dividend.

Question 40

Put−call forward parity

Answer 40

demonstrates that the outcome of a protective put with a forward contract (long put, long risk- free bond, long forward
contract) equals the outcome of a fiduciary call

Question 41

synthetically create a long asset position

Answer 41

by buying a call, shorting a put, and buying a bond.

Question 42

Put–call–forward parity

Answer 42

is based on the assumption that no arbitrage is possible within the spot, forward, and option markets.

Question 43

a long forward contract and a risk- free bond

Answer 43

creates a synthetic asset