Derivatives

Question 1

Describe the risk transfer process in OTC derivative markets.

Answer 1

OTC dealers, known as market makers, typically enter into offsetting transactions with one another to transfer the risk of derivative contracts entered with end users.

Question 1

Identify one potential risk concern about the central clearing of derivatives.

Answer 1

The central clearing mandate transfers the systemic risk of derivatives transactions from the counterparties, typically financial intermediaries, to the CCPs. One concern is the centralization and concentration of risks in CCPs. Careful oversight must occur to ensure that these risks are properly managed.

Question 2

Describe the steps for clearing a credit default swap.

Answer 2

The counterparties are financial intermediaries that first execute the trade on an SEF (swap execution facility). Then, trade details are shared with a CCP; the novation process substitutes the original contract with another where the CCP steps into the trade and acts as the new counterparty for each original party. The CCP clears and settles the trade.

Question 3

Which of the following statements correctly describes a difference between a forward contract and a futures contract?

A forward contract sets an agreed-on price for buyer and seller, while a futures contract does not.
A forward contract sets an agreed-on transaction date for the seller to deliver the underlying to the buyer, while a futures contract does not.
A forward contract does not require daily settlement of gains and losses, while a futures contract does.

Answer 3

A forward contract does not require daily settlement of gains and losses, while a futures contract does.

Question 4

A put option buyer earns a positive profit in which of the following conditions?

The price of the underlying at option expiration is less than the option’s exercise price.
The price of the underlying at option expiration is greater than the option’s exercise price.
The price of the underlying is less than the option’s exercise price minus the option’s premium.

Answer 4

C is correct. For a put option buyer to earn a positive profit, the underlying price must be sufficiently below the put option’s exercise price such that (1) the put option can be exercised with a positive payoff and (2) the positive payoff is greater than the option premium paid

Question 5

Describe a similarity of and a difference between forward and swap contracts.

Answer 5

Similarities: Both forwards and swaps represent firm commitments with an initial value of zero where cash flows are exchanged in the future at a pre-agreed price.

Difference: Forwards usually involve one future exchange of cash flows, while a swap contract involves more than one exchange of future cash flows.

Question 6

Describe the point at which a short forward and a long put with an exercise price (X) equal to the forward price, F0(T) have the same profit.

Question 7

Which of the following statements does not describe a likely operational advantage of a futures market transaction as compared to a cash market transaction?

It is easier to take a short position in the futures market than in the cash market.

There is greater liquidity in the futures market than in the cash market.

Cash requirements to buy in the cash market are lower than margin requirements to buy in the futures market.

Answer 7

C is correct. The opposite is true: Margin requirements of a futures contract are typically only a small percentage of the cash requirement to buy the same amount of underlying in the cash market. A and B are both incorrect because both of these statements describe operational advantages of futures markets over cash markets.

Question 8

Which of the following hedge accounting designations is appropriate for categorizing a corporate issuer’s use of an interest swap converting a floating-rate debt into a fixed-rate debt?

Fair value hedge
Cash flow hedge
Net investment hedge

Answer 8

Cash flow hedge treatment is appropriate for instances in which a variable cash flow is converted to a fixed cash flow through the use of a derivative. A is incorrect because a fair value hedge is appropriate accounting treatment for derivative contracts that offset fluctuations in the fair value of the underlying. C is incorrect because a net investment hedge offsets the foreign currency risk of the value of a foreign subsidiary.

Question 9

Describe the counterparty credit risk faced by the seller of a call option

Answer 9

The seller of a call option receives an upfront premium in exchange for the right to purchase the underlying at the exercise price at maturity. Once the seller of a call option receives the premium from the option buyer, it has no further counterparty credit risk to the option buyer.

Question 10

Describe hedge accounting treatment.

Answer 10

Hedge accounting allows an issuer to offset a hedging instrument (usually a derivative) against a hedged transaction or balance sheet item to reduce financial statement volatility.

Question 11

Describe an example of a fair value hedge an issuer might use.

Answer 11

An issuer might convert a fixed-rate bond issuance to a floating-rate obligation by entering into an interest rate swap to receive a fixed rate and pay a market reference rate through the bond’s maturity. Alternatively, a commodities producer might sell its inventory forward in anticipation of lower cash prices in the future

Question 12

An investment fund’s __________ typically specifies which derivative instruments may be used within a fund and for which purpose.

Answer 12

prospectus

Question 13

How can increasing an asset duration is possible with a derivative contract ?

Answer 13

In summary, entering into an interest rate swap where the investor pays the fixed rate and receives the floating rate can increase the duration of an asset by converting its cash flows from floating-rate (which typically have shorter durations) to fixed-rate (which typically have longer durations), thereby increasing the asset’s overall duration

Question 14

Describe two purposes of investor derivatives use within a fund.

Answer 14

The purpose of investor derivatives use within a fund is usually to modify the fund’s exposure to increase the return of the fund under specific market conditions and/or to offset or hedge the fund’s value against adverse movements in underlyings, such as exchange rates, interest rates, and securities markets.

Question 15

describe how to replicate a long forward position

Answer 15

Sell a risk-free bond, and buy a cash market position in the underlying.

Question 16

describe how to replicate a long forward position

Answer 16

Buy a risk-free bond, and sell a cash market position in the underlying.

Question 17

Which of the following statements provides the correct description as to how a call option’s value changes if the income on the underlying declines unexpectedly, holding all else equal.

The call option value increases.
The call option value decreases.
The call option value does not change

Answer 17

A is correct. Income or other, non-cash benefits (such as convenience yield) accrue to the owner of an underlying asset but not to the owner of a derivative, whose value is based on the underlying. A call option on an underlying with income has lower value than an identical call option on the same underlying without income. Thus, a decline in income on an underlying asset increases the value of a call option.

Question 19

When using a one-period binomial model to price a call option, an increase in the actual probability of an upward move in the underlying asset will result in the call option price:

decreasing.

staying the same.

increasing.

Answer 19

The correct answer is B. The call option price will stay the same. The actual (real-world) probabilities of an up or a down price movement in a binomial model do not influence the (no-arbitrage) price of an option.

Question 20

Determine the correct answers to fill in the blanks: To price a contingent claim, such as an option, a model for the __________ of the underlying asset is needed due to the ___________ nature of the contract’s payoff.

Answer 20

To price a contingent claim, such as an option, a model for the future price behavior of the underlying asset is needed due to the asymmetric nature of the contract’s payoff.

Question 21

Describe the main difference between pricing a contingent claim and pricing a forward commitment.

Answer 21

The symmetric nature of a forward commitment’s payoff (i.e., the obligation to transact at maturity) allows the commitment to be perfectly replicated without the need to model the future price behavior of the underlying asset. However, the asymmetric nature of a contingent claim’s payoff (i.e., the right but not the obligation to transact at maturity) does require the future price behavior to be modeled.

Question 22

Explain how increasing the up gross return, Ru, and/or decreasing the down gross return, Rd, in a one-period binomial model would influence the price of a call and a put option.

Answer 22

In a one-period binomial model, the volatility of the underlying asset is represented by the spread between the up gross return, Ru, and the down gross return, Rd. Therefore, if either the up gross return increases or the down gross return decreases (or both), the price of the underlying asset at maturity will be more volatile. If all else remains equal, then the price of both call and put options will increase when the underlying asset is expected to have a higher volatility over the life of the option.

Question 23

Determine the correct answers to fill in the blanks: When the _______________ applies, the rate of return on all (real or synthetic) risk-free assets should equal the __________.

Answer 23

When the law of one price applies, the rate of return on all (real or synthetic) risk-free assets should equal the risk-free rate.

Question 24

Which of the following factors influences the value of an option price when using a binomial model?

The risk-free rate of return
The level of investors’ risk aversion
The probability of an upward price move

Answer 24

A, the risk-free rate of return. The value of an option is determined by its risk-neutral expectation discounted at the risk-free rate. In a one-period binomial model, the risk-neutral probabilities are determined only by the risk-free rate over the life of the option and the underlying asset’s volatility (as measured by the up and down gross returns, Ru and Rd). Because of the ability to construct a perfect hedge of the option using the underlying asset, an option’s price is independent of investors’ risk aversion and the probability of the underlying price moving up (or down).

Question 25

Determine the correct answers to fill in the blanks: If a call option is trading at a higher price than that implied from the binomial model, investors can earn a return in excess of the risk-free rate by ________ at the risk-free rate, __________ the call, and _________ the underlying.

Answer 25

If a call option is trading at a higher price than that implied from the binomial model, investors can earn a return in excess of the risk-free rate by borrowing at the risk-free rate, selling the call, and buying the underlying.

A synthetic risk-free asset can be created by this strategy that earns a return higher than the risk-free rate. Selling the over-priced call will provide a higher cash inflow than is required to generate the risk-free rate of return

Question 26

Identify the following statement as true or false and justify your answer: If futures prices are positively correlated with interest rates, long futures contracts are more attractive than long forward positions for the same underlying and maturity.

Answer 26

The statement is true. If futures contract prices rise as interest rates rise, a long futures contract holder can reinvest futures contract profits at higher interest rates.

Question 27

Explain why short futures contracts are more attractive than short forward positions if futures prices are negatively correlated with interest rates for positions with the same underlying and maturity.

Answer 27

The reason that short futures contracts are more attractive than short forward positions if futures prices are negatively correlated with interest rates is because falling prices lead to futures profits that are reinvested in periods of rising interest rates, and rising prices lead to losses that occur in periods of falling interest rates.

Question 28

Which of the following transactions would allow a fixed-income portfolio manager to gain from falling interest rates?

Buy a floating-rate bond
Enter into a receive-fixed, pay-floating interest rate swap
Enter into a pay-fixed, receive-floating interest rate swap

Answer 28

B is correct. A fixed-income portfolio manager seeking to gain from falling interest rates may consider entering a receive-fixed, pay-floating interest rate swap rather than purchasing bonds. The fixed-rate payments become more valuable as interest rates decline

A is incorrect as the floating-rate bond interest rate payments decline as interest rates decline, thus the bond does not increase in value. C is incorrect as the fixed interest rate payments become more costly as interest rates decline.

Question 29

Which of the following statements provides a correct description of a pay-fixed, receive-floating interest rate swap position?

Long a floating-rate note priced at the MRR and short a fixed-rate bond with a coupon equal to the fixed swap rate

Long a fixed-rate bond with a coupon equal to the fixed swap rate and short a floating-rate note priced at the MRR

Long a floating-rate note priced at the MRR

Answer 29

A is correct. An interest rate swap is economically equivalent to a long and short position in underlying debt securities. In the case of a pay-fixed, receive-floating swap, the cash flow received reflects the long position. In this case, the party receives floating payments, so this is like buying a floating-rate note. The pay-fixed portion of the swap is like selling a fixed-rate bond and paying fixed coupons to the bond buyer.

Question 30

Determine the correct answers to fill in the blanks: A fixed-rate payer on a swap or FRA will realize a(n) ______ if the MRR sets at a rate higher than the agreed-on fixed rate and will ______ a net payment ______ the floating-rate payer.

Answer 30

A fixed-rate payer on a swap or FRA will realize a gain if the MRR sets at a rate higher than the agreed-on fixed rate and will receive a net payment from the floating-rate payer.

Question 31

What is the internal rate of return on the implied forward rates over the life of an interest rate swap ?

Answer 31

The fixed swap rate is the internal rate of return on the implied forward rates over the life of an interest rate swap.

Question 32

Explain how an active fixed-income portfolio manager might use an interest rate swap rather than underlying bonds to realize a gain in a lower–interest rate environment, and justify your response.

Answer 32

A manager may choose to receive fixed, pay floating on an interest rate swap, with the fixed cash flow stream being similar to owning a fixed-coupon bond. If interest rates are expected to fall, the manager will realize an MTM gain in a lower-rate environment.

Question 33

Determine the correct answers to fill in the blanks: A rise in the expected forward rates after inception will ______ the present value of floating payments, causing a fixed-rate receiver to realize a(n) ______ in MTM value on the swap contract.

Answer 33

A rise in the expected forward rates after inception will increase the present value of floating payments, causing a fixed-rate receiver to realize a decline in MTM value on the swap contract.

Question 34

Determine the correct answers to fill in the blanks: The value of a swap on any settlement date equals the ______ settlement value plus the present value of all remaining ______ swap settlements.

Answer 34

The value of a swap on any settlement date equals the current settlement value plus the present value of all remaining future swap settlements.

Question 35

Describe how an investor may use an interest rate swap to reduce the duration of a fixed-income portfolio, and justify your response

Answer 35

A pay-fixed swap is similar to a short bond position that reduces duration, because the fixed-rate payer (floating-rate receiver) is effectively long a floating-rate note priced at the MRR and short a fixed-rate bond with a coupon equal to the fixed swap rate.

Question 36

Determine the correct answers to complete the following sentence: The lower bound of a call price is the underlying’s price ______ the present value of its ________ price or zero, whichever is greater.

Answer 36

The lower bound of a call price is the underlying’s price minus the present value of its exercise price or zero, whichever is greater.

Question 37

Determine the correct answers to complete the following sentences: A key distinction between forward commitments and contingent claims is the __________ of a derivative’s price change for a given change in the underlying value. For a forward commitment, the derivative value is a ______ function of the underlying price, while for an option it is a _______ relationship

Answer 37

A key distinction between forward commitments and contingent claims is the magnitude of a derivative’s price change for a given change in the underlying value. For a forward commitment, the derivative value is a linear function of the underlying price, while for an option it is a non-linear relationship.

Question 38

Describe how a debtholder’s position may be considered similar to the sale of a put option on firm value.

Answer 38

If the value of the firm (VT) is below the face value of its debt outstanding, or VT < D at time T, we say the firm is insolvent and debtholders receive less than the face value (D) to settle their debt claim. Stated differently, a debtholder’s payoff is min(D, VT) = D – max(0, D – VT) and equals the debt face value (D) minus a put option on firm value (VT) with an exercise price of D, which represents a sold put on firm value.

Question 39

The pricing of forwards and futures will most likely differ if:

interest rates exhibit zero volatility.

futures prices and interest rates are negatively correlated.

futures prices and interest rates are uncorrelated.

Answer 39

The pricing of forwards and futures will differ if futures prices and interest rates are negatively correlated. A negative correlation between futures prices and interest rates makes forwards more desirable than futures in the long position.

Question 40

The strategy that identifies opportunities for future merger, bankruptcy, or spin-offs and seeks profit from pricing inefficiencies is known as:

event driven.
relative value.
opportunistic.

Answer 40

Event-driven strategies include mergers, bankruptcies, and spin-offs. Relative value strategies (Choice B) seek to profit from a price or return discrepancy between securities based on a short-term relationship. Opportunistic strategies (Choice C) use managed futures and macro strategies.