Derivatives

Question 1

Which of the following is NOT considered to be a derivative?

A. Warrant
B. Unit Investment Trust
C. Credit Default Swap
D. Option Contract

Answer 1

The best answer is B.

A derivative security has a value that is “derived” from another investment, but it is not a directly proportional piece of an investment, which is the case with an investment company product such as a unit investment trust. Options are derivative because their premium movement (price) is based on the price movements of the underlying security. A warrant is a long-term issuer created call option that can be attached to stock and bond offerings to make them more attractive.

A credit default swap (CDS) is a contract where the holder of a debt instrument makes a series of payments to a seller in return for a payoff if the credit quality of the issue deteriorates below a stated level. Thus, the contract becomes more valuable as an issuer’s credit quality declines, since the seller is then obligated to make the payoff. CDSs are issued and traded OTC - there is no listed exchange for these.

Question 2

A customer would buy call contracts because:

A. the customer is bullish on the underlying security
B. the customer is bearish on the underlying security
C. the customer wishes to generate ordinary income
D. the customer wishes to defer taxation of gains on the underlying stock

Answer 2

The best answer is A.

Call contracts are bought when a customer is bullish on the market.

Question 3

The writer of a call on a listed stock is exercised. The writer MUST:

I deliver stock
II deliver cash
III take delivery of stock
IV take delivery of cash

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 3

The best answer is B.

If the writer of a call option on listed stocks is exercised, he must deliver 100 shares of stock, for which the writer will receive the strike price in cash.

Question 4

A customer who is long put contracts would have what kind of market sentiment?

A. Bullish
B. Bearish
C. Neutral
D. Bullish and bearish

Answer 4

The best answer is B.

Put contracts are bought when a customer is bearish on the market.

Question 5

A customer would buy put contracts because:

A. the customer is bullish on the underlying security
B. the customer is bearish on the underlying security
C. the customer is neutral on the underlying security
D. the customer wishes to generate ordinary income

Answer 5

The best answer is B.

Put contracts are purchased when a customer is bearish on the market. If the market falls, the puts go “in the money” and the holder would exercise, selling the stock for the strike price that is higher than the current market price. The maximum potential gain for the holder of a put will occur if the price falls to “0”. Gains and losses on options transactions are treated as capital gain or loss for income tax purposes. It is not ordinary income, making Choice D incorrect.

Question 6

If the writer of an equity put contract is exercised, the writer MUST:

A. deliver cash in 1 business day
B. deliver stock in 1 business day
C. deliver cash in 3 business days
D. deliver stock in 3 business days

Answer 6

The best answer is C.

If the writer of an equity put contract is exercised, he is obligated to buy the stock at the strike price (paying cash) from the holder of the put. Settlement is 3 business days after exercise date - this is a regular way stock trade.

Question 7

The purchase of a call is a:

A. bull strategy
B. bear strategy
C. neutral strategy
D. bear/neutral strategy

Answer 7

The best answer is A.

The buyer of a call has the right to buy stock at a fixed price in a rising market. The buyer has unlimited gain potential as the market rises, so this is a bull market strategy.

Question 8

In November, a customer buys 1 ABC Jan 75 Call @ $6 when the market price of ABC is 73. The customer’s maximum potential gain is:

A. $600
B. $6,900
C. $8,100
D. unlimited

Answer 8

The best answer is D.

The holder of a call has unlimited gain potential. He has the right to buy stock at a fixed price - and the stock can rise an unlimited amount.

Question 9

In January, a customer buys 1 ABC Jun 80 Call @ $7 when the market price of ABC is 81. The customer’s maximum potential gain is:

A. $700
B. $7,300
C. $8,000
D. unlimited

Answer 9

The best answer is D.

The holder of a call has unlimited gain potential. He has the right to buy stock at a fixed price - and the stock can rise an unlimited amount.

Question 10

In January, a customer buys 1 ABC Jun 80 Call @ $7 when the market price of ABC is 81. The customer’s maximum potential loss is:

A. $700
B. $7,300
C. $8,000
D. unlimited

Answer 10

The best answer is A.

In a falling market, a long call position will expire “out the money” and the holder loses the premium paid. This is the maximum potential loss.

Question 11

Which of the following options strategies provides a gain equal to the premium in a bear market?

A. Long Call
B. Short Call
C. Long Put
D. Short Put

Answer 11

The best answer is B.

The writer of a call (short call) collects a premium in return for agreeing to sell stock at a fixed price, no matter how high the market price of the stock may go. If the market price falls, the call expires “out the money” and the writer keeps the collected premium. This is the maximum potential gain.

Question 12

A customer sells 1 ABC Jan 50 Call @ 3 when the market is at 49. The maximum potential gain is:

A. $300
B. $5,000
C. $5,300
D. unlimited

Answer 12

The best answer is A.

The maximum potential gain for the writer of a naked call option is the premium received. This occurs if the market drops and the call expires “out the money”.

Question 13

A customer sells 1 ABC Feb 40 Call @ $2 when the market price of ABC is 39.50. The customer’s maximum potential loss is:

A. $200
B. $3,950
C. $4,200
D. unlimited

Answer 13

The best answer is D.

The writer of a naked call is obligated to deliver stock that he does not own. If exercised, the stock must be bought in the market for delivery. Since the market price can rise an unlimited amount, the maximum potential loss is unlimited as well.

Question 14

The purchase of a put is a:

A. bull strategy
B. bear strategy
C. neutral strategy
D. bear/neutral strategy

Answer 14

The best answer is B.

The buyer of a put has the right to sell stock at a fixed price in a falling market. The buyer has ever increasing gain potential as the market falls, so this is a bear market strategy.

Question 15

A customer buys 1 ABC Jul 45 Put at $4 when the market price of ABC is 46. The customer’s maximum potential gain is:

A. $400
B. $4,100
C. $4,900
D. unlimited

Answer 15

The best answer is B.

The maximum gain for the holder of a put occurs if the market goes to “0”. If it does, he can sell the stock at 45 and purchase it for nothing. Since he paid $400 in premiums for this right, the maximum potential gain is: $4,500 - $400 = $4,100.

Question 16

A customer buys 1 ABC Jul 50 Put at $4 when the market price of ABC is 51. The maximum potential loss to the holder is:

A. $0
B. $400
C. $4,000
D. unlimited

Answer 16

The best answer is B.

The holder of a put buys the right to sell at a fixed price. If the contract expires “out the money,” the maximum loss is the premium paid. This occurs if the market price rises above the strike price.

Question 17

A customer buys 2 ABC Jan 60 Puts @ $4 when the market price of ABC is $59. The maximum potential loss for the customer is:

A. $400
B. $800
C. $11,200
D. $12,000

Answer 17

The best answer is B.

The holder of a put buys the right to sell at a fixed price. If the contract expires “out the money,” the maximum loss is the premium paid. $400 was paid per contract ($800 for 2 contracts), so $800 is the maximum potential loss. This occurs if the market price rises above the strike price.

Question 18

A customer could be obligated to purchase stock at a future date if the customer is the:

A. buyer of a call
B. seller of a call
C. buyer of a put
D. seller of a put

Answer 18

The best answer is D.

The seller (writer) of a put is obligated to buy the underlying security at the strike price if the market falls. In a falling market, the buyer of the put will exercise the contract, selling the stock to the writer at the strike price. Because the writer had to buy the stock at a strike price that is higher than the market price, the writer will have a loss.

Question 19

A customer sells 1 ABC Jul 40 Put at $6 when the market price of ABC is 38. The customer’s maximum potential gain is:

A. $600
B. $3,400
C. $4,000
D. unlimited

Answer 19

The best answer is A.

The maximum gain for the writer of a naked call or put is the premium collected. This happens if the contract expires “out the money”.

Question 20

A customer sells 2 ABC Jan 45 Puts @ $3 when the market price of ABC is $46. The maximum potential loss for the customer is:

A. $600
B. $8,400
C. $9,000
D. $9,200

Answer 20

The best answer is B.

If the market goes to zero, the put writer will experience the maximum potential loss. The writer of the puts will be exercised, forcing him to buy worthless stock at the $45 strike price. However, the customer has received $3 per share in premiums. The net loss is $42 per share x 200 shares = $8,400.

Question 21

A customer that is short ABC stock in his portfolio buys put options on that stock. Why would the customer do this?

A. To protect the ABC stock position from an adverse market move
B. To derive additional income from the ABC stock position
C. To speculate on the price of the stock going up
D. To lock in a price at which the short position can be increased in the portfolio

Answer 21

The best answer is D.

The purchase of a put gives the customer the right to sell shares at the strike price. The only reason why a person who is already short that stock would buy puts on the stock would be to give the customer the ability to sell more shares at the strike price if the market price of the stock should move down.

Question 22

A customer with no stock position sells 1 ABC Call and sells 1 ABC Put. The customer would do this to maximize potential profit if the market:

A. stays flat
B. rises
C. falls
D. is volatile

Answer 22

The best answer is A.

The seller of an option receives a premium, hoping that the contract expires worthless. If a call is sold, the contract expires if the market stays flat (or if the market falls). If a put is sold, the contract expires if the market stays flat (or if the market rises). Maximum profit occurs if the market stays flat and both contracts expire “at the money.” Then the seller keeps the 2 collected premiums. If the market rises, the seller starts to lose on the short naked call. If the market falls, the seller starts to lose on the short naked put.

Question 23

A customer owning 100 shares of stock could receive protection by:

A. buying another 100 shares of the stock
B. buying a call
C. buying a put
D. selling a put

Answer 23

The best answer is C.

In order to hedge a long stock position against a downside market move, the best choice is to buy a put. The long put option allows the holder to put (sell) the stock at the exercise price if the market falls - protecting the stock position from downside market risk.

Question 24

A customer buys 100 shares of ABC stock at 48 and buys 1 ABC Jan 50 Put @ 7. The maximum potential gain is:

A. $700
B. $4,300
C. $5,500
D. unlimited

Answer 24

The best answer is D.

The customer has paid $48 for the stock and $7 for the put, for a total outlay of $55. If the stock declines, he is hedged, since he has the right to sell for $50 with the long put; so he can lose only 5 points (bought at $55 total; sold at $50 upon exercise). However, if the stock rises, he lets the put expire “out the money” and can ride the price of the stock up, with theoretically unlimited gain potential.

Question 25

A customer buys 100 shares of XYZ at 51 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential loss is:

A. $500
B. $600
C. $4,600
D. unlimited

Answer 25

The best answer is B.

The long put gives the stock owner the right to sell at $50. Since he bought the stock at 51, exercising results in a 1 point stock loss. In addition, the premiums paid of $5 are lost, for a total loss of 6 points or $600 maximum.

Question 26

What position can an investor take to hedge a short stock position?

A. long put
B. short put
C. long call
D. short call

Answer 26

The best answer is C.

When one has a short stock position, borrowed shares have been sold with the agreement that the customer will buy back the position at a later date. If the market rises, the loss potential is unlimited. The purchase of a call allows the stock to be bought in at a fixed price, limiting upside risk.

Question 27

A customer sells short 100 shares of ABC stock at 52 and buys 1 ABC Mar 55 Call @ 5. The maximum potential gain is:

A. $500
B. $4,700
C. $5,700
D. unlimited

Answer 27

The best answer is B.

If the stock falls, the customer gains on the short stock position. He sold the stock for $52. If it falls to “0,” he can buy the shares for “nothing” to replace the borrowed shares sold and make 52 points. He lets the call expire “out the money” losing 5 points, so the maximum potential gain is 47 points.

Question 28

A customer sells short 100 shares of PDQ at 58 and buys 1 PDQ Jul 60 Call @ $3. The customer’s maximum potential loss is:

A. $200
B. $300
C. $500
D. unlimited

Answer 28

The best answer is C.

The long call allows the customer to buy in the stock position at $60. Since the stock was sold at $58, exercise results in a net loss of $2 on the stock. The customer paid $3 for the call, so the total loss is $500.

Question 29

An investor owns a portfolio of large capitalization blue chip stocks, each of which happens to be in the Dow Jones Industrial Average. He wishes to protect his portfolio from a market downturn without selling the positions. The best recommendation is to:

A. buy a narrow based index put
B. sell a narrow based index put
C. buy a broad based index put
D. sell a broad based index put

Answer 29

The best answer is C.

Buying an index put, specifically the DJX option (Dow Jones Industrial Average), is the best way to protect the portfolio. The DJX is broad-based, because even though it only has 30 stocks, they are in differing industries. A narrow based index option is either industry specific or country specific.

Question 30

Which of the following option positions is used to generate additional income against a long stock position?

A. long call
B. short call
C. long put
D. short put

Answer 30

The best answer is B.

A covered call writer owns the underlying stock position. He sells the call contract to generate extra income from the stock during periods when the market is expected to be stable. If he expects the market to rise, he would not write the call against the stock position because the stock will be “called away” in a rising market. If he expects the market to fall, he would sell the stock or buy a put as a hedge. The customer would not sell a put to generate extra income against the long stock position, because if the market falls, the customer would be exercised on short put, and thus would have to buy another 100 shares at the strike price. Thus, in a declining market, the customer would lose double.

Question 31

A customer buys 200 shares of GE at 72 and sells 2 GE 70 Calls @ $6. The maximum potential gain is:

A. $800
B. $1,200
C. $7,000
D. unlimited

Answer 31

The best answer is A.

If the market rises, the calls are exercised. The stock (which cost $72) must be delivered at $70 for a loss of $2 per share. Since $6 was collected in premiums for selling the call, the net gain, if exercised, is 4 points or $400 per contract x 2 contracts = $800.

Question 32

A customer buys 200 shares of Ford at 68 and sells 2 Ford 70 Calls @ $3. The maximum potential gain is:

A. $500
B. $1,000
C. $6,800
D. unlimited

Answer 32

The best answer is B.

If the market rises, the calls are exercised. The stock (which cost $68) must be delivered at $70 for a gain of $2 per share. Since $3 was collected in premiums for selling each call, the net gain, if exercised, is 5 points or $500 per contract x 2 contracts = $1,000.

Question 33

A customer buys 100 shares of ABC stock at 45 and sells 1 ABC Jan 45 Call @ 2 on the same day in a cash account. The customer’s maximum potential loss is:

A. $4,300
B. $4,500
C. $4,700
D. unlimited

Answer 33

The best answer is A.

If the stock drops, the call expires “out the money”. As the stock keeps dropping, the customer loses more and more on the stock position. Because he effectively paid $4,300 ($45 price - $2 premium collected) for the stock, this is his maximum potential loss.

Question 34

An investment adviser manages the portfolio of a client on a discretionary basis. The customer’s objective is conservation of principal and income. Under prudent investor standards, which statement is TRUE about the use of options in the portfolio?

A. The use of options strategies is unsuitable for this client based on her investment objective
B. The use of options strategies is only suitable if the customer has previous investment experience with options
C. The use of options strategies is only suitable if the strategies are limited to the sale of covered options
D. The use of options strategies is only suitable is the strategies are limited to the purchase of options

Answer 34

The best answer is C.

Covered call writing is the most popular retail income strategy in a flat market, and is appropriate for conservative investors that are looking for extra income. The customer sells calls against stock that is already owned, getting premium income. If the stock stays flat, the calls expire and the customer keeps the premium. If the stock rises, the calls are exercised and the stock is called away at no loss to the customer. If the market falls, the calls expire and the customer loses on the stock (which he would have lost on anyway!).

Question 35

Selling a put against a stock position sold short is a suitable strategy when the market is expected to:

A. remain stable
B. rise sharply
C. fall sharply
D. fluctuate sharply

Answer 35

The best answer is A.

Selling stock short alone is a bearish position. Selling a put alone is neutral or bullish strategy. Selling a put against a short stock position is a neutral strategy (as is any income strategy). If the stock is sold short and a put is sold with the same strike price, then if the market stays the same, the put expires “at the money” and the premium collected is retained. If the stock falls, the short put is exercised, obligating the customer to buy the stock at the same price at which it was sold. In this case, only the premium is earned. If the put had not been sold, then the customer would have had an increasing gain on the short stock position as the market fell - so he does not make as much in a falling market. On the other hand, if the market rises, the short put expires “out the money” and the customer is exposed to unlimited upside risk on the short stock position that remains.

Question 36

A customer sells short 100 shares of DEF stock at $62 and sells 1 DEF Oct 60 Put @ $6. The maximum potential gain while both positions are in place is:

A. $800
B. $4,400
C. $5,400
D. unlimited

Answer 36

The best answer is A.

If the market drops, the short put is exercised and the customer must buy the stock at $60. Since he sold the stock at $62, he gains 2 points, in addition to collecting 6 points of premiums. Thus, the maximum gain is $800. Conversely, if the market rises, the short put expires, leaving a short stock position that has potentially unlimited loss.

Question 37

A customer sells short 100 shares of ABC stock at $60 and sells 1 ABC Oct 60 Put @ $6. The maximum potential loss is:

A. $600
B. $5,400
C. $6,000
D. unlimited

Answer 37

The best answer is D.

If the market rises, the short put expires and the short stock position must be covered by making a purchase in the market. The loss potential is unlimited.

Question 38

A customer sells short 100 ABC @ $35 and sells 1 ABC Jan 35 Put @ $3. The customer would NOT make money if the market price for ABC was at:

A. $30
B. $35
C. $37
D. $40

Answer 38

The best answer is D.

A customer with a short stock / short put position loses if the market rises. The customer sold the stock at $35 and collected $3 in premiums, for a total of $38. To break-even, the stock must be bought for this amount. If the stock is bought for more than $38, the customer loses. Therefore, a loss is experienced at $40. To summarize, the formula for break-even for a short stock / short put position is:

Combination of short stock and short put break-even = short sale price + premium

Question 39

A customer is long the Swiss Franc at a cost of $.60 per SF. The customer wishes to place a collar on the position using PHLX SF FLEX options. To create the collar, the customer would:

I Buy 1 PHLX 59 SF Call
II Buy 1 PHLX 59 SF Put
III Sell 1 PHLX 61 SF Call
IV Sell 1 PHLX 61 SF Put

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 39

The best answer is C.

A “collar” is the purchase of a put at a strike price below that of the underlying instrument (putting a floor on the instrument’s price); and the sale of a call at a strike price above that of the underlying instrument (creating a ceiling price, above which the instrument will be called away). By putting a collar on the price, the customer is essentially guaranteeing a minimum and maximum price for the underlying instrument. The net cost of such a collar should be close to “0” since both contracts are “out the money” and the premium received from the sale of the call offsets the premium paid to buy the put.

Question 40

To create a collar on XYZ stock when the stock is trading at $68, which option positions would be taken?

A. Long 1 XYZ Jan 70 Call / Short 1 XYZ Jan 65 Put
B. Long 1 XYZ Jan 70 Put / Short 1 XYZ Jan 65 Call
C. Long 1 XYZ Jan 65 Put / Short 1 XYZ Jan 70 Call
D. Long 1 XYZ Jan 65 Call / Short 1 XYZ Jan 70 Put

Answer 40

The best answer is C.

A “collar” on a stock position is designed to provide downside protection at minimal cost. The stock is trading at $68, so the purchase of an ABC Jan 65 Put (3 points “out the money”) would be cheaper than the purchase of a 70 put (2 points “in the money”). To offset the cost of the put purchase, the sale of an ABC Jan 70 Call (2 points “out the money”) would provide some premium income. If the stock drops, the 65 put would be exercised, protecting the position from further loss. On the other hand, if the stock rises above $70, the short call would be exercised, obligating the customer to deliver the stock at $70, with no further gain on the stock position. Thus, the price is “collared” between $65 and $70 per share.

Question 41

A portfolio manager would sell calls against the securities in the managed portfolio in order to:

A. protect the positions against a bear market
B. increase income and cash flow
C. increase the diversification of the portfolio
D. speculate on the direction of the market

Answer 41

The best answer is B.

Covered call writing is one of the most conservative and popular strategies used by portfolio managers to increase income (and hence return) from the investments. In addition to the dividend income from the stocks, if the market stays flat, the calls will expire and the premium income will be earned. To protect the stock positions, puts would be purchased. Diversification would be increased by purchasing stocks or call options on other companies than those held in the portfolio. To speculate on the direction of the market, long calls (speculating on a bull market) or long puts (speculating on a bear market) would be used.

Question 42

The earliest that an American style option can be exercised is:

A. anytime before the expiration date of the contract
B. the business day preceding the expiration of the contract
C. the Wednesday preceding the third Friday of the month
D. the Saturday following the third Friday of the month

Answer 42

The best answer is A.

European style options can only be exercised on the business day prior to the expiration of the contract. Contracts expire on the Saturday following the third Friday of the month. The last time to exercise is the third Friday of the month, up until 5:30 PM ET. In contrast, American style options can be exercised anytime prior to expiration. Stock options are American style; the vast majority of index options are European style.

Question 43

What type of option can only be exercised at expiration?

A. American Style
B. European Style
C. Eastern Style
D. Western Style

Answer 43

The best answer is B.

An American style option is one that can be exercised at any time. In contrast, a European style option can only be exercised at expiration - not before. Individual stock options are American style; most index options are European style.

Question 44

A speculator that initiates a long futures position in Euros:

I believes that the Euro will decline
II believes that the Euro will increase
III will need to sell Euro futures to close his position if he wants to avoid taking delivery in the future
IV can only satisfy the terms of the contract by taking delivery of Euros on the delivery date

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 44

The best answer is C.

When one goes long a futures contact, this is a “bet” that the price of the reference asset will increase. Futures contracts can be offset at anytime by trading, so the contract can be closed with an offsetting sale. If the contract is not closed with an offsetting sale, then the seller is required to take delivery and pay for the Euros on the delivery date.

Question 45

The purchaser of a futures contract has the:

A. right to buy a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
B. obligation to buy a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
C. right to sell a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
D. obligation to sell a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange

Answer 45

The best answer is B.

A futures contract differs from an options contract because the buyer of an option has the right to exercise, but does not have to do so at expiration, while the holder of a futures contract has agreed to buy the underlying commodity at a fixed price at the expiration date, unless the contract is closed by trading. Similarly, the seller of a futures contract must deliver the underlying commodity at a fixed price at the expiration date, unless the contract is closed by trading.

Question 46

To protect against rising prices before a future purchase, one would:

A. buy a futures contract
B. sell a futures contract
C. establish a spread
D. establish a straddle

Answer 46

The best answer is A.

The purchase of a futures contract is a contract to buy the physical commodity at a future date and price that is set today. Thus, it will protect against rising prices before a future purchase is made.

Question 47

A client has a large position of 30-year Treasury Bonds is concerned that interest rates may start to rise. To protect against this, the customer could:

A. go long a 30-year T-Bond futures contract
B. go short a 30-year T-Bond futures contract
C. buy 30-year T-Bond calls
D. sell 30-year T-Bond puts

Answer 47

The best answer is B.

The risk to this investor is that T-Bond prices will fall as interest rates rise. To hedge against this, the customer could buy T-Bond puts or could sell T-Bond forward or futures contracts. The forward or futures contract specifies a set date in the future and a set price at which the bonds can be sold. If bond prices fall, the contract can be “bought back” cheaper, giving a profit that will offset the loss on the physical T-Bonds if interest rates should rise.

Question 48

The seller of a futures contract has the:

A. right to buy a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
B. obligation to buy a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
C. right to sell a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange
D. obligation to sell a specific commodity at a certain price and grade at a specific date and location through an organized futures exchange

Answer 48

The best answer is D.

A futures contract differs from an options contract because the buyer of an option has the right to exercise, but does not have to do so at expiration, while the holder of a futures contract has agreed to buy the underlying commodity at a fixed price at the expiration date, unless the contract is closed by trading. Similarly, the seller of a futures contract must deliver the underlying commodity at a fixed price at the expiration date, unless the contract is closed by trading.

Question 49

Which of the following information is included in a (standardized) commodities futures contract?

I Acceptable grades of the commodity
II Quantity of the commodity
III Delivery location of the commodity
IV Price of the commodity

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 49

The best answer is C.

Commodities futures contracts are “standardized,” which makes them easier to trade. Each exchange has its own contract for a standard size (quantity) and quality of the commodity (the exchange sets the different varieties or grades that can be delivered at various price differentials to the contract price) and there are standardized future delivery dates for the underlying commodity, if the contract is not closed by trading as of that date. What is not standardized is the price of the contract - this is determined between buyer and seller on the floor of the exchange.

Question 50

A contract to purchase or sell a specified commodity at a specified price and grade to a specified location on a specified date, entered into through an organized exchange:

I is a forward contract
II is a futures contract
III reflects the characteristic of standardization
IV reflect the characteristic of commoditization

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 50

The best answer is C.

Futures markets are exchanges that trade “standardized” contracts, which makes them easier to trade. The standardizations include contract size, contract expiration, contract price intervals, contract delivery location (for physical commodities like corn or wheat, if the contract is not closed by trading prior to its expiration date). In contrast, forward contracts are non-standardized custom contracts entered into between a buyer and seller. There is virtually no secondary market for these. Commoditization is a meaningless term in the context of this question - a commoditized product is one that loses its uniqueness or brand value, and hence is treated as a “commodity.”

Question 51

When comparing options to futures contracts, which statements are TRUE?

I Options are securities that are regulated and exchange traded
II Options are not securities and are unregulated and trade OTC
III Futures are contracts that are regulated and exchange traded
IV Futures are not contracts and are unregulated and trade OTC

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 51

The best answer is A.

Both options and futures are regulated, standardized, exchange-traded contracts. Only forward contracts are “custom” contracts that trade OTC.

Question 52

Forward contracts:

I can be closed by trading on an exchange
II cannot be closed by trading on an exchange
III are standardized
IV are not standardized

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 52

The best answer is D.

Forward contracts require delivery of an asset at a fixed price and date in the future, but they are custom contracts that are created between 2 institutions. They are not standardized and only trade OTC.

Question 53

A food manufacturer has entered into a contract to buy 5,000 bushels of corn at $4.23 per bushel, to be delivered at the firm’s place of business, 6 months from now. The firm has entered into a(n):

A. options contract
B. futures contract
C. forward contract
D. delivery contract

Answer 53

The best answer is C.

Forward contracts are custom, unregulated, OTC contracts entered into between a buyer and a seller that specify that the underlying asset be delivered at the contract price at a stated date in the contract. These are non-standardized contracts that are not exchange traded. In contrast, futures and options contracts are standardized, are exchange traded, and are regulated. Delivery contract is a meaningless term in the context of this question.

Question 54

Forward contracts are:

I standardized and exchange traded
II non-standardized and OTC traded
III can be easily offset with a closing trade
IV cannot be easily offset with a closing trade

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 54

The best answer is D.

Forward contracts are custom contracts that are negotiated between buyer and seller. They are issued OTC and there is very limited trading - thus it may not be possible to do an offsetting trade with a forward contract. Forward contracts are not subject to federal regulation.

Question 55

The difference between a cash forward contract and a commodity futures contract is that the forward contract:

A. is traded over-the-counter
B. has a standardized delivery date
C. deals with a specific quantity of the commodity
D. has an acceptable deliverable grade of range of grades of the

Answer 55

The best answer is A.

Futures contracts are standardized exchange traded contracts to deliver a commodity at a future date. The expiration/delivery date is standardized in the contract. The contract size is standardized, as is the minimum acceptable grade of the commodity to be delivered. The price of the contract is established by auction on the exchange, so it is not standardized.

In contrast, a forward contract is NOT standardized. Rather, it is a custom-created contract between a buyer and seller for delivery of a specified commodity at a date in the future. All terms of a forward contract are negotiated, whereas the only thing negotiated in a futures contract is the price. Forward contracts are privately created and any trading (not likely) cannot occur on an exchange - rather, any trades would occur over-the-counter.

Question 56

Forward contracts differ from futures contracts in all of the following ways EXCEPT forward contracts are:

A. non-standardized
B. non-regulated
C. non-competitive
D. non-derivative

Answer 56

The best answer is D.

Forward contracts are custom contracts that are negotiated between buyer and seller. They are issued OTC and there is very limited trading - thus it may not be possible to do an offsetting trade with a forward contract. Forward contracts are not subject to federal regulation.

In contrast, futures contracts are standardized, exchange traded contracts. They are regulated by the CFTC - the Commodities Futures Trading Commission. Because they are actively traded, it is easy to do an offsetting trade before the delivery date.

Both futures and forwards are derivatives, because their price movements are based on the price movement of a reference asset.

Question 57

Which of the following derivatives is NOT defined as a security?

I LEAP
II Swap
III Real estate option
IV Futures option

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 57

The best answer is C.

LEAPs are long term options on single stocks or indexes that are exchange traded. They are defined as securities. Swaps are derivatives, but they are not defined as securities. A real estate option is a derivative, but it is not a security. Finally, while futures contracts are derivatives and are not securities; options contracts on futures are defined as a security.

Question 58

Which of the following is NOT a security?

A. Variable annuity for retirement
B. Treasury bond futures contract
C. Option on a precious metals futures contract
D. American depositary receipt

Answer 58

The best answer is B.

A fixed annuity is not security; a variable annuity is a security.

A futures contract is not a security; an option on a futures contract is a security.

An American Depositary Receipt is the way that foreign shares are held in the U.S. and is a security.

Question 59

To hedge an adverse currency move, a currency trader that is long the currency could:

I Buy currency calls
II Buy currency puts
III Buy forward contracts
IV Sell forward contracts

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 59

The best answer is D.

If a currency trader is long the currency, the risk is that price of the currency will drop. The purchase of put options (right to sell at a fixed price) will protect from a downward market move. The sale of a forward contract will also protect the trader, since the currency is then “presold” at a fixed price.