Derivatives Markets - Test 2 - Move to Main collection

Question 1

L3: What is the continuous interest rate that, given an investment horizon, delivers the same future value as a non-continuous interest rate?

Answer 1

See Test 2 Preparation: 1.

Question 2

L3: How do we calculate the cash price of a bond?

Answer 2

Discount each cash flow at the appropriate zero rate.

Question 3

L3: How we would calculate the theoretical price of a two year bond providing a 6% coupon per annum semiannually. The zero rate at the given maturities are given below:
Maturity (years) Zero Rate (%)
0.5                        5
1                            5.8
1.5                         6.4
2                           6.8

Answer 3

First work out the coupon rate per period. Then we discount it back using the formula: P = Fe(-rT)

3e^(-0.05 x 0.5) + 3e^(-0.058 x 1) + 3e^(-0.064 x 1.5) + 103e^(-0.068 x 2)

Note that the final cash flow will be for the principal amount and the final coupon.

Question 4

L3: What is the formula for valuing futures and forwards given the spot price of an investment, F0, and the futures price for a contract deliverable in T years being F0?

Answer 4

See Test 2 Preparation: 3.

Question 5

L3: What is the formula for valuing the forward price of an investment when the investment asset provides a known income?

Answer 5

See Test 2 Preparation: 4.

Question 6

L3: What is the formula for the forward price of an investment when the underlying asset is a stock index?

Answer 6

See Test 2 Preparation: 5.1

Question 7

L3: For an investment when the underlying asset is a stock index, when would an arbitrageur take action and how?

Answer 7

See Test 2 Preparation: 5.2

Question 8

L3: Forward price when the underlying is a currency pair formula?

Answer 8

See Test 2 Preparation: 5.3

Question 9

L3: Forward price when the underlying is a commodity without storage formula?

Answer 9

See Test 2 Preparation: 5.4

Question 10

L3: Forward price when the underlying is a commodity with storage costs formula?

Answer 10

See Test 2 Preparation: 5.5

Question 11

L3: How does shortselling work from the standpoint of the broker?

Answer 11

Suppose an individual wishes to short an amount of shares. The broker will borrow the amount of shares from an individual that has already purchased the shares. The broker will then sell these shares in the market. At some later stage, the investor will close out their position by purchasing shares from the market These shares are then used to replace the borrowed shares so that the short position is closed out. If the value of the shares falls, the broker loses money, if it rises, the broker make money.

Question 12

L3: When do arbitrage opportunities exist in relation to forwards and futures?

Answer 12

If the forward price and spot price are out of line for an asset providing no income. So if the forward price is too high or too low in relation to the sport price.

Question 13

L5: Options: What is the strike/ exercise price?

Answer 13

The price at which the underlying stock can be bought or sold.

Question 14

L5: Options: Maturity Date?

Answer 14

The latest date when an option may be exercised before it lapses.

Question 15

L5: What is the difference between European and American Options?

Answer 15

European options can only be exercised at maturity date.

American options can be exercised at any date, but not later than the maturity date.

Question 16

L5: Options: Writer?

Answer 16

Sells the option.

Question 17

L5: Holder?

Answer 17

Buys the option.

Question 18

L5: Options: In-the-money?

Answer 18

An option that, if exercised, will generate a positive cash flow for the long position.

Question 19

L5: Options: Out-the-money?

Answer 19

An option that, if exercised, will break even.

Question 20

L5: Options: at-the-money?

Answer 20

An option that, if exercised, will generate a negative cash flow for the long position.

Question 21

L4: What is the most important market for the trading of swaps? What percentage of swaps take place in $?

Answer 21

London.

Around 50% of swaps take place using $.

Question 22

L4: Why would a company enter into a swap?

Answer 22

To transform a variable-rate liability (so interest at the LIBOR rate) into a fixed-rate liability (Interest paid at a fixed rate per annum.
If a company has an outstanding liability with a variable rate and expects that rates will go up, it may want to enter into a swap to lock in an interest rate.

Question 23

L4: If a party enters into a semi-annual interest rate swap in March, when would it expect to receive its first payment be expected to be received? What would the floating cash flow rate be on a table?

Answer 23

6 months from then, so September.
The floating cash flow will be half of the LIBOR Rate, as LIBOR is paid annually, so half is paid semi-annually. Note that the CF will at the semi annual rate will be lagged by 6 months, so if LIBOR was 4.2% in March, the Floating Cash Flow recorded in September will be 2.1%.

Question 24

L4: What is the notional amount of an interest rate swap?

Answer 24

The amount that is paid interest on.

This amount does not change hands but will be used to price the bond.

Question 25

L4: Show how cash flows change with an interest rate swap procedure between two companies with a diagram. Liabilities first and then assets. Then Add a Financial Institution that takes 0.03% from the value of the fixed asset. Look at test 2 preparation 6.

Answer 25

Look at test 2 preparation 6.

Question 26

L4: How does a financial institution take its percentage from an interest rate swap?

Answer 26

It takes an amount from the party exchanging the fixed to floating, and and amount from the party receiving the floating to fixed. Not subtracted or added to the LIBOR though. The payer of the fixed amount pays a higher amount and the received receives a lower amount.

Question 27

L4: What are the bid and offer on a table showing quotes of a market maker for an interest rate swap and what is the swap rate?

Answer 27

The Bid is how much the FI is willing to pay at a fixed rate per annum to receive LIBOR.
The offer is how much the bank requires (fixed rate) to make LIBOR payment.
The swap rate is the bid-offer spread.
The offer will always be be higher than the bid.

Question 28

L4: How do we value an interest rate swap over time?

Answer 28

It will be the difference between the value of a fixed-rate bond and the value of a floating-rate bond.

Question 29

L4: What are the formulas for the floating-rate payer and fixed rate payer that participate in an interest rate swap? (Hint: Bond)

Answer 29

Floating Rate Payer:
Vswap = Bfix - Bfloat
They will make money following a swap from there initial position if the floating rate falls below the fixed rate.

Fixed-rate Payer:
Vswap = Bfloat - Bfix
They will make money from their initial position following a swap if the fixed rate falls below the

Question 30

L4: Interest rate swaps: Envision a diagram of the payment times given the bonds.

Answer 30

See Test Two Preparation 7

Question 31

L5: Difference between a call option premium and price?

Answer 31

There is no difference. The two terms are used interchangeably.

Question 32

L5: Difference between a call option premium and price?

Answer 32

There is no difference. The two terms are used interchangeably.

Question 33

L5: Why should you not sell an American option that pays dividends prior to maturity?

Answer 33

You will make a loss.

Question 34

L5: Options: What is the intrinsic value?

Answer 34

The value of an option (could be in the money, out of the money or on the money).

Question 35

L5: Options: Time value?

Answer 35

How much time is left until maturity.

Question 36

L5: Options: When could an option be out of the money but have a value.

Answer 36

If it is close to the value of the option but has lots of time value, meaning it could be sold positively in the market.

Question 37

L5: Options: Can an option have a negative value? Explain.

Answer 37

No. The option is worthless if the long holder is out of the money at maturity, but otherwise it will always hold positive value.