Mid-term test Topic 1 and 2

Question 1

1. A one-year forward contract is an agreement where
   A. One side has the right to buy an asset for a certain price in one year’s time.
   B. One side has the obligation to buy an asset for a certain price in one year’s time.
   C. One side has the obligation to buy an asset for a certain price at some time during the next year.
   D. One side has the obligation to buy an asset for the market price in one year’s time.

Answer 1

1. B

A one-year forward contract is an obligation to buy or sell in one year’s time for a predetermined price. By contrast, an option is the right to buy or sell.

Question 2

2. Which of the following is NOT true
   A. When a call option on IBM is exercised, IBM issues more stock
   B. An American option can be exercised at any time during its life
   C. An call option will always be exercised at maturity if the underlying asset price is greater than the strike price
   D. A put option will always be exercised at maturity if the strike price is greater than the underlying asset price.

Answer 2

2. A

When an IBM call option is exercised the option seller must buy shares in the market to sell to the option buyer. IBM is not involved in any way. Answers B, C, and D are true.

Question 3

3. Which of the following best describes the term “spot price”
   A. The price for immediate delivery
   B. The price for delivery at a future time
   C. The price of an asset that has been damaged
   D. The price of renting an asset

Answer 3

3. A

The spot price is the price for immediate delivery. The futures or forward price is the price for delivery in the future

Question 4

4. Which of the following is true about a long forward contract
   A. The contract becomes more valuable as the price of the asset declines
   B. The contract becomes more valuable as the price of the asset rises
   C. The contract is worth zero if the price of the asset declines after the contract has been entered into
   D. The contract is worth zero if the price of the asset rises after the contract has been entered into

Answer 4

4. B

A long forward contract is an agreement to buy the asset at a predetermined price. The contract becomes more attractive as the market price of the asset rises. The contract is only worth zero when the predetermined price in the forward contract equals the current forward price (as it usually does at the beginning of the contract).

Question 5

5. An investor sells a futures contract on an asset when the futures price is $1,500. Each contract is on 100 units of the asset. The contract is closed out when the futures price is $1,540. Which of the following is true
   A. The investor has made a gain of $4,000
   B. The investor has made a loss of $4,000
   C. The investor has made a gain of $2,000
   D. The investor has made a loss of $2,000

Answer 5

5. B

An investor who buys (has a long position) makes a gain when a futures price increases. An investor who sells (has a short position) takes a loss when a futures price increases.

Question 6

6.	Which of the following describes European options?
A.	Sold in Europe
B.	Priced in Euros
C.	Exercisable only at maturity
D.	Calls (there are no European puts)

Answer 6

6. C

European options can be exercised only at maturity. This is in contrast to American options which can be exercised at any time. The term “European” has nothing to do with geographical location, currencies, or whether the option is a call or a put.

Question 7

7. Which of the following is NOT true about call and put options:
   A. An American option can be exercised at any time during its life
   B. A European option can only be exercised only on the maturity date
   C. Investors must pay an upfront price (the option premium) for an option contract
   D. A long call option provides the obligation to buy the underlying asset

Answer 7

7. D

A long call option has the right but no obligation to buy the underlying asset. A, B, and C are true.

Question 8

8.	The price of a stock on July 1 is $57. A trader buys 100 call options on the stock with a strike price of $60 when the option price is $2. The options are exercised when the stock price is $65. The trader’s net profit is
A.	$700
B.	$500
C.	$300
D.	$600

Answer 8

8. C

The payoff from the options is 100×(65-60) or $500. The cost of the options is 2×100 or $200. The net profit is therefore 500−200 or $300.

Question 9

9.	The price of a stock on February 1 is $124. A trader sells 200 put options on the stock with a strike price of $120 when the option price is $5. The options are exercised when the stock price is $110. The trader’s net profit or loss is
A.	Gain of $1,000
B.	Loss of $2,000
C.	Loss of $2,800
D.	Loss of $1,000

Answer 9

9. D

The payoff that must be made on the options is 200×(120−110) or $2000. The amount received for the options is 5×200 or $1000. The net loss is therefore 2000−1000 or $1000.

Question 10

10.	The price of a stock on February 1 is $48. A trader sells 200 put options on the stock with a strike price of $40 when the option price is $2. The options are exercised when the stock price is $39. The trader’s net profit or loss is
A.	Loss of $800
B.	Loss of $200
C.	Gain of $200
D.	Loss of $900

Answer 10

10. C

The payoff is 40−39 or $1 per option. For 200 options the payoff is therefore 1×200 or $200. However the premium received by the trader is 2×200 or $400. The trader therefore has a net gain of $200.

Question 11

11. A company knows it will have to pay a certain amount of a foreign currency to one of its suppliers in the future. Which of the following is true
    A. A forward contract can be used to lock in the exchange rate
    B. A forward contract will always give a better outcome than an option
    C. An option will always give a better outcome than a forward contract
    D. An option can be used to lock in the exchange rate

Answer 11

11. A

A forward contract ensures that the effective exchange rate will equal the current forward exchange rate. An option provides insurance that the exchange rate will not be worse than a certain level, but requires an upfront premium. Options sometimes give a better outcome and sometimes give a worse outcome than forwards.

Question 12

12.	A trader has a portfolio worth $5 million that mirrors the performance of a stock index. The stock index is currently 1,250. Futures contracts trade on the index with one contract being on $250 times the index. To remove market risk from the portfolio the trader should
A.	Buy 16 contracts
B.	Sell 16 contracts
C.	Buy 20 contracts
D.	Sell 20 contracts

Answer 12

12. B

One futures contract protects a portfolio worth 1250×250. The number of contract required is therefore 5,000,000/(1250×250)=16. To remove market risk we need to gain on the contracts when the market declines. A short futures position is therefore required.

Question 13

13. Which of the following is NOT true
    A. Futures contracts nearly always last longer than forward contracts
    B. Futures contracts are standardized; forward contracts are not.
    C. Delivery or final cash settlement usually takes place with forward contracts; the same is not true of futures contracts.
    D. Forward contracts usually have one specified delivery date; futures contract often have a range of delivery dates.

Answer 13

13. A

Forward contracts often last longer than futures contracts. B, C, and D are true

Question 14

14.	Who initiates delivery in a corn futures contract?
A.	The party with the long position
B.	The party with the short position
C.	Either party
D.	The exchange

Answer 14

14. B

The party with the short position initiates the delivery of a futures contract.