Reading 49: forward commitment and contingent claim features and instruments

Question 1

Which type of contract always requires daily marking to market of gains and losses?
Futures contracts only.
Forward contracts only.
Both futures and forward contracts.

Answer 1

Futures contracts are marked to market daily. Forward contracts typically are not, but could be if there is central clearing party.
(LOS 49.a)

Question 2

Compared to a futures contract, an otherwise identical forward contract most likely has greater:
liquidity.
transparency.
counterparty risk.

Answer 2

Forward contracts involve counterparty risk; futures contracts trade through a clearinghouse. Because futures contracts trade on organized exchanges, they have greater liquidity and transparency than forward contracts. (LOS 49.a)

Question 3

Interest rate swaps are:
highly regulated.
equivalent to a series of forward contracts.
contracts to exchange one asset for another.

Answer 3

A swap is an agreement to buy or sell an underlying asset periodically over the life of the swap contract. It is equivalent to a series of forward contracts. (LOS 49.a)

Question 4

A call option is:
the right to sell at a specific price.
the right to buy at a specific price.
an obligation to buy at a certain price.

Answer 4

A call gives the owner the right to call an asset away (buy it) from the seller. (LOS 49.a)

Question 5

At expiration, the exercise value of a put option is:
positive if the underlying asset price is less than the exercise price.
zero only if the underlying asset price is equal to the exercise price.
negative if the underlying asset price is greater than the exercise price.

Answer 5

The exercise value of a put option is positive at expiration if the underlying asset price is less than the exercise price. Its exercise value is zero if the underlying asset price is greater than or equal to the exercise price. The exercise value of an option cannot be negative because the holder can allow it to expire unexercised. (LOS 49.b)

Question 6

At expiration, the exercise value of a call option is:
the underlying asset price minus the exercise price.
the greater of zero or the exercise price minus the underlying asset price.
the greater of zero or the underlying asset price minus the exercise price.

Answer 6

If the underlying asset price is greater than the exercise price of a call option, the value of the option is equal to the difference. If the underlying asset price is less than the exercise price, a call option expires with a value of zero. (LOS 49.b)

Question 7

An investor writes a put option with an exercise price of $40 when the stock price is $42. The option premium is $1. At expiration the stock price is $37. The investor will realize:
a loss of $2.
a loss of $3.
a profit of $1.

Answer 7

Because the stock price at expiration is less than the exercise price, the buyer of the put option will exercise it against the writer. The writer will have to pay $40 for the stock and can only sell it for $37 in the market. However, the put writer collected the $1 premium for writing the option, which reduces the net loss to $2. (LOS 49.b)

Question 8

Which of the following derivatives is a forward commitment?
Stock option.
Interest rate swap.
Credit default swap.

Answer 8

This type of custom contract is a forward commitment. (LOS 49.c)