TEST BANK for An Introduction to Derivative Securities, Financial Markets, and Risk Management 1st E

CHAPTER 1: Derivatives and Risk Management MULTIPLE CHOICE 1. The following is NOT a feature of current derivatives markets: a. there is a huge variety in the number and type of derivatives contracts that are traded b. the derivatives markets are now global and measured in trillions of dollars c. commodity derivatives have emerged as the most popular kind of derivatives traded in the new millennium d. colleges and universities now offer many kinds of derivative courses e. Wall Street firms hire graduate degree holders in finance and quantitative methods for designing and trading derivatives ANS: C MSC: Factual

DIF: Easy

REF: 1.1

TOP: Introduction

REF: 1.2

TOP: Financial Innovation

2. A derivative security: a. is useful only for speculation b. is useful only for hedging c. is useful only for manipulating markets d. can be used for all of these purposes e. is useful for none of these purposes ANS: D MSC: Factual

DIF: Easy

3. Foreign exchange prices became volatile during the 1970s mainly because of: a. an end of the policy of fixing interest rates by the US Federal Reserve Bank b. the demise of the Bretton Woods system of fixed exchange rates c. supply shocks of the 1970s d. technology that helped us overcome the vagaries of Mother Earth e. hedge funds manipulating exchange trades ANS: B MSC: Factual

DIF: Easy

REF: 1.2

TOP: Financial Innovation

4. Interest rates in the United States became volatile during the late 1970s mainly due to: a. an end of the policy of fixing interest rates by the US Federal Reserve Bank b. the demise of the Bretton Woods system of fixed exchange rates c. technological changes that enabled banks to modify interest rates d. hedge funds manipulating interest rates ANS: A MSC: Factual

DIF: Easy

REF: 1.2

5. The International Monetary Market is: a. an OTC market where money market instruments trade

TOP: Financial Innovation

b. c. d. e.

a part of the World Bank that lends funds to developing countries a division of the Chicago Mercantile Exchange created for trading foreign currency futures a London-based market for interbank lending None of these answers are correct.

ANS: C MSC: Factual

DIF: Easy

REF: 1.2

TOP: Financial Innovation

6. In the United States, the Great Moderation refers to: a. a 15-year-long period that began around 1900 during which the growth of real output fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated b. the time period between 1920 and 1933 when sale, manufacture, and transportation of alcohol was prohibited c. a time period that began in 1955 and lasted for nearly a decade during which business cycle fluctuations declined and inflation was under control d. a time period that began after World War II and lasted for nearly a decade during the growth of real output fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated e. a time period that began during the mid-1980s and lasted a little over two decades during which the growth of real output fluctuated, inflation declined, stock market volatility was reduced, and business cycles were moderated ANS: E MSC: Factual

DIF: Easy

REF: 1.2

TOP: Financial Innovation

7. Nobel Prize–winning economist Ronald Coase’s view is: a. arbitrage is the adhesive that holds financial markets together b. derivatives destroy financial markets via excessive speculation c. derivatives improve social welfare through better risk allocation in the economy d. firms often appear when they can lower transaction costs e. regulations and taxes cause financial innovation ANS: D MSC: Factual

DIF: Easy

REF: 1.2

TOP: Financial Innovation

8. The following was NOT an example cited by Nobel laureate economist Merton Miller in support of his view that “regulations and taxes cause financial innovation”: a. Eurobonds b. Eurodollars c. futures contracts d. swaps e. zero-coupon bonds ANS: C MSC: Factual

DIF: Easy

REF: 1.2

TOP: Financial Innovation

9. In financial markets, a coupon refers to: a. the detachable part of a stock that entitles the holder to get dividends from the company b. the interest paid on a bond on a regular basis, typically semiannually c. one side of a financial swap that entitles the holder to net payments d. the discount from the principal amount at which a zero-coupon bond is sold in the market e. a paper on whose submission a trader gets a reduction in brokerage fees ANS: B

DIF: Moderate

REF: 1.3

TOP: Traded Derivative Securities

MSC: Factual 10. Who has described derivatives as “time bombs, both for the parties that deal in them and the economic system”? a. Warren Buffett b. Ronald Coase c. Alan Greenspan d. Peter Lynch e. Merton Miller ANS: A MSC: Factual

DIF: Easy

REF: 1.3

TOP: Traded Derivative Securities

11. Which of the following statements is INCORRECT? a. Derivatives trade in zero net supply markets. b. A derivatives trade is a zero-sum game in the absence of market imperfections like transaction costs. c. Derivatives are powerful financial tools that can be used for speculation as well as hedging. d. Derivatives have a history of always causing significant losses to any trader who trades these contracts. e. Derivatives can help traders to reduce price risk from economic activities.

ANS: D MSC: Factual

DIF: Moderate

REF: 1.3

TOP: Traded Derivative Securities

12. Suppose regulators cap the maximum interest one can charge at 5 percent. Let the underlying market interest rate be 8 percent. Charging anything lower will drive you out of business.

You devise a compensatory balance scheme: for every $100 that the customer borrows, she will have to keep a certain amount with you as a compensatory balance. What should the amount of the loan and the compensatory balance be if the customer wants to borrow $5,000? a. $5,000 loan and $1,000 as compensatory balance b. $5,000 loan and $1,500 as compensatory balance c. $5,000 loan and $3,000 as compensatory balance d. $8,000 loan and $3,000 as compensatory balance e. $8,000 loan and $5,000 as compensatory balance ANS: D MSC: Applied

DIF: Difficult

REF: 1.3

TOP: Traded Derivative Securities

13. The Basel Committee’s Risk Management Guidelines for Derivatives (July 1994) did NOT list which of the following risks? a. credit risk b. legal risk c. liquidity risk d. market risk e. value-at-risk ANS: E DIF: Easy REF: 1.5 TOP: The Regulator’s Classification of Risk 14. Which of the following risks can be very difficult to hedge? a. credit risk b. legal risk c. market risk

MSC: Factual

d. operations risk e. portfolio risk ANS: D DIF: Easy REF: 1.7 TOP: Corporate Financial Risk Management

MSC: Factual

15. Procter & Gamble’s balance sheet suggests that which of the following is NOT a characteristic of the company’s risk exposure or risk management practice? a. P&G is exposed to currency risk, interest rate risk, and commodity price risk. b. P&G consolidates currency risk, interest rate risk, and commodity price risk, and tries to naturally offset them. It then tries to hedge the residual risk with derivatives. c. P&G holds some derivatives for trading purposes and trades them strategically to maximize shareholder value. d. P&G monitors derivative positions using techniques including market value, sensitivity analysis, and value-at-risk. e. P&G uses interest rate swaps to hedge its underlying debt obligations and enters into certain currency interest rate swaps to hedge the company’s foreign net investments.

ANS: C DIF: Moderate REF: 1.7 TOP: Corporate Financial Risk Management

MSC: Factual

16. Procter & Gamble’s balance sheet suggests that which of the following is NOT a characteristic of the company’s risk exposure or risk management practice? a. P&G manufactures and sells its products in many countries. It mainly uses forwards and options to reduce the risk that the company’s financial position will be adversely affected by short-term changes in exchange rates. b. P&G uses futures, options, and swaps to manage price volatility of raw materials. c. P&G designates a security as a hedge of a specific underlying exposure and monitors its effectiveness in an ongoing manner. d. P&G is exposed to significant volatility from commodity hedging activity and credit risk exposure. e. P&G grants stock options and restricted stock awards to key managers and directors.

ANS: D DIF: Moderate REF: 1.7 TOP: Corporate Financial Risk Management

MSC: Factual

CHAPTER 2: Interest Rates MULTIPLE CHOICE 1. A fixed-income security may be defined as: a. a security that earns a fixed return b. a security that makes interest and principal repayments according to a fixed schedule c. a security that is sold at a fixed discount d. a security that earns dividends according to a fixed schedule e. a security that is sold at a fixed price ANS: B MSC: Factual

DIF: Easy

REF: 2.1

TOP: Introduction

2. Suppose that you bought a stock for $40, received a dividend of $0.50, and sold it for $41 after 91 days. Your annualized arithmetic rate of return equals: a. 5.01 percent b. 10.03 percent c. 15.04 percent d. 16.07 percent e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 2.2

TOP: Rate of Return

3. Suppose that you are planning to enroll in a master’s program two years in the future. The cost to enroll is $150,000. You expect to have the following funds: • From your current job, you can save $5,000 after one year and $7,000 after two years.

• You expect a year-end bonus of $9,000 after one year and $15,000 after two years.

• Your grandparents saved money for your education in a tax-favored savings account and will give you $18,000 after one year.

• Your parents offer you the choice of taking $50,000 at any time, but that amount is deducted from your inheritance. They are risk-averse investors and put money in ultra-safe government bonds giving 2 percent per year.

The borrowing and the lending rate at the bank is 4 percent per year, compounded daily.

Approximating this by continuous compounding, how much money will you need to borrow when you start your master’s degree education two years from today? a. $39,489 b. $40,530 c. $42,489 d. $47,501 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Difficult

REF: 2.2

TOP: Rate of Return

4. The interest rate is 7 percent per year. Compute the eight-month zero-coupon bond price using a compound interest rate with monthly compounding. a. $0.9533 b. $0.9540 c. $0.9545

d. $0.9554 e. None of these answers are correct.

ANS: C DIF: Easy REF: 2.3 TOP: Basic Interest Rates: Simple, Compound, and Continuously Compounded MSC: Applied 5. The simple interest rate is 5 percent per year. What is the dollar return after nine months? a. $1.0312 b. $1.0375 c. $1.0381 d. $1.0450 e. None of these answers are correct.

ANS: B DIF: Easy REF: 2.3 TOP: Basic Interest Rates: Simple, Compound, and Continuously Compounded MSC: Applied Use the following table, where the interest rate is 5 percent per year, compounded once a year to answer the questions that follow.

Time (in years) 0 (today) 1 2 3

Cash flow (in dollars) – 105 7 9 106

6. Compute the present value of the above cash flows. a. –$3.78 b. $0.53 c. $1.06 d. $1.40 e. None of these answers are correct.

ANS: D DIF: Moderate REF: 2.4 TOP: Discounting (PV) and Compounding (FV): Moving Money across Time MSC: Applied 7. Compute the future value of the above cash flows in three years. a. $0.05 b. $1.62 c. $4.82 d. $5.68 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 2.4 TOP: Discounting (PV) and Compounding (FV): Moving Money across Time MSC: Applied 8. If the price of a zero-coupon bond maturing in three years is $0.90, what is the continuously compounded rate of return? a. 0.0351 b. 0.0426 c. 0.0542 d. 0.0744

e. None of these answers are correct.

ANS: A DIF: Moderate REF: 2.4 TOP: Discounting (PV) and Compounding (FV): Moving Money across Time MSC: Applied 9. Which of the following is NOT true about US Treasury securities? a. These securities are virtually free from default risk. b. They trade in a market with some of the smallest bid/ask spreads in the world. c. Their interest payments are free from state and local taxes. d. They have low minimum denominations and offer a spectrum of maturities that range from one day to thirty years. e. They accurately reflect a company’s cost of borrowing.

ANS: E MSC: Factual

DIF: Easy

REF: 2.5

TOP: US Treasury Securities

10. A discriminatory auction of US Treasury securities: a. raises more revenue than a uniform price auction b. raises less revenue than a uniform price auction c. raises equal revenue as a uniform price auction d. may raise more or less revenues than a uniform price auction e. None of these answers are correct.

ANS: D DIF: Moderate TOP: US Federal Debt Auction Markets

REF: 2.6 MSC: Conceptual

11. What is the when-issued market with respect to US Treasuries? a. It’s a special kind of call market that begins a week or so before a Treasury securities auction. b. It’s a special kind of forward market that begins a week or so before a Treasury securities auction. c. It’s a special kind of futures market that begins a week or so before a Treasury securities auction. d. It’s a special kind of repo market that begins a week or so before a Treasury securities auction. e. None of these answers are correct.

ANS: B DIF: Easy REF: 2.7 TOP: Different Ways of Investing in Treasury Securities

MSC: Factual

12. A repo agreement: a. involves the sale of securities together with an agreement that the seller buys back the securities at a later date at a price that is negotiated at the time of initial sale b. involves the sale of securities together with an agreement that the seller buys back the securities at a later date at a price to be negotiated in the future c. involves the sale of securities together with an agreement that the seller will have the option to buy back the securities at a later date at a price to be negotiated in the future d. is an agreement that allows banks to take possession of homes that become delinquent on mortgage payments e. None of these answers are correct.

ANS: A DIF: Easy REF: 2.7 TOP: Different Ways of Investing in Treasury Securities

MSC: Factual

13. US Treasury notes are: a. coupon bonds that have original maturity of more than ten years up to a maximum of thirty years b. coupon bonds that have original maturity of more than one year up to a maximum of ten years c. coupon bonds whose interest payments fluctuate with the inflation rate d. zero-coupon bonds that don’t pay interest but pay back the principal at maturity e. zero-coupon bonds that mature in more than ten years ANS: B DIF: Easy REF: 2.8 TOP: Treasury Bills, Notes, Bonds, and STRIPS

MSC: Factual

14. Using a banker’s discount yield of 3 percent per year, the price of a US Treasury bill that matures in 181 days is a. $0.9750 b. $0.9849 c. $0.9874 d. $0.9881 e. None of these answers are correct.

ANS: B DIF: Easy REF: 2.8 TOP: Treasury Bills, Notes, Bonds, and STRIPS

MSC: Applied

15. Eurodollars are: a. US dollar–denominated deposits held in Europe b. US dollar–denominated bonds that are held outside the USA c. US dollar–denominated time deposits that are held outside the United States in a foreign bank or a subsidiary of a US bank d. Any time deposit denominated in a particular currency but held outside the country of the currency e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Moderate

REF: 2.9

TOP: Libor versus Bbalibor

16. Bbalibor is: a. the rate at which a bank with surplus funds lends to another bank for a fixed time period in the London interbank market b. the rate at which a bank with surplus dollars lends to another bank for a fixed time period in the London interbank market c. the rate at which a bank with a shortage of funds offers to borrow excess funds from another bank for a fixed time period in the London interbank market d. a trimmed average of libor quotes computed every trading day by the British Banker’s Association e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Easy

REF: 2.9

TOP: Libor versus Bbalibor

17. The yield spread between Eurodollar deposits and Treasury Bill rates is called the: a. BED spread b. DA spread c. NOB spread d. TBE spread e. TED spread

ANS: E MSC: Factual

DIF: Easy

REF: 2.9

TOP: Libor versus Bbalibor

CHAPTER 3: Stocks MULTIPLE CHOICE 1. The primary market for a stock is: a. an initial public offering b. an auction c. a private placement d. a subscription offering e. None of these answers are correct.

ANS: A DIF: Easy REF: 3.2 TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets MSC: Factual 2. Which of the following is NOT true about stockholders? a. A stockholder has fractional ownership over a company. b. A stockholder usually gets dividend payments from a company. c. A stockholder can lose more than her initial investment because the company is a “legal person” and must meet its debts and legal obligations. d. A stockholder can play a role in changing the top management of the company. e. A stockholder cannot be sued for misdeeds of a company.

ANS: C DIF: Moderate REF: 3.2 | 3.3 TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets | Brokers, Dealers, and Traders in Securities Markets MSC: Factual 3. US stock exchanges are: a. regulated by the CFTC b. regulated by the Congress c. regulated by the Federal Reserve Bank d. regulated by the EPA e. regulated by the SEC ANS: E DIF: Easy REF: 3.2 TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets MSC: Factual 4. Which of the following statements about self-regulation of exchange-traded securities markets is INCORRECT? a. It makes the markets more honest. b. It helps demonstrate to the federal agencies that the industry is doing a good job policing itself and thus more regulatory oversight may not be necessary. c. It deals with problems before they get wide publicity. d. It builds the reputation of the marketplace and thus attracts high-quality customers and greater trade volume. e. Its net costs are far more than the benefits it provides.

ANS: E DIF: Easy REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets

MSC: Factual

5. Which of the following is NOT true about a dealer? a. A dealer has inventory risk. b. A dealer matches a buyer and a seller and earns commissions for this service.

c. A dealer posts bid and ask prices. d. A dealer must have adequate capital to maintain her portfolio of securities. e. A dealer trades on her own account.

ANS: B DIF: Easy REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets

MSC: Factual

6. Which of the following is NOT true about a spread in a financial market? a. A spread may refer to the gap between bid and ask prices of a stock or other security. b. A spread may refer to the simultaneous purchase and sale of separate futures or options contracts for the same commodity for delivery in different months. c. A spread may refer to the difference between the price at which an underwriter buys an issue from a firm and the price at which the underwriter sells it to the public. d. A spread may refer to the difference between the price that someone purchasing an item in an auction pays and the price that the seller receives. e. A spread may refer to the price an issuer pays above a benchmark fixed-income yield to borrow money.

ANS: D DIF: Moderate REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets

MSC: Factual

7. The foreign exchange market is one of the world’s largest: a. exchanges b. primary markets c. auction markets d. dark pools e. over-the-counter markets ANS: E DIF: Easy REF: 3.2 TOP: Primary and Secondary Markets, Exchanges, and Over-the-Counter Markets MSC: Factual 8. The following individuals do not trade in the derivative securities markets: a. day traders b. market makers c. position traders d. scalpers e. specialists ANS: E DIF: Easy REF: 3.3 | 3.6 TOP: Brokers, Dealers, and Traders in Securities Markets | Buying and Selling Stocks MSC: Factual 9. You are a dealer and post a price of $100.00 to $100.50 for a stock. There are more sell orders than buy orders and you find your inventory is growing. What is the correct way to adjust your quotes? a. Lower the bid price and then lower the ask price. b. Lower the ask price and then lower the bid price. c. Raise the ask price and then raise the bid price. d. Raise the bid price and then raise the ask price. e. Do nothing—orders arrive randomly and they will self-adjust.

ANS: A DIF: Moderate REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets 10. Traders with superior information are more likely to trade in the:

MSC: Applied

a. stock market b. bond market c. money market d. options market e. swaps market ANS: D DIF: Moderate REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets

MSC: Conceptual

11. Which statement below is INCORRECT? a. Arbitrageurs seek price discrepancies among securities and attempt to extract riskless arbitrage profits. b. Hedgers try to reduce risk by trading securities and are often cited as the chief reason for the existence of derivative markets. c. Position traders (also called trend followers) maintain speculative trading positions for longer periods of time. d. Scalpers open their positions in the morning, try to profit from price movements over the day, and close their positions at the end of the trading day. e. Speculators often take calculated risks in their pursuit of profits.

ANS: D DIF: Easy REF: 3.3 TOP: Brokers, Dealers, and Traders in Securities Markets

MSC: Factual

12. Which statement below is INCORRECT about block trades? a. They involve trades of 5,000 shares or more. b. They involve trades of 10,000 shares or more. c. They are often negotiated away from the trading floor in the “upstairs market.” d. They may or may not involve the services of a broker. e. They are rarely handled by the specialists.

ANS: A MSC: Factual

DIF: Easy

REF: 3.6

TOP: Buying and Selling Stocks

13. Which statement below is correct about the Financial Industry Regulatory Authority (FINRA)? a. FINRA is the successor to NASDAQ. b. FINRA was created as a regulator of the stock market during the 1930s. c. FINRA is the new name for NASD. d. NASD and the member regulation, enforcement, and arbitration functions of the New York Stock Exchange were consolidated to form FINRA. e. FINRA operates the NASDAQ Stock Market LLC. ANS: D MSC: Factual

DIF: Easy

REF: 3.6

TOP: Buying and Selling Stocks

14. Which of the following is NOT true about an electronic communications network (ECN)? a. It is an alternate trading system that must be registered with the SEC as a broker-dealer. b. Its participants include institutional investors, broker-dealers, and market makers. c. It publicly displays the limit order book to subscribers. d. It is primarily a trading venue for stocks and currencies. e. It is a secretive trading network that does not send an order directly to an exchange or display it in a limit order book.

ANS: E MSC: Factual

DIF: Easy

REF: 3.6

TOP: Buying and Selling Stocks

15. A stock’s price cum-dividend is $50. If the market is free of riskless profit opportunities, then the ex-dividend price of the stock after the payment of a $1 dividend would be: a. $48 b. $49 c. $50 d. $51 e. None of these answers are correct.

ANS: B DIF: Easy REF: 3.7 TOP: Dollar Dividends and Dividend Yields

MSC: Applied

16. Consider an asset that has a continuously compounded dividend yield of  = 0.03 per year, which is reinvested back into the asset. Then, a unit investment in the asset today grows after ten months to: a. 1.0202 units b. 1.0228 units c. 1.0253 units d. 1.0279 units e. None of these answers are correct.

ANS: C DIF: Moderate REF: 3.7 TOP: Dollar Dividends and Dividend Yields

MSC: Applied

17. Boni holds some YBM stocks in what’s called the “street name,” which enables her broker to short her stocks. Her broker Brokerman helps Chini borrow those shares and short-sell them to Honey Bunny at $100 per share. When YBM declares a $1 dividend, then: a. YBM pays $1 to Boni b. YBM pays $1 to Chini, who passes it on to Boni c. Brokerman pays $1 to Boni from his own money d. Chini pays $1 to Boni e. Honey Bunny pays $1 to Boni ANS: D MSC: Applied

DIF: Easy

REF: 3.8

TOP: Short-Selling Stocks

18. Suppose that a stock trader has bought $20,000 worth of securities. He kept $10,000 in an initial margin in his brokerage account and borrowed the rest from his broker. The maintenance margin is 25 percent. The value of the account has fallen to $3,500. The account holder has to come up with a variation margin of: a. $1,000 b. $1,500 c. $3,500 d. $6,500 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 3.9 TOP: Margin: Security Deposits That Facilitate Trading

MSC: Applied

19. Consider the following data: YBM’s stock price is $110. The initial margin is 50 percent and the maintenance margin is 25 percent. If you buy 150 shares, borrowing 50 percent from the broker, at what stock price will you start to receive a margin call? (Hint: use the formula Margin = (Market value of assets − Loan) / Market value of assets.) a. $25 b. $55.25 c. $66.67 d. $73.33

e. None of these answers are correct.

ANS: D DIF: Difficult REF: 3.9 TOP: Margin: Security Deposits That Facilitate Trading

MSC: Applied

CHAPTER 4: Forwards and Futures MULTIPLE CHOICE 1. The holder of a long forward contract has: a. the option to buy the underlying asset at a fixed price on a fixed future date b. the option to sell the underlying asset at a fixed price on a fixed future date c. the obligation to buy the underlying asset at a fixed price on a fixed future date d. the obligation to sell the underlying asset at a fixed price on a fixed future date e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Easy

REF: 4.2

TOP: Forward Contracts

2. The holder of a short forward position has: a. the option to buy the underlying asset at a fixed price on a fixed future date b. the option to sell the underlying asset at a fixed price on a fixed future date c. the obligation to buy the underlying asset at a fixed price on a fixed future date d. the obligation to sell the underlying asset at a fixed price on a fixed future date e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Easy

REF: 4.2

TOP: Forward Contracts

3. Shaq buys a futures contract today. Which of the following is true? a. Shaq agrees to buy the asset at a fixed price at some future date. b. Shaq will get dividends on the underlying asset. c. Shaq acquires voting rights on the asset. d. Shaq will have to return the asset when closing out his position. e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

REF: 4.2

TOP: Forward Contracts

4. Which of the following is INCORRECT? a. The buyer and seller in a forward contract agree to trade a commodity on some later delivery date at a fixed delivery (forward) price. b. Forwards are zero net supply contracts. c. Forward trading is a zero-sum game. d. Forward contracts have significant counterparty risk. e. Forward contracts are regulated by the Commodity Futures Trading Commission.

ANS: E MSC: Factual

DIF: Easy

REF: 4.2

TOP: Forward Contracts

• A US company has bought a machine worth 3 million euros from a German manufacturer with payment due in three months. The treasurer finds that DeutscheUSA (a fictitious name), a large commercial bank, bids euros for $1.5000 and offers euros for $1.5010 in three months’ time. He readily agrees and locks in that price.

• Suppose DeutscheUSA would like to hedge its trade. It finds that a German importer hoping to buy 2 million euros worth of computer parts from the United States in three months’ time. They also agree to trade.

5. What is the price risk exposure remaining for DeutscheUSA?

a. b. c. d. e.

$1 million US dollars today $2 million US dollars in three months’ time 3 million euros today 1 million euros in three months’ time None of these answers are correct.

ANS: D DIF: Easy REF: 4.3 TOP: The Over-the Counter Market for Trading Forwards 6.

MSC: Applied

What is DeutscheUSA’s profit and risk exposure after three months time? a. a profit of $1,000 US dollars plus risk exposure on $2 million dollars b. a profit of $2,000 US dollars c. a profit of $2,000 US dollars plus risk exposure on $1 million dollars d. a profit of $2,000 US dollars plus risk exposure on 1 million euros e. None of these answers are correct.

ANS: D DIF: Moderate REF: 4.3 TOP: The Over-the Counter Market for Trading Forwards

MSC: Applied

7. Which statement is INCORRECT about futures contracts? a. Futures contracts are regulated. b. Futures require counterparties to know each other. c. Futures trades require margins. d. Performance of futures contracts are guaranteed by a clearinghouse. e. Most futures contracts are closed out before maturity.

ANS: B MSC: Factual

DIF: Easy

REF: 4.4

TOP: Futures Contracts

8. The main distinction between a forward and a futures contract is: a. a forward contract has a final cash flow, while a futures contract has daily cash flows b. a forward contract requires no collateral, while a futures contract requires traders to post margins c. a forward trade is usually closed out early, while a futures trade usually ends with physical delivery d. a forward trade requires cash settlement, while a futures trade does not require this e. minor—they are the same contracts ANS: A MSC: Factual

DIF: Moderate

REF: 4.4

TOP: Futures Contracts

9. Which of the following is NOT a job performed by a futures clearinghouse? a. guaranteeing contract performance b. providing price support in case of a market crash c. resolving small disputes among traders regarding an executed trade d. recording and recognizing trades e. checking that trades match ANS: B DIF: Easy REF: 4.5 TOP: Exchange Trading of a Futures Contract

MSC: Factual

10. Settlement of a futures trade: a. takes place on the following trading day b. takes place five days after a trade is executed c. have real time, instant settlement due to advances in technology

d. takes place on every trading day until the contract is closed out or it matures e. None of these answers are correct.

ANS: D DIF: Moderate REF: 4.5 TOP: Exchange Trading of a Futures Contract

MSC: Factual

11. The open interest on a futures contract is: a. the sum of both the outstanding long and short positions b. the total of all hedged positions c. the total number of contracts that got traded during the day d. the number of contracts in which traders have shown trading interest by submitting a bid or an ask price quote e. the total of all outstanding contracts ANS: E DIF: Easy REF: 4.5 TOP: Exchange Trading of a Futures Contract

MSC: Factual

12. Suppose that July gold futures just become eligible for trading. Tim buys 20 of those contracts from Ned. Next, he sells 10 contracts to Mary. Finally, Ned buys 10 contracts from Tim. As a result of these three trades: a. trading volume is 20 contracts and open interest rate is 20 contracts b. trading volume is 30 contracts and open interest rate is 15 contracts c. trading volume is 40 contracts and open interest rate is 10 contracts d. trading volume is 40 contracts and open interest rate is 20 contracts e. None of these answers are correct.

ANS: C DIF: Moderate REF: 4.5 TOP: Exchange Trading of a Futures Contract

MSC: Applied

13. You manufacture silver jewelry. To hedge some of your risks, you can: a. go long silver futures to hedge input price risk b. go short silver futures to hedge input price risk c. go long silver futures to hedge output price risk d. do nothing with silver futures e. do nothing as silver futures do not trade ANS: A DIF: Easy REF: 4.6 TOP: Hedging with Forwards and Futures

MSC: Applied

14. Golddiggers, Inc., mines gold and sells refined, pure gold in the world market. To hedge some of its price risk, the company can: a. short gold futures to hedge input risk b. long gold futures to hedge output risk c. short gold futures to hedge output risk d. long gold futures to hedge input risk e. There’s no suitable contract that Golddiggers can use for hedging purposes.

ANS: C DIF: Easy REF: 4.6 TOP: Hedging with Forwards and Futures

MSC: Applied

15. Suppose you trade futures contracts on precious metals. Which of the following risks are you are exposed to? a. credit risk, legal risk, liquidity risk, and market risk b. no credit risk; legal risk, liquidity risk, and market risk c. no credit risk or legal risk; liquidity risk and market risk

d. no credit risk, legal risk, or liquidity risk; market risk e. no credit risk, legal risk, liquidity risk, or market risk ANS: C DIF: Moderate REF: 4.6 TOP: Hedging with Forwards and Futures

MSC: Applied

CHAPTER 5: Options MULTIPLE CHOICE 1. The seller (or the writer) of a call option: a. has the right to buy the underlying asset at a strike price until an expiration date b. has the right to sell the underlying asset at a strike price until an expiration date c. may have the obligation to buy the underlying asset at a strike price until an expiration date d. may have the obligation to sell the underlying asset at a strike price until an expiration date e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Easy

REF: 5.2

TOP: Options

2. The seller (or the writer) of a put option: a. has the right to buy the underlying asset at a strike price until an expiration date b. has the right to sell the underlying asset at a strike price until an expiration date c. may have the obligation to buy the underlying asset at a strike price until an expiration date d. may have the obligation to sell the underlying asset at a strike price until an expiration date e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Easy

REF: 5.2

TOP: Options

3. The distinction between American and European options is that: a. American options trade in the United States, while European options trade in Europe b. American options can be exercised at any time until expiration, while European options can only be exercised at the time of expiration c. American options have a capped payoff, while European options traders can have unlimited profits or losses d. American options end in physical delivery of the underlying asset, while European options end in cash settlement e. None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 5.2

TOP: Options

4. When the stock price is greater than the strike price, a call is: a. in-the-money b. at-the-money c. out-of-the money d. intrinsically at risk e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

REF: 5.3

TOP: Call Options

5. Compute the net profit or loss on the maturity date for a December 45 call for which the buyer paid a premium of $3.75 and the spot price at maturity is $49.25. a. –$1

b. –$0.50 c. $0.50 d. $1 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 5.3

TOP: Call Options

6. When the stock price is greater than the strike price, a put is: a. in-the-money b. at-the-money c. out-of-the money d. intrinsically at risk e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Easy

REF: 5.4

TOP: Put Options

7. The following option prices are given for YBM, whose stock price equals $99: Strike Price 95 100 105

Call Price 10.50 2.50 1.50

Put Price 2.00 3.50 11.00

Which of the following statements is correct? a. b. c. d. e.

The intrinsic value for 95 call is $4 and for 105 put is $6.

The intrinsic value for 95 call is $4.50 and for 100 put is $2.

The intrinsic value for 100 call is $1 and for 95 put is $4.

The intrinsic value for 105 call is 0 and for 105 put is $5.

None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 5.3 | 5.4

TOP: Call Options | Put Options

8. If S is the stock price on an option’s expiration date and K is the strike price, then a put seller’s (writer’s) payoff at expiration is: a. max(0, S – K) b. min(0, K – S) c. max(0, K – S) d. min(0, S – K) e. None of these answers is correct.

ANS: D MSC: Conceptual

DIF: Difficult

REF: 5.3 | 5.4

TOP: Call Options | Put Options

9. BUG’s stock price is $53 and its put price is $4.50 for a strike price of $55. This put option’s intrinsic value is: a. $2 b. $2.50 c. $3 d. $4 e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Easy

REF: 5.4

TOP: Put Options

10. The maximum loss that a writer of a naked put can incur is: a. 0 b. the stock price c. unlimited d. the strike price e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Easy

REF: 5.4

TOP: Put Options

REF: 5.4

TOP: Put Options

11. A short put is a: a. bullish strategy b. bearish strategy c. neutral market strategy d. bet on volatility e. None of these answers are correct.

ANS: A MSC: Conceptual

DIF: Moderate

12. Suppose you go both long a call option and short a put option. Both options are on the same underlying stock and have the same strike price and expiration date. You have created: a. a short forward b. a long forward c. a long futures d. a short futures e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 5.3 | 5.4

TOP: Call Options | Put Options

13. The primary function of the Options Clearing Corporation (OCC) is to: a. regulate all options markets b. act as a clearinghouse for a majority of exchange-traded options c. regulate all futures markets d. act as a clearinghouse for all exchange-traded derivative contracts e. None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 5.5

TOP: Exchange-Traded Options

14. The following contracts have daily settlements: a. forward contracts b. futures contracts c. exchange-traded options d. options on futures e. over-the-counter options ANS: B MSC: Factual

DIF: Moderate

REF: 5.5

TOP: Exchange-Traded Options

15. Suppose that you find that YBM’s October 100 put has an ask price of $4.10 and a bid price of $4.00.

If you want to buy these put options to protect your holding of 400 YBM shares from declining, what is your total cost including commission? Assume that the broker charges a commission equal to a flat fee of $15 plus $2 per contract. a. $1,623 b. $1,647 c. $1,655 d. $1,663 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Moderate

REF: 5.5

TOP: Exchange-Traded Options

16. Suppose that a dealer is quoting an ask/offer price $50.10 and bid price $50.00 for BUG stock. You would like to sell your holdings of 6,000 BUG shares at a price of $55 or something close to it. To really ensure that the sell goes through, you should place: a. a market order at $55 b. a limit sell order at $55 c. a market-if-touched sell order at $55 d. a stop-loss sell order at $55 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 5.7

TOP: Order Placement Strategies

17. A stop-loss order (or a sell stop order): a. becomes a market order as soon as a trade takes place at this price, which is higher than the current market price b. is a limit sell order above the current market price c. is a sell order placed at the ongoing current ask price d. is a sell order placed at a price lower than the current bid price e. None of these answers are correct.

ANS: D MSC: Conceptual

DIF: Moderate

REF: 5.7

TOP: Order Placement Strategies

18. An order to buy a put option with a strike price of $100 and simultaneously sell a put option with a strike price of $105 is an example of: a. a scale order b. a spread order c. a one cancels the other order d. a switch order e. None of these answers are correct.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 5.7

TOP: Order Placement Strategies

19. The current price of platinum is $1,800 per ounce. You are expecting that in three months the price of platinum will rise above $1,900. You are also worried that there is a small chance platinum’s price may fall below $1,700. If you are setting up speculative strategies based on your views, you are unlikely to use which of the following strategies? a. Buy platinum in the spot market, and place a stop-loss order at $1,700 or a little below. b. Buy call options on platinum. c. Buy call options on platinum futures. d. Buy platinum in the spot market and protect against the downside by buying put options or

put options on platinum futures. e. Buy platinum futures.

ANS: E MSC: Applied

DIF: Moderate

REF: 5.7

TOP: Order Placement Strategies

CHAPTER 6: Arbitrage and Trading MULTIPLE CHOICE 1. Arbitrage is: a. a zero initial wealth trading strategy that has a likelihood of making profits without risk of a loss b. a way of resolving disputes c. a risky way of making money for arbitrators d. a zero-investment trading strategy in which the likelihood of portfolio gain overwhelms the likelihood of loss e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

REF: 6.1

TOP: Introduction

2. Which of the following class of arbitrage opportunities is irrelevant for our pricing models? a. arbitrage across time b. arbitrage across space c. the sum of the parts is greater than the whole d. the sum of the parts is less than the whole e. government granted tax credits ANS: E MSC: Conceptual

DIF: Easy

REF: 6.2

TOP: The Concept of Arbitrage

3. Suppose a two-year Treasury note is trading at its par value of $1,000. You examine the cash flows and discover that if you sell them individually in the market, you get $46.23 for the six-month coupon, $44.67 for the one-year coupon, $42.21 for the eighteen-month coupon, $40.22 for the two-year coupon, and $831.56 for the principal. The amount of arbitrage profit you can make by trading each security is: a. $2.58 b. $4.89 c. $10.34 d. $41.78 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 6.2

TOP: The Concept of Arbitrage

4. The law of one price states that: a. the same financial security, no matter how it is created, should trade at the same price b. two financial securities that have the same price today and same risk must have the same price in the future c. two securities that have the same price today must have the same prices at all future dates d. two securities that have the same standard deviation and expected return must have the same price e. None of these answers are correct.

ANS: A MSC: Conceptual

DIF: Moderate

REF: 6.2

TOP: The Concept of Arbitrage

5. Which statement below is FALSE? a. Weak-form efficiency asserts that stock prices reflect all relevant information that can be

gathered by examining current and past prices. b. If the market is weak-form efficient, then there are no arbitrage opportunities. c. Semistrong-form efficiency asserts that stock prices reflect not only historical price information but also all publicly available information that is relevant to those particular stocks. d. Strong-form efficiency asserts that stock prices reflect all relevant information, both private and public, that may be known to any market participant. e. None of these answers are correct.

ANS: E MSC: Factual

DIF: Easy

REF: 6.4

TOP: Efficient Markets

6. Which statement below is FALSE? a. Technical analysis is useless in weak-form efficient markets. b. Arbitrage opportunities may be present in semistrong-form efficient markets. c. Fundamental analysis is worthless in semistrong-form efficient markets. d. Insider trading restrictions are unnecessary in strong-form efficient markets. e. Strong-form efficient markets are also weak-form efficient.

ANS: B MSC: Conceptual Stock

Today’s Price

YBM BUG

$98 $48

DIF: Moderate

REF: 6.4

TOP: Efficient Markets

Shares Today’s Tomorrow’s Tomorrow’s Outstanding Market Value Market Value Price (Million) (Million) (Million) $101 50 $4,900 $5,050 $49 20 $960 $980

7. A price-weighted index’s value would be: a. 71 today and 75 tomorrow b. 68 today and 70 tomorrow c. 69 today and 71 tomorrow d. 73 today and 75 tomorrow e. None of these answers are correct.

ANS: D DIF: Moderate REF: 6.5 TOP: In Pursuit of Arbitrage Opportunities

MSC: Applied

8. A value-weighted index’s value would be (assuming today’s value is normalized to 100): a. 100 today and 101.08 tomorrow b. 100 today and 102.40 tomorrow c. 100 today and 102.90 tomorrow d. 100 today and 103.80 tomorrow e. None of these answers are correct.

ANS: C DIF: Moderate REF: 6.5 TOP: In Pursuit of Arbitrage Opportunities

MSC: Applied

9. An index arbitrage involves buying the cheaper portfolio and selling the more expensive portfolio where: a. the portfolios try to replicate the performance of two different but related stock indexes b. one portfolio consists of an index future while the other portfolio tries to replicate the performance of the underlying index c. one portfolio consists of an index option while the other portfolio tries to replicate the performance of the underlying index

d. one portfolio consists of an index future while the other portfolio consists of an index option, where both derivatives are written on the same underlying index e. None of these answers are correct.

ANS: B DIF: Moderate REF: 6.5 TOP: In Pursuit of Arbitrage Opportunities

MSC: Factual

10. Which of the following is NOT a characteristic of algorithmic trading (or algos)? a. Algos are a kind of program trading that try to exploit fleeting mispricings or arbitrage opportunities. b. An objective of algos is to reduce latency, or the time duration between order placement and execution. c. Algos require trades to have real-time settlement. d. Servers for conducting algos are placed near the trading venue for reducing latency. e. None of these answers are correct.

ANS: C DIF: Moderate REF: 6.5 TOP: In Pursuit of Arbitrage Opportunities

MSC: Factual

11. Which of the following is NOT a characteristic of a hedge fund? a. They allow only wealthy investors to invest. b. They hedge all of their investment risks. c. Hedge fund managers tend to specialize in one investment strategy, but enjoy broad investment flexibility. d. Hedge funds are structured so as to avoid direct regulation and taxation in most countries. e. Hedge funds have a penchant for secrecy and disclose little information to the public.

ANS: B DIF: Easy REF: 6.5 TOP: In Pursuit of Arbitrage Opportunities

MSC: Factual

12. Which of the following is NOT an example of floor trading abuse? a. bucketing b. cross trading c. ginzy trading d. prearranged trading e. rolling the hedge forward ANS: E DIF: Easy TOP: Illegal Arbitrage Opportunities

REF: 6.6 MSC: Factual

13. Front running in futures market involves: a. a floor broker who executes customer orders acting as a dealer in some other transactions on the same day b. trading based on an impending transaction by another person, for example, a floor trader buying on his own account in front of his customer’s buy order c. taking a customer’s order and placing it ahead of accumulated limit orders d. placing orders during the first few minutes of a trading day e. None of these answers are correct.

ANS: B DIF: Easy TOP: Illegal Arbitrage Opportunities

REF: 6.6 MSC: Factual

14. Which of the following statements is FALSE? In the United States, to prove market manipulation in a court of law: a. the manipulator must be shown to have had the ability to set an artificial futures price

b. the manipulator must have intended to set an artificial price c. the manipulator must have succeeded in setting an artificial price d. it is difficult to demonstrate that price movements are due to the manipulator’s trades and not due to changing market conditions e. many manipulators are wrongly prosecuted because manipulation trades, like speculation trades, enhance market efficiency by enabling prices to reflect information quickly ANS: E DIF: Moderate TOP: Illegal Arbitrage Opportunities

REF: 6.6 MSC: Conceptual

CHAPTER 7: Financial Engineering and Swaps MULTIPLE CHOICE 1. The holder of the following security gives an option to the issuer: a. a callable bond b. a convertible bond c. an employee stock option d. a stock e. a warrant ANS: A DIF: Easy TOP: The Build and Break Approach

REF: 7.2 MSC: Factual

2. The holder of the following security gets an additional option embedded within the bond: a. a callable bond b. a convertible bond c. an employee stock option d. a stock e. a warrant ANS: B DIF: Easy TOP: The Build and Break Approach

REF: 7.2 MSC: Factual

3. Hybrids: a. are bonds with repayment pegged to the stock’s price b. are derivative securities that combine swaps with options c. are derivative securities that combine calls with puts d. are derivatives whose payoffs are tied to exchange rates e. are combinations of options and futures ANS: A MSC: Factual

DIF: Easy

REF: 7.3

TOP: Financial Engineering

Your company is planning to buy euros in six months time. The spot price is $1.25 per euro. Boldman Bankers Inc. (fictitious name) designs a “fancy derivative” that provides protection against an appreciation in the euro, but it also limits your benefits if the euro declines. After six months, by the terms of this “range forward,” (1) if the spot exchange rate for the euro is above $1.30, then you pay $1.30; (2) if the spot exchange rate for the euro is below $1.20, then you pay $1.20; and (3) if the spot exchange rate lies between this range, then you buy euros at the prevailing market price.

4. Your cousin, who is studying derivatives at college, says “This is no big deal,” and breaks down this range forward into basic building blocks. His breakdown is: a. long zero-coupon bond with a face value $1.20, long call with strike price $1.20, and short call with strike price $1.30 b. long zero-coupon bond with a face value $1.20, short call with strike price $1.20, and short call with strike price $1.30 c. short zero-coupon bond with a face value $1.20, short call with strike price $1.20, and long call with strike price $1.30 d. short zero-coupon bond with a face value $1.30, short call with strike price $1.20, and long call with strike price $1.30 e. long zero-coupon bond with a face value $1.30, short call with strike price $1.20, and short call with strike price $1.30

ANS: A MSC: Applied

DIF: Moderate

REF: 7.3

TOP: Financial Engineering

5. Another cousin, who is also studying derivatives at university, said your portfolio must include a long spot position in euros, because you are planning to buy euros. Her breakdown is: a. long spot, short put with strike price $1.30, and short call with strike price $1.20 b. short spot, long put with strike price $1.30, and short call with strike price $1.20 c. long spot, long put with strike price $1.20, and short call with strike price $1.30 d. short spot, long put with strike price $1.20, and short call with strike price $1.30 e. long spot, long put with strike price $1.30, and long call with strike price $1.20 ANS: C MSC: Applied

DIF: Moderate

REF: 7.3

TOP: Financial Engineering

6. The following is NOT a feature of plain vanilla interest rate swap contracts: a. interest rate risk b. counterparty risk c. early termination of the swap with the consent of all counterparties d. existence of swap facilitators e. the Swap Trading Corporation (STC) overseeing all swap transactions ANS: E MSC: Factual

DIF: Easy

REF: 7.4

TOP: An Introduction to Swaps

7. A typical commodity swap involves: a. a payment of the difference between two different commodities’ prices on the expiration date b. an exchange of a fixed payment for the daily average of a commodity’s price over a time period c. an exchange of a fixed payment for a floating payment that depends on one of the counterparty’s fluctuating commodity need during the month d. payments in two different currencies e. None of these answers are correct.

ANS: B DIF: Easy TOP: Applications and Uses of Swaps

REF: 7.5 MSC: Factual

8. The following is NOT a characteristic feature of a plain vanilla interest rate swap: a. cash flows in the same currency b. counterparty risk c. exchange of principal at the beginning and at the end d. a net payment by one of the parties e. notional principal ANS: C MSC: Factual

DIF: Easy

REF: 7.6

TOP: Types of Swaps

9. A plain vanilla forex swap does NOT involve which of the following? a. exchange of principal at the beginning b. exchange back of principal along with interest payments c. cash flows in different currencies d. cash flows at intermediate dates e. more than two counterparties ANS: D

DIF: Easy

REF: 7.6

TOP: Types of Swaps

MSC: Factual 10. A plain vanilla currency swap does NOT involve which of the following? a. an exchange of equivalent amounts in two different currencies on the start date b. a net payment by one of the counterparties c. cash flows in different currencies at intermediate dates d. exchange of interest payments on these two currency loans on intermediate dates e. repayment of the principal amounts on the ending date along with the final period’s interest payments ANS: B MSC: Factual

DIF: Easy

REF: 7.6

TOP: Types of Swaps

Americana Bank has $200 million of excess funds and Britannia Bank has £100 million of excess funds in pound sterling. The spot exchange rate SA is $2 per pound sterling. They enter into a currency swap today that has a tenor of two months. The annual risk-free simple interest rates are i = 4 percent in the United States and iE = 5 percent in the United Kingdom. Cash flows are exchanged at the end of each month.

11. The currency swap begins today with: a. Americana paying $200 million to Britannia and receiving £200 million in return b. Americana paying $200 million to Britannia and receiving £100 million in return c. Americana paying $100 million to Britannia and receiving £100 million in return d. currency swaps have notional principal—no exchange of cash flows takes place today e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 7.6

TOP: Types of Swaps

12. At the end of one month: a. Americana pays £0.4167 million to Britannia and receives $0.6667 million in return b. Americana pays £0.8333 million to Britannia and receives $0.3333 million in return c. Americana pays £0.4167 million to Britannia and receives $0.3333 million in return d. Americana pays £0.8333 million to Britannia and receives $0.6667 million in return e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Easy

REF: 7.6

TOP: Types of Swaps

13. After two months, the swap ends with the following transaction: a. Americana pays £100 million to Britannia and receives $200 million in return b. Americana pays £100.8333 million to Britannia and receives $201.3333 million in return c. Americana pays £100.4167 million to Britannia and receives $200.6667 million in return d. Americana pays £100.4167 million to Britannia and receives $201.3333 million in return e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 7.6

TOP: Types of Swaps

14. Consider a swap between Americana Auto Company (which wants to build an auto plant in the United Kingdom) and Britannia Bus Corporation (which wants to build an auto plant in the United States; both fictitious names): • The automakers enter into a swap with a three-year term on a principal of $200 million.

• The spot exchange rate SA is $2 per pound. Americana raises 100  2 = $200 million and gives it to Britannia, who, in turn, raises £100 million and gives it to Americana.

• Americana pays Britannia at the coupon rate of 4 percent per year on £100 million and Britannia pays Americana at the coupon rate of 5 percent per year on $200 million for three years.

Now assume that the companies make payments every six months: the swap ends after six semiannual payments, and the principals are handed back after three years.

Zero-Coupon Bond Prices in the United States (Domestic Country) and the United Kingdom (Foreign Country) Time to Maturity (in Years)

US (Domestic) Zero-Coupon Bond Prices (in Dollars)

0.5 1 1.5 2 2.5 3

B(0.5) = $0.99 B(1) = $0.97 B(1.5) = $0.95 B(2) = $0.93 B(2.5) = $0.91 B(3) = $0.88

UK (Foreign or European) Zero-Coupon Bond Prices (in Pounds Sterling) B(0.5)E = £0.98 B(1)E = £0.96 B(1.5)E = £0.93 B(2)E = £0.91 B(1.5)E = £0.88 B(3)E = £0.85

Using zero-coupon bond prices (maturing every six months) given above, one can compute the dollar value of this foreign currency swap to Americana as: a. $8.96 b. $12.11 million c. $18.22 million d. $108.13 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Difficult

REF: 7.6

TOP: Types of Swaps

15. A credit default swap (CDS) on a bond with physical delivery is: a. a term insurance policy, with a regular premium payment, that pays the face value of the bond if there is a credit event b. a term insurance policy, with a regular premium payment, that pays the value of the firm’s equity if there is a credit event c. a term insurance policy, with a one time up-front premium, that pays the face value of the bond if there is a credit event d. a term insurance policy, with a one time up-front premium, that pays the value of the firm’s equity if there is a credit event e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

REF: 7.6

TOP: Types of Swaps

16. Suppose that you want to short BUG’s outstanding ten-year, 5 percent coupon bond, but you cannot find anyone willing to lend you the bond (to short). Given that US Treasuries and CDS trade, you can create a short position in BUG’s bond by: a. going long a ten-year CDS on BUG b. going short a ten-year CDS on BUG c. going long a ten-year CDS on BUG and buying a ten-year US Treasury bond d. going long a ten-year CDS on BUG and shorting a ten-year US Treasury bond e. going short a ten-year CDS on BUG and shorting a ten-year US Treasury bond

ANS: D MSC: Applied

DIF: Difficult

REF: 7.6

TOP: Types of Swaps

CHAPTER 8: Forwards and Futures Markets MULTIPLE CHOICE 1. Modern futures trading has most recently descended from: a. derivatives trading in Amsterdam during the Dutch Golden Age b. derivatives trading at Dojima Rice Exchange, Osaka, Japan c. derivatives trading at the Chicago Board of Trade d. derivatives trading at the New York Mercantile Exchange e. derivatives trading at the Chicago Mercantile Exchange ANS: C DIF: Easy REF: 8.3 TOP: A Brief History of Forwards and Futures

MSC: Factual

2. The ten-year period 1972–82 saw amazing developments in the futures marketplace. These developments did NOT include which of the following? a. introduction of the first foreign currency futures b. introduction of the first interest rate futures c. a post-market global electronic transaction system called Globex d. the first cash-settled contract, the Eurodollar futures e. introduction of the first options on futures ANS: C DIF: Easy REF: 8.3 TOP: A Brief History of Forwards and Futures

MSC: Factual

3. Developments in futures markets since 1970 did NOT possess which of the following characteristics? a. the introduction of numerous new futures contracts b. the opening of many new exchanges c. the consolidation and greater linkages among exchanges d. the automation of trading e. a reduction of volatility in the interest rate markets ANS: E DIF: Easy REF: 8.3 TOP: A Brief History of Forwards and Futures

MSC: Factual

4. US futures markets are regulated by the federal regulator a. NFA b. SEC c. CFTC d. FINRA e. NASD ANS: C DIF: Easy REF: 8.3 TOP: A Brief History of Forwards and Futures

MSC: Factual

5. Nobel laureate economist Milton Friedman strongly supported the creation of the first successful financial futures exchange. In this regard, which of the following statements is INCORRECT? a. Friedman saw a need for a trading venue to sell the British pound forward. b. Friedman’s offer to sell pound sterling forward was turned down because he could not post enough collateral. c. Friedman’s offer to sell pound sterling forward was turned down because the banks felt that he did not have the necessary “commercial interest” for dealing in foreign currencies. d. The Chicago Mercantile Exchange chairman Leo Melamed commissioned Friedman to do a study that strongly supported the need for the creation of a futures market in currencies.

e. Friedman did a study and lobbied for the creation of a financial futures exchange by writing letters and issuing supporting statements.

ANS: B DIF: Easy REF: 8.3 TOP: A Brief History of Forwards and Futures

MSC: Factual

6. Gold futures contracts trade for “delivery during the current calendar month; the next two calendar months; any February, April, August, and October falling within a twenty-three-month period; and any June and December falling within a sixty-month period beginning with the current month.” Which contract does NOT trade on January 2, 2013? a. March 2013 b. April 2013 c. June 2014 d. October 2015 e. December 2016 ANS: D DIF: Moderate REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Applied

7. The minimum price fluctuation of a futures contract is called a: a. tick b. spread c. basis d. straddle e. jump ANS: A DIF: Easy REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Factual

8. A limit move in the futures market is: a. a movement of the futures price in either direction equal to the daily price limit b. an order to execute a futures trade only if it touches a certain price c. a movement of the position limit in the futures market d. an extreme movement in the commodity price index which shuts the market down e. None of these answers are correct.

ANS: A DIF: Easy REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Factual

9. Suppose that you have opened a futures position and posted funds with a broker in a margin account.

The minimum level to which a margin account’s value may fall before requiring additional margin is known as the: a. daily margin b. initial margin c. maintenance margin d. profit margin e. variation margin ANS: C DIF: Easy REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Factual

10. The gold futures contract that trades in the CME Group’s COMEX division may be ended by: a. a cash and carry b. an exercise c. a cash settlement

d. an exchange for physical e. daily settlement ANS: D DIF: Moderate REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Factual

11. A trading at settlement futures contract allows a trader to trade anytime during the trading day but get a price that is determined during the day’s close. Suppose that this price is the settlement price determined by computing a volume-weighted average price (VWAP) during the last two minutes of the trading day. A trader plans to manipulate the market by trading on one side of the market earlier in the day and then trading in the opposite direction during the VWAP’s computation period to affect the price to their advantage. Which of the following strategies can she employ? a. selling earlier in the day and then steadily buying during the VWAP computation period to create a higher VWAP price at which the earlier sell is executed b. buying earlier in the day and then steadily selling during the VWAP computation period to create a lower VWAP price at which the earlier buy is executed c. either a or b would work d. neither a nor b would work e. the strategies in a or b only work in conjunction with index arbitrage ANS: C DIF: Difficult REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Conceptual

12. For computing position limits, the following positions are on the same side of the market: a. long call, long put, and long stock b. long call, long put, and short stock c. short call, long put, and short stock d. short call, short put, and long stock e. None of these answers are correct.

ANS: C DIF: Moderate REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Conceptual

13. Which of the following statements is INCORRECT about the settlement price in the futures markets? a. It’s always the last trading price of the day. b. It’s computed for all futures contracts—both active and inactive. c. For actively traded contracts with little price fluctuations, the exchange’s settlement committee picks a settlement price from this closing range, often the last traded price. d. The settlement price is used for the futures position to be marked-to-market. e. For inactive contracts, the settlement committee considers the spreads relative to other futures prices and other relevant information to determine a settlement price.

ANS: A DIF: Moderate REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Factual

14. A clearinghouse does NOT have the following risk: a. credit risk b. market risk c. operations risk d. legal risk e. regulatory risk ANS: B DIF: Easy REF: 8.4 TOP: Futures Contract Features and Price Quotes

MSC: Conceptual

15. Which of the following statements is FALSE? An examination of the Reuters/Jeffries CRB Index reveals that commodity prices: a. stayed at a low level and fluctuated little during 1956–2012 b. exhibited more volatility, but no discernable trend during the 70s, 80s, and 90s c. went up rapidly starting in 2003 and remained at this high level d. went up rapidly starting in 2003 but exhibited large price swings at the new higher level e. went up rapidly starting in 2003, fell again, and never reached back to the 2003 level ANS: A MSC: Factual

DIF: Easy

REF: 8.5

TOP: Commodity Price Indexes

16. Commodity price indexes do NOT have which of the following features? a. These indexes often use futures prices in index computation. b. As these indexes are weighted averages, they typically have a fairly heavy weighting in the energy sector. c. The managers of the index must periodically roll the futures index by replacing the expiring futures with similar new contracts. d. Many financial products have been devised based on these indexes. e. Exchange traded funds (ETFs) are futures that have been devised based on commodity price indexes.

ANS: E MSC: Factual

DIF: Easy

REF: 8.5

TOP: Commodity Price Indexes

17. The bet between professors Julian Simon and Paul Ehrlich involved a derivative that was: a. a collection of forward contracts b. a collection of futures contracts c. a commodity swap contract d. a collection of options on commodities e. a collection of options on forward contracts ANS: A MSC: Factual

DIF: Moderate

REF: 8.5

TOP: Commodity Price Indexes

CHAPTER 9: Futures Trading MULTIPLE CHOICE 1. Which of the following statements is true about floor traders (or locals) in a futures exchange’s trading floor? a. They stand on an exchange floor in trading pits to execute clients’ trades. b. They often band together to form associations to better handle large and complex orders. c. They earn commissions for their service. d. They become counterparties to futures trades. e. They never have inventory risk.

ANS: D DIF: Moderate REF: 9.2 TOP: Brokers, Dealers, and the Futures Industry

MSC: Factual

2. An out-trade in a futures market refers to which of the following? a. a trade executed outside the regular trading hours b. a trade in which the buyer and the seller orders do not match c. a trade that circumvents the competitive process required for a valid transaction d. a transaction that is conducted at a location away from the contract’s stipulated delivery terms e. None of these answers are correct.

ANS: B DIF: Moderate REF: 9.3 TOP: Floor Trading of Futures Contracts MSC: Factual 3. Futures contracts were traditionally traded: a. in pits by open-outcry trading b. on exchange floors in front of a specialist’s trading post c. on exchange floors where accumulated orders were cleared using a market-clearing auction price d. in an over-the-counter market e. on exchange floors via a continuous auction mechanism ANS: A DIF: Easy REF: 9.3 TOP: Floor Trading of Futures Contracts MSC: Factual 4. Which of the following is NOT a valid way of ending a futures contract? a. a closing transaction b. physical delivery c. cash settlement d. an exchange for physicals e. an exercise ANS: E DIF: Easy REF: 9.4 TOP: Entering and Ending a Futures Position

MSC: Factual

5. The following contract is more likely to be closed by an exchange-for-physicals: a. a Treasury bonds futures b. an oil futures c. a gold futures d. an index futures e. a Eurodollar futures

ANS: B DIF: Easy REF: 9.4 TOP: Entering and Ending a Futures Position

MSC: Conceptual

6. Marking-to-market refers to: a. adjusting a futures trading account for the day’s trading gains and losses so that the futures position has a zero value after the adjustment b. issuing a bond with a coupon rate equivalent to the market interest rate c. adjusting a forward’s price so that the forward contract has zero value d. issuing an option with a strike price that is the same as the underlying asset’s market price e. None of these answers are correct.

ANS: A DIF: Easy REF: 9.4 TOP: Entering and Ending a Futures Position

MSC: Factual

7. Suppose that the July gold futures has increased $4 by today’s close. The holder of a long position in three contracts (contract size = 100 oz.): a. will have her margin account increase by $400 today b. will have her margin account decrease by $1,200 today c. will have her margin account increase by $1,200 today d. nothing will happen now, but she will be rewarded in July e. None of these answers are correct.

ANS: C DIF: Easy REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

8. Suppose that the July gold futures prices declined $5 by today’s close. The holder of a short position in two contracts (contract size = 100 oz.): a. will have her margin account increase by $500 today b. will have her margin account increase by $1,000 today c. will have her margin account decrease by $500 today d. will have her margin account decrease by $1,000 today e. None of these answers are correct.

ANS: B DIF: Easy REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

9. Suppose that a futures trader has deposited the initial margin of $2,000 in her brokerage account. The maintenance margin is 75 percent. The value of the account falls to $1,100. The account holder has to come up with a variation margin of: a. $300 b. $400 c. $500 d. $900 e. $1,100 ANS: D DIF: Easy REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

10. Suppose that a futures trader has an initial margin of $2,000 in her brokerage account. The maintenance margin is 75 percent. If the equity in her account falls by $1,200, the account holder has to come up with a variation margin of: a. $300 in cash, or a letter of credit, or short-term Treasury securities b. $300 in cash c. $800 in cash, or a letter of credit, or short-term Treasury securities d. $800 in cash

e. None of these answers are correct.

ANS: D DIF: Easy REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

Use the following data for gold and platinum futures (where prices are in dollars per troy ounce and margin account balances do not earn any interest) to answer the questions that follow: Trading Date Jan 20 Jan 21 Jan 22

June Gold Futures 100 troy oz. per contract 1,594.50 1,592.40 1,597.70

April Platinum Futures 50 troy oz. per contract 1,874.50 1,878.50 1,883.10

11. Suppose that you go short two contracts of April platinum futures on January 20 and long three contracts of June gold on January 21. Then the value of your portfolio at the closing of January 22 has changed by: a. –$230 b. –$100 c. –$100 d. –$730 e. None of these answers are correct.

ANS: D DIF: Difficult REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

12. Suppose that you go short three contracts of April platinum futures on January 20 and long two contracts of June gold on January 21. Then the value of your portfolio at the closing of January 22 has changed by: a. –$230 b. –$100 c. –$100 d. –$730 e. None of these answers are correct.

ANS: A DIF: Difficult REF: 9.5 TOP: Margin Accounts and Daily Settlement

MSC: Applied

13. A forward price can differ from a futures price due to any one the following EXCEPT: a. the two contracts have different commodity price risks b. the two contracts have different credit risks c. the two contracts have different legal risks d. the two contracts have different interest rate risks in the reinvestment of cash flows e. the contracts are structured as different entities—a forward has a terminal cash flow, while futures have daily cash flows ANS: A DIF: Difficult REF: 9.6 TOP: Futures and Forward Price Relations

MSC: Applied

14. The difference between two different maturity futures prices on the same commodity is known as: a. the basis b. the depth c. liquidity d. the strike

e. the spread ANS: E MSC: Factual

DIF: Easy

REF: 9.7

TOP: Trading Spreads

15. The price of a September crude oil futures contract is $20 per barrel, while that of a September gasoline futures contract is $25 per barrel. You expect that in a month, the price difference will reduce to $3 per barrel. A profit generating trading strategy is to: a. long September crude oil futures and short September gasoline futures b. short September crude oil futures and long September gasoline futures c. long September crude oil futures and long September gasoline futures d. short September crude oil futures and short September gasoline futures e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 9.7

TOP: Trading Spreads

16. The price of a September crude oil futures contract is $20 per barrel, while that of a September gasoline futures contract is $25 per barrel. You expect that in a month, the price difference will increase to $10 per barrel. A profit generating trading strategy is to: a. long September crude oil futures and short September gasoline futures b. short September crude oil futures and long September gasoline futures c. long September crude oil futures and long September gasoline futures d. short September crude oil futures and short September gasoline futures e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 9.7

TOP: Trading Spreads

CHAPTER 10: Futures Regulations MULTIPLE CHOICE 1. Successful futures markets are NOT associated with the following feature: a. competitive markets for the underlying commodity b. an ability for the commodity to be sold in standardized units c. volatile commodity prices that change randomly across time in an erratic fashion d. an ability to attract algorithmic traders who supply large trading volumes e. a well-designed structure of margins and daily settlement to hold down credit risk ANS: D DIF: Easy TOP: Which Markets Have Futures?

REF: 10.2 MSC: Factual

2. In July 2003, the US Department of Defense’s research wing DARPA submitted a proposal to Congress to create a “policy analysis market,” which would be a futures market based on terrorist indicators. The policy analysis market a. was discontinued after a month because it attracted very little trading volume b. never got started because the trading mechanism was badly designed c. lost out to other websites that offered the same facilities d. never got started because it received negative publicity e. was designed to help traders protect against terrorist events ANS: D DIF: Easy TOP: Which Markets Have Futures?

REF: 10.2 MSC: Factual

3. Hedging in a futures market does NOT have which of the following features? a. Hedging protects against adverse price swings. b. Hedging requires that the spot and the futures prices are positively correlated. c. Hedging can protect (one’s investment or an investor) against loss by making balancing or compensating contracts or transactions. d. Hedging requires no payment between counterparties due to futures having zero initial value. e. Hedging protects against the downside but allows you to benefit from the upside.

ANS: E DIF: Easy TOP: Which Markets Have Futures?

REF: 10.2 MSC: Factual

4. Which of the following statements is FALSE? a. Many economists believe that speculators generally play a beneficial role in markets by moderating price swings. b. Speculators often play a beneficial role by adding liquidity to the markets. c. In well-functioning futures markets, hedgers buy insurance against adverse price movements and speculators are among the sellers of such insurance, bearing the risk that adverse price movements will not occur. d. Speculators are always detrimental to any market in which they participate. e. In well-functioning markets, speculators can help the process of price discovery.

ANS: D DIF: Moderate TOP: Which Markets Have Futures?

REF: 10.2 MSC: Conceptual

5. Which of the following statements regarding why no futures market exists for diamonds is INCORRECT? a. Diamond sellers, led by South African diamond manufacturing conglomerate De Beers,

have acted as an effective cartel. b. Diamonds are hard to standardize. c. Price volatility is largely controlled by the De Beers–led cartel, which kills any incentive for hedgers and speculators to participate. d. There is no hedging demand from firms using diamonds for jewelry production. e. Given the market structure, a futures contract fails to play a price discovery role in the diamond market.

ANS: D DIF: Easy TOP: Which Markets Have Futures?

REF: 10.2 MSC: Factual

6. Which of the following statements is INCORRECT regarding the oil futures market? a. The organization of the Petroleum Exporting Countries (OPEC) exhibits market power, but it is not the only force affecting oil prices. b. The global business cycle probably plays a more powerful role than OPEC in influencing oil prices. c. Demand from developing countries like China and India can play a significant role in determining oil futures prices. d. The presence of large players like OPEC and China makes it impossible for oil futures contracts to help in price discovery. e. Due to the existence of numerous users and suppliers of oil, oil prices are volatile and oil futures can be successfully used by the hedgers.

ANS: D DIF: Moderate TOP: Which Markets Have Futures?

REF: 10.2 MSC: Factual

7. Which of the following statement is FALSE regarding price discovery in a futures market? a. As futures markets are believed to be semi–strong-form efficient, futures trading generates prices that reflect more information and provide better price forecasts. b. Price discovery has long been justified by regulators as a prime reason for the existence of futures markets. c. Futures markets can help discover prices in manipulated markets. d. Futures markets cannot play their price discovery role in times of extreme market volatility. e. Price discovery makes a futures market useful for planning output and input decisions in the production of goods.

ANS: C DIF: Moderate TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Conceptual

8. Which of the following statements is INCORRECT? a. Futures markets got started in Chicago to help farmers manage price risk. b. Futures on agricultural commodities dominated futures trading in the early years because agriculture constituted a significant portion of the US economy. c. In nineteenth-century Chicago, metal futures could not overtake agricultural futures on corn and wheat because metal prices were fixed by the government. d. Early regulators of futures markets were associated with the US Department of Agriculture because agricultural futures were the most actively traded futures contracts. e. The modern futures contract developed through time as its structure evolved to reflect the economic needs of the market participants.

ANS: C DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

9. The Commodity Futures Trading Commission (CFTC) was established in 1974 to regulate:

a. b. c. d. e.

forward markets futures markets options markets stock markets the libor market

ANS: B DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

10. The Commodity Futures Modernization Act of 2000 (CFMA) led to the creation of the a. CFTC b. NFA c. 35 percent rule d. futures on individual stocks e. Dodd-Frank Wall Street Reform and Consumer Protection Act ANS: D DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

11. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 did NOT have the following feature: a. increased regulation by the SEC and the CFTC b. required central clearing and exchange trading for more derivatives c. required greater market transparency d. additional financial safeguards e. streamlining of regulation through the creation of three types of markets with decreasing amounts of regulation: designated contract markets, derivative transaction execution facilities, and an exempt board of trades ANS: E DIF: Moderate TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

12. The Commodity Futures Trading Commission (CFTC) does NOT consider the following criteria while approving futures trading on a particular commodity: a. usefulness to speculators b. usefulness for price discovery c. usefulness to hedgers d. whether trading in the contract is contrary to the public interest e. manipulation possibilities of the proposed futures contract ANS: A DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

13. Which of the following statements is INCORRECT? a. The CFTC must approve new contracts and changes to existing contracts. b. The CFTC develops rules and regulations that govern the NFA and all futures exchanges. c. The CFTC detects market manipulations but leaves its prevention and prosecution to the Treasury. d. The CFTC does research on futures markets and provides technical assistance to government bodies. e. The CFTC helps coordinate global regulatory efforts.

ANS: C DIF: Moderate TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

14. In the United States, options on futures are regulated by the: a. CFTC b. Fed c. OCC d. SEC e. Treasury ANS: A DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

15. In the United States, options on equity are regulated by the: a. CFTC b. Fed c. OCC d. SEC e. Treasury ANS: D DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

16. Which of the following statements is INCORRECT about the National Futures Association (NFA)? a. The NFA is a self-regulating organization composed of futures commission merchants, commodity pool operators, commodity trading advisers, introducing brokers, leverage transaction merchants, commodity exchanges, commercial firms, and others who work in the futures industry. b. The NFA must approve new contracts and changes to existing contracts. c. The NFA screens and tests registration applicants and determines their qualifications and proficiency. d. The NFA requires futures commission merchants and introducing brokers to keep sufficient capital and maintain good trading records. e. The NFA audits, examines, and conducts financial surveillance to enforce compliance by members.

ANS: B DIF: Easy TOP: Regulation of US Futures Markets

REF: 10.3 MSC: Factual

17. Which of the following was NOT a feature in the three manipulation stories (Great Western, Hunt brothers, Salomon) involving forwards or futures markets? a. There were “shorts” generated in a futures or forward market. b. Shorts were “cornered” because the manipulators took significant control of the deliverable supply. c. Deliverable supply could not be increased without incurring significant additional costs. d. Shorts were forced to pay high prices when they tried to buy the underlying commodity from the manipulator. e. The regulators broke the squeeze by ordering producers to increase their supply.

ANS: E DIF: Easy TOP: Manipulation in Futures Markets

REF: 10.4 MSC: Factual

18. Which of the following is NOT an effective tool in the hands of regulators to fight a short corner and market squeeze? a. forcing the manipulator to quit the market when the short positions mature (liquidation-only trading) b. restricting the manipulator from increasing the size of their position c. limiting the amount of contracts the manipulator can hold (enforce position limits, lower

position limits) unless they are doing it for legitimate hedging purposes d. imposing significant penalties and fines on the manipulators e. ordering producers to produce more to increase the deliverable supply ANS: E DIF: Moderate TOP: Manipulation in Futures Markets

REF: 10.4 MSC: Applied

19. Onion futures are banned in the United States because: a. onions are perishable b. some traders manipulated onion futures during the 1950s, and farmers lobbied to pass legislation banning these contracts because they were prone to manipulation c. onion futures are not useful for price discovery d. onion futures market attracted too many speculators who destabilized prices and destroyed the market e. onion futures are not useful to hedgers ANS: B DIF: Easy TOP: Manipulation in Futures Markets

REF: 10.4 MSC: Factual

20. Which of the following was an unlikely factor that contributed to a spectacular increase in oil prices and volatility in the new millennium? a. A new kind of trader, a commodity index trader, increased activity in the commodity markets. b. A new kind of trader, a swap dealer, increased activity in the commodity markets. c. Day traders increased their trading activity in the spot oil market through exchange-traded funds. d. Lax regulatory oversight allowed many speculators to trade and destabilize energy markets. e. Demand from emerging economies and production squeezes.

ANS: C DIF: Moderate TOP: Managing Commodity Markets

REF: 10.5 MSC: Conceptual

CHAPTER 11: The Cost-of-Carry Model MULTIPLE CHOICE 1. Suppose that today’s price of gold in the spot market is $1,510 per ounce. The price of a zero-coupon bond maturing in six months is $0.98. Then the six-month forward price for gold is: a. $1,515.08 b. $1,531.61 c. $1,540.82 d. $1,550.69 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 11.2

TOP: A Cost-of-Carry Example

2. The current price of BUG stock is $51. The continuously compounded interest rate is 5.25 percent per year. What is the five-month forward price for BUG stock? a. $51.22 b. $51.89 c. $66.31 d. $52.13 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Easy

REF: 11.2

TOP: A Cost-of-Carry Example

3. The current price of YBM stock is $103. The seven-month forward price for YBM stock is $106. If the forward price is determined according to a simple cost-of-carry model, then the continuously compounded interest rate is: a. 3.23 percent per year b. 2.87 percent per year c. 4.92 percent per year d. 5.25 percent per year e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 11.2

TOP: A Cost-of-Carry Example

Today’s spot price of gold is $1,600 per ounce. The continuously compounded interest rate is 5 percent per year. The quoted six-month forward price for gold is $1,650.

4. The arbitrage-free six-month forward price for gold is: a. $1,616.16 b. $1,630.00 c. $1,640.50 d. $1,648.03 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 11.2

TOP: A Cost-of-Carry Example

5. The arbitrage profit that you can make today by trading one forward contract and other securities is: a. $5.08 b. $9.26

c. $8.07 d. $9.38 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 11.2

TOP: A Cost-of-Carry Example

6. The assumptions underlying the cost-of-carry model do NOT include the following: a. no market frictions b. no credit risk c. competitive and well-functioning markets d. constant interest rates e. no arbitrage opportunities ANS: D MSC: Factual

DIF: Easy

REF: 11.3

TOP: The Assumptions

7. If the assumption of “no market frictions” holds, then which of the following is INCORRECT? a. no transactions costs b. no margin requirements c. no short sales restrictions d. no taxes e. no credit risk ANS: E MSC: Factual

DIF: Easy

REF: 11.3

TOP: The Assumptions

8. Suppose that trades now require a transactions cost of $3 per ounce whenever spot gold is traded, a $2 per ounce one-time fee for trading forward contracts, but no charges for trading bonds. If you have to pay transactions costs, the arbitrage profit that you can make today by trading one forward contract and other securities is: a. 0 b. $4.26 c. $2.53 d. $7.53 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 11.4

TOP: The Cost-of-Carry Model

9. Consider two portfolios, A and B. We consider their values today and on some future date, time T. There are no cash flows on intermediate dates. If arbitrage opportunities are ruled out, then which of the following statements is INCORRECT? a. If the portfolios A and B always have the same value at time T, then they must have the same value today. b. If the portfolios A and B have the same value today, then they must always have the same value at time T. c. If we subtract portfolio A from B, and the resulting portfolio always has a zero value at time T, then it must have a zero value today. d. If we subtract portfolio A from B, and the resulting portfolio always has a positive value at time T, then it has a positive value today. e. If we subtract portfolio A from B, and the resulting portfolio has a zero value today, then it need not have a zero value at time T. ANS: B

DIF: Difficult

REF: 11.4

TOP: The Cost-of-Carry Model

MSC: Conceptual 10. Suppose you bought a forward on January 1 that matures a year later. The forward price was $214 at that time and the simple interest rate was 7 percent per year. Six months have passed, and the spot price is now $190. The value of your forward contract today is: a. –$16.76 b. –$3.56 c. 0 d. $16.76 e. None of these answers are correct.

ANS: A DIF: Moderate REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

11. A forward contract that began earlier matures on May 15. The value of the contract is $3, the spot is $100, a zero-coupon bond maturing on May 15 is worth $0.98, and the forward price is $100. The arbitrage profit that you can make today by trading one forward contract and other securities would be: a. 0 b. $1 c. $1.50 d. $3.75 e. None of these answers are correct.

ANS: B DIF: Easy REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

12. Suppose that you trade a forward contract today that matures after one year. The forward price is $105 and the simple interest rate is 7 percent per year. If after six months from today, the spot price is going to be $125 and the value of the forward contract is $20, the arbitrage profit that you can make today by trading one forward contract and other securities is: a. 0 b. $1.56 c. $2.96 d. $3.55 e. None of these answers are correct.

ANS: D DIF: Difficult REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

13. Suppose that the value of a forward contract that you were holding for the last six months is $50 today.

It matures in three more months. If today’s spot price is $97 and the underlying simple interest rate is 5 percent per year, what was the forward price negotiated when you purchased the contract six months back? a. $15.57 b. $38.76 c. $47.59 d. $50.63 e. None of these answers are correct.

ANS: C DIF: Moderate REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

14. Today is January 1. The forward price for a gold forward maturing on April 1 is $1,560 per ounce. The continuously compounded interest rate is 6 percent per year. Then the forward price for a forward contract on gold maturing on July 1 is:

a. b. c. d. e.

$1,529.56 $1,541.08 $1,569.24 $1,583.58 None of these answers are correct.

ANS: D DIF: Difficult REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

15. Today is January 1. The forward price for contracts maturing on April 1 is $103 and on October 1 is $108. On April 1, the price of a zero-coupon bond maturing on October 1 is $0.97. Assuming that the underlying interest rate is a continuously compounded interest rate, the amount of profit that you can make on October 1 by trading one contract each of the near and distant maturity forwards and other securities is: a. $0.50 b. $0.81 c. $1.81 d. $2.98 e. None of these answers are correct.

ANS: C DIF: Easy REF: 11.5 TOP: Valuing a Forward Contract at Intermediate Dates

MSC: Applied

CHAPTER 12: The Extended Cost-of-Carry Model MULTIPLE CHOICE 1. In a simple cost-of-carry model with dollar dividends, we: a. lower the stock price by the present value of all future dividends b. lower the stock price by the present value of all future dividends paid over the forward’s life c. lower the stock price by more than the amount of the dividends due to taxes and transactions costs d. lower the stock price by less than the amount of the dividends due to the signaling effect of dividends e. adjust the quantity of shares held for dividends and not the stock price ANS: B DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Conceptual

2. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months. If the continuously compounded interest rate is 4 percent per year, then the six-month forward price on BUG stock is: a. $49.75 b. $50 c. $50.45 d. $50.76 e. None of these answers are correct.

ANS: D DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

3. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months and $0.30 after five months. If the continuously compounded interest rate is 4 percent per year, then the forward price of a six-month forward contract on BUG is: a. $49.75 b. $50 c. $50.46 d. $50.76 e. None of these answers are correct.

ANS: C DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

4. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months and $0.30 after five months. The continuously compounded interest rate is 4 percent per year. If the six-month forward price is $51, the arbitrage profit that you can make today by trading one forward contract and other securities is: a. 0 b. $0.18 c. $0.41 d. $0.53 e. None of these answers are correct.

ANS: D DIF: Difficult REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

5. BUG’s stock price S is $50 today. It pays a dividend of $0.25 after two months and $0.30 after five months. The continuously compounded interest rate is 4 percent per year. Transactions costs are $0.10 per stock traded, a $0.25 one-time fee for trading forward contracts, and no charges for trading bonds.

If the six-month forward price is $51, the arbitrage profit that you can make today by trading one forward contract and other securities is: a. 0 b. $0.18 c. $0.41 d. $0.53 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

6. The following is NOT an implication of the cost-of-carry relation for valuing a stock index futures contract: a. the futures price depends directly upon the level of the stock market index b. if the stocks in the index increase the level of dividend payments over the life of the futures contract, the futures price will fall, with everything else constant c. if the level of interest rates increases, the futures price will increase, with everything else constant d. if the level of interest rates increases, the futures price will decrease, with everything else constant e. None of these answers are correct.

ANS: D DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Conceptual

7. Assume that interest rates are constant. Given a risk-free rate of 6 percent, a dividend yield of 2 percent, and index level of 1,100, then the stock market index futures price with delivery in 3 months is: a. 1,000.01 b. 1,111.06 c. 1,040.00 d. 10,000.10 e. None of these answers are correct.

ANS: B DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

8. Some index funds modify the index matching strategy to boost performance. Such strategies do NOT include the following: a. investing dividend income to buy stocks in the same proportion as in the index as soon as they arrive b. buying futures instead of stocks when futures are cheaper c. picking up extra income by lending securities d. temporarily holding a bit more of a thinly traded stock than is called for in a benchmark e. buying stocks being added to an index in advance of the effective date of those changes ANS: A DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Factual

9. Which of the following statements is INCORRECT about exchange-traded funds (ETFs)? a. ETFs are securities giving the holder fractional ownership rights over a basket of securities.

b. c. d. e.

ETFs trade on exchanges continuously during trading hours.

ETF trades require brokerage commissions.

ETF shares cannot be shorted.

Arbitrage helps to ensure that an ETF’s price will not move too far from its net asset value.

ANS: D DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Factual

10. Which of the following statements is INCORRECT? a. A stock market index is a hypothetical portfolio formed according to some criteria or rules. b. Most indexes, unlike total return indexes, make no adjustment for regular cash dividends. c. Total return indexes assume that all disbursements from the company including regular dividends get reinvested in the hypothetical index portfolio. d. The cost-of-carry model that has a total return index as the underlying requires dividend adjustments. e. The cost-of-carry model that uses indexes like the Dow Jones Industrial Average and the Standard and Poor’s 500 index requires dividend adjustments.

ANS: D DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Factual

11. Which of the following statements about a stock index is INCORRECT? a. A stock index is a hypothetical portfolio formed according to some criteria or rules. b. A stock index can be sold short. c. A stock index gives a quick sense of the performances of the market or a sector of the economy. d. A stock index provides a benchmark against which performance of fund managers are measured. e. A stock index can be used for creation of derivative products.

ANS: B DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

12. Consider the “SINDY index” obtained by averaging stock prices and a synthetic index “SINDY spot” that replicates its performance. SINDY’s current level I is 11,000 and the synthetic index’s price S is $11,000. Stocks constituting SINDY spot paid $200 in dividends last year and are expected to pay the same this year. Let the continuously compounded interest rate r be 5 percent per year. Then the six-month forward price on a newly written forward contract on SINDY is: a. $10,981 b. $11,176 c. $11,201 d. $11,276 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

13. Consider the “SINDY index” obtained by averaging stock prices and a synthetic index “SINDY spot” that replicates its performance. SINDY’s current level I is 11,000 and the synthetic index’s price S is $11,000. Stocks constituting SINDY spot paid $200 of dividends last year and are expected to pay the same this year. Let the continuously compounded interest rate r be 5 percent per year. If the six-month forward price on a newly written forward contract on SINDY is being quoted in the market for 11,200, then the arbitrage profit that you can make today by trading one contract as well as other securities is:

a. b. c. d. e.

0 $5 $17 $23 None of these answers are correct.

ANS: D DIF: Difficult REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

14. Today’s spot exchange rate SA is $1.30 per euro in American terms. The continuously compounded annual risk-free interest rates are r = 4 percent in the United States (domestic) and rE = 3 percent in the Eurozone. Then a trader using the cost-of-carry model will quote the six-month forward rate in American terms as: a. $1.2107 b. $1.3005 c. $1.3065 d. $1.3508 e. None of these answers are correct.

ANS: C DIF: Easy REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

15. Turkish interest rates are 4 percent per annum, while US interest rates are at 5 percent per annum. The spot exchange rate is 1.75 Turkish lira per US dollar, while the six-month forward price is 1.70 lira per US dollar. The arbitrage profit that you can generate today by trading one six-month forward contract and other securities is: a. $0.057 b. $0.137 c. $0.374 d. $0.574 e. None of these answers are correct.

ANS: A DIF: Moderate REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

16. The spot exchange rate is $0.56 per Brazilian real in American terms. Assume interest rates are continuously compounded. A US dollar invested in Treasury bonds grows to $1.0101 after ninety days. A real invested in risk-free Brazilian government Treasury securities grows to 1.0113 reals at the end of the same time period. A broker offers to trade a ninety-day forward contract to buy or sell 1 million reals at the exchange rate of $0.55 per real. The arbitrage profit that you can make today by trading one forward and other securities is approximately equal to: a. $7,550 b. $9,242 c. $10,546 d. $17,630 e. None of these answers are correct.

ANS: B DIF: Difficult REF: 12.3 TOP: Forwards on Dividend-Paying Stocks

MSC: Applied

17. Alloyum costs $0.10 per month to store (which is paid up front) but gives a convenience yield of $0.12 per month (which is received on the maturity date). If Alloyum’s spot price S is $200 per ounce and the continuously compounded interest rate r is 5 percent per year, then the six-month forward price is: a. $204.96 b. $210.03

c. $205.05 d. $224.93 e. None of these answers are correct.

ANS: A DIF: Moderate TOP: Extended Cost-of-Carry Models

REF: 12.4 MSC: Applied

18. COMIND index is computed by averaging commodity prices. Compute the six-month forward price for this index if the spot price is 1,000 and the continuously compounded annual rates for various costs and benefits are 5 percent for the interest rate, 2 percent for the dividend yield, 3 percent for the storage cost, and 1 percent for the convenience yield. a. $1,021.05 b. $1,025.32 c. $1,030.45 d. $1,040.81 e. None of these answers are correct.

ANS: B DIF: Easy TOP: Extended Cost-of-Carry Models

REF: 12.4 MSC: Applied

19. When the forward price is less than the expected future spot price, we say that the: a. market is in backwardation b. market is in contango c. market is in normal backwardation d. net hedging hypothesis is in effect e. None of these answers are correct.

ANS: C DIF: Moderate REF: 12.5 TOP: Backwardation, Contango, Normal Backwardation, and Normal Contango MSC: Factual 20. A trader can borrow money at 6 percent and lend money at 5 percent, where the interest rates are continuously compounded annual rates. A brokerage commission of 0.5 percent of the stock price is charged today but the broker waives transactions costs on the maturity date. If BUG’s stock price S is $50 today, then the seven-month forward price on BUG’s stock should lie between: a. $51.22 and $52.04 b. $51.47 and $51.78 c. $51.22 and $52.54 d. $51.22 and $51.47 e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 12.6

TOP: Market Imperfections

CHAPTER 13: Futures Hedging MULTIPLE CHOICE 1. Which of the following statements related to a corporation hedging in the real world is INCORRECT? a. Corporations should not hedge because a shareholder can always replicate such policies themselves trading related securities. b. In case a decision is made to hedge, corporations can do it at lower transaction costs than shareholders can. c. A company hedge is often better than a shareholder’s hedge because companies can dedicate competent personnel to hedging. d. A company can hedge by issuing a whole range of securities that individuals cannot create on their own. e. A company can hedge for strategic reasons that may lie beyond an ordinary shareholder’s knowledge.

ANS: A MSC: Factual

DIF: Moderate

REF: 13.2

TOP: To Hedge or Not to Hedge

2. Which of the following statements related to the benefits of corporate hedging using forward and futures contracts is INCORRECT? a. Hedging can enable the locking-in of stable prices and facilitate the planning of production and marketing activities with greater certainty. b. Hedging can permit forward pricing of products. c. Hedging can facilitate the raising of capital. d. Hedging can reduce the risk of default and financial distress. e. Hedging can enable a firm to develop a diverse product line.

ANS: E MSC: Conceptual

DIF: Easy

REF: 13.2

TOP: To Hedge or Not to Hedge

3. An airlines company is unlikely to use the following derivative for risk management: a. a commodity swap b. a credit default swap c. an interest rate swap d. an oil futures contract e. an option on oil futures contract ANS: B MSC: Conceptual

DIF: Easy

REF: 13.2

TOP: To Hedge or Not to Hedge

4. Which of the following statements related to the hedging of fuel price risk by airlines is INCORRECT? a. Fuel is a major cost of the airline business and it can range from 10 percent (in good times) to more than 35 percent (in bad times) of average expenses. b. All airlines hedge price risk of between 75 to 100 percent of their fuel purchase. c. The amount of fuel needs hedged by the airlines has ranged from zero to over 75 percent. d. What Southwest Airlines characterizes as their successful derivatives hedging program was some combination of hedging and speculation that worked well for a time. e. An airline’s decision to charge for checked-in baggage is a natural hedge, because loss of revenue from losing customers is offset by money received from the fees and making airplanes lighter (which are cheaper to fly).

ANS: B

DIF: Moderate

REF: 13.2

TOP: To Hedge or Not to Hedge

MSC: Factual Goldmines Inc. (fictitious name) makes a pretax profit of $150 million when gold prices increase (which happens with probability 0.5) but zero otherwise. Alternatively, the company can hedge with gold futures and have a known profit of $70 million.

5. Assuming a tax rate of 30 percent, the expected after-tax profit for an unhedged firm and the after-tax profit for a hedged firm, respectively, are: a. $52.5 million for the unhedged firm and $49 million for the hedged firm b. $50 million for the unhedged firm and $49 million for the hedged firm c. $50 million for the unhedged firm and $52.1 million for the hedged firm d. $52.5 million for the unhedged firm and $52.1 million for the hedged firm e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 13.2

TOP: To Hedge or Not to Hedge

6. Suppose that Goldmines has accumulated losses totaling $30 million. It can deduct this loss from this year’s profit and thus lower its tax burden. If unutilized, this opportunity disappears. Assuming a tax rate of 30 percent, the expected after-tax profit for an unhedged firm and the after-tax profit for a hedged firm, respectively, are: a. $50 million for the unhedged firm and $49 million for the hedged firm b. $55 million for the unhedged firm and $54 million for the hedged firm c. $57 million for the unhedged firm and $59 million for the hedged firm d. $57 million for the unhedged firm and $58 million for the hedged firm e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Difficult

REF: 13.2

TOP: To Hedge or Not to Hedge

7. The difference between the futures and the spot price is known as: a. the basis b. the depth c. liquidity d. the strike e. the spread ANS: A MSC: Factual

DIF: Easy

REF: 13.3

TOP: Hedging with Futures

8. Let the spot price of gold today be $1,500 per ounce. Jewelry maker Jewelrygold Inc. sets up a buying hedge by going long gold futures. The basis is –$50 today and –$5 on the day the company lifts the hedge by buying gold in the spot market and selling the futures. The company’s effective buying price for gold is: a. $1,505 b. $1,545 c. $1,550 d. $1,555 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 13.3

TOP: Hedging with Futures

9. Suppose that you buy oat to make breakfast cereals and trade oat futures to hedge input price risk.

Your factories are located far from places where oat may be delivered as per contract terms. Your assistant prepares for you the following table based on price changes for oat spot and futures.

Futures Contracts Previous month futures Spot month futures Next month futures Sixth month futures

Correlation of Price Changes 0.79 0.89 0.87 0.71

Variance of Basis 3.20 0.88 0.99 9.80

Which contract would you choose to obtain the best hedge? a. previous month futures b. spot month futures c. next month futures d. sixth month futures e. cannot form a judgment based on above information ANS: C MSC: Applied

DIF: Moderate

REF: 13.3

TOP: Hedging with Futures

10. Hedging with forwards and futures contracts is different due to the nature of the two contracts. Which of the following statements is incorrect in terms of a comparison of the two derivatives? a. Forward contracts are better at reducing legal risk. b. Futures contracts are better at reducing transaction costs. c. Futures contracts are better at reducing credit risk. d. Futures contracts are more standardized. e. Futures contracts are better at reducing liquidity risk.

ANS: A MSC: Conceptual

DIF: Easy

REF: 13.3

TOP: Hedging with Futures

11. Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49, the variance of quarterly changes in a futures price on the commodity is 0.81, and the coefficient of correlation between the two changes is 0.6. The optimal hedge ratio for the contract is: a. 0.10 b. 0.4667 c. 0.5444 d. 0.9 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 13.4

TOP: Risk-Minimization Hedging

12. Suppose that the variance of quarterly changes in the spot prices of a commodity is 0.49, the standard deviation of quarterly changes in a futures price on the commodity is 0.64, and the coefficient of correlation between the two changes is 0.8. The optimal hedge ratio for the contract is: a. 0.771 b. 0.363 c. 0.700 d. 0.875 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Moderate

REF: 13.4

TOP: Risk-Minimization Hedging

13. The variance of monthly changes in the spot price of live cattle is (in cents per pound) is 1.7. The variance of monthly changes in the futures price of live cattle for the April contract is 1.5. The correlation between these two price changes is 0.75. Today is March 11. The beef producer is committed to purchasing 400,000 pounds of live cattle on April 15. The producer wants to use the April cattle futures contract to hedge its risk. How many contracts should the producer buy, if the contract size is 40,000 pounds? a. 5 b. 7 c. 8 d. 11 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Difficult

REF: 13.4

TOP: Risk-Minimization Hedging

14. Kellogg will buy 2 million bushels of oats in two months. Kellogg finds that the ratio of the standard deviation of the change in spot and futures prices over a two-month period for oats is 0.86 and the coefficient of correlation between the two-month change in the price of oats and the two-month change in its futures price is 0.75. How many contracts do they need to hedge their position, if the size of each oats contract is 5,000 bushels, and oat trades in the CME Group? a. 230 b. 258 c. 260 d. 279 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 13.4

TOP: Risk-Minimization Hedging

CHAPTER 14: Options Markets and Trading MULTIPLE CHOICE 1. Government actual usage of derivatives does NOT include which of the following? a. China’s use of put options for defending the value of their currency during the Asian financial crisis of 1997. b. Warrants used as part of the Troubled Asset Relief Program (TARP) by the US government in 2008. c. Use of option pricing models in connection with warrant valuation in TARP. d. The when-issued market for US Treasury securities. e. The callability of US Treasury securities before 1985.

ANS: A MSC: Factual

DIF: Easy

REF: 14.1

TOP: Introduction

2. Option contracts did NOT trade in: a. seventeenth-century Amsterdam, Netherlands b. the Dojima Rice Exchange, Osaka, Japan c. nineteenth-century London, Great Britain d. nineteenth-century New York City, USA e. the Chicago Board Options Exchange, USA ANS: B MSC: Factual

DIF: Easy

REF: 14.3

TOP: A History of Options

3. The following was NOT a characteristic of the financial markets in Amsterdam during the sixteenth and seventeenth centuries: a. clearinghouse facilities b. commodity price manipulation c. credit risk d. foreign exchange transactions e. price transparency ANS: A MSC: Factual

DIF: Moderate

REF: 14.3

TOP: A History of Options

4. The following was NOT associated with Russell Sage’s extensive financial operations during the late nineteenth-century New York: a. a clearinghouse b. dividend adjustments c. dual trading and manipulation d. the importance of collateral e. put–call parity ANS: A MSC: Factual

DIF: Easy

REF: 14.3

TOP: A History of Options

5. Many major developments took place in the exchange-traded options market during 1975–85. They do NOT include the: a. establishment of the Options Clearing Corporation b. introduction of exchange-traded put options c. opening of the Chicago Board Options Exchange d. introduction of exchange-traded currency options

e. introduction of exchange-traded options on bond futures ANS: C MSC: Factual

DIF: Easy

REF: 14.3

TOP: A History of Options

6. The primary function of the Options Clearing Corporation is to: a. regulate all options markets b. act as a clearinghouse for exchange-traded options c. regulate all futures markets d. act as a clearinghouse for various over-the-counter derivatives e. execute option trades ANS: B MSC: Factual

DIF: Easy

REF: 14.3

TOP: A History of Options

7. During the nineteenth and early twentieth century, futures trading in the United States steadily gained acceptance, while options trading stayed in the shady corners of the financial markets and was viewed with suspicion. Which of the following was NOT a reason for this development? a. Futures contracts had a history of being developed to help farmers and purchasers hedge price risk, while options trading had no such justification. b. Options were used for market manipulation. c. Option contracts traded in over-the-counter markets and had substantial legal risk. d. Option contracts were guaranteed by well-capitalized large traders. e. Option contracts were used for speculation in the United States.

ANS: A MSC: Factual

DIF: Easy

REF: 14.3

TOP: A History of Options

8. Suppose the price of gold in the spot market is $1,830 and the price of a call option on gold futures with a strike price of $1,825 is $35 (all prices are per ounce). If you exercise this call option, you get: a. $5 and a long position in gold futures b. $25 and a long position in gold futures c. $30 and a long position in gold futures d. $5 and a short position in gold futures e. $30 and a short position in gold futures ANS: A MSC: Applied

DIF: Moderate

REF: 14.3

TOP: A History of Options

9. Suppose the price of gold in the spot market is $1,830 and the price of a put option on gold futures with a strike price of $1,840 is $55 (all prices are per ounce). If you exercise this put option, you get: a. $10 and a long position in gold futures b. $45 and a long position in gold futures c. $10 and a short position in gold futures d. $30 and a short position in gold futures e. $45 and a short position in gold futures ANS: C MSC: Applied

DIF: Moderate

REF: 14.3

TOP: A History of Options

10. Which of the following is NOT true about exchange-trade equity options that mature in different months? a. They are certificateless securities trading on the CBOE, NYSE Euronext, Eurex, and other exchanges. b. They stop trading on the third Thursday of the expiration month and expire on the

following Friday afternoon. c. Each option contract usually represents rights to 100 shares. d. The option contract is adjusted for cash dividends. e. Their value primarily depends on underlying instrument’s price and standard deviation, time to maturity, strike price, interest rate.

ANS: B MSC: Factual

DIF: Easy

REF: 14.4

TOP: Option Contract Features

Regular equity options that expire each month belong to quarterly “cycles.” For example, IBM has a January cycle, Hewlett Packard has a February cycle, and Wal-Mart has a March cycle. At any time, options trade which expire during the next two months plus the two months after the next three-month quarter quarterly cycle.

11. On February 1, Wal-Mart with a March cycle has options expiring in: a. February, March, April, and May b. February, March, May, June c. February, March, May, June d. February, March, June, August e. February, March, June, September ANS: E MSC: Applied

DIF: Easy

REF: 14.4

TOP: Option Contract Features

12. On February 28, IBM, with a January cycle, has options expiring in: a. February, March, April, and July b. March, April, May, June c. March, April, July, September d. March, April, July, October e. March, April, July, December ANS: D MSC: Applied

DIF: Easy

REF: 14.4

TOP: Option Contract Features

13. Strike price intervals for equity options are set at $2.50 intervals when the stock price is between $5 and $25, $5 intervals when the stock price is between $25 and $200, and $10 intervals when the stock price is over $200. Consider a stock that had an initial public offering price of $19, which then rose and closed at its highest level $26 at the end of the day. Which full set of strike price options are traded? a. $15, $20, $25, and $30 b. $17.50, $20, $22.50, $25, and $30 c. $17.50, $20, $22.50, $25, $27.50, and $30 d. $20, $22.50, $25, and $30 e. $20, $25, $30, and $35 ANS: B MSC: Applied

DIF: Moderate

REF: 14.4

TOP: Option Contract Features

14. Buyers of options maturing in more than nine months can borrow up to 25 percent of the purchase price, while buyers of shorter maturity options must keep the full purchase price in their margin accounts. If you are buying two contracts of a put option maturing in six months for $6 and three contracts of a call option maturing in ten months for $4, then the minimum amount that you must keep in the margin account is: a. $900 b. $1,200

c. $2,100 d. $2,400 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 14.4

TOP: Option Contract Features

15. State the dollar amount of margin you are required to keep with a broker when selling two call options on Your Beloved Machine with strike price $105 when the current stock price of YBM is $104, the call price is $4, and each call is on 100 shares. The rule for margin (borrowing) requirement for option writing as set by the Federal Reserve Bank is as follows: for writers of call options on equity and “narrow-based index,” the margin account initial requirement is 100 percent of option proceeds plus 20 percent of underlying security/index value less out-of-the-money amount, if any, to a minimum of option proceeds plus 10 percent of underlying security/index value for calls. a. $2,080 b. $2,880 c. $4,160 d. $4,760 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Difficult

REF: 14.4

TOP: Option Contract Features

16. For computing position limits, the following positions are considered to be on the same side of the market: a. long call and long put with the same strike price b. short call and long put c. short call and short put d. short call and a long call with a higher strike price e. None of these answers are correct.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 14.4

TOP: Option Contract Features

17. Peter owns two call options on Your Beloved Machine that expire on the third Friday of March and have an exercise price of $90. After a 3 for 1 split, he holds YBM March calls. a. 2, 60 b. 2, 90 c. 6, 90 d. 6, 30 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Easy

REF: 14.4

TOP: Option Contract Features

18. Your Beloved Machine’s current stock price is $96. If YBM December 90 calls trade for $6 and the stock has a 3 for 2 split, then the following will happen: a. an investor holding two shares now owns three shares, the new share price is $64, the new strike price is $60, and each contract has 150 shares b. an investor owns the same number of shares, the new share price is $64, the new strike price is $60, and each contract has 100 shares c. an investor holding two shares now owns three shares, the new share price is $144, the new strike price is $60, and each contract has 66 shares d. an investor holding two shares now owns three shares, the new share price is $60, the new strike price is $60, and each contract has 150 shares

e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 14.4

TOP: Option Contract Features

19. Market manipulation cases involving options do NOT include the following: a. buying out-of-the money options and simultaneously buying the underlying shares to artificially increase the stock price so that the options end up in-the-money b. the dividend play strategy (or dividend spread arbitrage strategy) c. dual trading abuses d. option pools and stock price manipulation e. the tulip bulb price bubbles ANS: B DIF: Moderate REF: 14.7 TOP: Regulation and Manipulation in Options Markets

MSC: Factual

CHAPTER 15: Option Trading Strategies MULTIPLE CHOICE 1. Which of the following statements regarding Warren Buffett’s views and experiences with derivatives is INCORRECT? a. Buffett has characterized derivatives as “time bombs, both for the parties that deal in them and the economic system.” b. Buffett declared that all derivatives should be outlawed. c. Under chairman Buffett’s supervision, Berkshire Hathaway has written more than 200 long maturity derivatives on major indexes. d. Buffett sold derivatives because he felt that these contracts were “mispriced at inception, sometimes dramatically so” and viewed them as similar to arbitrage opportunities. e. Buffett’s company is extensively involved in reinsurance—activities that are similar to trading put options.

ANS: B DIF: Moderate REF: 15.2 | 15.7 TOP: Traders in Options Markets | Spread Strategies

MSC: Factual

2. Suppose you write a covered put option by depositing a cash amount equal to the strike price in your brokerage account. Then which of the following statements is INCORRECT? a. This is a covered strategy. b. This is a hedged strategy. c. This is a put writing strategy. d. This is similar to a short put strategy. e. This is an uncovered strategy.

ANS: E MSC: Conceptual

DIF: Moderate

REF: 15.5

TOP: Options Strategies

3. Suppose you both short a call option and long a put option. Both these European options are on the same underlying stock and have the same strike price and expiration date. You have created a: a. short forward b. long forward c. long option d. long stock e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Easy

REF: 15.5

TOP: Options Strategies

4. A European call on OPSY stock with a strike price of $22.50 is worth $1.75. Let the present value of the strike price be $22.25. A European put on the stock with identical terms is worth the same. If the price of OPSY stock is $22, the arbitrage profit that you can create today by trading the stock and other related securities is: a. $0.25 b. $0.50 c. $0.75 d. $1 e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Easy

REF: 15.5

TOP: Options Strategies

5. To insure a stock, we generally combine: a. a short call with a long stock b. a long call with a long stock c. a short put with a long stock d. a long put with a long stock e. a long futures with a long stock ANS: D MSC: Conceptual

DIF: Easy

REF: 15.6

TOP: Hedged Strategies

6. Suppose you have sold short YBM. To hedge this trade so as to “keep the upside” while “protecting the downside,” you should add to your portfolio: a. a short call on YBM b. a long call on YBM c. a long futures on YBM d. a short futures on YBM e. a long put on YBM ANS: B MSC: Applied

DIF: Moderate

REF: 15.6

TOP: Hedged Strategies

7. Which of the following statements is INCORRECT about covered call writing? a. Covered call writing is known as a buy-write if one simultaneously buys the stock and sells the call, but it’s an overwrite if one sells the call after purchasing the share. b. The Chicago Board Options Exchange’s S&P 500 BuyWrite Index (BXM) is a benchmark for measuring the performance of covered call writing strategies. c. Covered call writing is considered a speculative strategy whose objective is to beat the market. d. Covered call writing is considered a hedge strategy. e. Many traders write covered calls to generate extra income.

ANS: C MSC: Conceptual

DIF: Moderate

REF: 15.6

TOP: Hedged Strategies

8. Identify the INCORRECT statement about spread strategies created by trading options of the same type (either all calls or all puts) on the same underlying with identical terms (unless noted otherwise): a. Vertical spreads (also called money, perpendicular, or price spreads) are established by buying one option and selling another option with a different strike price. b. Horizontal spreads (or, time or calendar spreads) are established by buying one option and selling another option with the same strike but different maturity dates. c. Diagonal spreads are established by buying one option and selling another option that differ both in terms of strike price and maturity dates. d. A butterfly spread is created by trading four options with three different strike prices: two options with extreme strike prices are bought (written) and two options are written (bought) with the middle strike price. e. A condor spread is created by trading four options with three different strike prices: two options with extreme strike prices are bought (written) and two options are written (bought) with the same middle strike price.

ANS: E MSC: Factual

DIF: Easy

REF: 15.7

TOP: Spread Strategies

9. If the market goes up, you want to make a small profit; if it goes down, you want to make a small loss.

How would you create such a “spread” strategy by trading some of the following options?

Stock Price 29 29 a. b. c. d. e.

Strike 25 30

Expiration Month May May

Call Price 5 2

Put Price 1 3

long May 25 call and short May 30 call long May 30 put and short May 25 put long May 30 call and short May 25 call long May 30 call and long May 25 put None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

10. The price of a long position of a stock in your portfolio is $20. You decide to buy a put with a strike price of $17.50 worth $2 and sell a call with a strike price of $22.50 also worth $2. Then you have created: a. a zero-cost collar b. a bear spread c. a covered call d. a butterfly spread e. a straddle ANS: A MSC: Applied

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

11. Which of the following statements is INCORRECT about the risks that an insurer faces? a. Insurance businesses have been successful through the centuries because insurers are skillful in finding natural hedges. b. Insurance companies employ actuaries who calculate the likelihood of loss events and fair premiums for insuring risks. c. Actuaries cannot foretell whether any particular insured entity will suffer a loss, but they can estimate with reasonable accuracy the expected losses in a large population. d. Insurers try to manage risks by diversifying their losses across a large number of policyholders with the hope that the law of large numbers holds. e. Insurance companies often hedge their losses on catastrophic events by purchasing reinsurance.

ANS: A MSC: Factual

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

CatIns Corp. (a fictitious name) sells homeowners’ insurance contracts to homes along the shores of the Gulf of Mexico. The contract provides protection against hurricanes and has the following features: • • • •

Annual premium $20,000.

Fixed deductible $10,000.

Maximum coverage amount $400,000 (which is less than the value of each home).

The contract pays for losses from one hurricane in a given year.

Assume that if a hurricane hits, it does the same dollar damage to all homes covered by the insurance policy.

12. If a hurricane hits, the maximum amount that the insurance company CatIns can lose per home in a given year would be: a. $275,000

b. c. d. e.

$300,000 $370,000 $380,000 None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 15.7

TOP: Spread Strategies

13. Suppose that the insurance company CatIns buys reinsurance that pays for hurricane losses to a home over $150,000 for a premium of $5,000 payable to a reinsurance company. If the company has insured 200,000 homes, the maximum amount that CatIns can lose would be: a. $12.5 billion for “Loss per home” of $100,000 or more b. $15 billion for “Loss per home” of $150,000 or more c. $25 billion for “Loss per home” of $150,000 or more d. $35 billion for “Loss per home” of $200,000 or more e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

14. Suppose that the insurance company CatIns buys reinsurance that pays for hurricane losses to a home over $150,000 for a premium of $5,000 payable to a reinsurance company. Then the profit diagram for CatIns would be similar to: a. a bearish call spread on the hurricane losses b. a bullish call spread on the hurricane losses c. a butterfly spread on the hurricane losses d. a condor spread on the hurricane losses e. None of these answers are correct.

ANS: A MSC: Conceptual

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

15. An insurance company has insured oil fields in the Mideast (which includes Iran, Iraq, Kuwait, Saudi Arabia, and United Arab Emirates). Next, it purchases reinsurance to manage its “tail risk.” The reinsurance company decides to hedge some of its risks by trading derivatives. In this context, which derivative trade is unlikely to be effective? a. buy oil futures b. buy call options on oil futures c. sell oil futures d. sell put options on oil futures e. enter into a commodity swap where the insurance party receives an average oil price in exchange for a fixed rate payment ANS: C MSC: Conceptual

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

16. Goldminers Inc. mines and refines ore and sells pure gold in the global market. To raise funds, it sells a derivative security whose payoff is as follows: •

Part of the security is a zero-coupon bond (which is sold at a discount and makes no interest payments) that pays a principal of $1,000 at maturity T. • Goldminers also pays an additional amount that is indexed to gold’s price (per ounce) at maturity S(T): 0

if S(T)  $1,550

20[S(T) – 1,550] if $1,550<S(T) $1,600 1,000 if $1,600<S(T).

This derivative can be written as a combination of: a. (1) a long zero-coupon bond with face value $2,000, (2) long 20 European puts with strike price $1,600, and (3) short 20 European puts with strike price $1,550 b. (1) a long zero-coupon bond with face value $2,500, (2) short 20 European puts with strike price $1,600, and (3) long 20 European puts with strike price $1,550 c. (1) a long zero-coupon bond with face value $1,000, (2) long 20 European calls with strike price of $1,550, and (3) short 20 European calls with strike price $1,600 d. (1) a long zero-coupon bond with face value $1,500, (2) long 20 European calls with strike price of $1,550, and (3) short 20 European calls with strike price $1,600 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

Use the following data for a fictitiously named company OPPS to answer the questions that follow: — — — —

The current stock price S is $23.

The time to maturity T is six months.

The continuously compounded, risk-free interest rate r is 5 percent per year.

European option prices are given in the following table:

Strike Price K1 = $17.5 K2 = 20 K3 = 22.5 K4 = 25

Call Price 6.00 4.00 2.00 1.00

Put Price 0.10 0.50 1.00 2.50

17. You buy a call option with strike price K2 = 20 and sell a call option with strike price of K3 = 22.5.

Then which of the following statements is INCORRECT? a. You have set up a call spread. b. You have set up a bullish spread. c. The derivative has zero-profit when the stock price at expiration is $21.5. d. The maximum loss is –$2 for a stock price at expiration less than or equal to $20. e. The maximum profit is $0.5 for a stock price at expiration greater than or equal to $22.5.

ANS: C MSC: Applied

DIF: Moderate

REF: 15.7

TOP: Spread Strategies

18. Suppose you go long one call with a strike price K1 = 17.50, sell one call with K2 = 20, sell one call with K3 = 22.5 and buy one call with K4 = 25. Then which of the following statements is INCORRECT? a. You have set up a condor spread. b. You have set up a trade that bets on the volatility being low. c. The portfolio has zero-profits when the stock price at expiration is $18.5 and $24. d. The maximum loss is –$1. e. The maximum profit is $2.

ANS: E MSC: Applied

DIF: Difficult

REF: 15.7

TOP: Spread Strategies

19. Suppose you buy a call and a put with a strike price of $20. Then which of the following statements is INCORRECT? a. You have set up a straddle. b. You have set up a trade that bets on the volatility being low. c. The portfolio has zero-profits when the stock price at expiration is $15.5 and $24.5. d. The maximum loss is –$4.50. e. The maximum profit is unbounded.

ANS: B MSC: Applied

DIF: Easy

REF: 15.8

TOP: Combination Strategies

20. Suppose you buy a call with strike price K3 = 22.50 and a put with strike price K2 = 20. Then which of the following statements is INCORRECT? a. You have set up a strangle. b. You have set up a trade on the expectation that the volatility will be high. c. The portfolio has zero-profits when the stock price at expiration is $17.5 and $25. d. The maximum loss is –$2.50. e. The maximum profit is $17.5.

ANS: E MSC: Applied

DIF: Moderate

REF: 15.8

TOP: Combination Strategies

21. YBM has made an offer to buy Hot Products Inc. (HOP; a fictitious name) at $60 per share. The current price of HOP is $50. If the deal fails, HOP stock price will go down below $40 per share.

Suppose you decide to obtain some trading profits by creating a straddle. You find that an call has a price of $4 and an put has a price of $3; both options have a strike price of $50 and expire in three months. If you set up a straddle, then you trade: a. a long call and a short put b. a long call and a long put c. a short call and a long put d. a short call and a short put e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 15.8

TOP: Combination Strategies

CHAPTER 16: Option Relations MULTIPLE CHOICE 1. Consider a stock that pays no dividends whose value equals the strike price of a call and put with identical contract terms on the stock. Interest rates are positive. Then, which of the following is true? a. the call price must equal the put price b. the call price will be greater than the put price c. the call price will be less than the put price d. the call price will be less than or equal to the put price e. None of these answers are correct.

ANS: B DIF: Moderate REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

2. Consider a call and a put written on a stock that pays no dividends. If the interest rate is positive and the options have the same price and identical contract terms, then which of the following is true? a. stock price = strike price b. stock price is greater than the strike price c. stock price is greater than or equal to the strike price d. stock price is less than the strike price e. need more information ANS: D DIF: Moderate REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

3. The current price of YBM stock S is $101. European options with a strike price K = $100 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. If the call price c is $7.50, the put price p is: a. $4.03 b. $5.03 c. $5.60 d. $6.75 e. None of these answers are correct.

ANS: A DIF: Easy REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

4. The current price of YBM stock S is $101. European options with a strike price K = $100 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. If the put price p is $2.70, then the call price c is: a. $4.03 b. $5.17 c. $6.17 d. $8.03 e. None of these answers are correct.

ANS: C DIF: Easy REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

5. The current price of YBM stock S is $101. European options with a strike price K = $100 and maturing in T = 6 months trade on YBM. If the call price c is $8.07 and the put price p is $3.63, then the annual continuously compounded risk-free interest rate r is:

a. b. c. d. e.

4.55 percent 6 percent 6.65 percent 7 percent None of these answers are correct.

ANS: D DIF: Moderate REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

6. The current price of YBM stock S is $101. European options with a strike price K = $100 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. If the call price c is $7.50 and the put price p is $4.60, then the arbitrage profits that you can make today by trading one contract of each option (one contract is based on 100 shares) are: a. 0 b. $57 c. $112 d. $198 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 16.3 TOP: Put-Call Parity for European Options MSC:

Applied

7. The following is NOT an example of tax or regulatory arbitrage: a. STRIPS (Separate Trading of Registered Interests and Principal of Securities) program of the US Treasury b. Russell Sage using put-call parity to go around New York’s usury laws that set a maximum amount that a lender could charge borrowers c. using an equity swap to invest in a security market where some investors (such as foreigners) are prohibited from investing d. creation of Eurodollars to overcome Regulation Q, which put a ceiling on the maximum interest rate that US banks could pay their depositors e. using a currency swap or an equity swap to invest in a security market where some investors (such as foreigners) are prohibited from investing ANS: A MSC: Conceptual

DIF: Moderate

REF: 16.4

TOP: Market Imperfections

8. The following can be incorporated into an adjusted put-call parity (still an equality) for European options: a. known dividends b. short-selling restrictions c. transactions costs (such as brokerage commissions, bid and ask prices, and price impact of trades) d. taxes e. lack of perfectly divisibility of assets ANS: A MSC: Factual

DIF: Easy

REF: 16.4

TOP: Market Imperfections

9. The current price of YBM stock S is $101. European options with a strike price K = $100 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. A dividend of $1.10 is paid out after three months. If the put price p is $4.03, the call price c is: a. $5.25 b. $6.41 c. $7

d. $7.49 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 16.4

TOP: Market Imperfections

10. The current value of INDY index is 1,015 and a portfolio replicating this index has a value of $1,015.

European options with a strike price K = $1,000 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. The stocks underlying INDY index have a dividend yield  = 1.2 percent per year. A trader quotes a call price c = $80 and a put price p = $37. Then, the amount of arbitrage profits that you can make by trading securities based on one share of INDY are: a. 0 b. $3.31 c. $6.07 d. $9.38 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Difficult

REF: 16.4

TOP: Market Imperfections

11. The current price of YBM stock S is $101. American options with a strike price K = $100 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. If the American put price pA is $2.70, then the American call price cA will attain or lie between: a. $3.70 and $6.17 b. $6.50 and $7.50 c. $7 and $7.50 d. $6 and $8.83 e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 16.4

TOP: Market Imperfections

12. Suppose p is the current price of a European put and pA is that for an American put, where the two options have identical terms and conditions and differ only in terms of the early exercise feature. If B = $0.96 is today’s price of a zero-coupon bond that matures on the option’s expiration date and K = $50 is the strike price, then the following statement is correct: a. p  $50 and pA  48 b. p  $24 and pA  25 c. p  $48 and pA  50 d. p  $48 and pA  48 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 16.5

TOP: Options Price Restrictions

13. Suppose c and p are the current prices of a European call and put, while cA and pA are those corresponding to American options. If today’s price of the stock underlying the options is S, a zero-coupon bond that matures on the common expiration date for the options is B, and the common strike price is K, then the following statement is INCORRECT: a. c  max(S − BK, 0) b. cA  max(S − BK, 0) c. c  max(BK − S, 0)

d. p  max(BK − S, 0) e. pA  max(K − S, 0) ANS: C MSC: Applied

DIF: Moderate

REF: 16.5

TOP: Options Price Restrictions

14. Consider options that are otherwise identical. Then, the following statement is INCORRECT: a. the longer the time until expiration, the greater the price of a European put b. the lower the strike price, the more valuable the European call c. the higher the strike price, the more valuable the European put d. the longer the time until expiration, the greater the price of an American call e. the longer the time until expiration, the greater the price of a European call ANS: A MSC: Conceptual

DIF: Easy

REF: 16.5

TOP: Options Price Restrictions

15. Consider options that are identical in all respects except for the differences that are mentioned. Then which of the following statements is INCORRECT? a. The difference in American call prices cannot exceed the difference in exercise prices. b. The price difference between two European puts cannot exceed the difference in exercise prices. c. The longer the time until expiration, the less valuable an American put is. d. Before expiration, an American put must be worth at least the exercise price less the stock price. e. Before expiration, a call option must be worth at least the stock price less the present value of the strike price.

ANS: C MSC: Conceptual

DIF: Difficult

REF: 16.5

TOP: Options Price Restrictions

16. Consider options that are identical in all respects except for the differences that are mentioned. Then which of the following statements is INCORRECT? a. Exercise an American call the first time its price is equal to the stock price minus the strike price. b. Exercise an American put the first time its price is equal to the strike price minus the stock price. c. Exercise an American put early when the stock price is small enough relative to the strike price with consideration for the time to maturity. d. Never exercise early an American call on a stock that pays no dividends over the option’s life. e. The only times when it may be optimal to exercise early an American call would be just after the stock goes ex-dividend.

ANS: E DIF: Easy REF: 16.6 TOP: Early Exercise of American Options

MSC: Factual

17. A cash dividend lowers the value of: a. a cash-protected American call b. a cash-protected American put c. an exchange-traded American call d. an exchange-traded American put e. an exchange-traded European put ANS: C DIF: Moderate REF: 16.6 TOP: Early Exercise of American Options

MSC: Conceptual

18. In the absence of cash dividends, you may exercise the following option early: a. an American put option b. an American call option c. a European put option d. a European call option e. None of these answers are correct.

ANS: A DIF: Easy REF: 16.6 TOP: Early Exercise of American Options

MSC: Conceptual

19. Which of the following statements is INCORRECT? a. American and European calls on a non-dividend stock always have the same value. b. American and European puts on a non-dividend stock always have the same value. c. An American put may be exercised early when the stock gets close enough to zero. d. An American put is more likely to be exercised after the stock goes ex-dividend, rather than before the stock goes ex-dividend. e. An American call is more likely to be exercised before the stock goes ex-dividend, rather than after the stock goes ex-dividend.

ANS: B DIF: Moderate REF: 16.6 TOP: Early Exercise of American Options

MSC: Conceptual

20. It may make sense to exercise early an American call option (like the ones that trade in the Chicago Board Options Exchange) just before the time of: a. a stock dividend payment b. a stock split c. a reverse stock split d. a cash dividend payment e. None of these answers are correct.

ANS: D DIF: Easy REF: 16.6 TOP: Early Exercise of American Options

MSC: Conceptual

21. Given strictly positive interest rates and an underlying stock that pays no dividends, the best way to close out a long American call option position early is to: a. exercise the call b. sell the call c. buy the call d. exchange for a physical e. None of these answers are correct.

ANS: B DIF: Easy REF: 16.6 TOP: Early Exercise of American Options

MSC: Conceptual

CHAPTER 17: Single-Period Binomial Model MULTIPLE CHOICE 1. Which of the following statements is INCORRECT about the Troubled Asset Relief Program (TARP) of the US government during the financial crisis of 2007–09? a. TARP used nearly $700 billion to support banks with troubled assets. b. The Treasury purchased preferred shares from banks and injected funds into these financial institutions. c. The banks also issued warrants that allowed the government to buy the company’s shares at a predetermined price over a ten-year period. d. After the banks recovered, the US government sold these warrants back to the banks or to others at a “fair price” determined with the help of the Black-Scholes-Merton and binomial models. e. Like most other government policies, TARP was a failure and cost the government significantly more than the amount that was originally estimated.

ANS: E MSC: Factual

DIF: Easy

REF: 17.1

TOP: Introduction

2. Which of the following statements is INCORRECT about the binomial option pricing model? a. The binomial model is popular because it is accessible and easy to understand. b. The binomial model gives more accurate results than the Black-Scholes Merton model. c. The binomial model is a useful teaching tool. d. The binomial model is a versatile model that can price a variety of derivatives. e. The binomial model illustrates the main tenets of martingale pricing, the key technique that lies at the heart of derivative pricing.

ANS: B MSC: Factual

DIF: Easy

REF: 17.1

TOP: Introduction

3. Which of the following statements is INCORRECT about the binomial option pricing model? a. The binomial model had been used as a teaching tool at MIT and other places before its publication. b. The binomial model was first printed in Sharpe’s classic textbook Investments. c. Cox, Ross, and Rubinstein; Rendleman and Bartter; and Jarrow and Rudd developed popular versions of the binomial model. d. The binomial model is accurate because in the real world, stock price usually goes up or down with only two possible values. e. Unlike the cost-of-carry models which can be priced with the help of the “no-arbitrage principle” alone, option-pricing models need an explicit assumption about the evolution of stock prices.

ANS: D DIF: Moderate REF: 17.2 TOP: Applications and Uses of the Binomial Model

MSC: Conceptual

4. The model that was the first true ancestor of modern option-pricing models was developed by: a. Louis Bachelier b. James Boness c. Paul Samuelson d. Case Sprenkle e. Edward Thorp and Sheen Kassouf ANS: A

DIF: Easy

REF: 17.3

TOP: A Brief History of Options Pricing Models

MSC: Factual

5. Which of the following was NOT a key insight that helped Fischer Black, Myron Scholes, and Robert Merton formulate their 1973 option pricing model? a. adjustment for known dollar dividends b. the lognormal distribution for stock prices c. the no-arbitrage principle d. hedging an option with a stock and the creation of a “perfect hedge” e. the focus on a stock’s price return’s volatility as opposed to measuring a risk-premium ANS: A DIF: Easy REF: 17.3 TOP: A Brief History of Options Pricing Models

MSC: Factual

6. The following was NOT a major development in the history of option pricing: a. the Black-Scholes-Merton model for pricing European options b. the James-Jones model for dollar dividend adjustment c. the Merton and Jarrow-Turnbull models for pricing derivatives with credit risk d. Harrison-Kreps and Harrison-Pliska’s martingale pricing methodology e. Vasicek, Ho-Lee, and the Heath-Jarrow-Morton (HJM), and HJM Libor models ANS: B DIF: Easy REF: 17.3 TOP: A Brief History of Options Pricing Models

MSC: Factual

USe the following data for a single-period binomial model to answer the questions that follow.

YBM’s stock price S is $102 today.

— After six months, the stock price can either go up to $115.63212672, or go down to $93.52995844.

— Options mature after T = 6 months and have an exercise price of K = $105.

— The continuously compounded risk-free interest rate r is 5 percent per year.

7. Given the above data, the pseudo-probability of an up movement and the discounted expected stock price using the pseudo-probabilities are given by: a. 0.50 for the pseudo-probability and 100 for the stock price b. 0.50 for the pseudo-probability and 102 for the stock price c. 0.45 for the pseudo-probability and 102 for the stock price d. 0.45 for the pseudo-probability and 105 for the stock price e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 17.4

TOP: An Example

8. Given the above data, the hedge ratio and the call option’s value are given by: a. 0.2523 for the hedge ratio and $4.1853 for the call option’s value b. 0.3810 for the hedge ratio and $5.5557 for the call option’s value c. 0.4810 for the hedge ratio and $5.1853 for the call option’s value d. 0.5810 for the hedge ratio and $6.2543 for the call option’s value e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 17.4

TOP: An Example

9. Given the above data, suppose that a trader quotes a call price of $6. Then the arbitrage profit that you can make today by trading this call and related securities is: a. $0 b. $0.25 c. $0.81 d. $1.22 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 17.4

TOP: An Example

10. Given the above data, the hedge ratio and the put option’s value are given by: a. −0.2523 for the hedge ratio and $2.35 for the put option’s value b. 0.2523 for the hedge ratio and $4.81 for the put option’s value c. 0.5190 for the hedge ratio and $5.59 for the put option’s value d. −0.5190 for the hedge ratio and $5.59 for the put option’s value e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Moderate

REF: 17.4

TOP: An Example

11. Given the above data, suppose that a trader quotes a put price of $5. Then the arbitrage profit that you can make today by trading this call and related securities is: a. $0 b. $0.33 c. $0.59 d. $1.54 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 17.4

TOP: An Example

Use the following data for a single-period binomial model to answer the questions that follow.

— The stock’s price S is $50. After three months, it either goes up by the factor U = 1.16038286 or it goes down by the factor D = 0.85963276.

— Options mature after T = 0.25 years.

— The continuously compounded risk-free interest rate r is 4 percent per year.

12. Given the above data, the value of a call option with a strike price of $45 is: a. $1.65 b. $3.45 c. $6.45 d. $7.08 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 17.4

TOP: An Example

13. Given the above data, consider an exotic option whose payoff at expiration is given by the stock price S(1) squared less a strike price (K = $2,500) if it has a positive value, zero otherwise, that is: max[S(1)2 − 2500, 0].

The value of this exotic option is given by: a. $350.06

b. c. d. e.

$428.92 $451.92 $676.50 None of these answers are correct.

ANS: B MSC: Applied

DIF: Moderate

REF: 17.4

TOP: An Example

14. Given the above data, consider an exotic option whose payoff at expiration is given by the stock price S(1) squared less a strike price (K = $2,500) if it has a positive value, zero otherwise, that is: max[S(1)2 − 2500, 0].

Suppose a trader quotes a price of $450 for this option. Then you can make an immediate arbitrage profit of: a. $21.08 by selling the traded call and buying the synthetic call involving buying 57.60 shares of stock and selling 2,451.28 units of the money market account b. $226.50 by buying the traded call and selling the synthetic call involving selling 90.85 shares of stock and buying 3,866.21 units of the money market account c. $50 by buying the traded call and selling the synthetic call involving selling 60.54 shares of stock and buying 2,321.21 units of the money market account d. $337.76 by selling the traded call and buying the synthetic call involving buying 16.74 shares of stock and selling 641.35 units of the money market account e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Difficult

REF: 17.4

TOP: An Example

15. Given the above data, consider an exotic option whose payoff at expiration is given by the square root of the stock price less the strike price (K = $6) if it has a positive value, zero otherwise, that is: max[S(1) − 6, 0].

The value of this exotic option is given by: a. $0.55 b. $0.89 c. $1.08 d. $1.55 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Difficult

REF: 17.4

TOP: An Example

16. The following is NOT an assumption underlying the binomial option pricing model: a. no market frictions b. no credit risk c. competitive and well-functioning markets d. no interest rate uncertainty e. stock prices follow a lognormal process ANS: E MSC: Factual

DIF: Easy

REF: 17.5

TOP: The Assumptions

17. Which of the following is an INCORRECT step in pricing an option by the no-arbitrage principle in a single-period binomial framework? a. We consider a market where a stock, a money market account, and an option trade. b. The stock can take one of two possible values at the expiration date and so does the

option. c. We create a portfolio of the stock and money market account to replicate an option’s payoff. d. We choose the portfolio of the stock and money market account to have the same value as the option today. Then, to prevent arbitrage, this “synthetic option” and the market-traded option must have the same payoffs on the option’s expiration date. e. A portfolio holding the market-quoted option and the synthetic option on opposite sides of the market are free from price risk. This demonstrates that while solving the pricing problem, we also learn how to hedge the exposure.

ANS: D MSC: Conceptual

DIF: Moderate

REF: 17.6

TOP: The Single-Period Model

18. A necessary and sufficient condition to rule out arbitrage profits in the binomial tree is that the following must hold: a. “up factor  down factor  dollar return” [U  D  (1 + R)] b. U  (1 + R)  D c. (1 + R)  U  D d. (1 + R) = (U + D)/2 e. None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 17.6

TOP: The Single-Period Model

19. Which of the following statements is INCORRECT? a. The method of computing a stock’s present value by its expected payoff using the actual probabilities is known as martingale pricing. b. A martingale is a stochastic process X(t) whose time t value equals its expected value X(T) at some later date T. c. Martingales are associated with “fair gambles” because what you have today is what you expect to have tomorrow. d. In finance, martingales are used to price derivatives in a framework that allows no arbitrage opportunities. e. The probabilities we use in martingale pricing are pseudo-probabilities and not the actual probabilities.

ANS: A MSC: Factual

DIF: Moderate

REF: 17.6

TOP: The Single-Period Model

20. Which of the following statements is INCORRECT? a. The hedge ratio is the number of shares of the stock to hold for each written option to form the perfect hedge. b. The hedge ratio lies between 0 and 1 in the case of a call option. c. The hedge ratio lies between 0 and −1 in the case of a put option. d. The hedge ratio may be defined as the ratio of the change in option price to change in stock price. e. Pseudo-probabilities are useful for computing the hedge ratio.

ANS: E MSC: Conceptual

DIF: Moderate

REF: 17.6

TOP: The Single-Period Model

21. Which of the following statements about Robert Merton’s “Trick” is INCORRECT? a. Merton used to give the intuition of risk-neutral valuation to MIT students with an argument that he called The Trick. b. The Trick involves considering two worlds: the real world (where investors could be

risk-averse) and a pseudo-world (where investors would be risk-neutral). c. The same securities: a bond (which may be viewed as a money market account), a stock, and an option trade in both worlds. d. The probabilities of the stock going up and down are the same in both the real world and the pseudo-world. e. One can easily move from the real world to the pseudo-world where things are tractable, price the option there by risk-neutral valuation, and bring that price back to the real world.

ANS: D MSC: Factual

DIF: Moderate

REF: 17.6

TOP: The Single-Period Model

CHAPTER 18: Multiperiod Binomial Model MULTIPLE CHOICE Use the following data for a two-period binomial model to answer the questions that follow.

— The stock’s price S is $100. After three months, it either goes up and gets multiplied by the factor U = 1.13847256, or it goes down and gets multiplied by the factor D = 0.88664332.

— Options mature after T = 0.5 year and have a strike price of K = $105.

— The continuously compounded risk-free interest rate r is 5 percent per year.

— Today’s European call price is c and the put price is p. Call prices after one period are denoted by cU in the up node and cD in the down node. Call prices after two periods are denoted by cUD in the “up, and then down node” and so on. Put prices are similarly defined.

1. The stock price tree (in dollars) is given by: a. S = 100; US = 113.8473 and DS = 88.6643; U 2S = 135.3238, UDS = 100, and D2S = 74.2672 b. S = 100; US = 113.8473 and DS = 88.6643; U 2S = 129.6120, UDS = 100.9419, and D2S = 78.6136 c. S = 100; US = 113.8473 and DS = 88.6643; U 2S = 123.9862, UDS = 101.5113, and D2S = 83.1104 d. S = 100; US = 113.8473 and DS = 88.6643; U 2S = 130.2617, UDS = 101.4479, and D2S = 79.0077 e. None of these answers are correct.

ANS: B DIF: Easy REF: 18.2 TOP: Toward a Multiperiod Binomial Option Pricing Model

MSC: Applied

2. Call prices (in dollars) are given by: a. c = 8.81, cU = 17.84, cUU = 36.11, and zero at other nodes b. c = 7.68, cU = 15.09, cD = 0.47, cUU = 29.61, cUD = 0.94, cDD = 0 c. c = 4.78, cU = 9.69, cUU = 19.61, and zero at other nodes d. c = 6.00, cU = 12.16, cUU = 24.61, and zero at other nodes e. None of these answers are correct.

ANS: D DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

3. To create the arbitrage-free synthetic call after one period (in the up state) you need to: a. buy 0.8585 shares of the stock and short sell 85.5777 units of the money market account b. buy 0.4827 shares of the stock and short sell 42.2642 units of the money market account c. buy 0.8585 shares of the stock and short sell 42.2642 units of the money market account d. buy 0.9343 shares of the stock and short sell 93.2677 units of the money market account e. None of these answers are correct.

ANS: A DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

4. To create the arbitrage-free synthetic call today, you need to: a. buy 0.8585 shares of the stock and short sell 85.5777 units of the money market account b. buy 0.8585 shares of the stock and short sell 42.2642 units of the money market account c. buy 0.9343 shares of the stock and short sell 93.2677 units of the money market account d. buy 0.4827 shares of the stock and short sell 42.2642 units of the money market account

e. None of these answers are correct.

ANS: D DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

5. Suppose a trader quotes a call price of $4.50. Then, you can make an immediate arbitrage profit of: a. $1.50 by buying the synthetic call and selling the market-quoted call b. $1.50 by selling the synthetic call and buying the market-quoted call c. $7.66 by buying the synthetic call and selling the market-quoted call d. $7.66 by selling the synthetic call and buying the market-quoted call e. None of these answers are correct.

ANS: B DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

6. The arbitrage-free price of a put option is: a. $2.00 b. $6.45 c. $8.41 d. $15.03 e. None of these answers are correct..

ANS: C DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

7. Which set of arbitrage-free put prices (in dollars) is correct? a. p = 2.00, pU = 0, and pD = 4.06 b. p = 8.41, pU = 2.00, and pD = 15.03 c. p = 15.03, pU = 4.06, and pD = 26.39 d. p = 8.41, pU = 0, and pD = 26.39 e. None of these answers are correct.

ANS: B DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

8. To create the arbitrage-free synthetic put after one period (in the down state) you need to: a. short sell 1 share of the stock and buy 103.70 units of the money market account b. short sell 0.14 shares of the stock and buy 18.12 units of the money market account c. buy 0.48 shares of the stock and short sell 42.2642 units of the money market account d. buy 0.9343 shares of the stock and short sell 93.2677 units of the money market account e. None of these answers are correct.

ANS: A DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

9. To create the arbitrage-free synthetic put today, you need to: a. buy 0.48 shares of the stock and short sell 42.2642 units of the money market account b. short sell 1 share of the stock and buy 103.70 units of the money market account c. short sell 0.14 shares of the stock and buy 18.12 units of the money market account d. short sell 0.52 shares of the stock and buy 60.14 units of the money market account e. None of these answers are correct.

ANS: D DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

10. Suppose a trader quotes a put price of $6. Then, you can make an immediate arbitrage profit of: a. $2.41 by buying the synthetic put and selling the market-quoted put b. $2.41 by selling the synthetic put and buying the market-quoted put c. $7.66 by buying the synthetic put and selling the market-quoted put d. $7.66 by selling the synthetic put and buying the market-quoted put e. None of these answers are correct.

ANS: B DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Applied

11. Which of the following statements about the multiperiod binomial option pricing model is INCORRECT? a. The pricing technique is described as forward induction. b. The pricing technique is described as backward induction. c. When the model’s parameters are properly set and the model is run over many small intervals, then it gives an answer that approaches the Black-Scholes-Merton model value. d. The binomial model can be used to price exotic options. e. Strictly speaking, the binomial model is not a separate model but an approximation method.

ANS: A DIF: Easy TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Factual

12. Which of the following statements about option pricing in a multiperiod framework using synthetic construction is INCORRECT? a. The two assets, a stock and a money market account, dynamically complete the market by matching all possible option values at maturity. b. The replicating portfolio is self-financing. c. The replicating portfolio is arbitrage-free. d. Option prices obtained for different period setups are different. e. The pricing model estimates real-world probabilities and uses them for the expected payoff computations.

ANS: E DIF: Moderate TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Factual

13. The formula for pricing options by repeated application of risk-neutral pricing is given by which of the following formulas, where  = [(1 + R) − D]/(U − D); U and D are the up and down factors, respectively; (1 + R) is the dollar return; optionU is the option price at the next node in the up state; and optionD is the option price at the next node in the down state? a. option price = [  option U + (1 − )  optionD]  (1 + R) b. option price = [  option U + (1 − )  optionD] / R c. option price = [  option U + (1 − )  optionD] / (1 + R) d. option price = [2  optionU + (1 − )2  optionD]  (1 + R) e. None of these answers are correct.

ANS: C DIF: Easy TOP: A Two-Period Binomial Model

REF: 18.3 MSC: Factual

14. For a stock price following a binomial process, the up factor U = 1.1, the down factor D = 0.9, the dollar return (1 + R) = 1.05 percent (per period), and the initial stock price is 100. The probability that the stock will have 18 up movements and 2 down movements is: a. 0.0556 b. 0.0669

c. 0.075 d. 0.10 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 18.4 TOP: The Multiperiod Binomial Option Pricing Model

MSC: Applied

Use the following data for an eight-period binomial model to answer the questions that follow.

— The stock’s price S is $100. The stock price evolves according to an eight-period binomial model.

— Options mature after T = 1 year and have a strike price of K = $70.

— The continuously compounded risk-free interest rate r is 5 percent per year.

— The annualized volatility of stock price returns  = 0.25 or 25 percent per year.

15. Today’s price of a European call in this eight-period binomial model is: a. $11.7628 b. $33.4139 c. $33.7858 d. $36.4527 e. None of these answers are correct.

ANS: C DIF: Difficult REF: 18.4 TOP: The Multiperiod Binomial Option Pricing Model

MSC: Applied

16. Today’s price of a European put in this eight-period binomial model is: a. $0.1107 b. $0.3719 c. $0.3910 d. $1.2798 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 18.4 TOP: The Multiperiod Binomial Option Pricing Model

MSC: Applied

17. Which of the following statements is correct regarding a binomial option pricing model? a. In case of a dollar dividend, lower the call price by the dividend amount. b. In case of a dollar dividend, lower the put price by the dividend amount. c. In case of a dollar dividend paid (at an intermediate date) at the end of some time period, lower the stock price by the dividend amount. d. In case of a dollar dividend, the binomial stock price tree recombines. e. None of these answers are correct..

ANS: C DIF: Easy TOP: Extending the Binomial Model

REF: 18.5 MSC: Factual

Use the following data for a two-period binomial model to answer the questions that follow.

— The stock’s price S is $100. After three months, it either goes up and gets multiplied by the factor U = 1.13847256, or it goes down and gets multiplied by the factor D = 0.88664332.

— Options mature after T = 0.5 year and have a strike price of K = $105.

— The continuously compounded risk-free interest rate r is 5 percent per year.

18. If the stock pays a $1 dividend just before the end of the first three months, then today’s price of a European call is: a. $4.86 b. $5.73 c. $6.00 d. $11.59 e. None of these answers are correct.

ANS: B DIF: Moderate TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

19. If the stock pays a $1 dividend just before the end of the first three months, then today’s price of a European put is: a. $2.44 b. $5.73 c. $9.12 d. $16.03 e. None of these answers are correct.

ANS: C DIF: Moderate TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

20. If the stock pays a 1 percent dividend just before the end of the first three months, then today’s price of a European call is: a. $5.69 b. $5.73 c. $6.00 d. $7.96 e. None of these answers are correct.

ANS: A DIF: Moderate TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

21. If the stock pays a 1 percent dividend just before the end of the first three months, then today’s price of a European put is: a. $8.41 b. $9.09 c. $9.12 d. $10.03 e. None of these answers are correct.

ANS: B DIF: Moderate TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

22. Today’s price of an American call option is: a. $4.86 b. $5.73 c. $6.00 d. $11.59 e. None of these answers are correct.

ANS: C DIF: Easy TOP: Extending the Binomial Model 23. Today’s price of an American put option is:

REF: 18.5 MSC: Applied

a. $8.41 b. $9.05 c. $9.12 d. $10.03 e. None of these answers are correct.

ANS: B DIF: Moderate TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

24. Consider the following exotic option whose payoff at maturity is given by the stock price squared less a strike price if it has a positive value, zero otherwise, that is: max[S(1)2 − K, 0].

Using the above data except for assuming a new strike price is $5, today’s arbitrage-free price of this exotic option is: a. $210.13 b. $438.85 c. $786.63 d. $888.60 e. None of these answers are correct.

ANS: B DIF: Difficult TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

25. Consider the following exotic option whose payoff at maturity is given by the square root of the stock price less the strike price if it has a positive value, zero otherwise, that is: max[S(2) − K, 0].

Using the above data except for assuming a new strike price is $5, today’s arbitrage-free price of this exotic option is: a. $0.21 b. $0.29 c. $0.36 d. $0.70 e. None of these answers are correct.

ANS: C DIF: Difficult TOP: Extending the Binomial Model

REF: 18.5 MSC: Applied

26. Which of the following statements is INCORRECT? A binomial model may be used for valuing: a. European options in the presence of known dollar dividends b. European options in the presence of a known dividend yield c. an exotic option whose payoff depends on some function of the current stock price and the strike price d. a European option in an incomplete market e. an American option ANS: D DIF: Easy TOP: Extending the Binomial Model

REF: 18.5 MSC: Conceptual

CHAPTER 19: The Black-Scholes-Merton Model MULTIPLE CHOICE 1. The stock market has been fluctuating widely, and a “market guru” declares in his newsletter that the traditional Black-Scholes-Merton option pricing model is no longer valid. Instead, he says traders should use the following model for computing an option’s price: take the average of the highest and the lowest prices for each of the previous seven trading days. If you use this pricing model, then you are: a. a mathematical modeler b. a statistical modeler c. a “lottery” buyer d. a day trader e. None of these answers are correct.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 19.2

TOP: Applications and Uses

2. The first successful option pricing model was built by: a. Louis Bachelier b. James Boness and Case Sprenkle c. Paul Samuelson d. Fischer Black, Myron Scholes, and Robert Merton e. Sheen Kassouf and Edward Thorp ANS: D MSC: Factual

DIF: Easy

REF: 19.3

TOP: Nobel Prize-Winning Works

3. The assumptions underlying the Black-Scholes-Merton model for pricing European options do NOT include: a. no market frictions b. no credit risk c. competitive and well-functioning markets d. no interest rate uncertainty e. trading only at discrete time intervals ANS: E MSC: Factual

DIF: Easy

REF: 19.4

TOP: The Assumptions

4. Which of the following statements is INCORRECT about asset price bubbles? a. A price bubble happens when an asset’s price substantially deviates from its intrinsic or fundamental value. b. A price bubble implies the existence of arbitrage and they are excluded by the no arbitrage assumption. c. Price bubbles cannot be accommodated in the Black-Scholes-Merton model because the assumption that the stock price follows a lognormal distribution excludes bubbles. d. A price bubble can happen when the assumption “competitive and well-functioning market” fails to hold. e. In the presence of price bubbles, many of the standard results of option pricing are no longer valid.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 19.4

TOP: The Assumptions

5. The Black-Scholes-Merton model assumes that the stock price follows: a. a normal distribution b. a lognormal distribution c. a binomial distribution d. an additive distribution e. a uniform distribution ANS: B MSC: Factual

DIF: Moderate

REF: 19.4

TOP: The Assumptions

6. Which statement about the argument underlying the Black-Scholes-Merton model is INCORRECT? a. The argument utilizes a practice common among option writers in nineteenth-century London: hedge an option position with an opposing stock trade. b. The argument combines and solves the pricing and hedging problem in one stroke. c. The argument assumes that call and underlying stock prices are positively correlated. d. The argument combines the call and the underlying stock to form a riskless portfolio that is assumed to grow at the risk-free rate. e. The argument assumes that all traders are risk-neutral, and therefore one can value the option by taking expected discounted values.

ANS: E DIF: Moderate REF: 19.5 TOP: The Pricing and Hedging Argument

MSC: Conceptual

7. The model developed by Fischer Black and Myron Scholes (1973) was initially used for pricing: a. an American option on equity with dividends b. an American option on equity with no dividends c. a European option on commodity with a known dividend yield d. a European option on equity with no dividends e. a European option on an index ANS: D DIF: Easy REF: 19.6 TOP: The Black-Scholes-Merton Formula

MSC: Factual

A stock’s current price S is $100. Its return has a volatility of  = 25 percent per year. European call and put options trading on the stock have a strike price of K = $105 and mature after T = 0.5 years. The continuously compounded risk-free interest rate r is 5 percent per year.

8. The Black-Scholes-Merton model gives the price of the European call as: a. $5.99 b. $8.26 c. $10.00 d. $12.34 e. None of these answers are correct.

ANS: A DIF: Easy REF: 19.6 TOP: The Black-Scholes-Merton Formula

MSC: Applied

9. The Black-Scholes-Merton model gives the price of the European put as: a. $5.79 b. $5.99 c. $8.40 d. $9.88 e. None of these answers are correct.

ANS: C

DIF: Easy

REF: 19.6

TOP: The Black-Scholes-Merton Formula

MSC: Applied

10. If the stock pays a dividend at the continuously compounded rate of  = 0.01 per year, then the Black-Scholes-Merton model gives the price of a European call as: a. $5.75 b. $5.99 c. $9.46 d. $9.88 e. None of these answers are correct.

ANS: A DIF: Moderate REF: 19.6 TOP: The Black-Scholes-Merton Formula

MSC: Applied

11. If the stock pays a dividend at the continuously compounded rate of  = 0.01 per year, then the Black-Scholes-Merton model gives the price of a European put as: a. $5.75 b. $5.99 c. $8.66 d. $10.34 e. None of these answers are correct.

ANS: C DIF: Moderate REF: 19.6 TOP: The Black-Scholes-Merton Formula

MSC: Applied

12. Identify the correct sentence. In the Black-Scholes-Merton model (1973): a. the European option price can be computed as its discounted expected payoff using the actual probabilities and the risk-free rate b. the European option price can be computed as its discounted expected payoff using the actual probabilities and the expected return c. the European option price can be computed as its discounted expected payoff using the pseudo-probabilities and the expected return d. the European option price can be computed as its discounted expected payoff using the pseudo-probabilities and the risk-free rate e. None of these answers are correct.

ANS: D DIF: Moderate REF: 19.7 TOP: Understanding the Black-Scholes-Merton Model

MSC: Factual

13. If a put option has a delta close to −0.5, then the call is likely to be: a. deeply in-the-money b. at-the-money or the stock price is close to the strike price c. deeply out-of-the-money d. either deeply in-the-money or deeply out-of-the money e. None of these answers are correct.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 19.8

TOP: The Greeks

14. Which of the following statements is INCORRECT? a. An option’s delta measures the change in the option’s value when there is a small change in the underlying stock price. b. The delta of a call option lies between 0 and 1. c. The delta of a put option lies between −1 and 0. d. An option’s gamma is the change in the option’s delta when there is a small change in the underlying stock price.

e. The gamma for otherwise identical European put and call options on the same stock are different.

ANS: E MSC: Factual

DIF: Moderate

REF: 19.8

TOP: The Greeks

15. When pricing options, the following input is the hardest to estimate the: a. interest rate b. dividend yield c. volatility d. strike price e. yield to maturity ANS: C MSC: Factual

DIF: Easy

REF: 19.9

TOP: The Inputs

16. The following input is not needed to solve the option price in the Black-Scholes-Merton framework: a. the asset’s risk premium b. the asset price c. the time to maturity d. the risk-free rate of interest e. the strike price ANS: A MSC: Factual

DIF: Easy

REF: 19.9

TOP: The Inputs

17. Identify the correct statement. A stock’s historic volatility is obtained by: a. computing the standard deviation of stock prices b. computing the standard deviation of price relatives of the stock prices c. computing the standard deviation of logarithm price relatives d. computing volatility as implied by market-traded option prices e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Moderate

REF: 19.9

TOP: The Inputs

18. Suppose that you have computed a stock return’s variance with weekly data. To convert this to an annual variance, you need to use the adjustment: a. Variance (Annual) = Variance (Weekly)  12 b. Variance (Annual) = Variance (Weekly)  52 c. Variance (Annual) = Variance (Weekly)  250 d. Variance (Annual) = Variance (Weekly)  260 e. None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 19.9

TOP: The Inputs

19. A modification to the BSM option pricing model developed by Robert Merton (1973) was formulated to price: a. American options on equity with dividends b. American options on equity with no dividends c. European options on equity with a known dividend yield d. European options on equity with no dividends e. European options on commodity futures

ANS: C DIF: Easy REF: 19.10 TOP: Extending the Black-Scholes-Merton ModelMSC:

Factual

20. The SINDY index is currently at I = 10,100. European options on SINDY have a strike price K = $10,000 and mature in T = 90 days. The risk-free interest rate r = 5 percent per year. SINDY has a dividend yield  = 2 percent per year and an implied volatility of  = 20 percent per year. Then the Black-Scholes-Merton model gives a call option price of: a. $314.18 b. $430.39 c. $487.03 d. $516.76 e. None of these answers are correct.

ANS: C DIF: Moderate REF: 19.10 TOP: Extending the Black-Scholes-Merton ModelMSC:

Applied

21. A European call on the euro matures after T = 90 days. The call pays on the maturity 100[SA (T) − 1.20] dollars if it ends in-the-money, zero otherwise, where 100 is the contract multiplier and $1.20 is the strike price K. The euro’s volatility  is 15 percent per year. Today’s spot exchange rate SA is $1.3 per euro (in American terms). The continuously compounded annual risk-free interest rates are r = 4 percent in the United States (domestic) and rE = 3 percent in the Eurozone. Then the Black-Scholes-Merton model gives a call option price of: a. $0.62 b. $0.71 c. $10.56 d. $10.84 e. None of these answers are correct.

ANS: D DIF: Difficult REF: 19.10 TOP: Extending the Black-Scholes-Merton ModelMSC:

Applied

22. Which of the following statements is INCORRECT? a. The Black-Scholes-Merton model can be used to price an American call option on a stock paying known dollar dividends. b. The binomial model can be used to price an American call option in the presence of known dividends. c. The Black-Scholes-Merton model can be used to price a European call option on a stock with a known dividend yield. d. The Black-Scholes-Merton model can be used to price a European put option on a stock paying known dollar dividends. e. None of these answers are correct.

ANS: A DIF: Easy REF: 19.10 TOP: Extending the Black-Scholes-Merton ModelMSC:

Applied

23. Which of the following statements is INCORRECT? a. An American option’s price can be determined by the Black-Scholes-Merton model. b. An American option’s price can be determined by a multiperiod binomial option pricing model. c. An American option’s price can be determined by numerically solving the underlying partial differential equation. d. An American option’s price can be determined by using Monte Carlo simulation techniques. e. None of these answers are correct.

ANS: A DIF: Moderate REF: 19.10 TOP: Extending the Black-Scholes-Merton ModelMSC:

Factual

CHAPTER 20: Using the Black-Scholes-Merton Model MULTIPLE CHOICE 1. Which of the following statements is INCORRECT? a. Option dealers in nineteenth-century London were using a statistical model influenced by insurance industry practices for determining option prices. b. Option dealers in nineteenth-century New York were selling options primarily for strategic reasons and manipulating option prices. c. Option dealers in nineteenth-century New York were using “judgment” or “shrewd guessing” to determine option values. d. Russell Sage’s strategy of using put-call parity to charge higher interest rates than the 7 percent maximum allowed by the New York State’s usury law was discovered by the authorities and forced Sage to serve jail time. e. Option trading had more legitimacy in London than in New York.

ANS: D DIF: Easy TOP: A Brief History of Model Usage

REF: 20.2 MSC: Factual

2. The delta for a call option in the Black-Scholes-Merton model is: a. the number of shares of stock to buy for each written call to eliminate price risk from the resulting position b. the partial derivative of the option price with respect to the time remaining to maturity c. the partial derivative of the option price with respect to the volatility d. the number of shares of the money market account to short for each written call to eliminate price risk from the resulting position e. the time change in a delta-hedged call option portfolio ANS: A MSC: Factual

DIF: Easy

REF: 20.3

TOP: Hedging the Greeks

3. Using a Taylor series expansion of the Black-Scholes-Merton model, one can hedge the following risks in an option and stock portfolio: a. volatility risk b. small and large stock price risk c. small stock price risk and interest rate risk d. small stock price risk and volatility risk e. small and large stock price risk and volatility risk ANS: B MSC: Factual

DIF: Easy

REF: 20.3

TOP: Hedging the Greeks

4. In a delta-hedged call option position over a discrete time interval [t, t + t]: a. volatility risk is eliminated b. small price movement risk is eliminated c. large price movement risk is eliminated d. interest rate risk is eliminated e. both small and large price movement risks are eliminated ANS: B MSC: Factual

DIF: Easy

REF: 20.3

TOP: Hedging the Greeks

5. In a delta- and gamma-hedged call option position over a discrete time interval [t, t + t]: a. volatility risk is eliminated

b. c. d. e.

small price movement risk is eliminated large price movement risk is eliminated interest rate risk is eliminated both small and large price movement risk are eliminated

ANS: E MSC: Factual

DIF: Moderate

REF: 20.3

TOP: Hedging the Greeks

6. Gamma hedging is needed when hedging in the Black-Scholes-Merton model because: a. there is volatility risk in holding the option b. there is interest rate risk in holding the option c. when hedging, one can only trade discretely in time and not continuously d. when hedging, the interest rate is not constant e. there is time decay in holding the option ANS: C MSC: Factual

DIF: Moderate

REF: 20.3

TOP: Hedging the Greeks

7. Which of the following is true with respect to hedging in the Black-Scholes-Merton model? a. One can hedge interest rate risk using rho. b. One can hedge volatility rate risk using vega. c. One can hedge time decay risk using theta. d. One can hedge small price risk using delta. e. One can hedge large price risk using delta.

ANS: D MSC: Factual

DIF: Moderate

REF: 20.3

TOP: Hedging the Greeks

8. A delta for a portfolio of options on the same stock is: a. the sum of the delta for the individual options times the number of shares of each option b. the sum of the delta for the individual options times the percentage of each option in the portfolio’s value c. the sum of the delta for the individual options times one minus the percentage of each option in the portfolio’s value d. the sum of the delta for the individual options divided by the number of shares of each option e. cannot be computed if the options have different strikes ANS: A DIF: Moderate TOP: Hedging a Portfolio of Options

REF: 20.4 MSC: Factual

9. A portfolio which has a delta value of −0.25 is: a. a bullish portfolio b. a neutral portfolio c. a bearish portfolio d. a high-volatility portfolio e. None of these answers are correct.

ANS: C DIF: Moderate TOP: Hedging a Portfolio of Options

REF: 20.4 MSC: Conceptual

10. Which of the following Black-Scholes-Merton model inputs are parameters and risks? a. Parameters (r, , K, T), risk (S) b. Parameters (r, K, T), risks (S, r) c. Parameters (r, K, T), risks (S, )

d. Parameters (K, T), risks (S, r, ) e. Parameter (K), risks (S, r, , T) ANS: A MSC: Factual

DIF: Moderate

REF: 20.5

TOP: Vega Hedging

11. Which of the following statements is correct? a. Theoretical models capture correlations in past market data. b. Statistical models include cause and effect. c. Theoretical models include cause and effect. d. Statistical models capture structural shifts. e. Statistical models dominate theoretical models because they use market data.

ANS: C MSC: Factual

DIF: Moderate

REF: 20.6

TOP: Calibration

REF: 20.6

TOP: Calibration

12. The Black-Scholes-Merton model is a: a. theoretical model b. statistical model c. econometric model d. equilibrium model e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

13. Calibration in the Black-Scholes-Merton model corresponds to: a. setting the delta equal to 1/2 b. setting the delta and gamma equal to zero c. computing an implied volatility d. setting the interest rate equal to the relevant T-bill rate e. setting the delta equal to 1 ANS: C MSC: Factual

DIF: Easy

REF: 20.6

TOP: Calibration

14. The Black-Scholes-Merton model’s implied volatility is: a. the market’s estimate of the future value of the stock’s random volatility over the option’s life b. the volatility that equates the BSM model price to the market price, if all other inputs are known c. the market’s estimate of the future value of the stock’s random volatility over an infinitesimal time interval d. the market’s estimate of the stock’s random volatility over an infinitesimal time interval beginning when the option matures e. another name for estimating the volatility using historical stock price data ANS: B MSC: Factual

DIF: Easy

REF: 20.6

TOP: Calibration

15. Which of the following statements is INCORRECT? a. The VIX was introduced during the 1990s to measure the market’s expectation of the 30-day volatility implied by at-the-money S&P 100 Index (OEX) option prices. b. During the early 2000s, VIX index was modified to represent an expected volatility instead of an implied volatility.

c. VIX is also known as the “fear index” because it has become a widely watched barometer of stock market volatility, reflecting investor anxiety. d. The VIX is a measure of the level of the S&P 100 stock market index. e. The VIX tends to increase during financial crises.

ANS: D MSC: Factual

DIF: Easy

REF: 20.6

TOP: Calibration

16. The Black-Scholes-Merton model is: a. empirically validated because implied volatilities match market-to-model prices b. rejected because implied volatilities are not constant across strikes and maturities c. empirically validated because calibrated BSM models are used on Wall Street d. empirically validated because BSM theory enabled successful delta and gamma hedging e. is rejected because implied volatilities can only be computed for at-the-money options ANS: B MSC: Factual

DIF: Moderate

REF: 20.6

TOP: Calibration

17. Since the Black-Scholes-Merton model is rejected when using historical volatilities as input: a. using implied volatilities transforms the BSM theoretical model into a statistical model b. implied volatilities enable one to accept the BSM theoretical model c. one needs to use implied volatilities to delta-hedge an option d. one needs to use implied volatilities to vega-hedge an option e. one needs to use implied volatilities to both delta- and gamma-hedge an option ANS: A MSC: Factual

DIF: Easy

REF: 20.6

TOP: Calibration

CHAPTER 21: Yields and Forward Rates MULTIPLE CHOICE 1. The TED spread is: a. the difference between a bbalibor rate for Eurodollars and the interest rate on a similar maturity Treasury security b. a measurement of a Treasury security’s maturity adjusted for the coupon rate c. the difference between the interest rate on a Treasury security and Euribor’s dollar rate d. the difference between the interest rate on a Treasury security and the euro’s domestic rate e. None of these answers are correct.

ANS: A MSC: Factual

DIF: Easy

REF: 21.2

TOP: Yields

2. The yield on a zero-coupon bond of maturity T is equal to: a. the expected return on the zero-coupon bond b. the forward rate for time T − 1 c. the forward rate for time T d. the return on the bond each period, if the bond is held until maturity e. the spot rate of interest ANS: D MSC: Factual

DIF: Easy

REF: 21.2

TOP: Yields

3. The yield on a coupon bond with face value L, coupon C per year, and maturity T is equal to: a. the expected return on the bond b. the forward rate for time T − 1 c. the forward rate for time T d. the spot rate of interest e. the internal rate of return on the coupon bond ANS: E MSC: Factual

DIF: Easy

REF: 21.2

TOP: Yields

4. Which of the following is true? a. When investing in coupon bonds, holding constant for risk, the bond with the highest yield is preferred. b. The yield measures the expected return on a coupon bond. c. The yield should not be used as the sole determinate for selecting among bonds for investment purposes. d. Bond yields are always increasing in the bond’s maturity. e. A coupon bond’s yield always exceeds the spot rate of interest.

ANS: C MSC: Factual

DIF: Moderate

REF: 21.2

TOP: Yields

5. When one puts on a trade to take advantage of an abnormal spread that one hopes will converge to the normal spread, which of the following is true? a. Spread trades only work when the underlying prices of the two securities increase together. b. A spread trade is always an arbitrage opportunity across time. c. A spread trade works regardless of whether the underlying prices of the two securities increase or decrease.

d. A spread trade is always an arbitrage opportunity across space. e. Spread trades always have a positive probability of losing money.

ANS: C MSC: Conceptual

DIF: Moderate

REF: 21.2

TOP: Yields

6. The economy is booming. You believe that the Federal Reserve Bank is likely to raise short-term rates but keep long-term rates unchanged. To act on your belief, you decide to set up a spread strategy. Your initial trade should be as follows: a. buy both the short-term bond and the long-term bond b. sell both the short-term bond and the long-term bond c. buy the short-term bond and sell the long-term bond d. buy the long-term bond and sell the short-term bond e. None of these answers are correct.

ANS: D MSC: Conceptual

DIF: Moderate

REF: 21.2

TOP: Yields

7. Suppose two zero-coupon bonds are available for trading that have face values of $100 each. Current yields are 2 percent for the two-year bond and 5 percent for the ten-year bond. As the economy is expanding, you believe that the Federal Reserve Bank will raise short-term rates by 25 basis points (or 0.25 percent) to prevent the economy from overheating. The Fed has no influence over long-term interest rates and you expect them to remain unchanged. If you set up a spread strategy and it works as conjectured, then you will make a profit of: a. $0.26 b. $0.33 c. $0.47 d. $0.94 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Difficult

REF: 21.2

TOP: Yields

8. Which of the following is NOT true with respect to duration? a. All else constant, the larger is the bond’s maturity, the smaller is the bond’s duration. b. Duration has an interpretation of the bond’s average life. c. Duration can be used to approximate the bond’s price change when yields change. d. The duration of a zero-coupon bond is the maturity of the bond. e. Modified duration is the duration divided by (1 + y) where y is the bond’s yield.

ANS: A MSC: Conceptual

DIF: Moderate

REF: 21.3

TOP: The Traditional Approach

9. A newly issued two-year coupon bond has a par value of $100, a coupon rate of 5 percent ($5) and a yield y = 4 percent per year. If the yield goes up by 0.5 percent, then, according to the modified duration formula for a bond’s price change, the bond price will: a. go up by $0.90 b. go up by $1.90 c. go down by $0.96 d. go down by $1.90 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Difficult

REF: 21.3

TOP: The Traditional Approach

10. Which of the following is true with respect to modified duration hedging? a. Modified duration hedging always works as a good approximation when yields change. b. Modified duration hedging always works except when yields changes are large. c. Modified duration hedging can only be applied to zero-coupon bonds. d. Modified duration hedging always works if combined with convexity hedging. e. Modified duration hedging works only for parallel shifts in the yield curve.

ANS: E MSC: Factual

DIF: Moderate

REF: 21.3

TOP: The Traditional Approach

11. Which of the following is true with respect to forward rates? a. A forward rate is another name for a zero-coupon bond’s yield. b. A forward rate is equal to the expected return on a zero-coupon bond. c. A forward rate is the rate one can contract today for riskless borrowing or lending at a future date. d. Forward rates are always increasing in time to maturity. e. Forward rates are always decreasing in time to maturity.

ANS: C MSC: Conceptual

DIF: Moderate

REF: 21.4

TOP: Forward Rates

12. Given the following zero-coupon bond prices, what are the forward rates f(0,0), f(0,1), f(0,2)?

a. 0.0222, 0.0217, 0.0638 b. 0.0255, 0.03222, 0.0566 c. 0.0638, 0.0217, 0.0222 d. 0.0566, 0.03222, 0.0255 e. 0.02, 0.04, 0.06 ANS: C MSC: Applied

DIF: Moderate

REF: 21.4

TOP: Forward Rates

13. Given the following zero-coupon bond prices, what is the forward rate agreement (FRA) rate for a contract maturing at time 2?

a. 0.0222 b. 0.0217 c. 0.0638 d. 0.0566 e. 0.02 DIF: Moderate REF: 21.5 ANS: B TOP: The Basic Interest Rate Derivatives Contracts

MSC: Applied

14. Given the following zero-coupon bond prices, what is the forward rate agreement rate for a contract maturing at time 3?

a. 0.0222 b. 0.0217 c. 0.0638 d. 0.0566 e. 0.02 ANS: A DIF: Moderate REF: 21.5 TOP: The Basic Interest Rate Derivatives Contracts

MSC: Applied

15. A company buys a 5  11 (begins after five months, ends after eleven months), 100-million-Eurodollar forward rate agreement (FRA) that has an FRA rate of 4 percent per year. If the six-month bbalibor rate announced after five months is 5.5 percent per year, then (assuming 182 days in the six-month period and 360 days in the year), the buyer will receive on the settlement date (after five months): a. $491,878.60 b. $737,817.90 c. $758,333.33 d. $983,757.20 e. None of these answers are correct.

ANS: B DIF: Moderate REF: 21.5 TOP: The Basic Interest Rate Derivatives Contracts

MSC: Applied

16. Which of the following is NOT true? a. Forward rate agreements (FRAs) and interest rate futures are contracts that bet on future movements of the spot rate of interest. b. FRAs trade over the counter. c. Interest rate futures trade on an organized exchange. d. FRAs and interest rate futures are identical contracts in all respects, except that one trades over the counter and the other trades on an exchange. e. FRAs have no intermediate cash flows before maturity, and interest rate futures have daily settlement cash flows.

ANS: D DIF: Moderate REF: 21.5 TOP: The Basic Interest Rate Derivatives Contracts

MSC: Factual

17. Identify the correct statement. For an interest rate Eurodollar futures contract: a. the quoted futures price equals the price used to determine daily settlement b. the quoted futures price equals 100 minus the futures interest rate c. the futures interest rate is a continuously compounded rate d. the futures interest rate is the same as the FRA rate e. interest rate futures have no cash flows until the futures delivery date ANS: B DIF: Moderate REF: 21.5 TOP: The Basic Interest Rate Derivatives Contracts

MSC: Factual

CHAPTER 22: Interest Rate Swaps MULTIPLE CHOICE 1. The history of swaps did NOT involve the following: a. the introduction of new swap contracts b. an ability to warehouse swap contracts c. a shift from a dealership market to a brokerage business d. the founding of the ISDA and the standardization of contracts e. the use of technology and the automation of trading ANS: C MSC: Factual

DIF: Easy

REF: 22.2

TOP: A Brief History

2. Which of the following is NOT a reason financial swaps have become popular contracts? a. Swaps provide a clever way of exploiting the theory of comparative advantage. b. Swaps exchange cash flows from two different investments and sometimes notional values as well. c. Swaps can be warehoused. d. Swaps provide a cheap way of transforming cash flows. e. A movement from a brokerage business to a dealership market allowed fast and efficient processing of swap agreements.

ANS: A MSC: Factual

DIF: Moderate

REF: 22.2

TOP: A Brief History

3. Which statement is INCORRECT regarding ISDA? a. Originally founded as the International Swap Dealers Association, ISDA was later renamed the International Swaps and Derivatives Association to reflect its broader scope. b. ISDA published standardized documents known as master agreements to facilitate trading of over-the-counter derivatives contracts. c. ISDA lowers credit risk by guaranteeing contract performance to the counterparties. d. An ISDA master agreement has two parts: a preprinted form that cannot be amended, and a schedule that allows the two counterparties to note changes and amend some provisions on the printed form. e. ISDA periodically updates master agreements to reflect changing market conditions.

ANS: C MSC: Factual

DIF: Moderate

REF: 22.2

TOP: A Brief History

4. Which statement regarding entering into or ending a swap contract is INCORRECT? a. A swap may be initiated by a phone-based conversation or direct negotiation. b. A swap may be initialed via a web-based trading platform. c. A swap may be initiated by running an auction to select counterparties. d. A swap, once entered, must be held until maturity. e. A swap may be closed through a buyout.

ANS: D MSC: Factual

DIF: Easy

REF: 22.3

TOP: Institutional Features

5. Consider a five-year floating rate loan with principal of $10 million and quarterly payments based on the three-month bbalibor rate. Suppose the bbalibor rates are 0.01 for the first three years and 0.02 for the last two years. What is the value of the floating rate loan when it is issued? a. $9.27 million

b. c. d. e.

$9.85 million $9.90 million $10 million $10.55 million

ANS: D MSC: Applied

DIF: Easy

REF: 22.4

TOP: Valuation

6. Consider a five-year floating rate loan with principal of $10 million and quarterly payments based on the three-month bbalibor rate. Suppose the bbalibor rates are 0.01 for the first three years and 0.02 for the last two years. What is the value of the floating rate loan on its first quarterly payment date? a. $9.27 million b. $9.85 million c. $9.90 million d. $10 million e. $10.55 million ANS: D MSC: Applied

DIF: Easy

REF: 22.4

TOP: Valuation

7. If you have three years left on a five-year fixed rate loan paying 2 percent quarterly, and you want to transform it into a floating rate loan using a swap, which of the following would be an appropriate method? a. Enter a five-year receive floating, and pay a fixed swap where the swap rate is 2 percent paid quarterly. b. Enter a five-year receive fixed, and pay a floating swap where the swap rate is 2 percent paid quarterly. c. Enter a three-year receive floating, and pay a fixed swap where the swap rate is 2 percent paid quarterly. d. Enter a three-year receive fixed, and pay a floating swap where the swap rate is 2 percent paid quarterly. e. Enter a four-year receive fixed, and pay a floating swap where the swap rate is 2 percent paid quarterly.

ANS: D MSC: Applied

DIF: Easy

REF: 22.4

TOP: Valuation

8. If you have three years left on a five-year floating rate based on bbalibor paid quarterly, and you want to transform it into a fixed rate loan using a swap, which of the following would be an appropriate method? a. Enter a five-year receive floating, and pay a fixed swap where the swap rate is paid quarterly. b. Enter a five-year receive fixed, and pay a floating swap where the swap rate is paid quarterly. c. Enter a three-year receive floating, and pay a fixed swap where the swap rate is paid quarterly. d. Enter a three-year receive fixed, and pay a floating swap where the swap rate is paid quarterly. e. Enter a four-year receive fixed, and pay a floating swap where the swap rate is paid quarterly.

ANS: C MSC: Applied

DIF: Easy

REF: 22.4

TOP: Valuation

Use the zero-coupon bond prices given in the following table to answer the questions that follow.

9. Consider a three-year fixed rate coupon bond with principal of $10 million dollars and paying a coupon of 2 percent per year, paid yearly. What is the value of the bond when it is issued? a. $9,448,000 b. $9,552,000 c. $10,000,000 d. $10,448,000 e. $10,552,000 ANS: B MSC: Applied

DIF: Moderate

REF: 22.4

TOP: Valuation

10. Consider a three-year swap receiving fixed paying floating with principal of $10 million dollars, receiving a fixed rate of 2 percent per year, and paying the one-year floating spot rate yearly. What is the value of the swap when it is issued? a. $448,000 b. $552,000 c. − $448,000 d. − $552,000 e. 0 ANS: C MSC: Applied

DIF: Moderate

REF: 22.4

TOP: Valuation

11. Consider a three-year swap receiving floating paying fixed with principal of $10 million dollars, paying a fixed rate of 2 percent per year paid yearly, and receiving the one-year floating spot rate yearly. What is the value of the swap when it is issued? a. $448,000 b. $552,000 c. − $448,000 d. − $552,000 e. $0 ANS: A MSC: Applied

DIF: Moderate

REF: 22.4

TOP: Valuation

12. Consider a newly issued three-year swap receiving floating paying fixed with principal $10 million dollars, paying the one-year swap rate yearly, and receiving the one-year floating spot rate yearly.

What is the value of the swap when it is issued? a. $300,335 b. $341,335 c. − $300,335 d. − $341,335 e. $0 ANS: E MSC: Applied

DIF: Moderate

REF: 22.4

TOP: Valuation

13. Consider a newly issued three-year swap receiving floating paying fixed with principal $10 million dollars, paying the one-year swap rate yearly, and receiving the one-year floating spot rate yearly.

What is the swap rate? a. 0.02303

b. c. d. e.

0.03254 0.03623 0.04207 0.05135

ANS: C MSC: Applied

DIF: Difficult

REF: 22.4

TOP: Valuation

14. Use the discrete time model of the text, where a forward rate agreement (FRA) pays based on the spot rate of interest. Consider an FRA with maturity time 3. What is the FRA rate? a. 0.02000 b. 0.02222 c. 0.02445 d. 0.03122 e. 0.03355 ANS: B MSC: Applied

DIF: Difficult

REF: 22.4

TOP: Valuation

15. Consider a three-year swap receiving floating paying fixed with principal of $10 million, paying a fixed rate of 2 percent per year paid yearly, and receiving the one-year floating spot rate yearly. How would one synthetically construct the swaps payoff at time 3 using FRAs and zero-coupon bonds?

(Hint: use the answer to question 11.) a. long a $10 million notional FRA maturing at time 3 and long 22,222 zero-coupon bonds maturity at time 3 b. long a $10 million notional FRA maturing at time 3 and long 20,000 zero-coupon bonds maturity at time 3 c. short a $10 million notional FRA maturing at time 3 and short 22,222 zero-coupon bonds maturity at time 3 d. short a $10 million notional FRA maturing at time 3 and short 20,000 zero-coupon bonds maturity at time 3 e. long a $10 million notional FRA maturing at time 3 and short 22,222 zero-coupon bonds maturity at time 3 ANS: A MSC: Applied

DIF: Difficult

REF: 22.4

TOP: Valuation

16. Consider a three-year swap paying floating receiving fixed with principal of $10 million dollars, paying a fixed rate of 2 percent per year paid yearly, and using the one-year floating spot rate paid yearly. How would one synthetically construct the swaps payoff at time 3 using FRAs and zero-coupon bonds? (Hint: use the answer to question 10.) a. long a $10 million notional FRA maturing at time 3 and long 22,222 zero-coupon bonds maturity at time 3 b. long a $10 million notional FRA maturing at time 3 and long 20,000 zero-coupon bonds maturity at time 3 c. short a $10 million notional FRA maturing at time 3 and short 22,222 zero-coupon bonds maturity at time 3 d. short a $10 million notional FRA maturing at time 3 and short 20,000 zero-coupon bonds maturity at time 3 e. long a $10 million notional FRA maturing at time 3 and short 22,222 zero-coupon bonds maturity at time 3 ANS: C MSC: Applied

DIF: Difficult

REF: 22.4

TOP: Valuation

17. Which of the following statements about the swap transacted between Procter & Gamble (P&G) and Bankers Trust (BT) and the developments that followed is INCORRECT? a. P&G underestimated the risk of large financial losses that could occur from a special “spread” term embedded in an otherwise innocuous looking fixed-for-floating interest rate swap. b. Initially P&G had little chance of winning the lawsuit against BT because caveat emptor or “buyer beware” is a standard warning that applies to all economic activities. c. P&G argued before the court that BT was criminally fraudulent in transacting the swap. d. P&G alleged that BT did not properly disclose the swap’s terms and risks and explain the potential costs of extricating itself from the swap. e. BT suffered enormous damage to its reputation and was eventually acquired by the Deutsche Bank.

ANS: C DIF: Moderate TOP: Interest Rate Swaps: A Postscript

REF: 22.5 MSC: Applied

18. The notional principal is decreased over the life of: a. an amortized swap b. a constant yield swap c. a rate-capped swap d. a forward swap e. a constant maturity swap ANS: A DIF: Easy TOP: Interest Rate Swaps: A Postscript

REF: 22.5 MSC: Factual

19. Which of the following statements is INCORRECT? a. A swap is equivalent to a combination of forward rate agreements and zero-coupon bonds. b. Analogous to a yield curve for US Treasury securities, one can create a “swap curve” from bbalibor rates for Eurodollars and par swap rates. c. The primary difference between the Treasury yield curve and the swap curve is usually attributed to credit risk. d. As the swap curve is constructed from swap rates, which in turn are based on Treasury securities, it must be identical to the Treasury yield curve. e. Just as forward rates can be computed from coupon bond prices, they can also be computed from swap rates via an analogous procedure.

ANS: D MSC: Conceptual

DIF: Moderate

REF: 22.6

TOP: Swaps and FRAs

20. Which of the following statements about municipal swaps is INCORRECT? a. A municipal swap has a state, local, or municipal government as counterparty. b. Municipal swaps are often sold through auctions. c. Many government entities use swaps and other derivatives for managing their cash flows. d. Due to privacy concerns, governments rely on regular employees for designing and executing swaps and rarely seek outside help. e. Municipal swaps face counterparty risk, basis risk, termination risk, rollover risk, and amortization risk.

ANS: D DIF: Easy TOP: Interest Rate Swaps: A Postscript

REF: 22.5 MSC: Factual

CHAPTER 23: Single-Period Binomial Heath-Jarrow-Morton Model MULTIPLE CHOICE 1. Which of the following statements about the binomial interest rate option pricing model is INCORRECT? a. The binomial model is popular because it is accessible and easy to understand. b. The binomial model is a useful teaching tool. c. The binomial model is a versatile model that can price a variety of derivatives. d. The binomial model illustrates the main tenets of martingale pricing, the key technique that lies at the heart of derivative pricing. e. The binomial model is more accurate than the Heath-Jarrow-Morton model because it makes a more realistic assumption about the bond price evolution than the HJM model.

ANS: E DIF: Easy REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Factual

2. An interest rate cap is: a. a European call option on the spot interest rate b. an American call option on the spot interest rate c. a portfolio of European call options on the spot interest rate d. a portfolio of American call options on the spot interest rate e. a portfolio of European put options on the spot interest rate ANS: C DIF: Easy REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Factual

3. Which of the following statements about an interest rate cap is correct? a. For a company that has borrowed using a floating-rate loan, a long position in an interest rate cap prevents interest costs from going above a fixed level. b. For a company that has purchased a floating-rate loan, a long position in an interest rate cap provides protection against the interest cost going above some fixed level. c. An interest rate cap guarantees a forward rate that is binding at a future date. d. An interest rate cap guarantees payments if spot prices move outside an interval, with caps at the top and bottom. e. None of these answers are correct.

ANS: A DIF: Easy REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Conceptual

4. An interest rate floor is: a. a European put option on the spot interest rate b. an American put option on the spot interest rate c. a portfolio of European put options on the spot interest rate d. a portfolio of American put options on the spot interest rate e. a portfolio of European call options on the spot interest rate ANS: C DIF: Easy REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Factual

5. Which of the following statements is correct? a. The buyer of an interest rate cap earns an amount on each payment date that is equal to the cap rate (or the strike rate) on the contract times the notional. b. The buyer of an interest rate cap earns an amount on each payment date that is, at a

minimum, the cap rate (or the strike rate) on the contract times the notional. c. The buyer of an interest rate cap earns profits when interest rates decline, so it is contract that is bearish on interest rates. d. If the buyer of an interest rate cap borrows using a floating rate bond that pays bbalibor, then its borrowing cost in any period is no larger than the cap rate (or the strike rate of the contract) times the notional. e. If the buyer of an interest rate cap purchases a floating rate bond that earns bbalibor, then it earns the cap rate (or the strike rate) times the notional each payment date.

ANS: D DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Conceptual

6. Which of the following statements is correct? a. The buyer of an interest rate floor earns an amount on each payment date that is equal to the floor rate (or the strike rate) on the contract times the notional. b. The buyer of an interest rate floor earns an amount on each payment date that has a minimum value equal to the floor rate (or the strike rate) on the contract times the notional. c. The buyer of an interest rate floor earns profits when interest rates increase, so it is contract that is bullish on interest rates. d. If the buyer of an interest rate floor issues a floating rate bond that pays bbalibor, then its borrowing cost equals the floor rate (or the strike rate) times the notional. e. If the buyer of an interest rate floor purchases a floating rate bond that earns bbalibor, then it earns at least the floor rate (or the strike rate) times the notional on each payment date.

ANS: E DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Conceptual

7. The writer of an interest rate cap: a. has the obligation to sell the underlying bond at a fixed price b. has the obligation to buy the underlying bond at a fixed price c. has the obligation to pay (the spot rate minus the strike rate) times the notional d. has the obligation to pay (the spot rate minus the strike rate) times the notional in case it’s a positive number e. has the obligation to pay (the strike rate minus the spot rate) times the notional in case it’s a positive number ANS: D DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Factual

8. The writer of an interest rate floor contract: a. has the obligation to buy the underlying bond at a fixed price b. has the obligation to sell the underlying bond at a fixed price c. has the obligation to pay (the strike rate minus the spot rate) times the notional d. has the obligation to pay (the spot rate minus the strike rate) times the notional in case it’s a positive number e. has the obligation to pay (the strike rate minus the spot rate) times the notional in case it’s a positive number ANS: E DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Factual

9. Suppose that a portfolio manager has purchased a floating rate bond. To create a zero-cost collar, the manager should trade the following interest rate derivatives that have equal values: a. sell a cap with a higher strike rate and buy a floor with a lower strike rate

b. c. d. e.

buy a cap with a higher strike rate and sell a floor with a lower strike rate sell a floor with a higher strike rate and buy a cap with a lower strike rate buy a floor with a higher strike rate and sell a cap with a lower strike rate None of these answers are correct.

ANS: A DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Applied

10. Suppose that a company has issued a floating rate note paying (bbalibor). To create an interest rate collar that confines the payments between 3 percent and 7 percent, the company should trade the following interest rate derivatives: a. buy a cap with a strike rate of 6.50 percent and sell a floor with a strike rate of 2.50 percent b. buy a cap with a strike rate of 7.00 percent and sell a floor with a strike rate of 3.00 percent c. buy a cap with a strike rate of 6.50 percent and sell a floor with a strike rate of 3.50 percent d. sell a cap with a strike rate of 7.00 percent and buy a floor with a strike rate of 3.00 percent e. sell a floor with a strike rate of 6.50 percent and buy a floor with a strike rate of 2.50 percent ANS: B DIF: Moderate REF: 23.2 TOP: The Basic Interest Rate Derivatives

MSC: Applied

11. Which of the following statements is INCORRECT? a. Vasicek built one of the first generalized interest rate option pricing models. b. Spot rate models for valuing interest rate options required the estimation of risk-premium. c. Spot rate models for valuing interest rate options could not easily match the initial yield curve. d. The Heath-Jarrow-Morton model is a continuous-time and multifactor model. e. Black’s model, a subcase of the Heath-Jarrow-Morton model, is widely used by traders.

ANS: E DIF: Easy REF: 23.3 TOP: A Brief History of Interest Rate Derivatives Models

MSC: Factual

12. The following is NOT an assumption underlying the binomial HJM option pricing model: a. no market frictions b. no credit risk c. competitive and well-functioning markets d. no interest rate uncertainty e. the forward rates follow a lognormal process ANS: E MSC: Factual

DIF: Easy

REF: 23.4

TOP: The Assumptions

13. Assume zero-coupon bond prices are B(0,0) = $1, B(0,1) = $0.967846, B(0,2) = $0.943010. What is the spot rate of interest? a. 0.0604 b. 0.0332 c. 0.0263 d. 0.0371 e. None of these answers are correct.

ANS: B

DIF: Easy

REF: 23.4

TOP: The Assumptions

MSC: Applied 14. Assume zero-coupon bond prices are B(0,0) = $1, B(0,1) = $0.967846, B(0,2) = $0.943010. What is the forward rate f (0,1)? a. 0.0332 b. 0.0375 c. 0.0263 d. 0.0604 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Easy

REF: 23.4

TOP: The Assumptions

15. A necessary and sufficient condition to rule out arbitrage profits in the single-period HJM binomial tree is that the following must hold: a. “up factor  down factor  dollar return” [U  D  (1 + R)] for all zero-coupon bonds b. U  (1 + R)  D for all zero-coupon bonds c. the pseudo-probabilities must be equal for all zero-coupon bond/money market account pairs d. the pseudo-probabilities must be equal to 1/2 e. None of these answers are correct.

ANS: C MSC: Factual

DIF: Easy

REF: 23.5

TOP: The Single-Period Model

Use the following tree to answer the questions that follow.

16. What are the dollar returns on the one-period zero-coupon bond in the up and down nodes? a. 1.0307, 1.0402 b. 1.0102, 1.0010 c. 1.0102, 1.0102 d. 1.0056, 1.0056 e. 1.0056, 1.0402 ANS: D MSC: Applied

DIF: Moderate

REF: 23.5

TOP: The Single-Period Model

17. What are the dollar returns on the two-period zero coupon-bond in the up and down nodes? a. 1.0307, 1.0402 b. 1.0102, 1.0010 c. 1.0102, 1.0102 d. 1.0056, 1.0056 e. 1.0354, 1.0056 ANS: B

DIF: Moderate

REF: 23.5

TOP: The Single-Period Model

MSC: Applied 18. What are the forward rates f (0,1), f (0,0)? a. 0.0307, 0.0402 b. 0.0102, 0.0010 c. 0.0102, 0.0102 d. 0.0056, 0.0056 e. 0.0354, 0.0056 ANS: E MSC: Applied

DIF: Moderate

REF: 23.5

TOP: The Single-Period Model

19. What are the forward rates f(1,1) in the up and down nodes? a. 0.0307, 0.0402 b. 0.0102, 0.0010 c. 0.0102, 0.0102 d. 0.0056, 0.0056 e. 0.0354, 0.0056 ANS: A MSC: Applied

DIF: Moderate

REF: 23.5

TOP: The Single-Period Model

Use the fact that the pseudo-probability of default at time zero is (1/ 2) to answer the questions that follow.

20. Consider a caplet with maturity time 1 and strike price 0.035. What are the payoffs to the option at time 1 in the up and down nodes? a. 0.0307, 0.0402 b. 0.0042, 0.0000 c. 0.0354, 0.0056 d. 0.0050, 0.0050 e. 0.0000, 0.0050 ANS: E MSC: Applied

DIF: Difficult

REF: 23.5

TOP: The Single-Period Model

21. Consider a caplet with maturity time 1 and strike price 0.035. What is the time 0 value of the caplet? a. 0.0025 b. 0.0000 c. 0.0042 d. 0.0050 e. 0.0021 ANS: A MSC: Applied

DIF: Difficult

REF: 23.5

TOP: The Single-Period Model

22. Consider a floorlet with maturity time 1 and strike price 0.035. What are the payoffs to the option at time 1 in the up and down nodes? a. 0.0307, 0.0402 b. 0.0042, 0.0000 c. 0.0354, 0.0056 d. 0.0050, 0.0050 e. 0.0000, 0.0050 ANS: B MSC: Applied

DIF: Difficult

REF: 23.5

TOP: The Single-Period Model

23. Consider a floorlet with maturity time 1 and strike price 0.035. What is the time 0 value of the floorlet? a. 0.0025 b. 0.0000 c. 0.0042 d. 0.0050 e. 0.0021 ANS: E MSC: Applied

DIF: Difficult

REF: 23.5

TOP: The Single-Period Model

CHAPTER 24: Multiperiod Binomial Heath-Jarrow-Morton Model MULTIPLE CHOICE 1. Which of the following statements is INCORRECT? a. The single-period Heath-Jarrow-Morton (HJM) model is useful as a teaching tool and cannot be used to get realistic option values. b. The single-period HJM model can be used to illustrate key ideas underlying the pricing and hedging methodology. c. Interest rate derivatives like American options, futures contracts, and swaptions need at least two periods to capture their complexity. d. Interest rate derivatives like American options, futures contracts, and swaptions need at least three periods to capture their complexity. e. The term structure evolution underlying a properly specified binomial model becomes realistic when the time between periods is small and the number of periods is large.

ANS: D MSC: Factual

DIF: Easy

REF: 24.1

TOP: Introduction

2. Identify the INCORRECT statement. If we try to fit the following derivatives in a single-period framework, then: a. an American call option becomes a European call option b. an American put option becomes a digital put option c. a futures contract simplifies to a forward contract d. a swaption becomes a deterministic security e. None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 24.1

TOP: Introduction

3. A multiperiod binomial interest rate derivative pricing model: a. has a vector of zero-coupon bonds evolving over time which are used for pricing derivatives b. requires only a spot rate evolving over time for pricing derivatives c. requires a money market account to earn a constant rate of interest across time d. requires a stock whose value goes up in the “up state” and down in the “down state” e. None of these answers are correct.

ANS: A MSC: Conceptual

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

4. Which of the following statements about the binomial interest rate derivative pricing model is INCORRECT? a. The binomial interest rate derivative pricing model assumes that the markets are competitive. b. The binomial interest rate derivative pricing model assumes that there is no credit risk. c. The binomial interest rate derivative pricing model requires as many bonds trading in each period as the number of periods in the entire tree. d. In its most general form, the branches in a binomial interest rate tree do not recombine. e. The binomial interest rate derivative pricing model imposes a structure on the evolution of zero-coupon bond prices.

ANS: C MSC: Factual

DIF: Easy

REF: 24.2

TOP: The Assumptions

5. A necessary and sufficient condition to rule out arbitrage profits in the multiperiod binomial tree is that the following must hold: a. “up factordown factordollar return” b. “up factordollar returndown factor” c. the pseudo-probability for an up movement must equal that for the down movement d. the pseudo-probabilities for an up movement at any node of the tree must be the same for all bond/money market account pairs e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

6. A multiperiod binomial model prices an interest rate derivative by: a. computing an expected payoff of the derivative’s values using actual probabilities b. computing an expected payoff of the derivative’s values using pseudo-probabilities c. computing an expected value, using actual probabilities, of the derivative’s values, discounted by the spot rates d. computing an expected value, using pseudo-probabilities, of the derivative’s values, discounted by the spot rates e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

7. Which of the following statements about caplet-floorlet parity is INCORRECT? a. It is a relationship in the interest rate world that is analogous to put-call parity for European options in the world of equities that pay no dividends. b. It enables you to price a floorlet using the price of a caplet along with some other relevant information. c. It enables you to price a caplet using the price of a floorlet along with some other relevant information. d. It is a relationship that links the prices of a caplet, a floorlet, and a zero-coupon bond with a forward rate. e. It is a relationship that links the prices of four securities: a caplet, a floorlet, a stock, and a bond.

ANS: E MSC: Factual

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

8. Which of the following statements about a binomial interest rate derivative pricing model is INCORRECT? a. The model can be used to price European caplets and floorlets. b. The model can be used to price a forward rate agreement. c. The model can be used to price a Eurodollar futures contract. d. The model can be used to price a swaption. e. The model can be used to price an equity option.

ANS: E MSC: Factual

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

9. What are the up and down dollar returns on the three-period zero-coupon bond at time 0? a. 1.046815, 1.032195 b. 1.044801, 1.034208 c. 1.039505, 1.039505 d. 1.045130, 1.038726 e. 1.031364, 1.041928 ANS: A MSC: Applied

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

10. What are the up and down dollar returns on the two-period zero-coupon bond at time 0? a. 1.046815, 1.032195 b. 1.044801, 1.034208 c. 1.039505, 1.039505 d. 1.045130, 1.038726 e. 1.031364, 1.041928 ANS: B MSC: Applied

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

11. What are the spot rates R(1) in the up and down nodes at time 1? a. 0.046815, 0.032195 b. 0.044801, 0.034208 c. 0.039505, 0.039505 d. 0.045130, 0.038726 e. 0.031364, 0.041928 ANS: E MSC: Applied

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

12. What is the value of the money market account in the up and down nodes at time 1? a. 1.046815, 1.032195 b. 1.044801, 1.034208 c. 1.039505, 1.039505 d. 1.045130, 1.038726 e. 1.031364, 1.041928

ANS: C MSC: Applied

DIF: Easy

REF: 24.3

TOP: The Two-Period Model

Use the fact that the pseudo-probability of default at time zero is (1 / 2) to answer the questions that follow.

13. Consider a caplet with maturity time 1 and strike price 0.035. What are the payoffs to the option at time 1 in the up and down nodes? a. 0.000000, 0.006649 b. 0.003525, 0.000000 c. 0.003198, 0.001696 d. 0.000000, 0.003325 e. 0.001763, 0.000000 ANS: A MSC: Applied

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

14. Consider a caplet with maturity time 1 and strike price 0.035. What is the time 0 value of the caplet? a. 0.000000 b. 0.003525 c. 0.003198 d. 0.000000 e. 0.001763 ANS: C MSC: Applied

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

15. Consider a floorlet with maturity time 1 and strike price 0.035. What are the payoffs to the option at time 1 in the up and down nodes? a. 0.000000, 0.006649 b. 0.003525, 0.000000 c. 0.003198, 0.001696 d. 0.000000, 0.003325 e. 0.001763, 0.000000

ANS: B MSC: Applied

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

16. Consider a floorlet with maturity time 1 and strike price 0.035. What is the time 0 value of the floorlet? a. 0.000000 b. 0.003525 c. 0.003198 d. 0.001696 e. 0.001763 ANS: D MSC: Applied

DIF: Moderate

REF: 24.3

TOP: The Two-Period Model

17. Consider a caplet with maturity time 1 and strike price 0.035. What are the holdings in the three-period bond and money market account at time 0 that replicate the caplet’s time 1 payoffs in both the up and down nodes? a. −0.499864, 0.458009 b. 0.265009, −0.239428 c. 0.003198, 0.001696 d. 0.000000, 0.006640 e. 0.003525, 0.000000 ANS: A MSC: Applied

DIF: Difficult

REF: 24.3

TOP: The Two-Period Model

18. Consider a floorlet with maturity time 1 and strike price 0.035. What are the holdings in the three-period bond and money market account at time 0 that replicate the floorlet’s time 1 payoffs in both the up and down nodes? a. −0.499864, 0.458009 b. 0.265009, −0.239428 c. 0.003198, 0.001696 d. 0.000000, 0.006640 e. 0.003525, 0.000000 ANS: B MSC: Applied

DIF: Difficult

REF: 24.3

TOP: The Two-Period Model

19. Consider a forward rate agreement (FRA) with maturity date 2. What is the FRA rate on this contract at time 0? a. 0.019941 b. 0.036619 c. 0.039505 d. 0.019963 e. 0.017755 ANS: B MSC: Applied

DIF: Difficult

REF: 24.3

TOP: The Two-Period Model

20. Consider a Eurodollar futures with maturity date 2. What is the Eurodollar futures rate on this contract at time 0? a. 0.019941 b. 0.036619 c. 0.039505 d. 0.019963 e. 0.017755

ANS: D MSC: Applied

DIF: Difficult

REF: 24.3

TOP: The Two-Period Model

CHAPTER 25: The Heath-Jarrow-Morton Libor Model MULTIPLE CHOICE 1. Why was Black’s model not useful for pricing caplets? a. It was a model for equity options, not futures. b. It assumed that the spot rate of interest rates is constant. c. It only applied to floorlets, not caplets. d. Caplets are American options, and Black’s model is for valuing European options. e. Both (b) and (d).

ANS: B MSC: Factual

DIF: Easy

REF: 25.3

TOP: A History of Caplet Pricing

2. The HJM libor model does NOT assume which of the following? a. no market frictions b. no credit risk c. competitive and well-functioning markets d. no arbitrage opportunities e. no interest rate risk ANS: E MSC: Factual

DIF: Easy

REF: 25.4

TOP: The Assumptions

3. The alleged manipulation of bbalibor by several London-based international banks in 2008 led to the violation of which of the following assumptions underlying the HJM libor model? a. no market frictions b. no credit risk c. competitive and well-functioning markets d. no intermediate cash flows e. no arbitrage opportunities ANS: C MSC: Factual

DIF: Easy

REF: 25.4

TOP: The Assumptions

4. Which statement in connection with the alleged manipulation of bbalibor by several London-based international banks in 2008 is INCORRECT? a. In early 2008, bbalibor was higher than what it should have been because of irrational reactions to the credit crisis. b. Toward the end of 2007 and in early 2008, many market observers complained that bbalibor was lower than what it should have been, and that it did not reflect the true cost of bank funds. c. Bbalibor’s originator, the British Bankers’ Association, initially denied any bias in bbalibor values, but eventually agreed to conduct a review of the matter. d. The alleged mispricing was reduced after it became known that British Bankers’ Association was conducting a review of the bbalibor. e. The alleged mispricing of bbalibor has attracted regulatory probes and lawsuits.

ANS: A MSC: Factual

DIF: Easy

REF: 25.4

TOP: The Assumptions

5. Which formula is correct for a simple forward interest rate over [T, T + ]?

a. b. c.

d.

e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Easy

REF: 25.4

TOP: The Assumptions

6. The HJM libor model assumes which of the following? a. continuously compounded forward rates are lognormally distributed b. zero-coupon bond prices are normally distributed c. simple forward rates are normally distributed d. simple forward rates are lognormally distributed e. continuously compounded forward rates are normally distributed ANS: D MSC: Factual

DIF: Easy

REF: 25.4

TOP: The Assumptions

Zero-coupon bond prices are given by B(0,T), where 0 is today, and T (measured in years) is the bond’s maturity date.

7. The spot rate f (0,0) and the forward rate f (0,1) are given by: a. 0.041667 and 0.042588 b. 0.041667 and 0.043478 c. 0.041667 and 0.042553 d. 0.043478 and 0.045455 e. None of these answers are correct.

ANS: B MSC: Applied

DIF: Easy

REF: 25.4

TOP: The Assumptions

8. Considering the time interval from 1 year to 1.5 years, the simple forward rate is given by: a. 0.041667 b. 0.043478 c. 0.042588

d. 0.042553 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Moderate

REF: 25.4

TOP: The Assumptions

9. Suppose that you compute the simple forward rate over the time period that begins after one year and continues over the next day, and use it as an approximation to the continuously compounded forward rate. Then the value that you obtain is: a. 0.041667 b. 0.043478 c. 0.042588 d. 0.042553 e. None of these answers are correct.

ANS: C MSC: Applied

DIF: Moderate

REF: 25.4

TOP: The Assumptions

A company buys a caplet today (time 0) with maturity T = 1 year and a strike rate of k = 3 percent on a notional of LN = $200 million. Suppose the six-month bbalibor rate realized after one year is 4.5 percent. Assume that there are 181 days in this six-month period and the year has 365 days.

10. The caplet’s payoff after 1.5 years: a. $971,945 b. $991,781 c. $1,457,918 d. $1,487,671 e. None of these answers are correct.

ANS: D MSC: Applied

DIF: Moderate

REF: 25.5

TOP: Pricing Caplets

11. Suppose that after one year, the price of a zero-coupon bond that matures after six months is worth $0.9780. The caplet’s payoff after one year is: a. $1,454,942 b. $1,470,000 c. $1,487,671 d. $1,500,000 e. None of these answers are correct.

ANS: A MSC: Applied

DIF: Moderate

REF: 25.5

TOP: Pricing Caplets

12. Which of the following inputs into the HJM libor model caplets formula are NOT easily observable? a. zero-coupon bond prices b. simple forward interest rates c. cap rate d. maturity e. the average forward rate volatility ANS: E MSC: Factual

DIF: Moderate

REF: 25.6

TOP: The Inputs

13. Which of the following statements is NOT true with respect to the average forward rate volatility? a. It can be estimated using historical data on forward rates.

b. It can be estimated implicitly using caplet prices. c. If the HJM libor model is rejected using historical data, it can be estimated using calibration. d. If the HJM libor model is accepted using historical data, it can be estimated using calibration. e. If the HJM libor model is rejected, it can be estimated using historical data.

ANS: C MSC: Factual

DIF: Moderate

REF: 25.6

TOP: The Inputs

14. Which of the following statements is NOT true with respect to the HJM libor model? a. The caplet’s price can be computed using risk-neutral valuation. b. The simple forward rate is a martingale using the pseudo-probabilities. c. The model assumes investors are risk-neutral. d. The pseudo-probabilities are the actual probabilities adjusted for an interest rate risk premium. e. The HJM libor caplet formula is similar in appearance to the Black-Scholes-Merton model call formula.

ANS: C MSC: Factual

DIF: Moderate

REF: 25.6

TOP: The Inputs

Use the following data for a caplet and floorlet to answer the questions that follow:

15. What is the caplet’s value? a. 0.000717 b. 0.005433 c. 0.001690 d. 0.003256 e. 0.306680 ANS: C MSC: Applied

DIF: Difficult

REF: 25.6

TOP: The Inputs

16. What is the floorlet’s value? a. 0.000717 b. 0.005433 c. 0.001690 d. 0.003256 e. 0.306680 ANS: A MSC: Applied

DIF: Difficult

REF: 25.8

TOP: Caps and Floors

Use the following data for a caplet and floorlet to answer the questions that follow:

17. What is the caplet’s value? a. 0.148434 b. 0.224304 c. 0.005835 d. 0.008877 e. 0.001248 ANS: E MSC: Applied

DIF: Difficult

REF: 25.5

TOP: Pricing Caplets

REF: 25.8

TOP: Caps and Floors

18. What is the floorlet’s value? a. 0.148434 b. 0.224304 c. 0.005835 d. 0.008877 e. 0.001248 ANS: C MSC: Applied

DIF: Difficult

19. Suppose that you have computed the historical average forward rate variance with weekly data. To convert this to an annual variance, use the following adjustment:

a. b. c. d. e.

Variance (Annual) = Variance (Weekly)  12 Variance (Annual) = Variance (Weekly)  52 Variance (Annual) = Variance (Weekly)  250 Variance (Annual) = Variance (Weekly)  260 None of these answers are correct.

ANS: B MSC: Factual

DIF: Easy

REF: 25.6

TOP: The Inputs

20. Once an interest rate caplet is priced using the HJM libor model, you CANNOT price which of the following derivatives using a closed-form solution? a. an interest rate cap, which is a series of caplets b. an Asian interest rate cap, by computing a series of caplets maturing on consecutive days and then taking their average c. an interest rate floorlet, by caplet-floorlet parity d. an interest rate floor, which is a series of floorlets e. an interest rate collar, by pricing a cap and a floor ANS: B MSC: Conceptual

DIF: Moderate

REF: 25.8

TOP: Caps and Floors

21. Which of the following statements is NOT true of the HJM libor model? a. Continuous compounded forward rates have a lognormal distribution. b. There are no closed-form solutions for floorlets. c. There are no closed-form solutions for American floorlets. d. There are no closed-form solutions for swaptions. e. Floorlets can be priced using caplet prices and caplet-floorlet parity.

ANS: B MSC: Factual

DIF: Moderate

REF: 25.9

TOP: Using the HJM Libor Model

22. Which of the following statements is INCORRECT? a. A caplet’s delta measures how a small change in the underlying simple forward rate changes the caplet’s value. b. A portfolio of caplets can be delta- and gamma-hedged. c. The hedging approach in the case of the HJM libor model is analogous to that of the Black-Scholes-Merton model. d. As the HJM libor model specifies an evolution for simple forward rates, rho hedging becomes an effective tool for managing interest rate risk in a portfolio consisting of caplets. e. A delta-hedge involves trading another interest rate–sensitive security in order to remove all the interest rate risk from a long caplet position.

ANS: D MSC: Factual

DIF: Moderate

REF: 25.9

TOP: Using the HJM Libor Model

23. Identify the INCORRECT statement. The HJM libor model’s closed-form solution: a. cannot be used for pricing American options b. cannot be used for pricing Asian options c. cannot be used for pricing interest rate futures d. cannot be used for pricing swaptions e. cannot be used for pricing an interest rate collar ANS: E DIF: Moderate REF: 25.10 TOP: American Options, Futures, Swaptions, and Other Derivatives

MSC: Factual

CHAPTER 26: Risk-Management Models MULTIPLE CHOICE 1. Which of the following statements regarding Goldman Sachs avoiding huge losses from mortgage-backed securities (MBS) is INCORRECT? a. Goldman Sachs’s model for measuring risks failed to give any indication of the impending crisis in the housing market. b. Goldman Sachs’s model for measuring risks indicated that there was something wrong in the MBS market. c. Goldman Sachs convened a meeting of risk managers and senior executives who discussed the market and decided to reduce their MBS risk exposure. d. Goldman Sachs’s action enabled the firm to avoid billions of dollars in losses when the housing market crashed in summer 2007. e. While some observers claim that this incident illustrated a failure of models, a careful consideration reveals that by raising warning signs in a timely fashion, the model saved the firm from multibillion dollar losses.

ANS: A MSC: Factual

DIF: Easy

REF: 26.1

TOP: Introduction

2. Many of the tools of risk management can be developed by focusing on computing a loss distribution.

Denote the time t value of a firm’s assets, liabilities, and equity by At, Lt, and Et, respectively. If  denotes a change in these quantities, and x denotes a predetermined value, then the risk measurement problem may be set up as: a. computing Prob Et  xwhere Et  At − Lt b. computing Prob Et  xwhere Et  At + Lt c. computing Prob At  xwhere At  Et − Lt d. computing Prob Lt  xwhere Lt  At − Et e. None of these answers are correct.

ANS: A DIF: Easy REF: 26.2 TOP: A Framework for Financial Risk Management

MSC: Factual

3. What is the definition of value-at-risk (VAR) for a one-year horizon? a. VAR is the standard deviation of the firm’s equity returns per year. b. VAR is the variance of the firm’s equity returns per year. c. VAR is the value that the firm’s losses will exceed with a given probability for a one-year horizon. d. VAR is the value that the firm’s profits will exceed with a given probability for a one-year horizon. e. VAR is the variance of the firm’s profits per year.

ANS: C DIF: Easy REF: 26.4 TOP: Value-at-Risk and Scenario Analysis

MSC: Factual

4. Which of the following is NOT true about value-at-risk (VAR)? a. VAR penalizes diversification for some asset/liability portfolios. b. VAR should be the sole measure used to quantify a firm’s insolvency risk. c. VAR ignores losses greater than the VAR –percentage level. d. VAR is computed using the equity’s loss distribution. e. VAR measures the firm’s insolvency risk.

ANS: B DIF: Easy REF: 26.4 TOP: Value-at-Risk and Scenario Analysis

MSC: Factual

5. Your Beloved Machines Inc.’s stock has a weekly expected return of 0.0025 and weekly volatility of the returns of 0.03. Then the weekly 95 percent and 99 percent confidence levels (value-at-risk at the 5 and 1 percent levels) for YBM are (where 5 percent left tail is 1.65 standard deviations and 1 percent tail is 2.33 standard deviations away from the mean): a. 4.70 percent and 6.74 percent b. 5.23 percent and 3.75 percent c. 4.70 percent and 3.75 percent d. 2.50 percent and 3.00 percent e. None of these answers are correct.

ANS: A DIF: Moderate REF: 26.4 TOP: Value-at-Risk and Scenario Analysis

MSC: Applied

6. The following is NOT a valid step in scenario analysis (popularly known as stress testing): a. select a particular set of “scenarios” that the firm wants to protect against b. scenarios can correspond to various states of the economy represented by paths of the state variables (which may be a collection of macroeconomic variables such as inflation, gross domestic product, unemployment, and interest rates) c. the set of scenarios can be generated by changing the state variables by some known amounts (such as raising interest rates by 1 percent or decreasing unemployment by 2 percent) d. for these scenarios, the firm computes the losses realized on its assets and liabilities e. the firm computes VAR based on the scenarios selected ANS: E DIF: Moderate REF: 26.4 TOP: Value-at-Risk and Scenario Analysis

MSC: Factual

7. Which of the following statements regarding risk measures is INCORRECT? a. A risk measure is a positive real valued function that quantifies the “risk” to changes in a firm’s equity capital—losses—over some time period. b. Examples of risk measures include the maximum loss, the expected loss, and the value-at-risk. c. Artzner, Delbaen, Eber, and Heath (1999) identified four different properties or axioms that a good risk measure should satisfy. d. A risk measure satisfying Artzner, Delbaen, Eber, and Heath (1999) four axioms is called a coherent risk measure. e. Value-at-risk is the best risk measure because it satisfies all four properties above.

ANS: E DIF: Moderate REF: 26.4 TOP: Value-at-Risk and Scenario Analysis

MSC: Factual

8. Which of the following are NOT included in market risk? a. equity price fluctuations b. interest rate fluctuations c. commodity price fluctuations d. risk of debt defaulting e. exchange rate fluctuations ANS: D MSC: Factual

DIF: Easy

REF: 26.5

9. In the structural model, the firm’s equity can be viewed as:

TOP: The Four Risks

a. b. c. d. e.

a European call option on the assets of the firm a European put option on the assets of the firm an American call option on the assets of the firm an American put option on the assets of the firm riskless debt plus shorting a put option on the assets of the firm

ANS: A MSC: Factual

DIF: Moderate

REF: 26.5

TOP: The Four Risks

10. In the structural model, the firm’s debt can be viewed as: a. a European call option on the assets of the firm b. a European put option on the assets of the firm c. an American call option on the assets of the firm d. an American put option on the assets of the firm e. riskless debt plus shorting a European put option on the assets of the firm ANS: E MSC: Factual

DIF: Moderate

REF: 26.5

TOP: The Four Risks

11. When a company undertakes risky ventures, who are most likely to lose if the firm defaults? a. senior debt holders b. junior debt holders c. preferred stock holders (who get paid after the junior debt holders) d. stockholders e. It’s impossible to know.

ANS: D MSC: Conceptual

DIF: Easy

REF: 26.5

TOP: The Four Risks

12. What is the key problem with the structural model? a. It assumes a simple liability structure for the firm’s balance sheet. b. It assumes the assets of the firm trade in frictionless and competitive markets. c. It assumes interest rates are constant. d. It assumes a lognormal distribution for asset returns. e. It assumes the equity pays no dividends.

ANS: B MSC: Conceptual

DIF: Moderate

REF: 26.5

TOP: The Four Risks

13. Which assumption(s) does the reduced-form model relax in the structural model? a. The simple liability structure for the firm’s balance sheet. b. The assets of the firm trade in frictionless and competitive markets. c. Interest rates are constant. d. All of these answers are correct. e. None of these answers are correct.

ANS: D MSC: Factual

DIF: Moderate

REF: 26.5

TOP: The Four Risks

14. Operational risk is: a. the risk to a firm’s financial condition resulting from adverse movements in the level or volatility of market prices b. the risk that a counterparty will fail to perform on an obligation c. the risk that a firm may not be able to, or cannot easily, unwind or offset an asset or liability position at or near the previous market price because of inadequate market depth

or because of disruptions in the marketplace d. the risk that deficiencies in information systems or internal controls will result in an unexpected loss e. the risk that a firm will become insolvent ANS: D MSC: Factual

DIF: Easy

REF: 26.5

TOP: The Four Risks

15. Which of the following is a reason why the financial crisis occurred? a. lax mortgage lending standards b. strong government regulation of over-the-counter derivatives markets c. accurate rating of structured debt by the credit rating agencies d. strong due diligence of financial institutions with respect to their investments e. sufficient capital in financial institutions ANS: A MSC: Factual

DIF: Difficult

REF: 26.6

TOP: The Credit Crisis of 2007

16. Which of the following is a possible reason why credit rating agencies incorrectly rated structured debt? a. incentive problems in the way credit rating agencies were paid b. the industry is collusive c. they were not overseen by the Securities and Exchange Commission d. the credit rating agencies were understaffed e. the credit rating agencies were losing profits before the crisis ANS: A MSC: Factual

DIF: Difficult

REF: 26.6

TOP: The Credit Crisis of 2007

17. Which of the following statements is NOT true about asset-backed securities (ABS)? a. ABS are issued by a legal entity called a special purpose vehicle (SPV). b. ABS SPV assets consist of a collection of loans. c. ABS are tranched so that the cash flows follow a “waterfall.” d. ABS are sometimes called structured debt. e. ABS are very similar to corporate debt.

ANS: E MSC: Factual

DIF: Difficult

REF: 26.6

TOP: The Credit Crisis of 2007

18. Which of the following statements is NOT true about derivatives? a. Derivatives are a newcomer to financial markets in the past fifty years. b. Derivatives help to complete markets. c. Derivatives are regulated by either the Securities and Exchange Commission or the Commodity Futures Trading Commission. d. Derivatives usually require models to determine hedge ratios. e. Derivatives can be used incorrectly if not well understood.

ANS: A DIF: Moderate REF: 26.7 TOP: The Future of Models and Traded Derivatives

MSC: Factual