Investments
Pre-Test Questions
Course Introduction
This course provides a comprehensive introduction to the principles and practices of investment analysis and portfolio management. Students will explore key concepts such as risk and return, asset allocation, diversification, and the functioning of financial markets. The curriculum covers a variety of investment vehicles, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and alternative investments. Emphasis is placed on valuation techniques, security analysis, and performance measurement, equipping students with practical skills for making informed investment decisions both as individuals and within institutional contexts. The course also examines behavioral finance and the impact of economic trends on investment strategies.
Recommended Textbook Fundamentals of Futures and Options Markets 8th Edition by John C. Hull
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Chapter 1: Introduction
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Q1) A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the stock with a strike price of $30 costs $4. Suppose that a trader buys two call options and one put option. The breakeven stock price below which the trader makes a profit is
A) $25
B) $28
C) $26
D) $20
Answer: D
Q2) Which of the following is NOT true?
A) When a CBOE call option on IBM is exercised, IBM issues more stock
B) An American option can be exercised at any time during its life
C) An call option will always be exercised at maturity if the underlying asset price is greater than the strike price
D) A put option will always be exercised at maturity if the strike price is greater than the underlying asset price
Answer: A
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3
Chapter 2: Mechanics of Futures Markets
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Q1) The frequency with which margin accounts are adjusted for gains and losses is
A) Daily
B) Weekly
C) Monthly
D) Quarterly
Answer: A
Q2) Margin accounts have the effect of
A) Reducing the risk of one party regretting the deal and backing out
B) Ensuring funds are available to pay traders when they make a profit
C) Reducing systemic risk due to collapse of futures markets
D) All of the above
Answer: D
Q3) Which of the following best describes central clearing parties?
A) Help market participants to value derivative transactions
B) Must be used for all OTC derivative transactions
C) Are used for futures transactions
D) Perform a similar function to exchange clearing houses
Answer: D
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4
Chapter 3: Hedging Strategies Using Futures
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Q1) A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary to reduce beta to 0.9?
A) Long 192 contracts
B) Short 192 contracts
C) Long 48 contracts
D) Short 48 contracts
Answer: D
Q2) Which of the following is true?
A) Hedging can always be done more easily by a company's shareholders than by the company itself
B) If all companies in an industry hedge, a company in the industry can sometimes reduce its risk by choosing not to hedge
C) If all companies in an industry do not hedge, a company in the industry can reduce its risk by hedging
D) If all companies in an industry do not hedge, a company is liable increase its risk by hedging
Answer: D
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5
Chapter 4: Interest Rates
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Q1) An interest rate is 12% per annum with semiannual compounding. What is the equivalent rate with quarterly compounding?
A) 11.83%
B) 11.66%
C) 11.77%
D) 11.92%
Q2) The two-year zero rate is 6% and the three year zero rate is 6.5%. What is the forward rate for the third year? All rates are continuously compounded.
A) 6.75%
B) 7.0%
C) 7.25%
D) 7.5%
Q3) Since the credit crisis that started in 2007 which of the following have derivatives traders started to use as the risk-free rate for some transactions?
A) The Treasury rate
B) The LIBOR rate
C) The repo rate
D) The overnight indexed swap rate
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6
Chapter 5: Determination of Forward and Futures Prices
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Q1) Which of the following is NOT true?
A) Gold and silver are investment assets
B) Investment assets are held by significant numbers of investors for investment purposes
C) Investment assets are never held for consumption
D) The forward price of an investment asset can be obtained from the spot price, interest rates and the income paid on the asset
Q2) Which of the following is true?
A) The convenience yield is always positive or zero
B) The convenience yield is always positive for an investment asset
C) The convenience yield is always negative for a consumption asset
D) The convenience yield measures the average return earned by holding futures contracts
Q3) Which of the following is a consumption asset?
A) The S&P 500 index
B) The Canadian dollar
C) Copper
D) IBM stock
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Chapter 6: Interest Rate Futures
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Q1) In the U.S. what is the longest maturity for 3-month Eurodollar futures contracts?
A) 2 years
B) 5 years
C) 10 years
D) 20 years
Q2) How much is a basis point?
A) 1.0%
B) 0.1%
C) 0.01%
D) 0.001%
Q3) Duration matching immunizes a portfolio against
A) Any parallel shift in the yield curve
B) All shifts in the yield curve
C) Changes in the steepness of the yield curve
D) Small parallel shifts in the yield curve
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8
Chapter 7: Swaps
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Q1) Which of the following describes an interest rate swap?
A) The exchange of a fixed rate bond for a floating rate bond
B) A portfolio of forward rate agreements
C) An agreement to exchange interest at a fixed rate for interest at a floating rate
D) All of the above
Q2) Which of the following is a way of valuing interest rate swaps where LIBOR is exchanged for a fixed rate of interest?
A) Assume that floating payments will equal forward LIBOR rates and discount net cash flows at the risk-free rate
B) Assume that floating payments will equal forward OIS rates and discount net cash flows at the risk-free rate
C) Assume that floating payments will equal forward LIBOR rates and discount net cash flows at the swap rate
D) Assume that floating payments will equal forward OIS rates and discount net cash flows at the swap rate
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Chapter 8: Securitization and the Credit Crisis of 2007
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Q1) Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 80%, mezzanine 10%, and equity 10%. (The portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from the mezzanine tranches with the same allocation of principal. Losses on the mortgage portfolio prove to be 16%. What, as a percent of tranche principal, are losses on the senior tranche of the ABS CDO?
A) 50%
B) 60%
C) 80%
D) 100%
Q2) Which of the following describes a subprime mortgage?
A) The rate of interest is less than the prime rate of interest
B) The loan-to-value ratio is below average
C) The life of the mortgage is less than 25 years
D) The credit risk is high
Q3) AIG lost money because
A) It bought tranches created from mortgages
B) It invested heavily in real estate
C) It invested heavily in the stock market
D) It insured AAA tranches of ABS CDOs
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Chapter 9: Mechanics of Options Markets
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Q1) Which of the following is an example of an option class?
A) All calls on a certain stock
B) All calls with a particular strike price on a certain stock
C) All calls with a particular time to maturity on a certain stock
D) All calls with a particular time to maturity and strike price on a certain stock
Q2) Which of the following is an example of an option series?
A) All calls on a certain stock
B) All calls with a particular strike price on a certain stock
C) All calls with a particular time to maturity on a certain stock
D) All calls with a particular time to maturity and strike price on a certain stock
Q3) An investor has exchange-traded put options to sell 100 shares for $20. There is a 2 for 1 stock split. Which of the following is the position of the investor after the stock split?
A) Put options to sell 100 shares for $20
B) Put options to sell 100 shares for $10
C) Put options to sell 200 shares for $10
D) Put options to sell 200 shares for $20
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11
Chapter 10: Properties of Stock Options
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Q1) Which of the following is true when dividends are expected?
A) Put-call parity does not hold
B) The basic put-call parity formula can be adjusted by subtracting the present value of expected dividends from the stock price
C) The basic put-call parity formula can be adjusted by adding the present value of expected dividends to the stock price
D) The basic put-call parity formula can be adjusted by subtracting the dividend yield from the interest rate
Q2) A stock price (which pays no dividends) is $50 and the strike price of a two year European put option is $54. The risk-free rate is 3% (continuously compounded). Which of the following is a lower bound for the option such that there are arbitrage opportunities if the price is below the lower bound and no arbitrage opportunities if it is above the lower bound?
A) $4.00
B) $3.86
C) $2.86
D) $0.86
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Page 12
Chapter 11: Trading Strategies Involving Options
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Q1) How can a straddle be created?
A) Buy one call and one put with the same strike price and same expiration date
B) Buy one call and one put with different strike prices and same expiration date
C) Buy one call and two puts with the same strike price and expiration date
D) Buy two calls and one put with the same strike price and expiration date
Q2) When the interest rate is 5% per annum with continuous compounding, which of the following creates a $1000 principal protected note?
A) A one-year zero-coupon bond plus a one-year call option worth about $59
B) A one-year zero-coupon bond plus a one-year call option worth about $49
C) A one-year zero-coupon bond plus a one-year call option worth about $39
D) A one-year zero-coupon bond plus a one-year call option worth about $29
Q3) What is a description of the trading strategy where an investor sells a 3-month call option and buys a one-year call option, where both options have a strike price of $100 and the underlying stock price is $75?
A) Neutral Calendar Spread
B) Bullish Calendar Spread
C) Bearish Calendar Spread
D) None of the above
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13
Chapter 12: Introduction to Binomial Trees
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Q1) Which of the following is NOT true in a risk-neutral world?
A) The expected return on a call option is independent of its strike price
B) Investors expect higher returns to compensate for higher risk
C) The expected return on a stock is the risk-free rate
D) The discount rate used for the expected payoff on an option is the risk-free rate
Q2) Which of the following are NOT true?
A) Risk-neutral valuation and no-arbitrage arguments give the same option prices
B) Risk-neutral valuation involves assuming that the expected return is the risk-free rate and then discounting expected payoffs at the risk-free rate
C) A hedge set up to value an option does not need to be changed
D) All of the above
Q3) If the volatility of a stock is 20% per annum and a risk-free rate is 5% per annum, which of the following is closest to the Cox, Ross, Rubinstein parameter p for a tree with a three-month time step?
A) 0.50
B) 0.54
C) 0.58
D) 0.62
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Chapter 13: Valuing Stock Options: the Bsm Model
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Q1) When there are two dividends on a stock, Black's approximation sets the value of an American call option equal to which of the following?
A) The value of a European option maturing just before the first dividend
B) The value of a European option maturing just before the second (final) dividend
C) The greater of the values in A and B
D) The greater of the value in B and the value assuming no early exercise
Q2) What was the original Black-Scholes-Merton model designed to value?
A) A European option on a stock providing no dividends
B) A European or American option on a stock providing no dividends
C) A European option on any stock
D) A European or American option on any stock
Q3) The volatility of a stock is 18% per year. What is the volatility per month?
A) 1.5%
B) 3.0%
C) 5.2%
D) None of the above
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15
Chapter 14: Employee Stock Options
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Q1) Which of the following strategies makes no sense?
A) An employee exercises stock options early and sells the stock. No dividends are expected
B) An employee exercises stock options early and keeps the stock. No dividends are expected
C) An employee exercises stock options early and sells the stock. Dividends are expected
D) An employee exercises stock options early and keeps the stock. Dividends are expected
Q2) What term is used to describe losses shareholders experience because the interests of managers are not aligned with their own?
A) Agency costs
B) Backdating scandals
C) Dilution
D) Income statement expense
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16
Chapter 15: Options on Stock Indices and Currencies
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Q1) What is the size of one option contract on the S&P 500?
A) 250 times the index
B) 100 times the index
C) 50 times the index
D) 25 times the index
Q2) A portfolio manager in charge of a portfolio worth $10 million is concerned that stock prices might decline rapidly during the next six months and would like to use options on an index to provide protection against the portfolio falling below $9.5 million. The index is currently standing at 500 and each contract is on 100 times the index. What position is required if the portfolio has a beta of 1?
A) Short 200 contracts
B) Long 200 contracts
C) Short 100 contracts
D) Long 100 contracts
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Chapter 16: Futures Options
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Q1) The risk-free rate is 5% and the dividend yield on the S&P 500 index is 2%. Which of the following is correct when a futures option on the index is being valued?
A) The futures price of the S&P 500 is treated like a stock paying a dividend yield of 5%
B) The futures price of the S&P 500 is treated like a stock paying a dividend yield of 2%
C) The futures price of the S&P 500 is treated like a stock paying a dividend yield of 3%
D) The futures price of the S&P 500 is treated like a non-dividend-paying stock
Q2) A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34 cents in the next six months. The risk-free interest rate is 6%. What is the value of a six-month put option with a strike price of 37 cents?
A) 3.00 cents
B) 2.91 cents
C) 1.16 cents
D) 1.20 cents
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18
Chapter 17: The Greek Letters
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Q1) What does rho measure?
A) The rate of change of delta with the asset price
B) The rate of change of the portfolio value with the passage of time
C) The sensitivity of a portfolio value to interest rate changes
D) None of the above
Q2) Which of the following is NOT true about gamma?
A) A highly positive or highly negative value of gamma indicates that a portfolio needs frequent rebalancing to stay delta neutral
B) The magnitude of gamma is a measure of the curvature of the portfolio value as a function of the underlying asset price
C) A big positive value for gamma indicates that a big movement in the asset price in either direction will lead to a loss
D) A long position in either a call or a put has a positive gamma
Q3) Vega tends to be high for which of the following?
A) At-the money options
B) Out-of-the money options
C) In-the-money options
D) Options with a short time to maturity
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Chapter 18: Binomial Trees in Practice
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Q1) A binomial tree prices an American option at $3.12 and the corresponding European option at $3.04. The Black-Scholes price of the European option is $2.98. What is the control variate price of the American option?
A) $3.06
B) $3.18
C) $2.90
D) $3.08
Q2) When the volatility of an option increases from 30% to 32% the value of the option increases from $2.00 to $2.40. What is the vega of the option?
A) 0.20 dollars per %
B) 0.50 dollars per %
C) 0.80 dollars per %
D) 2.00 dollars per %
Q3) What is the recommended way of making volatility a function of time in a Cox, Ross, Rubinstein tree?
A) Make u a function of time
B) Make p a function of time
C) Make u and p a function of time
D) Make the lengths of the time steps unequal
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Page 20
Chapter 19: Volatility Smiles
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Q1) Which of the following is true?
A) The volatility skew for equities is much more pronounced now than it was in 1985
B) The volatility skew for equities has a positive gradient
C) The volatility skew for equities is consistent with the Black-Scholes-Merton model
D) The volatility skew for equities is similar to that for foreign currencies
Q2) Which of the following is true for European call and put options?
A) If they have the same strike price, they have the same implied volatility
B) If they have the same time to maturity, they have the same implied volatility
C) If they have the same strike price and time to maturity, they have the same implied volatility
D) None of the above
Q3) Which of the following is true as time to maturity increases?
A) The volatility smile for currency options tends to become more pronounced
B) The volatility smile for currency options tends to become less pronounced
C) The volatility smile for currency options first becomes less pronounced and then becomes more pronounced
D) The volatility smile for currency options remains approximately the same
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Chapter 20: Value at Risk
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Q1) The 10-day VaR is often assumed to be which of the following?
A) The 1-day VaR multiplied by 10
B) The 1-day VaR multiplied by the square root of 10
C) The 1-day VaR divided by 10
D) The 1-day VaR divided by the square root of 10
Q2) An investor has $2,000 invested in stock A and $5,000 in stock B. The daily volatilities of A and B are 1.5% and 1% respectively and the coefficient of correlation is 0.8. What is the one day 99% VaR? (Note that N(-2.33)=0.01)
A) $177
B) $135
C) $215
D) $331
Q3) Which of the following describes stressed VaR?
A) It is based on movements in market variables in stressed market conditions
B) It is VaR with a very high confidence level
C) It is VaR multiplied by a factor of 3
D) None of the above
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Chapter 21: Interest Rate Options
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Q1) In a floor with semiannual reset dates, the floor rate is 3.5% per annum and the notional principal is $1 million. Suppose that the LIBOR rate is 3% per annum for a particular 6-month period. What is the approximate payoff at the end of the 6 months?
A) $10,000
B) $5,000
C) $2,500
D) $1,250
Q2) Which of the following is true?
A) A swaption that gives the holder the right to pay fixed is equivalent to a call option on a bond
B) A swaption that gives the holder the right to pay fixed is equivalent to a put option on a bond
C) A swaption that gives the holder the right to pay fixed is equivalent to a put option on one bond combined with a call option on another bond
D) None of the above
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Chapter 22: Exotic Options and Other Nonstandard Products
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Q1) As the barrier is observed more frequently, a knock out option becomes which of the following?
A) More valuable
B) Less valuable
C) There is no effect on value
D) May become more valuable or less valuable
Q2) A binary option pays of $100 if a stock price is greater than its current value in three months. The risk-free rate is 3% and the volatility is 40%. Which of the following is its value?
A) 99.25N(-0.1375)
B) 99.25N(0.1375)
C) 99.25N(-0.0625)
D) 99.25N(0.0625)
Q3) Which of the following would be referred to as an equity swap?
A) An exchange of the return from an equity index for a fixed rate of interest
B) An exchange of a long position in one stock for a long position in another stock
C) An exchange of a short position in one stock for a short position in another stock
D) None of the above
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Chapter 23: Credit Derivatives
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Q1) Which of the following is true about a CDS?
A) Restructuring is never a credit event
B) Restructuring is always a credit event
C) Certain types of restructuring qualify as credit events but others do not
D) Sometimes a CDS is defined so that restructuring is a credit event and sometimes it is not
Q2) Suppose that the cumulative probability of a company defaulting by years one, two, three and four are 3%, 6.5%, 10%, and 14.5%, respectively. What is the probability of default in the fourth year conditional on no earlier default?
A) 4.5%
B) 5.0%
C) 5.5%
D) 6.0%
Q3) What is the rating of the companies underlying the iTraxx index?
A) A or above
B) BBB or above
C) BB or below
D) BBB or below
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Chapter 24: Weather, Energy, and Insurance Derivatives
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Q1) Which of the following is NOT true about electricity?
A) Supply and demand for electricity are matched within 140 control areas in the US, then excess power sold to other control areas
B) The ability to sell excess power is constrained by transmission capacity
C) Electricity is a commodity that can be easily stored
D) Air conditioning is a big use of electricity
Q2) Which of the following are products refined from crude oil?
A) Heating oil
B) Gasoline
C) Kerosene
D) All of the above
Q3) Which of the following typically has the lowest volatility?
A) Crude oil
B) Natural gas
C) Electricity in the winter
D) Electricity in the summer
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