Chapter 10 Derivative Securities Markets

True/False Questions
1. Credit derivatives generally provide a means for lenders to hedge against an increase
in a borrower's default risk on a loan.
Answer: True Page: !" #evel: $asy
. %orward contracts are marked to market daily.
Answer: %alse Page: !& #evel: $asy
'. %utures or option e(change members who take positions on contracts for only a few
moments are called scalpers.
Answer: True Page: )1 #evel: $asy
*. The seller of a T+bond futures contract priced at 1,1+1& at the time of sale agrees to
deliver -1,,.,,, face value Treasury bonds in e(change for receiving -1,1.",, at
contract maturity.
Answer: True Page: )+)' #evel: /edium
". A negotiated non+standardi0ed agreement between a buyer and seller 1with no third
party involvement2 to e(change an asset for cash at some future date. with the price set
today is called a forward agreement.
Answer: True Page: !&+!3 #evel: $asy
&. /arking to market of futures contracts is the process of reali0ing gains and losses each
day as the futures contract changes in price.
Answer: True Page: !3 #evel: $asy
3. $uropean style options are options that are traded on the $ure( e(change.
Answer: %alse Page: !" #evel: $asy
!. 4n a futures contract if funds in the margin account fall below the maintenance margin
re5uirement. a margin call is issued.
Answer: True Page: !! #evel: $asy
1',
). 6ou would e(pect the price 5uote for a put option to be at least -1, if the put had an
e(ercise price of -*, and the underlying stock was selling for -",.
Answer: %alse Page: )) #evel: /edium
1,. A clearinghouse backs the buyer's and seller's position in an forward contract.
Answer: %alse Page: ) #evel: $asy
11. American options can only be e(ercised at maturity.
Answer: %alse Page: )) #evel: $asy
1. 4f you think that interest rates are likely to rise substantially over the ne(t several years
you might sell a T+bond futures contract or buy an interest rate cap to take advantage
of your e(pectations.
Answer: True Page: )*+)". '1 #evel: /edium
1'. 7riting a put option results in a potentially limited gain and a potentially unlimited
loss.
Answer: True Page: )! #evel: /edium
1*. The buyer of a put option on stock benefits if the underlying stock price rises.
Answer: %alse Page: )! #evel: $asy
1". An in the money American call option increases in value as e(piration approaches. but
an out of the money American call option decreases in value as e(piration approaches.
Answer: %alse Page: ))+',, #evel: /edium
1'1
Multiple Choice Questions
1&. 8f the following. the most recent derivative security innovations are
A2 %oreign currency futures
92 4nterest rate futures
C2 :tock inde( futures
;2 :tock options
$2 Credit derivatives
Answer: $ Page: !" #evel: $asy
13. 9y convention. a swap buyer on an interest rate swap agrees to
A2 Periodically pay a fi(ed rate of interest and receive a floating rate of interest
92 Periodically pay a floating rate of interest and receive a fi(ed rate of interest
C2 :wap both principle and interest at contract maturity
;2 9ack both sides of the swap agreement
$2 Act as the dealer in the swap agreement
Answer: A Page: ',! #evel: /edium
1!. An increase in which of the following would increase the price of a call option on
common stock. ceteris paribus<
4. :tock price
44. :tock price volatility
444. 4nterest rates
4=. $(ercise price
A2 44 only
92 44 and 4= only
C2 4. 44 and 444 only
;2 4. 444 and 4= only
$2 4. 44. 444 and 4=
Answer: C Page: ))+',, #evel: ;ifficult
1). 7hich of the following is true<
A2 %orward contracts have no default risk
92 %utures contracts re5uire an initial margin re5uirement be paid
C2 %orward contracts are marked to market daily
;2 %orward contract buyers and sellers do not know who the counterparty is
$2 %utures contracts are only traded over the counter
Answer: 9 Page: !3+!! #evel: /edium
1'
,. A professional futures trader who speciali0es in buying or selling futures contracts for
multiple days or weeks is called a
A2 :calper
92 ;ay trader
C2 Position trader
;2 :pecialist
$2 >edger
Answer: C Page: )1 #evel: $asy
1. 6ou have agreed to deliver the underlying commodity in ), days. Today the
underlying commodity price rises and you get a margin call. 6ou must have
A2 A long position in a futures contract
92 A short position in a futures contract
C2 :old a forward contract
;2 Purchased a forward contract
$2 Purchased a call option on a futures contract
Answer: 9 Page: )*+)" #evel: /edium
. 6ou find the following current 5uote for the ?une T+9ond contract: -1,,.,,,@ Pts
'nd. of 1,,A
6ou went long in the contract at the open. 7hich of the following isBare true<
4. 9y the end of the day your margin account would be increased
44. *".'*! contracts were traded that day
444. 6ou agreed to deliver in ?une -1,,.,,, face value T+9onds in e(change for
-!!.!3"
4=. 6ou agreed to purchase in ?une. -1,,.,,, face value T+9onds in e(change for
-!).",,
A2 4. 44 and 444 only
92 4. 44 and 4= only
C2 4 and 444 only
;2 4 and 4= only
$2 4= only
Answer: $ Page: )+)' #evel: ;ifficult
1''
'. A contract that gives the holder the right to sell a security at a preset price only
immediately before contract e(piration is a1n2.
A2 American call option
92 $uropean call option
C2 American put option
;2 $uropean put option
$2 Cnockout option
Answer: ; Page: )" #evel: $asy
*. A higher level of which of the following variables would make a put option on
common stock more valuable. ceteris paribus<
4. :tock price
44. :tock price volatility
444. 4nterest rates
4=. $(ercise price
A2 44 only
92 44 and 4= only
C2 4. 44 and 444 only
;2 4. 444 and 4= only
$2 4. 44. 444 and 4=
Answer: 9 Page: )) #evel: ;ifficult
". A speculator may write a call option on stock with an e(ercise price of -1" and earn a
-' premium if they thought
A2 The stock price would stay at or above -1"
92 The stock volatility would increase
C2 The stock price would rise above -1!
;2 The stock price would stay at or below -1!
$2 9oth A and 9 could be true
Answer: ; Page: )) #evel: ;ifficult
1'*
&. 6ou have taken an option position and if prices drop you could go bankrupt. but if
prices rise you might get a small gain. 6ou have
A2 9ought a call option
92 9ought a put option
C2 7ritten a call option
;2 7ritten a put option
$2 Done of the above
Answer: ; Page: )! #evel: ;ifficult
3. 6ou have taken an option position and if prices drop you could lose a fi(ed small
amount of money. but if prices rise your gain rises with it. you have
A2 9ought a call option
92 9ought a put option
C2 7ritten a call option
;2 7ritten a put option
$2 Done of the above
Answer: A Page: )& #evel: ;ifficult
!. 4n a bull market which option positions make money<
4. 9uying a call
44. 7riting a call
444. 9uying a put
4=. 7riting a put
A2 4 and 44
92 4 and 444
C2 4 and 4=
;2 44 and 444
$2 4 and 4=
Answer: $ Page: )&.)) #evel: ;ifficult
). The higher the e(ercise price. the EEEEE the value of a put and the EEEEE the value of
a call.
A2 >igher@ higher
92 #ower. lower
C2 >igher. lower
;2 #ower. higher
Answer: C Page: )) #evel: /edium
1'"
',. /easured by the amount outstanding. the largest type of derivative market in the
world is the
A2 %utures market
92 %orward market
C2 :wap market
;2 8ptions market
$2 Credit derivatives market
Answer: C Page: ',3 #evel: $asy
'1. A stock has a spot price of -'". 4ts /ay options are about to e(pire. 8ne of its puts is
worth -" and one of its calls is worth -". The e(ercise price of the put must be EEEEE
and the e(ercise price of the call must be EEEEE.
A2 ',. *,
92 '". '"
C2 *,. ',
;2 ". *"
$2 8ne cannot tell from the information given
Answer: C Page: )) #evel: /edium
'. An agreement between two parties to e(change specified periodic cash flows in the
future based on some underlying instrument or price is aBan
A2 %orward agreement
92 %utures contract
C2 4nterest rate collar
;2 8ption contract
$2 :wap contract
Answer: $ Page: ',! #evel: /edium
''. An investor has unreali0ed gains in 1,, shares of Ama0in stock upon which they do
not wish to pay ta(es. >owever. they are now bearish upon the stock for the short
term. The stock is at &* and he buys a put with a strike of &" for -,,. At e(piration
the stock is at -&1. 7hat is the net gain or loss on the entire stockBoption portfolio<
A2 -,,.,,
92 +-1,,.,,
C2 +-',,.,,
;2 +-,,.,,
$2 Done of the above
Answer: 9 Page: ',"+',& #evel: ;ifficult
Fationale: G1-&1 + -&*2 H 1,,I J 11-&"+ -&12H1,,2 + -,,
1'&
'*. Dew futures contracts must be approved by
A2 The C%TC
92 The :$C
C2 The 7arren Commission
;2 The D6:$
$2 The %ederal Feserve
Answer: A Page: !) #evel: $asy
'". A1n2 EEEEE is a succession of forward contracts on interest rates between two parties.
A2 Collar
92 4nterest rate swap
C2 Currency swap
;2 :waption
$2 Credit swap
Answer: 9 Page: ',3+',! #evel: $asy
'&. A bank with short term floating rate assets funded by long term fi(ed rate liabilities
could hedge this risk by
4. 9uying a T+bond futures contracts
44. 9uying options on a T+bond futures contract
444. $nter into a swap agreement to pay a fi(ed rate and receive a variable rate
4=. $nter into a swap agreement to pay a variable rate and receive a fi(ed rate
A2 4 and 444 only
92 4. 44 and 4= only
C2 44 and 4= only
;2 444 only
$2 4= only
Answer: 9 Page: ',! #evel: ;ifficult
'3. The swap market's primary direct government regulator is 1the2
A2 :$C
92 C%TC
C2 D6:$
;2 7T8
$2 Dobody
Answer: $ Page: '1 #evel: /edium
1'3
'!. A bank with long term fi(ed rate assets funded with short term rate sensitive liabilities
could do which of the following to limit their interest rate risk<
4. 9uy a cap
44. 9uy an interest rate swap
444. 9uy a floor
4=. :ell an interest rate swap
A2 4 and 44 only
92 444 only
C2 4 and 4= only
;2 44 and 444 only
$2 444 and 4= only
Answer: A Page: ',!+'1, #evel: ;ifficult
'). An interest rate floor is designed to protect an institution from
4. %alling interest rates
44. %alling bond prices
444. 4ncreased credit risk on loans
4=. :wap counterparty credit risk
A2 4 and 4=
92 44 and 444
C2 4 and 444
;2 44 and 4=
$2 4 only
Answer: $ Page: '1' #evel: /edium
*,. An interest rate collar is
A2 7riting a floor and writing a cap
92 9uying a cap and writing a floor
C2 An option on a futures contract
;2 9uying a cap and buying a floor
$2 Done of the above
Answer: 9 Page: '1' #evel: ;ifficult
1'!
*1. /y bank has a larger number of adKustable rate mortgage loans outstanding. To
stabili0e our interest rate income on these loans the bank could
4. $nter into a plain vanilla swap to pay fi(ed and receive variable
44. $nter into a plain vanilla swap to pay variable and receive fi(ed
444. 9uy an interest rate floor
4=. 9uy and interest rate cap
A2 4 and 444 only
92 4 and 4= only
C2 44 and 444 only
;2 44 and 4= only
Answer: C Page: '1'. ',!+',) #evel: /edium
*. A contract where the buyers agrees to pay a specified interest rate on a loan where the
loan will be originated at some future time is called aBan
A2 forward rate agreement
92 futures loan
C2 option on a futures contract
;2 interest rate swap contract
$2 currency swap contract
Answer: A Page: !&+!3 #evel: $asy
*'. Two competing fully electronic derivatives markets in the L.:. are
A2 Mlobe( and $ure(
92 Philadelphia $(change and A/$N
C2 D6:$ and A9:
;2 C/$ and Pacific $(change
$2 ;+Trade and 4//
Answer: A Page: !" #evel: /edium
1')
**. 6our firm enters into a swap agreement with a notional principle of -", million where
the firm pays a fi(ed rate of interest of "A and receives a variable rate of interest e5ual
to #498F plus ,, basis points. 4f #498F is currently '."A the D$T amount your
firm will receive 1J2 or pay 1+2 on the ne(t transaction date is
A2 +-.",,.,,,
92 -.&".,,,
C2 -1".,,,
;2 +-1".,,,
$2 +-!3".,,,
Answer: C Page: ',) #evel: ;ifficult
Fationale: 11'."AJA2+"A2H-", million
Lse the following to answer 5uestions *"+*3:
Fefer to this #isted :tock 8ption Price Ouote from %ebruary:
*". 9ased on the option 5uote the ?une call should cost more than
A2 -*33
92 -1!"
C2 -&&"
;2 -!,
$2 Cannot tell from information given
Answer: 9 Page: ', #evel: /edium
Fationale: The ?une call price must be greater than the /ar call price 5uote H 1,,
1*,
*&. 9ased on the option 5uote the /arch put should cost at least
A2 -*33
92 -1!"
C2 -&&"
;2 -!,
$2 Cannot tell from information given
Answer: A Page: ', #evel: /edium
Fationale: The /arch put price must be greater than the intrinsic value of 1-&,+
-"".'2 H 1,,
*3. 4f you buy the /arch call and don't e(ercise before contract maturity. you will make a
profit if the stock price increases by more than
A2 ).&"A
92 *."3A
C2 '.'"A
;2 11.))A
$2 !.&*A
Answer: ; Page: ', #evel: ;ifficult
Fationale: G1&, J 1.!"2 B "".'I + 1
Short Answer Questions
*!. 7hat determines the success or failure of an e(change traded derivative contract<
7hy were currency and interest rate futures introduced in the early and late 1)3,s
respectively<
Answer: The success of derivative contracts depends upon trading volume 1or trader
interest2 which is in turn dependent on price volatility in the underlying security or
commodity value. Currency futures were introduced in the early 1)3,s in response to
the collapse of fi(ed e(change rates as 9retton 7oods collapsed. $(change rates
5uickly proved themselves very volatile. 4nterest rate futures were needed once the
%ederal Feserve stopped targeting interest rates and began targeting non+borrowed
reserves in 1)3). allowing interest rates to float and interest rate volatility to increase.
Page: !*+!" #evel: ;ifficult
1*1
*). A L.:. firm has a $uropean subsidiary that earns euros. The subsidiary has borrowed
dollars at a floating rate of interest. 7hat kind of risk does the subsidiary have< 7hat
kind of swap could be used to limit the subsidiary's risk< 9e specific.
Answer: The subsidiary 1sub for short2 faces both currency risk and probably interest
rate risk. 4f the euro drops in value. the sub will have to use more euros to repay the
dollar debt. 4f interest rates rise. the subs financing costs will also rise. The sub may
be able to set up a currencyBrate swap where the sub pays euros at a fi(ed rate of
interest. and receives dollars at a variable rate of interest. This would reduce both
types of risk. Page: '11+'1 #evel: ;ifficult
",. 7hen would a forward contract be better for hedging than a futures contract<
Answer: A forward contract is better suited for a non+standard agreement where
specific terms need to be negotiated or when there are no suitable futures contracts
available 1e.g. hedging a #;C currency2. %orwards also avoid the daily li5uidity
problems that marking to market on futures contracts can cause. %orward contracts
are generally not marketable so the participant should be sure the contract is needed
and must be willing to take or make delivery. %orwards re5uire each party to assess
the creditworthiness of the counterparty. so one needs enough information about the
other party to assess the likelihood of default. ;efault risk is not an issue for futures
contracts. Page: !&+!! #evel: /edium
"1. 7hen might an option on a futures contract be preferable to an option on the
underlying instrument<
Answer: 4n general. the option on the futures will be preferable if it is cheaper andBor
easier to deliver the futures contract rather than the underlying instrument. This can
occur when the futures contract is more li5uid than the underlying instrument. or if
delivery of the underlying is more difficult and costly. Page: ',& #evel: $asy
". >ow does a futures or option clearinghouse assist traders<
Answer: The clearinghouse interposes itself between every buyer and seller. %or
e(ample. an option buyer buys from the clearinghouse@ an option seller sells to the
clearinghouse. :hould one party not perform as promised the clearinghouse performs
instead. /arket participants thus do not need to evaluate the creditworthiness of the
counterparty since the clearinghouse guarantees all trades. The clearinghouse nets all
transactions so that once a long participant sells the same contract. the clearinghouse
nets their position to 0ero. Page: ) #evel: /edium
1*
"'. 9uying an at the money call option and writing an at the money put option are two
ways to make money when prices rise. 7hen would each be the preferable strategy<
Answer: 4f spot prices rise a lot then buying the call is preferable. 4f spot prices rise
only a little then writing the put is preferable. 4n general. in low volatility markets
writing options will be the preferred strategy. but in high volatility markets buying
options will give larger gains and avoid catastrophic losses. 9uying options is also the
more risk averse strategy. Page: )&+',1 #evel: ;ifficult
"*. A stock is priced at -3. An American call option on this stock with a -" strike must
be worth at least how much< Dumerically show why.
Answer: 4t must be worth at least - per share or -,, per contract. :uppose the
premium is instead only -1 1per share2. 6ou could buy the call for -1 and sell the
stock short simultaneously at -3. e(ercise the call immediately and buy the stock for
-". 6our Pall inQ cost of the stock 1per share2 is -" J -1 R -&. and you sell the
stock for -3. a -1 gain that involves no risk and no investment 1although you will
have to post margin on the short sale2. As everyone does this. the option's price will
rise until the option premium is at least e5ual to the difference between the stock price
and the e(ercise price. Page: )) #evel: /edium
Lse the following to answer 5uestions ""+"&:
%D/A. a 5uasi government mortgage agency. has direct holdings of ', year fi(ed rate
mortgages financed by ' to " year agency securities sold to the public.
"". 7hat kind of interest rate swap could %D/A use to limit their interest rate risk<
$(plain.
Answer: %D/A's risk is from rising interest rates because the bonds mature more
5uickly than the mortgages 1the mortgage duration is greater2. Fising interest rates will
increase %D/A's funding cost. but the mortgage income will stay the same. To offset
this risk %D/A could agree to pay a fi(ed rate of interest on a given notional principle
and receive a variable rate of interest. 4f rates rose. %D/A would receive more
interest income. but pay out the same fi(ed rate on the swap. The swap gain could
then offset any loss on the balance sheet. Page: ',3+',! #evel: /edium
1*'
"&. 7hat kind of interest rate option could %D/A use to limit the interest rate risk<
$(plain how this would work. $(plain how a collar could also be used.
Answer: A cap could be used since %D/A's risk is from rising interest rates. Caps
generate income to the buyer if interest rates rise above some minimum value. %or
e(ample. a 1,A cap pays the holder i++1,A times the notional principle if i S 1,A.
This additional income could be used to offset higher funding costs of the agency
securities when rates rose. 9uying caps can be e(pensive. To help offset the
purchase price of the cap. %D/A could also sell a floor. The income from selling the
floor would help offset the price of the cap. 9uying a cap and selling a floor is termed
a Pcollar.Q Page: '1'+'1" #evel: /edium
"3. Lsing the 9lack+:choles model. e(plain what happens to the value of a call as :. T
and change. 7hy is the relationship between risk and price different for options
than for other securities<
Answer: 1. As : increases C 1the call premium2 increases because the right to buy at
the fi(ed price $ has more value as the sale price : rises. . As T increases C
increases. as T decreases C decreases. the less time remaining on the option the lower
its value since there is less time during which the option right is available. '. As
increases. C increases. Lnlike virtually all other securities. risk and price move in the
same direction. The reason is the option feature of the contract. 4f bad outcomes
occur you do not e(ercise the option. you do e(ercise if the good outcomes occur.
Mreater risk increases the odds of seeing either the very good or very bad outcomes.
but because you get all the gain from a stock price runup but none of the loss of a
stock decline. this means that risk increases the option's value. Page: ))+',1
#evel: ;ifficult
"!. 7hen would an option hedge be better than a futures or forward hedge<
Answer: 7henever you want the choice of whether or not to use the derivative
instrument and you are willing to pay to have that choice. %utures and forward hedges
limit losses. but also limit profit opportunities. 9ecause options are a right. rather than
a commitment. using options to hedge preserves the upside potential foregone with
other hedging methods. 8ptions re5uire the payment of a non+refundable premium to
ac5uire. whereas forward. futures and swaps do not have this outright cost. Page:
!!.)*.',"+',& #evel: /edium
1**
"). :uppose a stock is priced at -",. 6ou are bullish on the stock and are considering
buying /arch calls with an e(ercise price of -*" and -"" respectively. The *" call is
priced at -!.", and the "" call is 5uoted at -.3". 7hat should you consider in
deciding which to purchase if you do not plan on e(ercising prior to maturity< 9e
specific.
Answer: The *" is in the money and could be e(ercised right away. although the
e(erciser would lose the 1-!.", +-"2 R -'.", time value of the call by e(ercising. The
stock has to move up to -"!.", before the call buyer recovers the purchase price.
9uying the "" call is cheaper@ the 5uote is -.3" 1or -3"2. This is because the call is
currently out of the money. 4f you buy the "" call the stock price has to move up to
-"3.3" 1-"" J -.3"2 before you make a profit. 6ou have a lower breakeven than with
the more e(pensive in the money call. but your profit is considerably less 1-1, per
share to be e(act2 with the out of the money call. 6ou can also lose much less with the
out of the money call 1-3" versus -!",2. There is no definitive answer as to which is
better. it depends on your perception of how the stock price will move 1and the
underlying stock volatility2 and your own risk return tradeoff. Page: )"+)3 #evel:
;ifficult
1*"