DERIVATIVES

Question 1

Which of the following best describes the intrinsic value of an option? The intrinsic value is:

A) its economic value if it is exercised immediately.

B) highest if an option is at the money.
C) its economic value if it is exercised at maturity.
Answer: A

The intrinsic value of an option is only positive if positive economic value results from exercising the
option immediately.

Question 2

Consider a U.S. commercial bank that takes in one-year certificates of deposit (CDs) in its Hong Kong
branch, denominated in Hong Kong dollars, to fund three-year, fixed-rate loans the bank is making in the
U.S. denominated in U.S. dollars. Why would this bank wish to enter into a currency swap? The bank
faces the risk that the Hong Kong dollar:

increases in value against the U.S. dollar and the risk that interest rates increase in Hong
A)
Kong.
decreases in value against the U.S. dollar and the risk that interest rates increase in Hong
B)
Kong.
decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong
C)
Kong.
Answer: A

The bank faces two problems. First, if the Hong Kong dollar increases in value, it will take more U.S.
dollars to repay the Hong Kong depositors. Indeed, if the Hong Kong dollar increases significantly, it may
take more U.S. dollars to repay the Hong Kong depositors than the bank makes on the U.S. loan.
Secondly, if the interest rate in Hong Kong rises, the bank pays more in interest on its CDs while the rate
on the bank’s U.S. loans does not change. In this case, interest expense would rise and interest income
would remain the same, which narrows the bank’s profits.

Question 3

Which of the following statements regarding Treasury bond futures is least accurate?

Upon delivery, the long pays the short the futures price divided by the conversion factor for the
A)
bond the short chooses to deliver.
B) They are a deliverable contract.
C) The contract size is $100,000.
Answer: A

The delivery price for Treasury bonds under the contract is multiplied by the conversion factor for the
bond the short chooses to deliver. The other statements are true.
Question 4

Which of the following is NOT a method of terminating a forward contract prior to expiration?

A) Exercise a swaption.
B) Make an agreed upon payment to the counterparty.
C) Enter into an offsetting forward contract with the original counterparty.
Answer: A

A swaption can be used to terminate a swap. The others are both ways to terminate a forward contract
prior to expiration.

Question 5

An American option is:

A) exercised only at expiration.

B) exercisable at any time up to its expiration date.
C) an option on a U.S. stock or bond.
Answer: B) exercisable at any time up to its expiration date.

There is no geographical significance given to American (style) options. It simply refers to the fact that
they can be exercised at any time, up to and including the expiration date. European-style options can be
exercised only on their expiration dates.

Question 6

Which of the following statements regarding plain-vanilla interest rate swaps is least accurate?

A) In a swap contract, the counterparties usually swap the notional principal.

B) The settlement dates are when the interest payments are to be made.
C) The time frame covered by the swap is called the tenor of the swap.
Answer: A

The notional principal is generally not swapped, as it is usually the same for both parties in the swap deal.

Question 7

Which of the following statements regarding Eurodollar time deposits is NOT correct?

A) Rates are quoted as an add-on yield.

B) They are available in Switzerland.
C) Sometimes the best rates are available in New York City.
Answer: C) Sometimes the best rates are available in New York City.

Eurodollar time deposits are U.S. dollar denominated deposits outside the United States. Rates are
quoted as an annualized add-on yield, based on a 360-day year.
Question 8

No Errors Printing has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal.
No Errors receives a fixed rate of 5.5% on payments that occur at quarterly intervals. Platteville
Investments, a swap broker, negotiates with another firm, Perfect Bid, to take the pay-fixed side of the
swap. The floating rate payment is based on LIBOR (currently at 6.0%). Because of the current interest
rate environment, No Errors expects to pay a net amount at the next settlement date and has created a
reserve to cover the cash outlay. At the time of the next payment (due in exactly one quarter), the reserve
balance is $1,000. To fulfill its obligations under the swap, No Errors will need approximately how much
additional cash?

A) $250.
B) No Errors will receive $250.
C) $0.
Answer: A

The net payment formula for the floating rate payer is:

Floating Rate Paymentt = (LIBORt-1 − Swap Fixed Rate) × (# days in term / 360) × Notional Principal

If the result is positive, the floating-rate payer owes a net payment and if the result is negative, then the
floating-rate payer receives a net inflow. Note: We are assuming a 360 day year.

Here, Floating Rate Payment = (0.06 − 0.055) × (90 / 360) × 1,000,000 = $1,250. Since the result is
positive, No Errors will pay this amount. Since the reserve balance is $1,000, No Errors needs an
additional $250.

Question 9

What is the primary difference between an American and a European option?

A) The American option can be exercised at anytime on or before its expiration date.
B) American and European options are never written on the same underlying asset.
C) The European option can only be traded on overseas markets.
Answer: A

American and European options are virtually identical, except exercising the European option is limited to
its expiration date only. The American option can be exercised at anytime on or before its expiration date.
For the exam, the key concept relating to this difference is the value of the American option must be
equal or greater than the value of the corresponding European option, all else being equal.

Question 10

Which of the following statements concerning an American-style option is least accurate?

A) They are only traded in the U.S.

B) It allows the holder the right to exercise before maturity of the option.
C) The predominant option type is American-style, rather than European-style.
Answer: A
American-style options are traded throughout the world. The American• label simply identifies the option
as having the right to be exercised before maturity. American-style options are the predominant type of
options contract traded.

Question 11

Futures have greater market liquidity than forward contracts, because futures are:

A) developed with specific characteristics to meet the needs of the buyer.

B) standardized contracts.
C) sold only for widely traded commodities, unlike forwards.
Answer: B) standardized contracts.

Forward contracts do not have standardized terms as futures have. Forwards have the same terms as
futures, but those terms are written to meet the specific needs of the two or more parties to the contract.
This specialization limits the marketability, hence liquidity, of the forward contact.

Question 12

Which of the following statements about options is least accurate?

A) Option prices are generally higher the longer the time until the option expires.
If an American option is exercised at expiration, its value will be less than that of a European
B)
option.
For put options, the higher the strike price relative to the stock's underlying price, the more the
C)
put is worth.
Answer: B) If an American option is exercised at expiration, its value will be less than that of a European
option.

The American option cannot be worth less than the European option.

Question 13

Compared to European put options on an asset with no cash flows, an American put option:

A) will have the same minimum value.

B) will have a lower minimum value.
C) will have a higher minimum value.
Answer: C) will have a higher minimum value.

Early exercise of an in-the-money American put option on an asset with no cash flows can generate
more, X − S, than the minimum value of the European option, X / (1 + R)T − S. The possibility of profitable
early exercise leads to a higher minimum value on the price of the American put option.

Question 14

Consider a swap with a notional principal of $100 million.

Given the above diagrams, which of the following statements is CORRECT? At time period 2:

A) A pays B $2 million.
B) B pays A $1 million.
C) A pays B $7 million and B pays A $8 million.
Answer: B) B pays A $1 million.

The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the
appropriate variable rate is 7%, the fixed rate is 8%, and the interest payments are netted. The fixed-rate
payer, counterparty B, pays according to:

(Swap Fixed Rate - LIBORt-1)(# of days/360)(Notional Principal).

In this case, we have (0.08 - 0.07)(360/360)($100 million) = $1 million

Question 15

Consider a $10,000,000 1-year quarterly-pay swap with a fixed rate of 4.5% and a floating rate of 90-day
London Interbank Offered Rate (LIBOR) plus 150 basis points. 90-day LIBOR is currently 3% and the
current forward rates for the next four quarters are 3.2%, 3.6%, 3.8%, and 4%. If these rates are actually
realized, at the termination of the swap the floating-rate payer will:

A) pay $20,000.
B) pay $25,000.
C) pay $10,020,000.
Answer: A

The payment at the fourth (final) settlement date will be based on the realized LIBOR at the third quarter,
3.8%. The net payment by the floating rate payer will be:

(0.038 + 0.015 − 0.045) × 90/360 × 10,000,000 = $20,000

Question 16

Which of the following features is least likely part of a plain-vanilla interest rate swap?

A) Tenor.
B) Swap facilitator.
C) Exchange of notional amount.
Answer: C) Exchange of notional amount.

Since the notional principal swapped is the same (and in the same currency) for both counterparties,
there is no need to actually exchange cash. The counterparties are the pay-fixed and receive-fixed sides.
A swap facilitator helps to bring the counterparties together and may be either an agent or a broker. The
tenor of the swap is the time frame covered by the deal, or the time to maturity of the swap.

Question 17

Faye Sagler takes a long position in 12 August yttrium futures contracts at a contract price of $3.50 per
unit. Each contract is for 1,000 units of yttrium. The required initial margin is $400 per contract and the
maintenance margin is $300 per contract. August yttrium futures decline to $3.42, $3.38, and $3.31 on
the next three trading days. On the first day that Sagler will be required to deposit additional cash into her
futures account, the required deposit is closest to:

A) $240.
B) $960.
C) $1,440.
Answer: C) $1,440.

The initial margin is $400 × 12 = $4,800 and the maintenance margin level will be $300 × 12 = $3,600.
Each $0.01 change in the price of yttrium changes the value of the account by $0.01 × 1,000 × 12 = $120.

Day Price Daily Change Gain/Loss Balance

0 $3.50 $4,800 (initial margin)
1 $3.42 -$0.08 -$960 $3,840
2 $3.38 -$0.04 -$480 $3,360
3 $3.31 -$0.07 -$840 $2,520

At the end of Day 2, the account balance has fallen below the maintenance margin level of $3,600, so
Sagler must deposit enough cash to bring the balance back to the initial margin level of $4,800. The
deposit is $4,800 - $3,360 = $1,440.

Question 18

Consider a swap with a notional principal of $300 million, annual payments, and a 30E/360 daycount
convention (every month has 30 days, a year has 360 days).
LIBOR
Counterparty ▬▬▬▬▬▬▬▬▬▬► Counterparty
A ◄▬▬▬▬▬▬▬▬▬▬ B
7% Fixed
 0 1 2

LIBOR = 5.5% LIBOR = 6.5% LIBOR = 7%

Given the above diagram, which of the following statements is most accurate? At time period 2:

A) A pays B $1.5 million.

B) B pays A $1.5 million.
C) B pays A $21.0 million.
Answer: B) B pays A $1.5 million.

The variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the
appropriate variable rate is 6.5%, the fixed rate is 7%, and the interest payments are netted. The fixed-
rate payer, counterparty B, pays according to:

[Swap Fixed Rate - LIBORt-1][(# of days)/(360)][Notional Principal].

In this case, we have [0.07 - 0.065][360/360][$300 million] = 1.5 million.

Question 19

Which of the following statements about the potential profits and losses from selling a call is most
accurate?

A) Losses are theoretically unlimited.

B) Profits are theoretically unlimited.
C) Losses are limited to the strike price plus the premium.
Answer: A

The following table provides the potential payoffs from puts and calls.

Buyer/Holder Seller/Writer
Potential Gain Potential Loss Potential Gain Potential Loss
Call Unlimited Premium Premium Unlimited
Put Strike P - Premium Premium Premium Strike P - Premium

Question 20

Mosaks, Inc., has a put option with a strike price of $105. If Mosaks stock price is $115 at expiration, the
value of the put option is:

A) $10.
B) $0.
C) $105.
Answer: B) $0.
The put has a value of $0 because it will not be exercised. Put value is MAX (0, X-S).

Question 21

Which of the following statements about options is most accurate?

A) Most options throughout the world are European options.

B) A put writer who deposits shares of the underlying stock has written a covered put.
For call options, the lower the strike price relative to the stock's underlying price, the more the
C)
call option is worth.
Answer: C) For call options, the lower the strike price relative to the stock's underlying price, the more the
call option is worth.

The other statements are false. Most options throughout the world are American options. A call writer who
deposits shares of the underlying stock has written a covered call.

Question 22

All of the following are typically end users of forward contracts EXCEPT:

A) non-profit institutions.
B) a forwards dealer.
C) governmental units.
Answer: B) a forwards dealer.

A dealer is not an end user. Dealers typically take offsetting positions with different end users to limit their
exposure to the asset price risk in individual forward contracts.

Question 23

In a credit default swap (CDS), the buyer of credit protection:

A) exchanges the return on a bond for a fixed or floating rate return.

B) makes a series of payments to a credit protection seller.
C) issues a security that is paid using the cash flows from an underlying bond.
Answer: B) makes a series of payments to a credit protection seller.

In a credit default swap (CDS), the buyer of credit protection makes a series of payments to a credit
protection seller. The credit protection seller promises to make a fixed payment to the buyer if an
underlying bond or loan experiences a credit event, such as a default. In a total return swap, the buyer of
credit protection exchanges the return on a bond for a fixed or floating rate return. A security that is paid
using the cash flows from an underlying bond is known as a credit-linked note.

Question 24

Which of the following statements about futures and forwards is NOT correct?
 A) The buyer of a forward posts a margin directly with the seller.
B) Futures contracts are highly structured; forward contracts are unique to each transaction.
C) An individual could sell an asset in the future using either a future or a forward contract.
Answer: A

Although forward contracts are between private parties, no margin is required. The other statements are
true. Futures and forwards are both contracts to sell an asset in the future.

Question 25

A forward rate agreement (FRA):

requires the long to pay cash to the short if the rate specified in the contract at expiration is
A)
below the current floating rate.
B) generally uses a fixed reference interest rate.
C) can sometimes be viewed as the right to borrow money at below-market rates.
Answer: C) can sometimes be viewed as the right to borrow money at below-market rates.

If the floating rate is above the rate specified in the agreement, the long position can be viewed as the
right to borrow at below-market rates. Floating rates like LIBOR are used in FRAs. The long must pay the
short only if the contracted rate at the expiration date is above the floating rate.

Question 26

Which of the following is least likely a characteristic of futures contracts? Futures contracts:

A) require weekly settlement of gains and losses.

B) are traded in an active secondary market.
C) are backed by the clearinghouse.
Answer: A

Futures contracts require daily settlement of gains and losses. The other statements are accurate.

Question 27

XYZ, Inc. has entered into a "plain-vanilla" interest rate swap on $5,000,000 notional principal. XYZ
company pays a fixed rate of 8.5% on payments that occur at 180-day intervals. Platteville Investments, a
swap broker, negotiates with another firm, SSP, to take the receive-fixed side of the swap. The floating
rate payment is based on LIBOR (currently at 7.2%). At the time of the next payment (due in exactly 180
days), XYZ company will:

A) pay the dealer net payments of $65,000.

 B) pay the dealer net payments of $32,500.
C) receive net payments of $32,500.
Answer: B) pay the dealer net payments of $32,500.

The net payment formula for the fixed-rate payer is:

Fixed Rate Paymentt = (Swap Fixed Rate − LIBORt-1) × (# days in term / 360) × Notional Principal

If the result is positive, the fixed-rate payer owes a net payment and if the result is negative, then the
fixed-rate payer receives a net inflow. Note:We are assuming a 360 day year.

Fixed Rate Payment = (0.085 − 0.072) × (180 / 360) × 5,000,000 = $32,500.

Since the result is positive, XYZ owes this amount to the dealer, who will remit to SSP.

Question 28

Which of the following statements about put options is least accurate? The most the:

A) buyer can gain is unlimited.

B) writer can gain is the put premium.
C) writer can lose is the strike price less the premium.
Answer: A

The most the put buyer can gain is the strike price of the stock less the premium.

Question 29

The party to a forward contract that is obligated to purchase the asset is called the:

A) short.
B) receiver.
C) long.
Answer: C) long.

The long in a forward contract is obligated to buy the asset (in a deliverable contract). The term receiver
is used with swaps.

Question 30

Which of the following statements about closing a futures position is least accurate?

A) Few futures positions are settled by delivery of goods.

Closing a futures position requires physical delivery of goods, an offsetting trade, or an
B)
exchange for physicals.
Except for exchange-for-physicals transactions, futures contracts must be closed on the
C)
exchange floor.
Answer: B) Closing a futures position requires physical delivery of goods, an offsetting trade, or an
exchange for physicals.

In some futures markets, positions are closed through cash settlement of gains and losses rather than
physical delivery of goods. The other statements are true. Approximately one percent of futures
transactions are closed through actual delivery or cash settlement.

Question 31

Which of the following statements regarding call options is most accurate? The:

A) call holder will exercise (at expiration) whenever the strike price exceeds the stock price.
B) breakeven point for the buyer is the strike price plus the option premium.
C) breakeven point for the seller is the strike price minus the option premium.
Answer: B) breakeven point for the buyer is the strike price plus the option premium.

The breakeven for the buyer and the seller is the strike price plus the premium. The call holder will
exercise if the market price exceeds the strike price.

Question 32

An investor purchases a stock for $40 a share and simultaneously sells a call option on the stock with an
exercise price of $42 for a premium of $3/share. Ignoring dividends and transactions cost, what is the
maximum profit that the writer of this covered call can earn if the position is held to expiration?

A) $3.
B) $5.
C) $2.
Answer: B) $5.

This is an out of the money covered call. The stock can go up $2 to the strike price and then the writer will
get $3 for the premium, total $5.

Question 33

A put option with an exercise price of 59 on a non-dividend-paying stock expires in 3 months. The
underlying stock is trading at 53 and the risk-free rate is 5%. The minimum value of an American-style put
and of a European-style put are closest to:

American put European put

A) $5.28 $6.00
B) $6.00 $6.00
C) $6.00 $5.28
Answer: C)
$6.00 $5.28
The American put can be exercised immediately for a payoff of $6.00. The European put cannot be
exercised until expiration, so its minimum value is 59 / (1.05) 0.25 − 53 = $5.28. (Because the minimum
value of an in-the-money European put is less than the minimum value of an otherwise identical American
put, you can select the correct answer without performing this calculation.)

Question 34

Which of the following characteristics about swaps is least accurate? Swaps:

A) have no active secondary market.

B) are custom instruments.
C) are highly regulated.
Answer: C) are highly regulated.

Swap contracts are largely unregulated.

Question 35

Which of the following statements best describes marking-to-market of a futures contract? At the:

conclusion of each trade, the gains or losses from all previous trades in the futures contract
A)
are tallied.
end of the day, the maintenance margin is increased for traders who lost and decreased for
B)
traders who gained.
C) end of the day, the gains or losses are tallied to the trader's account.
Answer: C) end of the day, the gains or losses are tallied to the trader's account.

Marking-to-market means that, at the end of the day, all gains or losses are tallied to the trader’s account.

Question 36

Which of the following statements regarding a futures trade of a deliverable contract is NOT correct?

A) The long is obligated to purchase the asset.

B) Equilibrium futures price is known only at the end of the trading day.
C) The price is determined by open outcry.
Answer: B) Equilibrium futures price is known only at the end of the trading day.

Each trade is made at the then current equilibrium price, determined by open outcry on the floor of the
exchange, and is reported as it is executed. The long is obligated to buy, and the short is obligated to sell,
the specified quantity of the underlying asset.
Question 37

When a party to a forward contract terminates the contract prior to the original expiration date by entering
into a perfectly offsetting forward contract with a second counterparty:

there is no future liability, but default risk remains for all parties until the original contract
A)
settlement date.
B) the party terminating the contract is exposed to default risk, but has no further asset price risk.
the party terminating the forward contract has no default risk, but both counterparties face
C)
default risk.
Answer: B) the party terminating the contract is exposed to default risk, but has no further asset price risk.

When a forward contract is terminated by an offsetting contract with a second counterparty, there is no
further asset price risk, but since there are two separate contracts with different counterparties, all parties
are exposed to default risk until both contracts are settled. Since the two contracts may have different
forward prices, the terminating party may have a future liability at settlement, but the amount is fixed at
the time the offsetting contract is initiated. The terminating party may have ˜locked in’ a future gain or
loss, depending on the difference between the forward prices of the two offsetting contracts.

Question 38

Which of the following statements about arbitrage opportunities is CORRECT?

Pricing errors in securities are instantaneously corrected by the first arbitrageur to recognize
A)
them.
B) Engaging in arbitrage requires a large amount of capital for the investment.
C) When an opportunity exists to profit from arbitrage, it usually lasts for several trading days.
Answer: A

Arbitrage is the opportunity to trade in identical assets that are momentarily selling for different prices.
Arbitrageurs act quickly to make a riskless profit, causing the price discrepancy to be instantaneously
corrected. No capital is required, because opposite trades are made simultaneously.

Question 39

Swap contracts typically:

A) cover a single payment.

B) are standardized contracts.
C) do not require a payment from either party at initiation.
Answer: C) do not require a payment from either party at initiation.

Swaps typically do not require a payment from either party at initiation. The exception is currency swaps.
Question 40

Which of the following statements about swaps is least accurate?

A) The notional principal is swapped at the beginning of an interest rate swap.

B) The notional principal is swapped at the beginning and end of a currency swap.
C) Motivations to engage in swaps include reducing transaction costs and maintaining privacy.
Answer: A

In interest rate swaps, there is no need to actually exchange the notional amount, since the notional
principal swapped is the same for both counterparties and in the same currency units. Net interest is paid
by the one who owes it at settlement dates.

Explanations for other responses:

The reasons given now for using the swap markets are to: reduce transactions costs, avoid costly
regulations, and maintain privacy. Historically, there were two basic motivations for swaps: to exploit
perceived market inefficiencies and to attempt to obtain cheaper financing. Both of these motivations are
based on the concept that the financial markets are inefficient. This fact, unfortunately, is no longer true.
Today, the swap markets are mature and offer few arbitrage opportunities. Swap markets are now viewed
as being more operationally efficient and a more flexible means of packaging and transforming cash flows
than any other method. Currency swaps often occur because of comparative advantage. For example,
parties may want to reduce borrowing costs. One firm may have better access to a country’s domestic
capital markets than another firm. The U.S. firm (D) may have access to the U.S. capital markets but not
the German markets, while the German firm (M) may have access to the German markets but not the
U.S. markets. If each firm borrows locally and then exchanges the funds, they will both gain.

In a currency swap, interest payments are made without netting. Full interest payments are exchanged at
each settlement date. Currency swap counterparties actually exchange notional principal because the
motivation of the parties is to receive foreign currency.

Question 41

The owner, of an interest-rate cap will:

A) be required to make a payment if the market rate exceeds the cap rate.
B) receive a payment if the market rate is less than the cap rate.
C) receive a payment if the market rate exceeds the cap rate.
Answer: C) receive a payment if the market rate exceeds the cap rate.

An interest-rate cap will pay its owner the maximum of zero or the market rate minus the cap rate, times
the notional principal.
Question 42

A financial instrument that has payoffs based on the price of an underlying physical or financial asset is
a(n):

A) option.
B) future.
C) derivative security.
Answer: C) derivative security.

Options and futures are examples of types of derivative securities.

Question 43

Most deliverable futures contracts are settled by:

A) delivery of the asset at contract expiration.

B) an offsetting trade.
C) a cash payment at expiration.
Answer: B) an offsetting trade.

Most futures positions are closed out by an offsetting trade at some point during life of the contract.

Question 44

A decrease in the riskless rate of interest, other things equal, will:

A) decrease call option values and decrease put option values.

B) decrease call option values and increase put option values.
C) increase call option values and decrease put option values.
Answer: B) decrease call option values and increase put option values.

A decrease in the risk-free rate of interest will decrease call option values and increase put option values.

Question 45

Which of the following statements regarding a plain vanilla swap is NOT correct?

A) Only a net payment is made on each settlement date.

B) If interest rates decrease, the swap has a negative value to the fixed rate payer.
The notional principal amounts are exchanged at contract initiation and at the termination of
C)
the swap.
Answer: C) The notional principal amounts are exchanged at contract initiation and at the termination of
the swap.

There is no exchange of the principal amount at the initiation or termination of a plain vanilla swap.

Question 46

In commodity trading, the exchange removes any daily losses from a trader’s account and adds any gains
to the trader’s account. This process is known as:

A) marking to market.
B) initial margin.
C) variation margin.
Answer: A

To safeguard the clearinghouse, commodity exchanges require traders to settle their accounts on a daily
basis. Marking to market is when any loss for the day is deducted from the trader’s account, and any
gains are added to the account.

Question 47

Given the payoff diagram shown below of an option combined with a long position in a stock, which of the
following statements most accurately describes the profit or loss potential to the holder of the combined
position?

A) The maximum loss on the long put is its cost.

B) The maximum profit on the long call is unlimited.
C) The maximum profit on the short put is $2.
Answer: A
This is a graph of a protective put, which is a combination of owning the stock and purchasing a put on
the same stock. The maximum loss on the put is its $2 cost. The statements regarding the maximum
profit on a long call or a short put are true, but neither of these positions are held by the owner of the
protective put.

Question 48

A call option has a strike price of $120, and the stock price is $105 at expiration. The expiration day value
of the call option is:

A) $0.
B) $105.
C) $15.
Answer: A

A call option has an expiration day value of MAX (0, S-X). Here, X is $120 and S is $105. Because the
call option is out of the money at expiration, its value is zero.

Question 49

For two European call options that differ only in time to expiration, the strongest statement we can make
is that:

A) the longer-term option must be worth at least as much as the shorter-term option.
no relation can be established between the values of the two calls prior to expiration of the
B)
first.
C) the longer-term option must be worth more than the shorter-term option.
Answer: A

While longer-term options generally are worth more, for far in- or out-of-the-money options, the values
could be equal.

Question 50

In the trading of futures contracts, the role of the clearinghouse is to:

A) stabilize the market price fluctuations of the underlying commodity.

B) guarantee that all obligations by traders, as set forth in the contract, will be honored.
C) maintain private insurance that can be used to provide funds if a trader defaults.
Answer: B) guarantee that all obligations by traders, as set forth in the contract, will be honored.

The clearinghouse does not originate trades, it acts as the opposite party to all trades. In other words, it is
the buyer to every seller and the seller to every buyer. This action guarantees that all obligations under
the terms of the contract will be fulfilled.
Question 51

Which combination of interest rate options most likely has the same pattern of payoffs as the short
position in a forward rate agreement?

Interest rate call option Interest rate put option

A) Short Long
B) Long Short
C) Long Long
Answer: A

A short position in an FRA will have a positive payoff when the reference rate is less than the contract
rate, and a negative payoff when the reference rate is greater than the contract rate, at expiration. A short
interest rate call will have a negative payoff when the reference rate is greater than the strike rate, and a
long put will have a positive payoff when the reference rate is less than the strike rate.

Question 52

A call option that is in the money:

A) has an exercise price greater than the market price of the asset.
B) has an exercise price less than the market price of the asset.
C) has a value greater than its purchase price.
Answer: B) has an exercise price less than the market price of the asset.

A call option is in the money when the exercise price is less than the market price of the asset.

Question 53

Standardization features of futures contracts do not include the:

A) delivery time.
B) quality of the good that can be delivered.
C) delivery price of the commodity.
Answer: C) delivery price of the commodity.

The delivery, or spot price at contract expiration, of a commodity is a variable and cannot be included in a
futures contract. Quality and delivery time are both part of the standardized terms of a futures contract.

Question 54
HobbyHorse Syndicate has entered into a "plain-vanilla" interest rate swap on $100,000,000 notional
principal. HobbyHorse receives a fixed rate of 7.5% on payments that occur every six months. The
floating rate payment is based on LIBOR (currently at 6.75%). Because of the volatile interest rate
environment, HobbyHorse has created a reserve to cover any cash outlay required at settlement dates.
At the time of the next payment (due in exactly six months), the reserve balance is $250,000. To fulfill its
obligations under the swap at the next payment date, HobbyHorse will need approximately how much
additional cash?

A) $375,000.
B) $125,000.
C) $0.
Answer: C) $0.
The net payment formula for the floating rate payer is:
Floating Rate Paymentt = (LIBORt-1 - Swap Fixed Rate) × (# days in term / 360) × Notional Principal
If the result is positive, the floating-rate payer owes a net payment and if the result is negative, then the
floating-rate payer receives a net inflow. Note: We are assuming a 360 day year.
Here, floating rate payment = (0.0675 - 0.075) × (180 / 360) × 100,000,000 = -$375,000. Since the result
is negative, HobbyHorse will receive this amount. Thus, HobbyHorse needs $0 additional cash.
Question 55

An investor who bought a floating-rate security and wishes to establish a minimum periodic cash flow on
his investment could:

A) sell an interest-rate floor.

B) buy an interest-rate floor.
C) sell an interest-rate cap.
Answer: B) buy an interest-rate floor.

The buyer of a floor will receive a payment when the floating rate is below the floor rate, effectively
establishing a minimum rate on the floating rate security.

Question 56

Which of the following statements regarding exchange-traded derivatives is NOT correct? Exchange-
traded derivatives:

A) often trade in a physical location.

B) are illiquid.
C) are standardized contracts.
Answer: B) are illiquid.

Derivatives that trade on exchanges have good liquidity in most cases. They have the other
characteristics listed.

Question 57
An increase in the riskless rate of interest, other things equal, will:

A) decrease call option values and increase put option values.

B) increase call option values and decrease put option values.
C) decrease call option values and decrease put option values.
Answer: B) increase call option values and decrease put option values.

An increase in the risk-free rate of interest will increase call option values and decrease put option values.

Question 58

Which of the following statements about European and American options is least accurate?

A) European options offer more flexible trading opportunities for speculators.

B) American options are far more common than European options.
C) European options are easier to analyze and value than American options.
Answer: A

European options are less flexible for traders than American options because of the limitation on when
they can be exercised, which is only on the expiration date. Traders gain more flexibility with American
options that can be exercised at anytime on or before expiration.

Question 59

An option to buy Mexican pesos is:

A) an exchange rate option.

B) a currency option.
C) a foreign option.
Answer: B) a currency option.

Options on foreign currencies are called currency options and cover a specific number of foreign currency
units.

Question 60

A covered call position is:

A) the simultaneous purchase of the call and the underlying asset.

B) the purchase of a share of stock with a simultaneous sale of a put on that stock.
C) the purchase of a share of stock with a simultaneous sale of a call on that stock.
Answer: C) the purchase of a share of stock with a simultaneous sale of a call on that stock.
The covered call: stock plus a short call. The term covered means that the stock covers the inherent
obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s price will
not go up any time soon, and you want to increase your income by collecting some call option premiums.
To add some insurance that the stock won’t get called away, the call writer can write out-of-the money
calls. You should know that this strategy for enhancing one’s income is not without risk. The call writer is
trading the stock’s upside potential for the call premium. The desirability of writing a covered call to
enhance income depends upon the chance that the stock price will exceed the exercise price at which the
trader writes the call.

Question 61

Exchange-traded options are NOT:

A) backed by the Options Clearing Corporation.

B) issued by dealers.
C) standardized as to expirations and contract size.
Answer: B) issued by dealers.

Over-the-counter options are issued by dealers.

Question 62

Which of the following statements about notional principal in plain vanilla interest rate swaps is least
accurate? Notional principal:

is used to calculate the fixed rate interest payment; the swap's market value is used to
A)
calculate the floating rate payment.
B) is not exchanged by the counterparties.
C) does not vary during the swap tenor.
Answer: A

The notional amount is used to calculate both the fixed and the floating rate payment streams. Both of the
other choices are true.

Question 63

Which transaction would least likely be classified as an interest rate swap?

A) Receive AUD fixed, pay NZD floating.

B) Receive U.S. fixed, pay U.S. commercial paper.
C) Pay USD fixed, receive U.S. LIBOR.
Answer: A
Because it involves two different currencies, this would be a currency swap.

Question 64

In a plain vanilla interest rate swap:

A) payments equal to the notional principal amount are exchanged at the initiation of the swap.
one party pays a floating rate and the other pays a fixed rate, both based on the notional
B)
amount.
C) each party pays a fixed rate of interest on a notional amount.
Answer: B) one party pays a floating rate and the other pays a fixed rate, both based on the notional
amount.

A plain vanilla swap is a fixed-for-floating swap.

Question 65

An investor bought a 15 call for $14 on a stock trading at $20. If the stock is trading at $24 at option
expiration, what is the profit and the value of the call at option expiration?

Profit Value of the Call

A) -$5 $9
B) $1 $9
C) -$5 $5
Answer: A

The potential gains on a call purchase are unlimited. With a stock price of $24, the call at 15 is $9 in the
money. By subtracting out the 14 call price a loss of $5 results.

Question 66

Given the profit and loss diagram of two options at expiration shown below which of the following
statements is most accurate?
 The stock price would have to increase above $45 before the seller of the call starts losing
A)
money.
B) The maximum profit to the short put is $5.
C) Between a stock price of $40 and $45 the long call’s profit is between $0 and $5.
Answer: A

This is a graph of a long call and a short call at expiration with a $5 option premium and a strike price of
$40. Between a stock price of $40 and $45 the long call’s profit is between -$5 and $0. The maximum
profit to the short call is $5. Neither of the lines on this graph is the payoff of a short put.

Question 67

Which of the following statements about futures markets is least accurate?

A) Hedging is the prime social rationale for futures trading.

Futures markets allow market participants to discover the market's expectation of future cash
B)
market prices.
C) Initial margin can only be posted in cash.
Answer: C) Initial margin can only be posted in cash.

Margin can be posted in cash, bank letters of credit, or T-bills.

Question 68

Which of the following descriptions of how option payoffs are determined is most accurate?

The long position in an interest rate call option receives cash at expiration equal to Max[0,
A)
(reference rate-strike rate)] x notional principal amount.
 An equity call option holder receives cash in the amount by which the exercise price is greater
B)
than the strike price.
Payoffs on futures options can be determined without knowing the spot price of the underlying
C)
commodity.
Answer: C) Payoffs on futures options can be determined without knowing the spot price of the underlying
commodity.

When the holder exercises a futures option, he receives an underlying futures position. The cash payoff is
the value the holder gains when that position is marked to market. Thus, the payoff is the difference
between the exercise price and the futures contract price. Although it certainly influences the futures
price, the spot price of the underlying commodity does not enter into the calculation of the payoff on the
option.

The long position in an interest rate call option receives cash if the reference rate is greater than the strike
rate, but does not receive it at expiration. The term of the reference rate (for example, 90-day LIBOR)
determines the length of time after expiration when the cash changes hands. Options that pay at
expiration pay the present value of the amount described. Determining the payoff on a stock index option
requires the index level, the exercise price, and the contract multiplier. The strike price is another name
for the exercise price.

Question 69

An option’s intrinsic value is equal to the amount the option is:

A) in the money, and the time value is the market value minus the intrinsic value.
B) in the money, and the time value is the intrinsic value minus the market value.
C) out of the money, and the time value is the market value minus the intrinsic value.
Answer: A

Intrinsic value is the amount the option is in the money. In effect it is the value that would be realized if the
option were at expiration. Prior to expiration, the option’s market value will normally exceed its intrinsic
value. The difference between market value and intrinsic value is called time value.

Question 70

An investor can exit a forward position prior to contract expiration by all of the following methods
EXCEPT:

A) exercising the early delivery option.

making a cash payment or accepting a cash payment by agreement with the original
B)
counterparty.
C) entering into an offsetting contract with the original counterparty.
Answer: A

There is typically no early delivery option in a forward contract. The other two methods are both usual
ways of terminating a forward contract prior to the settlement date specified in the contract.

Question 7
The following value diagram illustrates a:

A) long call option.

B) long put option.
C) short put option.
Answer: A

This value diagram represents a long call position. The holder (buyer) of the option pays a premium to
receive a payment if the stock price is higher than the exercise price. As the stock price rises above the
exercise price, the option pays more to the buyer. The maximum that the call buyer can lose is the
amount of the premium, while the profit potential for the call buyer is unlimited.

Question 72

A U.S. bank enters into a plain vanilla currency swap with a notional principal of US$100m (£67m). At
each settlement date, the U.S. bank pays a fixed rate of 8% on the pounds received, and an English bank
pays a variable rate equal to London Interbank Offered Rate (LIBOR) on the U.S. dollars received. Given
the following information, what payment is made to whom at the end of year 2?

The U.S. bank pays:

A) £5.36m and the English bank pays US$6m.

B) US$5.5m and the English bank pays £5.36m.
C) £5.36m and the English bank pays US$5.5m.
Answer: C) £5.36m and the English bank pays US$5.5m.
The U.S. bank pays 8% fixed on £67m, which makes for an annual payment of £5.36m. The variable rate
to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the English bank pays
5.5% times US$100m for a payment of US$5.5m.

Question 73

Parties agreeing to swap cash flows are:

A) counterparties.
B) swap facilitators.
C) agents.
Answer: A

The parties agreeing to swap cash flows are called the counterparties.

Question 74

The following value diagram illustrates a:

A) short call option.

B) short put option.
C) long put option.
Answer: A

This value diagram represents a short call position. The seller (writer) of the option receives a premium.
However, as the stock price rises further above the exercise price, the seller of the option loses more.
Note that the greatest profit the call seller (writer) can receive is the amount of the premium, while the
potential loss is unlimited.

Question 75

An investor bought a futures contract covering 100,000 Mexican Pesos at 0.08196 and deposited margin
of $320. The following day the contract settlement price was 0.08201. The new margin balance in the
account is:

A) $320.
B) $314.
C) $325.
Answer: C) $325.

320 + 100,000(0.08201 − 0.08196) = $325

Question 76

A put option currently has an option premium of $3 and a strike price of $40. The market price of the
stock is $42 at expiration. The expiration day value of the option is:

A) $0.
B) $2.
C) $5.
Answer: A

The expiration day value of the put is $0 because it is trading out-of the money.

Question 77

If the balance in a trader’s account falls below the maintenance margin level, the trader will have to
deposit additional funds into the account. The additional funds required is called the:

A) margin call.
B) variation margin.
C) initial margin.
Answer: B) variation margin.

If the margin balance falls below a specified level (the maintenance margin), additional capital (the
variation margin) must be deposited in the account. Initial margin is the capital that must be in the trader’s
account before the initiation of the margin trade.

Question 78
Consider a call option on Intel with an exercise price of $25. The current stock price of Intel is $14. What
is the intrinsic value of the call option?

A) $0.
B) $11.
C) $25.
Answer: A

The option has an intrinsic value of $0 because the stock price is below the exercise price. The call’s
value is MAX (0, S − X). Equivalently, the option is out-of-the-money.

Question 79

Which of the following is a common criticism of derivatives?

A) Derivatives are too illiquid.

B) Derivatives are likened to gambling.
C) Fees for derivatives transactions are relatively high.
Answer: B) Derivatives are likened to gambling.

Derivatives are often likened to gambling by those unfamiliar with the benefits of options markets and how
derivatives are used.

Question 80

Consider a swap with a notional principal of $120 million.

Given the above diagrams, which of the following statements is CORRECT? At the end of 360 days:
 A) A pays B $0.6 million.
B) A pays B $13.2 million and B pays A $12 million.
C) A pays B $1.2 million.
Answer: A

The variable rate to be used at the end of 360 days is set at the 180-day period (the arrears method).
Therefore, the appropriate variable rate is 10%, the fixed rate is 11%, the time period is 180 days, and the
interest payments are netted. The fixed-rate payer, counterparty A, pays according to:

(Swap Fixed Rate - LIBORt-1)(# of days/360)(Notional Principal).

In this case, we have (0.11 - 0.10)(180/360)($120 million) = $0.6 million

Question 81

Donner Foliette holds stock in Hamilton Properties, which is currently trading at $25.70 per share. On the
advice of this investment advisor, he conducts a covered call transaction at a strike price of $30 and at a
premium of $3.50. The advisor drew the following graph to help explain the transaction.

Which of the following statements about this transaction is least accurate?

A) Foliette believes the stock will appreciate significantly in the near future.
B) The call buyer paid $3.50 for the right to any gain above $30.
C) If the stock price falls to $23, Foliette will gain $0.80 per share.
Answer: A

One reason for an investor to conduct a covered call transaction is that he believes that the stock's upside
potential is limited and he wants to collect some option premiums. The call writer thus trades the stock’s
upside potential for the premium. An investor is less likely to write a covered call if he believes the stock's
upside potential is significant because he would be giving up the expected gains if the stock is called
away.

The information about Foliette’s gains is correct. If the stock price decreases to $23.70, Foliette can
realize a gain of $0.80 if he sells the stock ($23.0 value − $25.70 + $3.50 premium).
Question 82

Using put-call parity, it can be shown that a synthetic European call can be created by a portfolio that is:

long the stock, long the put, and short a pure discount bond that pays the exercise price at
A)
option expiration.
long the stock, long the put, and long a pure discount bond that pays the exercise price at
B)
option expiration.
long the stock, short the put, and short a pure discount bond that pays the exercise price at
C)
option expiration.
Answer: A

A stock and a put combined with borrowing the present value of the exercise price will replicate the
payoffs on a call at option expiration.

Question 83

Which of the following statements regarding interest-rate options is least accurate?

A) Call option values move in the same direction as interest rates.

B) They are based on a fixed income security.
C) They are based on a specific interest rate rather than a bond.
Answer: B) They are based on a fixed income security.

Treasury bond or bill options are options on fixed income securities. Interest rate options are based on a
specific reference rate and interest rate calls have positive payoffs when the reference rate is above the
rate specified in the contract.

Question 84

Which of the following statements regarding a fixed-for-fixed currency swap of euros for British pounds is
least accurate?

The notional principal amounts, adjusted for exchange rate changes, are exchanged at the
A)
termination of the swap.
B) One party makes certain payments in Euros.
C) The periodic payments are not netted, both payments are always made.
Answer: A

The original notional principal amounts are exchanged at contract termination; there is no adjustment to
the amounts for the change in exchange rates over the life of the swap.
Question 85

Which of the following is a reason to use the swaps market rather than the futures market? To:

A) maintain the firm's privacy.

B) reduce the credit risk involved with the contract.
C) increase the liquidity of the contract.
Answer: A

The futures market, because of the use of a standardized contract, is more liquid; and, because the
exchange guarantees the contract, futures contracts have less credit risk. However, swaps contracts,
because they are over-the-counter (private) contracts, allow the firm to maintain privacy.

Question 86

An agreement that requires the parties to exchange a certain amount of Yen for a certain amount of
Euros on a specific date in the future is called a(n):

A) exchange rate agreement.

B) currency forward contract.
C) foreign exchange future.
Answer: B) currency forward contract.

Such an agreement is called a currency forward contract.

Question 87

If a farmer expects to sell his wheat in anticipation of a harvest and wants to hedge his risk, he needs to:

A) sell wheat futures contracts now.

B) sell wheat now.
C) buy wheat futures contracts now.
Answer: A

A futures contract is a forward contract that has been highly standardized and closely specified. As with a
forward contract, a futures contract calls for the exchange of some good at a future date for cash, with the
payment for the good to occur at the future delivery date. The purchaser of the contract is to receive
delivery of the good and pay for it while the seller (here the wheat farmer) of the contract promises to
deliver the good and receive payment. The payment price is determined at the initial time of the contract.
Question 88

Which of the following statements regarding forward contract dealers is NOT correct?

A) Forward contract dealers are often banks.

B) Dealers offer long and short forward contracts at different prices.
C) Dealers are compensated through up-front payments by the parties to forward contracts.
Answer: C) Dealers are compensated through up-front payments by the parties to forward contracts.

There is typically no payment from either the long or the short to enter into a forward contract. Dealers
make money through the bid-ask spread, the difference between the forward prices they offer to buyers
and sellers.

Question 89

The forward contract price of a coupon-bearing bond is typically quoted as:

A) a discount to the face value.

B) the bond dollar-price plus accrued interest as of the settlement date.
C) a yield to maturity at the settlement date.
Answer: C) a yield to maturity at the settlement date.

The contract price for a coupon-bearing bond is typically quoted as its yield to maturity. The accrued
interest is (customarily) added to the price on a deliverable contract, but not included in the stated price
quote.

Question 90

Which of the following statements about swaps is least accurate?

A) Swaps are illiquid.

B) Parties to swap contracts are often individual speculators.
C) Swaps typically have zero value at initiation.
Answer: B) Parties to swap contracts are often individual speculators.

Parties to swaps contracts are usually large institutions, rarely individual speculators or hedgers.

Question 91

Which of the following statements about forward contracts is least accurate?

 A) A forward contract can be exercised at any time.
B) The long promises to purchase the asset.
C) Both parties to a forward contract have potential default risk.
Answer: A

Forward contracts typically require a purchase/sale of the asset on the expiration/delivery date specified
in the contract. The other statements are true.

Question 92

The clearinghouse, in U.S. futures markets, does NOT:

A) guarantee performance of futures contract obligations.

B) act as a counterparty in futures contracts.
C) choose which assets will have futures contracts.
Answer: C) choose which assets will have futures contracts.

The exchange decides which contracts will be traded and their specifications. The clearinghouse acts as
the counterparty to every contract and guarantees performance.

Question 93

All of the following are ways to exit a swap contract EXCEPT:

A) entering an offsetting swap with the original counterparty.

B) selling a swaption.
C) making a cash payment to the original counterparty.
Answer: B) selling a swaption.

Selling a swaption gives the seller an obligation to enter into a swap if the swaption is exercised. To exit a
swap, the entity would want to buy the swaption.

Question 94

Closing out a futures position prior to expiration:

A) can only be done by the long.

B) removes price risk but not necessarily counterparty risk.
C) can be done by entering into an offsetting trade at the current futures price.
Answer: C) can be done by entering into an offsetting trade at the current futures price.
Taking the opposite position in an equal number of contracts on the same asset with the same expiration
date ends any further exposure under the original contract.

Question 95

Determine the transactions involved with a plain vanilla interest rate swap and whether or not notional
principal is generally swapped:

Plain vanilla interest rate swap Notional principal

A) pay floating rate, pay fixed rate not swapped
B) pay fixed rate, pay fixed rate swapped
C) pay fixed rate, pay floating rate swapped
Answer: A

The most common type of interest rate swap is called a plain vanilla interest rate swap. It involves trading
fixed interest rate payments for floating-rate payments. Notional principal is generally not swapped in
single currency swaps.

Question 96

Which of the following statements about closing a futures position through delivery is most accurate?

Although the popularity of physical delivery has decreased over time, delivery by cash
A)
settlement remains the most popular method of closing a futures position.
Depending on the wording of the contract, a trader may close a contract by either delivering
B)
the goods to a designated location or by making a cash settlement of any gains or losses.
C) Delivery is also known as exchange for physicals (EFP).
Answer: B) Depending on the wording of the contract, a trader may close a contract by either delivering
the goods to a designated location or by making a cash settlement of any gains or losses.

The other statements are false.

Physical deliveries and cash settlements combined represent less than one percent of all settlements.

An exchange for physicals differs from a delivery in that:

 The traders actually exchange the goods.

 The contract is not closed on the floor of the exchange.
 The two traders privately negotiate the terms of the transaction.

Question 97

The minimum value for a European call option is:

 A) max [0, S − X / (1 + R)T].
B) max [0, (S - X) / (1 + R)T].
C) min [0, S − X / (1 + R)T].
Answer: A

The minimum value of a European call option is max [0, S − X / (1 + R) T].

Question 98

Which of the following is NOT considered a reason for using the swaps market? To:

A) reduce transactions costs.

B) exploit market inefficiencies.
C) maintain privacy.
Answer: B) exploit market inefficiencies.

Historically, the two basic motivations for swaps were to exploit market inefficiencies and attempt to
achieve cheaper financing. Today, the swaps market has matured and now offers few arbitrage
opportunities to exploit market inefficiencies. In addition to seeking cheaper financing, current reasons for
using swaps include reducing transactions costs, avoiding costly regulations, and maintaining privacy.

Question 99

Consider a $10,000,000 1-year quarterly-pay swap with a fixed rate of 4.5 percent and a floating rate of
90-day London Interbank Offered Rate (LIBOR) plus 150 basis points. 90-day LIBOR is currently 3
percent and the current forward rates for the next four quarters are 3.2 percent, 3.6 percent, 3.8 percent,
and 4 percent. If these rates are actually realized, at the first quarterly settlement date:

A) the fixed-rate payer will be required to make a payment of $7,500.

B) the floating rate payer will be required to make a payment of $92,500.
C) no payments will be made.
Answer: C) no payments will be made.

The first floating rate payment is based on current LIBOR + 1.5% = 4.5%. This is equal to the fixed rate
so no (net) payment will be made on the first settlement date.

Question 100

Which of the following statements about put and call options at expiration is least accurate?

Put Call
The maximum gain to the buyer The maximum loss to the writer
A)
is unlimited. is the premium.
 The maximum loss to a writer is
The maximum gain to the buyer
B) the exercise price less the
is unlimited.
premium.
The maximum gain to the buyer
The maximum gain to the buyer
C) is limited to the exercise price
is unlimited.
less the premium.
Answer: A

The maximum gain to the buyer of a put is limited to the exercise price less the premium.

The maximum loss to the writer of a call is unlimited.

Question 101

Which of the following is most accurate regarding derivatives?

Exchange-traded derivatives are created and traded by dealers in a market with no central
A)
location.
B) Derivative values are based on the value of another security, index, or rate.
C) Derivatives have no default risk.
Answer: B) Derivative values are based on the value of another security, index, or rate.

Derivatives derive• their value from the value or return of another asset or security. Exchange-traded
derivatives are standardized and backed by a clearinghouse. An over-the-counter derivative, such as a
forward contract or a swap, exposes the derivative holder to the risk that the counterparty may default.

Question 102

A forward rate agreement is equivalent to:

A) either an interest rate put or an interest rate call.

B) a long interest rate call and a written interest rate put.
C) a swap.
Answer: B) a long interest rate call and a written interest rate put.

A long forward rate agreement is equivalent to a call (profits when interest rates go up) and a written put
(losses when interest rates go down).

Question 103

Which of the following statements regarding margin in futures accounts is NOT correct?

A) Margin is usually 10% of the contract value for futures contracts.

B) With futures margin, there is no loan of funds.
C) Margin must be deposited before a trade can be made.
Answer: A
The margin percentage is typically low as a percentage of the value of the underlying asset and varies
among contracts on different assets based on their price volatility. The other statements are true.

Question 104

A futures account is marked to market:

A) only when margin falls below the maintenance margin level.

B) daily.
C) weekly.
Answer: B) daily.

Margin balances are marked to market (adjusted) daily based on the change in settlement price from the
previous day.

Question 105

Consider a U.S. commercial bank that borrows funds in England for one year denominated in English
pounds. Why would the investor wish to enter into a swap contract? As the:

A) English pound decreases in value, it takes more U.S. dollars to pay off the English liability.
B) English pound increases in value, it takes more U.S. dollars to pay off the English liability.
C) U.S. interest rate increases, the value of the English liability increases.
Answer: B) English pound increases in value, it takes more U.S. dollars to pay off the English liability.

As the English pound increases in value, it takes more U.S. dollars to pay off the English liability, which
increases the interest cost of borrowing funds denominated in English pounds.

Question 106

Which of the following statements about futures margin is least accurate?

A) Initial margin must be posted to a futures account within three days after the first trade.
The initial margin on a contract approximately equals the maximum daily price fluctuation of
B)
the contract.
If the margin account balance falls below the maintenance margin level, the trader must bring
C)
the account back up to the initial margin level.
Answer: A

Initial margin must be posted before trading.

Question 107

Why are payments NOT usually netted out in a currency swap?

A) There are no payments in a currency swap except at initiation and maturity.

B) The payments are denominated in two different currencies.
C) There is no credit risk in a currency swap.
Answer: B) The payments are denominated in two different currencies.

Payments are not usually netted out because the payments are denominated in two different currencies,
which does not easily allow for netting.

Question 108

Which of the following statements about forward contracts and futures contracts is NOT correct?
Forwards:

A) have no default risk, unlike futures.

B) are private contracts, unlike futures.
C) are unique contracts, unlike futures.
Answer: A

Forwards have default risk because the seller may not deliver and the buyer may not accept delivery.

Question 109

Consider a call option expiring in 110 days on a non-dividend-paying stock trading at 27 when the risk-
free rate is 6%. The lower bound for a call option with an exercise price of 25 is:

A) $2.00.
B) $1.97.
C) $2.44.
Answer: C) $2.44.

27 - 25/(1.06)110/365 = 2.435.

Question 110
Which of the following represents a long position in an option?

A) Writing a call option.

B) Writing a put option.
C) Buying a put option.
Answer: C) Buying a put option.

A long position is always the buying position. Remember that the buyer of an option is said to have gone
long the position, while the writer (seller) of the option is said to have gone short the position.

Question 111

In June, Todd Puckett bought stock in SBC Communications for $30 per share. At that time, Puckett sold
an equivalent number of call options on SBC with an exercise price of $35 for $2.75. In September, at
expiration, the stock is trading at $26. What is Puckett’s profit per share from his covered call strategy?
Puckett:

A) gained $1.25.
B) lost $1.25.
C) gained $4.00.
Answer: B) lost $1.25.

Since the option is out-of-the-money at expiration (MAX (0, S − X)), the options are worthless. Also, the
stock decreased in value from $30 per share to $26 per share, creating a $4 loss. The $4 loss is partially
offset by the $2.75 premium Puckett received. Therefore, the loss per share from the covered call position
is $1.25 = (-$4 + $2.75).

Question 112

For a European call option X = 25 and a European call option X = 30 on the same stock with the same
time to expiration it is true that, when the 30 call is at- or in-the-money, the strongest statement we can
make is the:

A) value of the 25 call is greater than the value of the 30 call.

B) 30 call is worth at least as much as the 25 call.
C) value of the 25 call is greater than or equal to the value of the 30 call.
Answer: A

If the 30 call is at- or in-the-money at expiration, the strongest true statement is that the value of the 25
call is greater than the value of the 30 call. Even if the options are out of the money, the 25 call will be
more valuable than the 30 call before expiration (although if they are far out of the money and close to
expiration, both might have a value of effectively zero).
Question 113

In October, James Knight owned stock in Valerio, Inc., that was valued at $45 per share. At that time,
Knight sold a call option on Valerio with an exercise price of $60 for $1.45. In December, at expiration, the
stock is trading at $32. What is Knight’s profit (or loss) from his covered call strategy? Knight:

A) lost $11.55.
B) gained $11.55.
C) gained $1.45.
Answer: A

Since the option is out-of-the-money at expiration (MAX (0, S-X)), the option is worthless. Also, the stock
decreased in value from $45 per share to $32 per share, creating a $13 loss. The $13 loss is partially
offset by the $1.45 premium Knight received. Therefore, the total loss from the covered call position is
$11.55 (-$13+$1.45).

Question 114

The least likely way to terminate a swap agreement prior to expiration is to:

A) sell the swap.

B) make/receive a payment to/from the original counterparty.
C) exercise a swaption.
Answer: A

There is no functioning secondary market in swaps; selling a swap would be unusual and would require
the permission of the counterparty.

Question 115

A covered call position is equivalent to:

A) owning the stock and a long call.

B) owning the stock and a long put.
C) a short put.
Answer: C) a short put.

The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the
inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s
price will not go up any time soon, and you want to increase your income by collecting some call option
premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the
money calls. You should know that this strategy for enhancing one’s income is not without risk. The call
writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call
to enhance income depends upon the chance that the stock price will exceed the exercise price at which
the trader writes the call. This is similar reasoning to selling (or going short) a put. A put is in-the-money
when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay
the premium and never exercise, the seller wants the price of the stock to remain above the exercise
price.

Question 116

Which of the following statements regarding the mark to market of a futures account is least accurate?
Marking to market of a futures account:

A) may result in a margin balance above the initial margin amount.

B) is only done when the settlement price is below the maintenance price.
C) may be done more often than daily.
Answer: B) is only done when the settlement price is below the maintenance price.

Futures accounts are marked to market daily based on the new settlement price, which can result in
either an addition to or subtraction from the previous margin balance. Under extraordinary circumstances
(volatility) the mark to market can be required more frequently. Once the margin is marked to market, the
contract is effectively a futures contract at the new settlement price.

Question 117

Which of the following statements regarding forwards and futures is NOT correct?

A) Unlike forwards, futures are always deliverable contracts.

B) Unlike futures, forwards carry counterparty risk.
C) Like futures, forwards are priced to have zero value at contract initiation.
Answer: A

There are both deliverable and cash settlement futures contracts, just as with forwards.

Question 118

Consider a put option on Deter, Inc., with an exercise price of $45. The current stock price of Deter is
$52. What is the intrinsic value of the put option, and is the put option at-the-money or out-of-the-money?

Intrinsic Value Moneyness

Out-of-the-
A) $0
money
B) $7 At-the-money
 Out-of-the-
C) $7
money
Answer: A

The option has an intrinsic value of $0, because the stock price is above the exercise price. Put value is
MAX (0, X-S). Equivalently, the option is out-of-the-money.

Question 119

Which of the following is the best interpretation of the no-arbitrage principle?

A) There is no free money.

B) There is no way you can find an opportunity to make a profit.
C) The information flow is quick in the financial market.
Answer: A

An arbitrage opportunity is the chance to make a riskless profit with no investment. In essence, finding an
arbitrage opportunity is like finding free money. As you recall, in arbitrage, you observe two identical
assets with different prices. Your immediate response should be to buy the cheaper one and sell the
expensive one short. You can then deliver the cheap one to cover your short position. Once you take the
initial arbitrage position, your arbitrage profit is locked in. The no-investment statement referenced in the
text refers to the assumption that when you short the expensive asset, you will be given access to the
cash created by the short sale. With this cash, you now have the money to buy the cheaper asset. The
no-investment assumption means that the first person to observe a market pricing error will have the
financial resources to correct the pricing error instantaneously all by themselves.

Question 120

An investor buys a 30 put on a share of stock for a premium of $7 and simultaneously buys a share of
stock for $26. The breakeven price on the position and the maximum gain on the position are:

Breakeven price Maximum gain

A) $33 unlimited
B) $21 $11
C) $37 $11
Answer: A

To break even, the stock price should rise as high as the amount invested, $33 ($26 + $7). The maximum
gain is unlimited, as the gain will be as high as the increase in the stock price.
Question 121

Consider a call option with a strike price of $32. If the stock price at expiration is $41, the value of the call
option is:

A) $9.
B) $0.
C) $41.
Answer: A

The call has a $9 ($41 − $32) value at expiration, because the holder of the call can exercise his right to
buy the stock at $32 and then sell the stock on the open market for $41. Remember, the intrinsic value of
a call at expiration is MAX (0, S-X).

Question 222

Which type of futures contract does NOT allow for the underlying goods to be delivered?

A) Interest rate.
B) Index.
C) Agricultural.
Answer: B) Index.

The nature of an index future realistically prohibits settlement in the underlying commodity. For example,
the Standard and Poor’s 500 stock index would require settlement in 500 different common stocks, in the
exact proportion of the total value as exists in the index at expiration of the future. Agriculture and interest
rate futures both involve deliverable commodities.

Question 123

Collete Minogue holds stock in Bracken Entertainment. Although many of her associates still believe that
Bracken will be a high-performing stock, Minogue has lost faith and wants to conduct a covered call
transaction. Current market conditions are as follows:

 Stock price (S) at $33 per share.

 Strike price of $39.
 Premium of $5.
 No transaction costs.

In assessing whether she should conduct the covered call strategy, Minogue sketches out the following
graph. Although her sketch is correct, she cannot remember all the labels.
Which of the following statements about the graph and the covered call strategy is least accurate?

A) The distance between points C and D is $5.

B) The call writer will have unlimited upside potential.
C) If Minogue goes ahead with the covered call, she will limit her gain to $11.
Answer: B) The call writer will have unlimited upside potential.

The call buyer has unlimited upside potential. If the stock price exceeds $39, the buyer will exercise the
option and will realize all gains (once the cost of the premium is recovered).

The other statements are true. Minogue is the call writer (a covered call consists of the stock and a short
call). Her gain is limited to $11 (the call premium of $5 plus the gain on the stock as long as the market
price is less than the strike price, or $39 − $33). The distance between points C and D represents the call
premium, or $5.

Question 124

A trader is long four July gold futures contracts, each with a contract size of 300 oz. If the price of July
gold increases from $380.20 to $381.00 per ounce the change in the margin balance will be:

A) $960.
B) $240.
C) -$960.
Answer: A

4 × 300 × (381 - 380.20) = $960

Question 125

Which of the following statements about futures contracts on U.S. exchanges is least likely accurate?

A) Prices of currency futures contracts are quoted as U.S. dollars per unit of the foreign currency.
B) A $100,000 Treasury bond futures contract that settles at 102-16 represents Treasury bonds
 worth $102,500.
If annualized 90-day LIBOR decreases from 3.64% to 3.58%, a long position in a $1 million
C)
Eurodollar futures contract loses $150.
Answer: C) If annualized 90-day LIBOR decreases from 3.64% to 3.58%, a long position in a $1 million
Eurodollar futures contract loses $150.

The long position in a Eurodollar contract gains value when LIBOR decreases. Price quotes on Eurodollar
futures are calculated as 100 minus annualized 90-day LIBOR in percent. A change in 90-day LIBOR of
0.01% represents a $25 change in value on a $1 million Eurodollar futures contract. If LIBOR decreases
from 3.64% to 3.58%, the contract price increases six ticks from 96.36 to 96.42, so the long position gains
6 × $25 = $150.

Treasury bond futures that have a face value of $100,000 are quoted as a percent of face value with
fractions measured in 1/32nds. A bond futures quote of 102-16 represents 102 16/32, or 102.5% of
$100,000, which is $102,500.

Currency futures contracts are set in units of the foreign currency and stated as USD/unit.

Question 126

The following data applies to a forward rate agreement that settles in 60 days:

 It is based on 180-day LIBOR

 The notional principal amount is $15 million
 It calls for a forward rate of 6.5%
 In 30 days, 180-day LIBOR will be 6.2%
 In 60 days, 180-day LIBOR will be 7.0%
 In 180 days, 180-day LIBOR will be 7.5%

The short’s cash payment at settlement is closest to:

A) $37,500.
B) the short will not have to make a payment.
C) $36,232.
Answer: C) $36,232.

Settlement payment from short = notional principal × ((forward LIBOR at settlement − agreed forward
rate) × (180/360)) / (1 + (floating × 180/360))
Payment = $15 million × ((7.0% − 6.5%) × (180/360)) / (1 + (0.07 × 180/360))
Payment = $36,231.88

Question 127

Which of the following statements regarding both futures contracts and forward contracts is least
accurate?
 A) They are priced to have zero value at the initiation of the contract.
B) For deliverable contracts, the short must deliver the underlying asset at a future date.
C) They carry counterparty risk.
Answer: C) They carry counterparty risk.

The clearinghouse of the futures exchange is the counterparty to all futures contracts so that, unlike
forward contracts, counterparty risk is not a concern with futures contracts.

Question 128

For stock options, which of the following will least likely increase put option values and decrease call
option values?

A) A decrease in the riskless rate of interest.

B) An increase in the riskless rate of interest.
C) An increase in the exercise price.
Answer: B) An increase in the riskless rate of interest.

An increase in the riskless rate of interest will decrease put option values and increase call option values.

Question 129

Which statement about equity forward contracts is least accurate?

A) Equity forward contracts may require asset delivery or cash settlement.

B) Dividend payments are usually included in equity forward contracts.
C) Investors can use equity forward contracts to speculate on stock-price increases.
Answer: B) Dividend payments are usually included in equity forward contracts.

Dividend payments are usually not included in equity forward contracts. Investors can use equity forwards
to speculate on stock price movements. Most equity index forward contracts are settled in cash, but since
they are custom instruments, forwards may specify either cash settlement or delivery of the equity shares
specified in the contract.

Question 130

Regarding buyers and sellers of put and call options, which of the following statements concerning the
resulting option position is most accurate? The buyer of a:

A) call option is taking a long position and the buyer of a put option is taking a short position.
B) call option is taking a long position while the seller of a put is taking a short position.
 C) put option is taking a short position and the seller of a call option is taking a short position.
Answer: B) call option is taking a long position while the seller of a put is taking a short position.

The buyers of both puts and calls are taking long positions in the options contracts (but the buyer of a put
is establishing a potentially short exposure to the underlying), while writers (sellers) of each are taking
short positions in the options contracts.

Question 131

Which of the following statements is CORRECT concerning the above diagram? Counterparty:

A) B pays a fixed rate to counterparty A.

B) A will gain in the swap when interest rates increase.
C) B will gain in the swap when interest rates increase.
Answer: B) A will gain in the swap when interest rates increase.

From the diagram, counterparty A pays fixed to and receives variable from counterparty B. As interest
rates rise, counterparty B owes counterparty A higher variable payments.

Question 132

Which of the following statements regarding Eurodollar time deposits is NOT correct?

A) USD denominated deposits in large banks in Tokyo are Eurodollar accounts.

B) U.S. dollar (USD) denominated deposits at large banks in London are Eurodollar accounts.
C) Euro denominated deposits at large banks in the U.S. are Eurodollar accounts.
Answer: C) Euro denominated deposits at large banks in the U.S. are Eurodollar accounts.

Eurodollar deposits are USD denominated deposits in large banks held outside the United States. By
convention, the rates are quoted as an add-on yield. Following this convention, euro-denominated
deposits held outside of the euro-block countries would be Euroeuro• deposits.

Question 133

The process of arbitrage does all of the following EXCEPT:

 A) promote pricing efficiency.
B) produce riskless profits.
C) insure that risk-adjusted expected returns are equal.
Answer: C) insure that risk-adjusted expected returns are equal.

Arbitrage does not insure that the risk-adjusted expected returns to two risky assets will be equal.
Arbitrage is based on risk-free portfolios and promotes efficient pricing of assets. When an arbitrage
opportunity is presented by a mispricing of assets, the increased supply of the ˜overpriced’ asset and the
increased demand for the ˜underpriced’ asset by arbitrageurs, will move the prices toward equality and
act to correct the mispricing.

Question 134

Consider a $10,000,000 1-year quarterly-pay swap with a fixed rate of 4.5% and a floating rate of 90-day
London Interbank Offered Rate (LIBOR) plus 150 basis points. 90-day LIBOR is currently 3% and the
current forward rates for the next four quarters are 3.2%, 3.6%, 3.8%, and 4%. If these rates are actually
realized, at the second quarterly settlement date, the fixed-rate payer in the swap will:

A) receive a payment of $5,000.

B) receive a payment of $10,000.
C) neither make nor receive a payment.
Answer: A

The payment at the second settlement date will be based on 90-day LIBOR realized at the first settlement
date, 3.2%. The payment (net) by the floating-rate payer will be:

(0.032 + 0.015 − 0.045) × 90/360 × 10,000,000 = $5,000

Question 135

Typically, forward commitments are made with respect to all the following EXCEPT:

A) inflation.
B) equities.
C) bonds.
Answer: A

Forward commitments can be customized and could be written on some measure of inflation, but typically
they are not. The volume of forward commitments, including forward contracts and futures contracts, on
bonds, equities, and interest rates is in the many billions of dollars.

Question 136
When a futures trader receives a margin call what must he or she do to bring the position up to the initial
margin? The futures trader must:

A) sell stock to cover the margin call.

B) deposit maintenance margin.
C) deposit variation margin.
Answer: C) deposit variation margin.

When a futures trader receives a margin call, he/she must deposit variation margin to bring the account
up to the initial margin value.

Question 137

Jasper Quartermaine is interested in using the options market to create insurance• against a severe drop
in the value of a stock portfolio that he owns. How could he best accomplish this goal and what is this
type of strategy called?

Type of option Strategy

A) buy put options protective put
write call
B) protective put
options
write call
C) covered call
options
Answer: A

An investor can simulate portfolio insurance by purchasing put options. Losses in the underlying portfolio
are offset by gains in the put position. The investor is already long his portfolio and if he buys a long put
for his portfolio he is replicating a protective put strategy.

Question 138

A forward rate agreement (FRA):

A) is settled by making a loan at the contract rate.

B) can be used to hedge the interest rate exposure of a floating-rate loan.
C) is risk-free when based on the Treasury bill rate.
Answer: B) can be used to hedge the interest rate exposure of a floating-rate loan.

An FRA settles in cash and carries both default risk and interest rate risk, even when based on an
essentially risk-free rate. It can be used to hedge the risk/uncertainty about a future payment on a floating
rate loan.
Question 139

Which of the following statements about a currency swap is CORRECT?

A) Payments are netted at each settlement date.

B) If one party pays a fixed rate of interest, the other party must pay a floating rate.
C) Changes in exchange rates do not affect the swap payments.
Answer: C) Changes in exchange rates do not affect the swap payments.

Swap payments are based on the notional amounts of each currency and either a fixed or floating rate for
either or both parties. While changes in exchange rates might be reflected in interest rates, they have no
direct effect on any of the payment amounts over the term of the swap.

Question 140

All of the following are characteristics of futures contracts EXCEPT:

A) they are liquid.

B) the contract size is standardized.
C) they trade in a dealer (over the counter) market.
Answer: C) they trade in a dealer (over the counter) market.

Futures contracts trade on organized exchanges; forward contracts are created by dealers.

Question 141

Which of the following is an example of an arbitrage opportunity?

A) A put option on a share of stock has the same price as a call option on an identical share.
A portfolio of two securities that will produce a certain return that is greater than the risk-free
B)
rate of interest.
C) A stock with the same price as another has a higher rate of return.
Answer: B) A portfolio of two securities that will produce a certain return that is greater than the risk-free
rate of interest.

An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the
future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless
rate to purchase the position will produce a certain future amount greater than the amount required to
repay the loan.
Question 142

Which of the following is a difference between futures and forward contracts? Futures contracts are:

A) over-the-counter instruments.
B) standardized.
C) larger than forward contracts.
Answer: B) standardized.

As opposed to forward contracts, futures contracts are traded over an organized exchange and are
standardized in size, maturity, quality of deliverable, etc.

Question 143

Which of the following statements about forward and future contracts is least accurate?

A predetermined price to be paid for a good is a necessary requirement in the terms of a

A)
forward contract.
B) A future requires the contract purchaser to receive delivery of the good at a specified time.
The primary difference between forwards and futures is that only futures are considered
C)
financial derivatives.
Answer: C) The primary difference between forwards and futures is that only futures are considered
financial derivatives.

Forwards and futures are similar and serve similar needs. Both are considered types of financial
derivatives in that payoffs depend on another financial instrument or asset. The primary difference is that
forwards are designed for the needs of the particular parties entering the contract, where futures are
standardized contracts.

Question 144

Which method is NOT an appropriate way to close out a futures contract?

A) Default.
B) Reverse trade.
C) Delivery.
Answer: A

Default is failure to perform as required under the contract.

Question 145
The lower bound on European call option prices can be adjusted for cash flows of the underlying asset
by:

A) adding the present value of the expected dividend payments to the current asset price.
B) subtracting the present value of the expected dividend payments from the exercise price.
C) subtracting the present value of the expected dividend payments from the current asset price.
Answer: C) subtracting the present value of the expected dividend payments from the current asset price.

The correct adjustment is to subtract the present value of the expected dividend payments from the
current asset price.

Question 146

Consider the following four options on the same underlying instrument:

Option 1: September call, exercise price = $55.

Option 2: September call, exercise price = $60.
Option 3: December put, exercise price = $75.
Option 4: December put, exercise price = $80.

What is most likely the relationship among the values of these options?

September calls December puts

A) Option 2 > Option 1 Option 3 > Option 4
B) Option 1 > Option 2 Option 4 > Option 3
C) Option 1 > Option 2 Option 3 > Option 4
Answer: B)
Option 1 > Option 2 Option 4 > Option 3

For options that differ only by exercise price, a call with a lower exercise price typically has more value
than a call with a higher exercise price because the underlying instrument can be purchased at a lower
price. A put with a higher exercise price typically has more value than a put with a lower exercise price
because the underlying instrument can be sold for a higher price.

Question 147

A put option has a strike price of $80, and the stock price is $75 at expiration. The expiration day value of
the put option is:

A) $0.
B) $5.
C) $80.
Answer: B) $5.
A put option has an expiration day value of MAX (0, X-S). Here, X is $80 and S is $75.

Question 148

Which of the following statements about swaps is NOT correct?

A) In an interest rate swap, only the net interest payments are made.
In an interest rate swap, the pay-fixed party makes a sequence of fixed rate interest payments
B)
and receives a sequence of floating rate interest payments.
C) In a currency swap, only net interest payments are made.
Answer: C) In a currency swap, only net interest payments are made.

In a currency swap, the two parties exchange cash at the initiation, make periodic interest payments to
each other during the life of the swap agreement, and exchange the principal at the termination of the
swap.

Question 149

Which of the following statements regarding a forward commitment is NOT correct? A forward
commitment:

A) is not legally binding.

B) is a contractual promise.
C) can involve a stock index.
Answer: A

A forward commitment is a legally binding promise to perform some action in the future and can involve a
stock index or portfolio.

Question 150

The put-call parity relation can be adjusted for dividend payments on a stock by which of the following
methods?

A) Add the present value of the expected dividend payments to the exercise price.
B) Add the present value of the expected dividend payments to the current stock price.
C) Subtract the present value of the expected dividend payments from the current stock price.
Answer: C) Subtract the present value of the expected dividend payments from the current stock price.

The correct adjustment is to subtract the present value of the expected dividend payments from the
current stock price.
Question 151
Fixed
Counterparty ▬▬▬▬▬▬▬▬▬▬► Counterparty
A ◄▬▬▬▬▬▬▬▬▬▬ B
Variable

Which of the following statements is most accurate concerning the above diagram?

A) Counterparty A will gain in the swap when interest rates increase.

B) Counterparty B will gain in the swap when interest rates increase.
C) Counterparty B pays a fixed rate to counterparty A.
Answer: A

From the diagram, counterparty A pays fixed to and receives variable from counterparty B. As interest
rates rise, counterparty B owes counterparty A higher variable payments, while A’s obligations are fixed.

Question 152

MBT Corporation recently announced a 15% increase in earnings per share (EPS) over the previous
period. The consensus expectation of financial analysts had been an increase in EPS of 10%. After the
earnings announcement the value of MBT common stock increased each day for the next five trading
days, as analysts and investors gradually reacted to the better than expected news. This gradual change
in the value of the stock is an example of:

A) speculation.
B) efficient markets.
C) inefficient markets.
Answer: C) inefficient markets.

A critical element of efficient markets is that asset prices respond immediately to any new information that
will affect their value. Large numbers of traders responding in similar fashion to the new information will
create a temporary imbalance in supply and demand, and this will adjust asset market values.

Question 153

At the Chicago Board of Trade, futures on foreign currencies have a contract size fixed in:

A) dollars and are priced in dollars per foreign currency unit.

B) dollars and are priced in foreign currency units per dollar.
C) foreign currency units and are priced in dollars per foreign currency unit.
Answer: C) foreign currency units and are priced in dollars per foreign currency unit.
In the U.S., futures contracts for foreign currencies have a contract size fixed in foreign currency units
(e.g. 125,000 Euros) and are priced in dollars per foreign currency unit (e.g. $0.08341 per Peso).

Question 154

Which of the following is an advantage of the swaps market over the futures markets? The:

A) credit risk of the contract.

B) ability to hedge over long time horizons.
C) liquidity of the contract.
Answer: B) ability to hedge over long time horizons.

The futures market uses a standardized contract, which increases the liquidity of the contract. Also,
futures exchanges assume the credit risk. However, as the time horizon increases, the liquidity of futures
contracts decreases substantially. Therefore, swaps are considered a better method of hedging over long
time horizons.

Question 155

When calculating the settlement payment on a long position in a London Interbank Offered Rate (LIBOR)-
based forward rate agreement, the denominator is best described as:

A) a discount factor based on the contract LIBOR rate.

B) a discount factor based on LIBOR at settlement.
the interest differential between a loan made at the contract rate and one made at the market
C)
rate at contract expiration.
Answer: B) a discount factor based on LIBOR at settlement.

Since the interest differential between a loan made at the contract rate and one made at the market rate
would be realized at the end of a loan period beginning at the settlement date, it must be discounted to
get the value at the settlement date. The correct rate for this discounting is the actual rate (market rate) at
the settlement date. The interest differential is the numerator of the formula for calculating the settlement
value.

Question 156

Which of the following statements about arbitrage is NOT correct

A) Arbitrage can cause markets to be less efficient.

B) No investment is required when engaging in arbitrage.
C) If an arbitrage opportunity exists, making a profit without risk is possible.
Answer: A
Arbitrage is defined as the existence of riskless profit without investment and involves selling an asset
and simultaneously buying the same asset for a lower price. Since the trades cancel each other, no
investment is required. Because it is done simultaneously, a profit is guaranteed, making the transaction
risk free. Arbitrage actually helps make markets more efficient because price discrepancies are
immediately eradicated by the actions of arbitrageurs.

Question 157

Which of the following statements regarding an option prior to expiration is most accurate? The maximum
value of a(n):

A) American call is equal to the maximum value of a European call.

B) European call is greater than the maximum value of an American call.
C) American put is equal to the maximum value of a European put.
Answer: A

The theoretical maximum value of both a European and American call is the price of the underlying stock.
The theoretical maximum value of an American put is the exercise price, while the theoretical maximum
value of a European put is the present value of the exercise price. Thus the maximum value is less for a
European put than for an American put.

Question 158

Consider a currency swap in which Party A pays 180-day London Interbank Offered Rate on $1,000,000
and Party B pays the Japanese yen riskless rate on 130,000,000 yen. Which of the following statements
regarding the terms required at the initiation of the swap is CORRECT?

A) An exchange of principal amounts is not required at the initiation of the swap.

B) Party A must pay $1,000,000 and receive 130,000,000 yen.
C) Party A must pay 130,000,000 yen and receive $1,000,000.
Answer: C) Party A must pay 130,000,000 yen and receive $1,000,000.

Since Party A is paying in dollars, Party A must receive dollars in exchange for yen at the beginning of the
swap.

Question 159

Some forward contracts are termed cash settlement contracts. This means:

at contract expiration, the long can buy the asset from the short or pay the difference between
A)
the market price of the asset and the contract price.
B) either the long or the short in the forward contract will make a cash payment at contract
 expiration and the asset is not delivered.
C) at settlement, the long purchases the asset from the short for cash.
Answer: B) either the long or the short in the forward contract will make a cash payment at contract
expiration and the asset is not delivered.

In a cash settlement forward contract there is a cash payment at settlement by either the long or the short
depending on whether the market price of the asset is below or above the contract price at expiration.
The underlying asset is not purchased or sold at settlement.

Question 160

An investor writes a July 20 call on a stock trading at 23 for premium of $4. The breakeven price on the
trade and the maximum gain on the trade are, respectively:

Breakeven Price Maximum Gain

A) $24 $4
B) $24 $3
C) $27 $4
Answer: A

The breakeven price is the premium received on the call plus the strike price. For a writer of an option,
the maximum gain is the premium received.

Question 161

Which is the only type of commodity where trading in forward contracts is larger than trading with future
contracts?

A) Foreign currency.
B) Agricultural.
C) Interest rate.
Answer: A

Trading in foreign currency forwards is far larger than the trading in futures. For example, with
international trade, businesses can hedge against adverse currency fluctuations. But each business
arrangement is unique, and most require the flexibility of a forward, whose terms are not standardized,
that meets their special needs.

Question 162
Greater volatility in the price of the underlying asset will have what effect on the value of a call option and
the value of a put option?

Value of a call option Value of a put option

A) Increase Decrease
B) Increase Increase
C) Decrease Increase
Answer: B)
Increase Increase

Greater volatility in the price of the underlying asset increases the values of both puts and calls because
options are one-sided.• Since an option’s value can fall no lower than zero (it expires out of the money),
increased volatility increases an option’s upside potential but does not increase its downside exposure.

Question 163

Shigeo Kishiro recently purchased an American put option and Lendon Grey recently wrote an American
call option on the same underlying stock, Tackel Sports (currently trading at $40 per share). Kishiro paid
$2.75 for an exercise price of $38.00 and Grey received $3.75 for a strike price of $42. Assume that there
are no transaction costs to exercise.

Part 1)
At a stock price of $43:

A) the intrinsic put value is $0 and the put is at-the-money.

B) the intrinsic call value is $1.
C) if Grey exercises, he will have gained a total of $4.75.
Answer: B) the intrinsic call value is $1.

The intrinsic value of a call is given as: max [0, S − X], where S = stock price and X = strike price. Here,
max [0, 43 − 42] = max [0, 1] = 1.

The other answers are incorrect. Grey wrote the option and thus cannot exercise. The intrinsic value of
the put is correct at $0, or max [0, X − S], but as previously noted, the put is out-of-the money at a stock
price of $43. The put is at-the-money when the stock price is equal to the strike price, or $38.

Shigeo Kishiro recently purchased an American put option and Lendon Grey recently wrote an American
call option on the same underlying stock, Tackel Sports (currently trading at $40 per share). Kishiro paid
$2.75 for an exercise price of $38.00 and Grey received $3.75 for a strike price of $42. Assume that there
are no transaction costs to exercise.

Part 2)
Which of the following statements about the investors is least accurate?
 A) Grey's loss is unlimited.
B) Kishiro's gain is limited to the strike price minus the premium.
C) Grey's maximum gain and Kishiro's maximum loss sum to zero.
Answer: C) Grey's maximum gain and Kishiro's maximum loss sum to zero.

Although options are a zero-sum game, it is the counterparty exposures that nets to zero. For example,
the put buyer’s maximum loss = put writer’s maximum gain = the premium. The other statements are true.
Note that the reason why Grey’s loss is unlimited is that he does not currently own the stock. In other
words, he has a naked position. If the stock were to rise, Grey would be forced to buy the stock in the
open market to settle the exercise of the option. Because the potential for the stock to rise is unlimited,
the potential loss for the naked call writer is also unlimited.

Question 164

The money added to a margin account to bring the account back up to the required level is known as the:

A) daily settlement.
B) maintenance margin.
C) variation margin.
Answer: C) variation margin.

The money added to a margin account to bring the account back up to the required level is known as the
variation margin. The minimum allowed in the account is called the maintenance margin. The daily
settlement process requires marking-to-market each day.

Question 165

The practice of adjusting the margin balance in a futures account for the daily change in the futures price
is called:

A) marking to market.
B) settling up.
C) a margin call.
Answer: A

Marking to market is the practice of adding to or subtracting from the margin balance to adjust for the
daily change in the contract value.

Question 166

Initial margin deposits for futures accounts are:

 A) set by the Federal Reserve for U.S. markets.
B) typically 50% of the purchase price.
C) based on price volatility.
Answer: C) based on price volatility.

Margin deposits for futures trades are based on the price volatility of the underlying asset, are set by the
clearinghouse, and are typically a small percentage of the contract value.

Question 167

Financial derivatives contribute to market completeness by allowing traders to do all of the following
EXCEPT:

A) engage in high risk speculation.

B) increase market efficiency through the use of arbitrage.
C) narrow the amount of trading opportunities to a more manageable range.
Answer: C) narrow the amount of trading opportunities to a more manageable range.

Financial derivatives increase the opportunities to either speculate or hedge on the value of underlying
assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used
by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and
cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders.

Question 168

A 60-day $10 million forward rate agreement (FRA) on 90-day London Interbank Offered Rate (LIBOR) (a
2X5 FRA) is priced at 4%. If 90-day LIBOR at the expiration date is 4.1%, the long:

A) receives $2,500.00.
B) receives $2,474.63.
C) pays $2,474.63.
Answer: B) receives $2,474.63.

[(0.041 − 0.040)(90/360)(10,000,000)] / [1 + 0.041(90/360)] = $2,474.63.

Question 169

Exchange-traded stock options are all of the following EXCEPT:

A) backed by the options clearinghouse.

B) typically for 100 shares of stock.
 C) subject to counterparty risk.
Answer: C) subject to counterparty risk.

Exchange-traded options are backed by the clearinghouse and not subject to counterparty risk; over-the-
counter options are subject to counterparty risk.

Question 170

Which of the following statements about moneyness is most accurate? When the stock price is:

A) above the strike price, a put option is in-the-money.

B) above the strike price, a put option is out-of-the-money.
C) below the strike price, a call option is in-the-money.
Answer: B) above the strike price, a put option is out-of-the-money.

When the stock price is above the strike price, a put option is out-of-the-money.
When the stock price is below the strike price, a call option is out-of-the-money.

Question 171

Jimmy Casteel pays a premium of $1.60 to buy a put option with a strike price of $145. If the stock price
at expiration is $128, Casteel’s profit or loss from the options position is:

A) $15.40.
B) $18.40.
C) $1.60.
Answer: A

The put option will be exercised and has a value of $145-$128 = $17 [MAX (0, X-S)]. Therefore, Casteel
receives $17 minus the $1.60 paid to buy the option. Therefore, the profit is $15.40 ($17 less $1.60).

Question 172

Linda Reynolds pays $2.45 to buy a call option with a strike price of $42. The stock price at which
Reynolds earns $3.00 from her call option position is:

A) $2.45.
B) $47.45.
C) $42.00.
Answer: B) $47.45.
To earn $3.00, the stock price must be above the strike price by $3.00 plus the premium Reynolds paid to
buy the option ($42.00+$3.00+$2.45).

Question173

A futures contract is least likely to be:

A) regulated.
B) standardized.
C) illiquid.
Answer: C) illiquid.

Futures contracts are standardized and subject to governmental and exchange regulation. They are
actively traded in the secondary market.

Question 174

Default risk in a forward contract:

A) only applies to the short, who must make the cash payment at settlement.
B) is the risk to either party that the other party will not fulfill their contractual obligation.
only applies to the long, and is the probability that the short can not acquire the asset for
C)
delivery.
Answer: B) is the risk to either party that the other party will not fulfill their contractual obligation.

Default risk in forward contracts is the risk to either party that the other party will not perform, whether that
means pay cash or deliver the asset.

Question 175

An investor enters into a swap that requires the notional principal amounts be exchanged at the beginning
and at the end of the swap contract. This is most likely a:

A) plain-vanilla swap.
B) fixed-for-fixed swap.
C) currency swap.
Answer: C) currency swap.

A currency swap requires that the notional amount of one currency be exchanged for the notional amount
of the other currency at both the beginning and the end of the swap.
Question 176

Which of the following statements about a currency swap is least accurate?

A) The periodic interest payments are exchanged in full each period.

B) Notional principal is exchanged at the termination of the swap.
C) Most currency swaps are done to exploit market inefficiencies.
Answer: C) Most currency swaps are done to exploit market inefficiencies.

Unlike interest rate swaps, notional principal is swapped at both the initiation and the termination of the
swap. Full interest payments are exchanged at each settlement date. Exploiting market inefficiencies was
once a motivation for currency swaps, but it is not today (because the market is efficient). Today
motivations range from reducing transactions costs to maintaining privacy to avoiding regulation.

Question 177

A European option can be exercised by:

A) its owner, only at the expiration of the contract.

B) its owner, anytime during the term of the contract.
C) either party, at contract expiration.
Answer: A

A European option can be exercised by its owner only at contract expiration.

Question 178

A long interest rate call and a short interest rate put is an equivalent position to:

A) a long position in a forward rate agreement.

B) a pay-fixed interest rate swap.
C) a short position in a forward rate agreement.
Answer: A

A long call and short put on interest rates is equivalent to a long position in a forward rate agreement.
Both gain when forward rates increase and decline in value when interest rates decrease.

Question 179
Travis Dillard, CFA, is the equity return receiver in a monthly-pay equity swap. If the equity index declines
by 2% in a month, Dillard must pay the swap counterparty an amount of cash that is:

A) equal to 2% of the notional amount of the swap.

B) greater than 2% of the notional amount of the swap.
C) less than 2% of the notional amount of the swap.
Answer: B) greater than 2% of the notional amount of the swap.

If the equity return is negative, the equity return receiver (fixed rate payer) in an equity swap owes the
equity return payer (fixed rate receiver) the percentage decline in the equity index times the notional
amount, plus the fixed rate payment for the period.

Question 180

Consider a U.S. commercial bank that wishes to make a two-year, fixed-rate loan in Australia
denominated in Australian dollars. The U.S. bank will fund the loan by issuing two-year CDs in the U.S.
Why would the U.S. bank wish to enter into a currency swap? The bank faces the risk that:

A) the Australian dollar increases in value against the U.S. dollar.

B) interest rates in Australia decline.
C) the Australian dollar decreases in value against the U.S. dollar.
Answer: C) the Australian dollar decreases in value against the U.S. dollar.

There is no interest rate risk for the bank because the bank has fixed rates for two years on both the
asset and the liability. However, the bank faces a problem in that if the Australian dollar decreases in
value, the loan (and the interest payments from the loan) will not translate back into as many U.S. dollars.
Indeed, if the Australian dollar decreases significantly, the loan (and the interest payments from the loan)
may not translate back into enough U.S. dollars to repay the CDs.

Question 181

A forward contract that must be settled by a sale of an asset by one party to the other party is termed a:

A) take-and-pay contract.
B) deliverable forward contract.
C) physicals-only contract.
Answer: B) deliverable forward contract.

A deliverable forward contract can be settled at expiration only by actual delivery of the asset in exchange
for the contract value. The other terms are made up.

Question 182
A call option’s intrinsic value:

increases as the stock price increases above the strike price, while a put option’s intrinsic
A)
value increases as the stock price decreases below the strike price.
decreases as the stock price increases above the strike price, while a put option’s intrinsic
B)
value increases as the stock price decreases below the strike price.
increases as the stock price increases above the strike price, while a put option’s intrinsic
C)
value decreases as the stock price decreases below the strike price.
Answer: A

For a call option, as the underlying stock price increases above the strike price, the option moves farther
into the money, and the intrinsic value is increasing. For a put option, as the underlying stock price
decreases below the strike price, the option moves farther into the money, and the intrinsic value is
increasing.

Question 183

Al Steadman receives a premium of $3.80 for shorting a put option with a strike price of $64. If the stock
price at expiration is $84, Steadman’s profit or loss from the options position is:

A) $3.80.
B) $23.80.
C) $16.20.
Answer: A

The put option will not be exercised because it is out-of-the-money, MAX (0, X-S). Therefore, Steadman
keeps the full amount of the premium, $3.80.

Question 184

Which of the following regarding a plain vanilla interest rate swap is most accurate?

A) The notional principal is swapped.

B) The notional principal is returned at the end of the swap.
C) Only the net interest payments are made.
Answer: C) Only the net interest payments are made.

The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate
payments. Swaps are a zero sum game, what one party gains the other party loses. In interest rate
swaps, only the net interest rate payments actually take place because the notional principal swapped is
the same for both counterparties and in the same currency units, there is no need to actually exchange
the cash.
Question 185

An out-of-the-money put and an in-the-money call are defined as:

Put Call
market price > strike
A) strike price > market price
price
strike price > market
B) market price > strike price
price
market price > strike
C) market price > strike price
price
Answer: C)
market price > strike
market price > strike price
price

In-the-money put: strike > market; out-of-the-money put: market > strike.
In-the-money call: market > strike; out of the money call: strike > market.

Question 186

A derivative security:

A) has no default risk.

B) has a value based on stock prices.
C) has a value based on another security or index.
Answer: C) has a value based on another security or index.

This is the definition of a derivative security. Those based on stock prices are equity derivatives.

Question 187

An investor buys 5 calls on Stock XYZ with a strike price of $10 for a price of $1 per call. Three months
later, Stock XYZ is trading for $15 per share. Each call entitles the owner to buy 2 shares of Stock XYZ.
What is the investor’s net profit?

A) $45.
B) $20.
C) $0.
Answer: A

($15 - $10) × (5 × 2) - ($1 × 5 calls). The gross payoff is (15 - 10) × 10 = $50. The net profit is $50 - price
of calls ($5) = $45.
Question 188

Which statement regarding forward contract dealers is least accurate?

A) Not all of them are banks.

B) They bear default risk but not asset-price risk.
C) They try to balance their long and short positions to limit risk.
Answer: B) They bear default risk but not asset-price risk.

Dealers bear both default risk as well as asset-price risk from unhedged positions. Nonbank financial
institutions can deal in forward contracts. Ideally, dealers will balance their long contract positions with
other parties who seek the opposite risk exposure.

Question 189

Over-the-counter options are:

A) very liquid.
B) largely unregulated.
C) the most important type in terms of volume.
Answer: B) largely unregulated.

Over-the-counter options are largely unregulated, not liquid, and represent much less volume than
exchange-traded options.

Question 190

The short in a forward contract:

A) has the right to deliver the asset upon expiration of the contract.
B) is obligated to deliver the asset anytime prior to expiration of the contract.
C) is obligated to deliver the asset upon expiration of the contract.
Answer: C) is obligated to deliver the asset upon expiration of the contract.

The short in a forward contract is obligated to deliver the asset (in a deliverable contract) on (or close to)
the expiration date.

Question 191
Which of the following definitions involving derivatives is least accurate?

A) An option writer is the seller of an option.

B) An arbitrage opportunity is the chance to make a riskless profit with no investment.
A call option gives the owner the right to sell the underlying good at a specific price for a
C)
specified time period.
Answer: C) A call option gives the owner the right to sell the underlying good at a specific price for a
specified time period.

A call option gives the owner the right to buy the underlying good at a specific price for a specified time
period.

Question 192

All of the following are methods to close out a futures position EXCEPT:

A) delivery of the underlying commodity.

B) through an exchange for physicals with another trader.
C) allowing the contract to expire without taking action.
Answer: C) allowing the contract to expire without taking action.

A futures contract cannot expire without any action being taken. If the contract has not been closed out
through an offsetting trade, then one party must deliver the underlying commodity and the other party
must purchase the commodity.

Question 193

A currency forward contract:

A) requires a payment at settlement based on London Interbank Offered Rate.

B) is priced using the future interest rate on a foreign currency.
C) can be a deliverable contract.
Answer: C) can be a deliverable contract.

A currency forward contract can be a deliverable or cash-settlement contract. It is a contract to exchange

fixed amounts of two currencies at settlement and its value depends on market exchange rates at
contract expiration.

Question 194
A swap in which one party pays a fixed rate, one party pays a floating rate, and only a net payment is
made on the settlement dates is referred to as a:

A) straight swap.
B) net swap.
C) plain vanilla swap.
Answer: C) plain vanilla swap.

A swap in which one party pays a fixed rate, one party pays a floating rate, and only a net payment is
made on the settlement dates is referred to as a plain vanilla swap.

Question 195

Basil, Inc., common stock has a market value of $47.50. A put available on Basil stock has a strike price
of $55.00 and is selling for an option premium of $10.00. The put is:

A) out-of-the-money by $2.50.
B) in-the-money by $7.50.
C) in-the-money by $10.00.
Answer: B) in-the-money by $7.50.

The put allows a trader to sell Basil common stock for $7.50 more than the current market value ($55.00
− $47.50). The trade is normally closed out with a cash settlement, but the trader could buy 100 shares
for $47.50 per share and immediately sell them to the option writer for $55.00.

Question 196

Which of the following statements involving a plain vanilla interest rate swap is least accurate? In a plain
interest rate swap, the:

A) parties generally agree to swap the notional principal.

counterparty who receives the fixed payment by agreeing to pay variable rate interest is called
B)
the receive-fixed side of the swap.
C) parties involved in the swap agreement are called counterparties.
Answer: A

The notional principal is the dollar amount specified in the swap agreement. The counterparties use the
notional principal to determine the amount of the interest payments. They generally do not exchange the
notional principal.

Question 197
An equity swap can specify that one party pay any of the following EXCEPT:

A) the total return on a corporate bond.

B) the return on a specific portfolio of three stocks including dividends.
C) the return on a single stock.
Answer: A

A swap involving the return on a bond would not be an equity swap.

Question 198

Macklin Metals has received 80 million pounds sterling. The company plans to spend $120 million on a
project in the United States in 90 days. Macklin inters into a cash settlement currency forward to
exchange the pounds for U.S. dollars at a rate of $1.50 per pound in 90 days. If the exchange rate is
$1.61 per pound at the settlement date, the cash settlement Macklin will pay or receive is closest to:

A) $8.8 million payment.

B) $8.8 million receipt.
C) $5.5 million payment.
Answer: A

Under the contract, Macklin receives:

80 million pounds × $1.50 = $120.0 million
At market rates, Macklin would receive:
80 million pounds × $1.61 = $128.8 million
Macklin must pay the difference, $8.8 million ($128.8 million − $120 million), as the cash settlement to the
counterparty.

Question 199

A put option has a strike price of $65, and the stock price is $39 at expiration. The expiration day value of
the put option is:

A) $26.
B) $65.
C) $0.
Answer: A

A put option has an expiration day value of MAX (0, X-S). Here, X is $65 and S is $39.

Question 200

Which of the following statements about futures contracts is least accurate?

 A) Offsetting trades rather than exchanges for physicals are used to close most futures contracts.
To safeguard the clearinghouse, the exchange requires traders to post margin and settle their
B)
accounts on a weekly basis.
The futures clearinghouse allows traders to reverse their positions without having to contact
C)
the other side of the initial trade.
Answer: B) To safeguard the clearinghouse, the exchange requires traders to post margin and settle their
accounts on a weekly basis.

Each exchange has a clearinghouse. The clearinghouse guarantees that traders in the futures market will
honor their obligations. The clearinghouse does this by splitting each trade once it is made and acting as
the opposite side of each position. To safeguard the clearinghouse, the exchange requires traders to post
margin and settle their accounts on a daily basis. Before trading, the trader must deposit funds (called
margin) with their broker (who, in return, will post margin with the clearinghouse). The purpose of margin
is to ensure that traders will perform their contractual obligations. Margin can be posted in cash, bank
letters of credit, or in T-Bills.

The clearinghouse acts as the buyer to every seller and the seller to every buyer. By doing this, the
clearinghouse allows either side of the trade to reverse positions later without having to contact the other
side of the initial trade. This allows traders to enter the market knowing that they will be able to reverse
their position any time that they want. Traders are also freed from having to worry about the other side of
the trade defaulting, since the other side of their trade is now the clearinghouse. In the history of U.S.
futures trading, the clearinghouse has never defaulted.

Explanations for other choices:

A reverse, or offsetting, trade in the futures market is how most futures positions are settled. Since the
other side of your position is held by the clearinghouse, if you make an exact opposite trade (maturity,
quantity, and good) to your current position, the clearinghouse will net your positions out, leaving you with
a zero balance.

Listed below is additional information contrasting futures and forwards:

 Forwards are private contracts and do not trade on an organized exchange. Futures contracts
trade on organized exchanges.
 Forwards are unique contracts satisfying the needs of the parties involved. Futures contracts are
highly standardized. A futures contract specifies the quantity, quality, delivery date, and delivery
mechanism.
 Forwards have default risk. The seller may not deliver, and the buyer may not accept delivery.
With futures contracts, performance is guaranteed by the exchange’s clearinghouse.
 Forwards require no cash transactions until the delivery date. Futures contracts require that
traders post margin money to trade. Margin is good faith money that supports the trader’s
promise to fulfill their obligation.
 Forward contracts are usually not regulated. The government regulates futures markets.

Question 201

James Jackson currently owns stock in PNG, Inc., valued at $145 per share. Thinking that PNG is
overbought and will decrease in price soon, Jackson writes a call option on PNG with an exercise price of
$148 for a premium of $2.40. At expiration of the option, PNG stock is valued at $152 per share. What is
the profit or loss from Jackson’s covered call strategy? Jackson:

A) gained $9.40.
B) lost $4.60.
C) gained $5.40.
Answer: C) gained $5.40.

The option is in-the-money at expiration (MAX (0, S-X) and the PNG stock will be called away from
Jackson at $148 per share, limiting Jackson’s gain from owning the stock to $3 ($148-145). However,
Jackson also gains the $2.40 from writing the call option. Therefore, Jackson’s gain from the covered call
strategy is $5.40 ($3.00+$2.40).

Question 202

The initiation of a futures position:

A) is done through a bank or other large financial institution acting as a dealer.

B) is at a price negotiated between the buyer and seller.
C) requires both a buyer and a seller.
Answer: C) requires both a buyer and a seller.

Futures trades are done through open outcry on the futures exchange and require a buyer (long) and a
seller (short) for a trade to take place. The other statements are generally true for forward contracts,
which are all individually negotiated.

Question 203

The value of an interest-rate call option at expiration is zero or the:

market rate minus the exercise rate, adjusted for the period of the rate, times the principal
A)
amount.
exercise rate minus the market rate, adjusted for the period of the rate, times the principal
B)
amount.
present value of, the market rate minus the exercise rate, adjusted for the period of the rate,
C)
times the principal amount.
Answer: C) present value of, the market rate minus the exercise rate, adjusted for the period of the rate,
times the principal amount.

An interest rate call pays zero or the market rate at expiration minus the exercise rate. Since the payment
is made at a date after expiration by the period of the reference rate, the value at expiration is the present
value of this difference times the principal value.

Question 204
Which of the following is NOT a likely motivation today for entering into a swap agreement?

A) Exploit perceived market inefficiencies.

B) Maintain privacy.
C) Avoid costly regulation.
Answer: A

During the 1980s, some parties entered the swap market in an effort to exploit perceived market
inefficiencies. Today, the uses of the swaps market are not motivated by perceived informational
inefficiencies.

Question 205

Consider a call option expiring in 60 days on a non-dividend-paying stock trading at 53 when the risk-free
rate is 5%. The lower bound for a call option with an exercise price of 50 is:

A) $0.
B) $3.40.
C) $3.00.
Answer: B) $3.40.

53 − 50/(1.05)60/365 = 3.40.

Question 206

Any rational quoted price for a financial instrument should:

A) provide no opportunity for arbitrage.

B) provide an opportunity for investors to make a profit.
C) be low enough for most investors to afford.
Answer: A

Since any observed pricing errors will be instantaneously corrected by the first person to observe them,
any quoted price must be free of all known errors. This is the basis behind the text’s no-arbitrage
principle, which states that any rational price for a financial instrument must exclude arbitrage
opportunities. The no-arbitrage opportunity assumption is the basic requirement for rational prices in the
financial markets. This means that markets and prices are efficient. That is, all relevant information is
impounded in the asset’s price. With arbitrage and efficient markets, you can create the option and
futures pricing models presented in the text.

Question 207
Which of the following statements about futures and the clearinghouse is least accurate? The
clearinghouse:

A) has defaulted on one half of one percent of futures trades.

B) requires the daily settlement of all margin accounts.
C) guarantees that traders in the futures market will honor their obligations.
Answer: A

In the history of U.S. futures trading, the clearinghouse has never defaulted.

Other information on the clearinghouse:

The clearinghouse guarantees that traders in the futures market will honor their obligations. The
clearinghouse does this by splitting each trade once it is made and acting as the opposite side of each
position. The clearinghouse acts as the buyer to every seller and the seller to every buyer. By doing this,
the clearinghouse allows either side of the trade to reverse positions later without having to contact the
other side of the initial trade. This allows traders to enter the market knowing that they will be able to
reverse their position any time that they want. Traders are also freed from having to worry about the other
side of the trade defaulting, since the other side of their trade is now the clearinghouse.

To safeguard the clearinghouse, the exchange requires traders to post margin and settle their accounts
on a daily basis.

Question 208

Which term does NOT apply to interest rate swaps?

A) Trading exchange.
B) Time to maturity.
C) Notional principal amount.
Answer: A

Interest rate swaps are currently not traded on exchanges.

Question 209

Which of the following is NOT a feature that distinguishes futures contracts from forward contracts?
Futures contracts:

A) are regulated by the government.

B) cover a specific quantity of the underlying asset.
C) are not customized securities.
Answer: B) cover a specific quantity of the underlying asset.
Both futures contracts and forward contracts cover a specific quantity of the underlying asset. The other
characteristics only apply to futures contracts.

Question 210

Which statement best reflects the risk exposure of a put writer?

A) No risk.
B) Unlimited risk.
C) Limited risk.
Answer: C) Limited risk.

Because stock prices cannot fall below $0, a put writer’s risk is limited to the strike price.

Question 211

The price of a 90-day forward contract on a 90-day Treasury bill will be:

A) above the current price of a 90-day T-bill.

B) either above or below the current price of a 180-day T-bill.
C) above the current price of a 180-day T-bill.
Answer: C) above the current price of a 180-day T-bill.

Purchasing a 180-day T-bill today will result in a 90-day T-bill 90 days from now. Thus today's 90-day
forward price of a 90-day bill is the price a 180-day bill today is expected to have 90 days from now.
Because a T-bill is a pure-discount instrument, its price increases toward par as it gets closer to maturity.
Therefore its price 90 days from now is expected to be higher than its price today. As long as interest
rates are positive, no one would agree today to sell the bill 90 days later at a lower price than that.

Question 212

An agreement that gives the holder the right, but not the obligation, to sell an asset at a specified price on
a specific future date is a:

A) put option.
B) call option.
C) swap.
Answer: A

A put option gives the holder the right to sell an asset at a specified price on a specific future date. A call
option gives the holder the right to buy an asset at a specified price on a specific future date. A swap is an
obligation to both parties.

Question 213
For a European call option X=25 and a European call option X=30 on the same stock with the same time
to expiration, the strongest statement we can make is the:

A) 25 call is worth more than the 30 call.

B) 30 call is worth at least as much as the 25 call.
C) 25 call is worth at least as much as the 30 call.
Answer: C) 25 call is worth at least as much as the 30 call.

The strongest statement that we can make is that the 25 call is worth as least as much as the 30 call,
although it will generally be worth more.

Question 214

A derivative security:

A) is like a callable bond.

B) is one that is based on the value of another security.
C) has a value dependent on the shape of the yield curve.
Answer: B) is one that is based on the value of another security.

A derivative security is one that ˜derives’ its value from that of another security.

Question 215

Eurodollar time deposits are:

A) priced at a discount.
B) actively traded in the secondary market.
C) denominated in U.S. dollars (USD).
Answer: C) denominated in U.S. dollars (USD).

Eurodollar time deposits are USD denominated deposits with large banks outside the U.S. They are
usually short term and not traded in a secondary market.

Question 216

Using put-call parity, it can be shown that a synthetic European put can be created by a portfolio that is:

short the stock, long the call, and long a pure discount bond that pays the exercise price at
A)
option expiration.
short the stock, long the call, and short a pure discount bond that pays the exercise price at
B)
option expiration.
long the stock, short the call, and short a pure discount bond that pays the exercise price at
C)
option expiration.
Answer: A

A short position in the stock combined with a long call and lending the present value of the exercise price
will replicate the payoffs on a put at option expiration.
Question 217

Financial options include all of the following EXCEPT options on:

A) interest rates.
B) futures.
C) foreign currencies.
Answer: B) futures.

Options on futures are considered a separate type of options.

Question 218

George Mote owns stock in IBM currently valued at $112 per share. Mote writes a call option on IBM with
an exercise price of $120. The call option is sold for $1.80. At expiration, the price of IBM is $115. What is
Mote’s profit (or loss) from his covered call strategy? Mote:

A) gained $3.00.
B) lost $3.20.
C) gained $4.80.
Answer: C) gained $4.80.

Since the option is out-of-the-money at expiration (MAX (0, S - X)), the option is worthless. Also, the stock
increased in value from $112 per share to $115 per share, creating a $3 gain. The $3 gain in the stock
price is added to the $1.80 gain from writing the (unexercised) call option. Therefore, the total gain is
$4.80 ($3 + $1.80).

Question 219

The profit/loss diagram for a covered call strategy looks like what other type of profit/loss diagram?

A) Long put.
B) Short put.
C) Short call.
Answer: B) Short put.

The profit/loss diagram for the covered call looks like the profit/loss diagram for a short put position. Both
option positions have limited profit potential, with the potential loss equal to the strike price less the
premium.

Question 220

An investor buys a call option that has an option premium of $5 and a strike price of $22.50. The current
market price of the stock is $25.75. At expiration, the value of the stock is $23.00. The net profit/loss of
the call position is closest to:

A) $4.50.
B) -$4.50.
C) -$5.00.
Answer: B) -$4.50.

The option is in-the-money by $0.50 ($23.00 - $22.50). The investor paid $5.00 for the call option, thus
the net loss is -$4.50 ($0.50 - $5.00).

Question 221

Credit derivatives are least accurately characterized as:

A) contingent claims.
B) forward commitments.
C) insurance.
Answer: B) forward commitments.

Credit derivatives are contingent claims and not forward commitments because their payoff depends on a
future event taking place. Credit derivatives are essentially insurance against a credit event.

Question 222

If an oil wholesaler expects to buy some gasoline for his customers in the future and wants to hedge his
risk using a standardized and specific contract, he should:

A) buy a crude oil forward contract.

B) buy a crude oil futures contract.
C) sell a crude oil futures contract.
Answer: B) buy a crude oil futures contract.

A futures contract is a forward contract that has been highly standardized and closely specified. As with a
forward contract, a futures contract calls for the exchange of some good at a future date for cash, with the
payment for the good to occur at the future delivery date. The purchaser of the contract is to receive
delivery of the good and pay for it, (here the oil wholesaler) while the seller of the contract promises to
deliver the good and receive payment. The payment price is determined at the initial time of the contract.

Question 223

Which of the following statements about uncovered call options is least accurate?

A) The loss potential to the writer is unlimited.

The most the writer can make is the premium plus the difference between the exercise price
B)
(X) and the stock price (S).
C) The profit potential to the holder is unlimited.
Answer: B) The most the writer can make is the premium plus the difference between the exercise price
(X) and the stock price (S).

The most the writer can make is the premium. If the writer wrote a covered out of the money call, then the
writer would make the premium plus the increase in the stock's price X-S.

Question 224

An offsetting trade is used to:

 A) close out a futures position prior to expiration.
B) fully hedge a risk arising in the normal course of business activity.
C) partially hedge the interest rate risk of a bond position.
Answer: A

An offsetting/reversing trade is used to close out a futures position prior to expiration.

Question 225

Derivatives are often criticized by investors with limited knowledge of complex financial securities. A
common criticism of derivatives is that they:

A) can be likened to gambling.

B) increase investor transactions costs.
C) shift risk among market participants.
Answer: A

Derivatives are often likened to gambling due to the high leverage involved in the payoffs. One of the
benefits of derivatives is that they reduce transactions costs. Another benefit of derivatives is that they
allow risk to be managed and shifted among market participants.

Question 226

The offer rate on U.S. dollar (USD) denominated loans between large banks in London is called:

A) Eurobor.
B) London Interbank Offered Rate (LIBOR).
C) the Exchequer rate.
Answer: B) London Interbank Offered Rate (LIBOR).

The rate on USD denominated loans between large banks in London is the LIBOR.

Question 227

Which of the following statements regarding futures contracts is least accurate?

A) The exchange sets the times of trading for futures contracts.

B) The long will have gains when the futures price rises above the initial contract price.
C) Price fluctuations can be any amount.
Answer: C) Price fluctuations can be any amount.

The minimum price fluctuation, called a ˜tick’, is set by the exchange. The other statements are true

Question 228

The price of a stock is $44 per share, and the October put with an exercise price of $45 is selling for $3.
The intrinsic value of the option is:
 A) $2.00.
B) $0.00.
C) $1.00.
Answer: C) $1.00.

The intrinsic value of a put option at expiration will be the greater of (X-S) or 0. Put Value = max[0, (X-S)],
or max [0, (45-44)] = 1.

Question 229

Given the following data regarding Printer, Inc.’s call options, which of the following statements is least
accurate?

Stock Price Expiration Strike Option Prem. (Last)

50 June 45 6
50 June 50 2
50 June 55 0.50
The intrinsic value of the June $45.00 call is
A)
$5.00.
B) The June $45.00 call is an in-the-money option.
C) The June $55.00 call is an in-the-money option.
Answer: C) The June $55.00 call is an in-the-money option.

The June $55.00 call option is out-of-the money. It gives the purchaser the right to buy Printer, Inc. for
$55.00 when they would only have to pay $50.00 in the market.

Question 230

The shape of a protective put payoff diagram is most similar to a:

A) short call.
B) long call.
C) covered call.
Answer: B) long call.

The payoff diagram for a protective put is like that of a call option but shifted upward by the exercise price
of the put.

Question 231

A futures contract is least likely:

A) an equity security.
B) a forward contract.
C) exchange-traded.
Answer: A
A futures contract may be based on an equity price or return, but would be, in that case, an equity
derivative. A futures contract is a forward contract that is standardized and exchange traded.

Question 232
Consider a 1-year quarterly-pay $1,000,000 equity swap based on a fixed rate and an index
return. The current fixed rate is 3.0 percent and the index is at 840. Below are the index level at
each of the four settlement dates on the swap.
Q1 Q2 Q3 Q4
Index 881 850 892.5 900

At the first settlement date, the equity-return payer in the swap will pay:

A) $41,310.
B) $40,810.
C) $4,638.
Answer: A

The equity-return payer will pay the index return minus the fixed rate at the initiation of the swap.

[(881/840 - 1) - 0.0075] × 1,000,000 = $41,309.52

Question 233

A similarity of margin accounts for both equities and futures is that for both:

A) interest is charged on the margin loan balance.

B) the value of the security is the collateral for the loan.
C) additional payment is required if margin falls below the maintenance margin.
Answer: C) additional payment is required if margin falls below the maintenance margin.

Both futures accounts and equity margin accounts have minimum margin requirements that, if violated,
require the deposit of additional funds. There is no loan in a futures account; the margin deposit is a
performance guarantee. The seller does not receive the margin deposit in futures trades. The seller must
also deposit margin in order to open a position.

Question 234

XYZ company has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. XYZ
company pays a fixed rate of 8% on payments that occur at 90-day intervals. Six payments remain with
the next one due in exactly 90 days. On the other side of the swap, XYZ company receives payments
based on the LIBOR rate. Describe the transaction that occurs between XYZ company and the dealer at
the end of the first period if the appropriate LIBOR rate is 8.8%.

A) Dealer receives $2,000.

B) Dealer pays XYZ company $20,000.
C) XYZ company receives $2,000.
Answer: C) XYZ company receives $2,000.
XYZ company owes the dealer ($1,000,000)(0.08)(90/360) = $20,000. The dealer owes XYZ company
($1,000,000)(0.088)(90/360) = $22,000. Net: The dealer pays XYZ company $22,000 - $20,000 = $2,000

Question 235

A non-dividend-paying stock is trading at 62 when the risk-free rate is 5%. The minimum values for 6-
month American and European calls on the stock with a strike price of 50 are closest to:

American call European call

A) $13.20 $11.75
B) $13.20 $13.20
C) $11.75 $11.75
Answer: B)
$13.20 $13.20

For both the American and European call, the minimum value is the greater of zero or [S − X / (1 + RFR) T-
t] , where S = the price of the underlying stock, X = the exercise price of the option, RFR = the risk-free

rate, and (T-t) = time to expiration in years.

62 − (50 / 1.050.5) = $13.2

Question 236

A put on Stock X with a strike price of $40 is priced at $3.00 per share; while a call with a strike price of
$40 is priced at $4.50. What is the maximum per share loss to the writer of the uncovered put and the
maximum per share gain to the writer of the uncovered call?

Maximum Gain to Call

Maximum Loss to Put Writer
Writer
A) $40.00 $4.50
B) $37.00 $35.50
C) $37.00 $4.50
Answer: C)
$37.00 $4.50

The maximum loss to the uncovered put writer is the strike price less the premium, or $40.00 − $3.00 =
$37.00. The maximum gain to the uncovered call writer is the premium, or $4.50.

Question 237

ABEX Corporation common stock is selling for $50.00 per share. Both an American call option and a
European call option are available on ABEX common, and each have identical strike prices and expiration
dates. Which of the following statements concerning these two options is CORRECT?

The greater flexibility allowed in exercising the American option will normally result in a higher
A)
market value relative to an otherwise identical European option.
Because the American and European options have identical terms and are written against the
B)
same common stock, they will have identical option premiums.
 The European option will normally have a higher option premium because of their relative
C)
scarcity compared to American options.
Answer: A

Trading in European options is considerably less than trading in American options, because demand for
them is much lower. This is due to their relative inflexibility regarding when they can be exercised. The
greater exercising flexibility of American options gives them increased value to traders, which normally
results in a greater market value relative to an otherwise identical European option.

Question 238

A 4 percent Treasury bond has 2.5 years to maturity. Spot rates are as follows:

6 month 1 year 1.5 years 2 years 2.5 years

2% 2.5% 3% 4% 6%

The note is currently selling for $976. Determine the arbitrage profit, if any, that is possible.

A) $37.63.
B) $19.22.
C) $43.22.
Answer: B) $19.22.

Question 239

An offsetting swap is a swap that:

A) is opposite to an existing swap in cash flows.

B) reduces the credit risk of an earlier swap.
C) reduces the principal amount of a swap.
Answer: A

An offsetting swap is a swap with opposite cash flows to an existing swap. It is one way to exit a swap
position, just as an offsetting trade is used to close out a futures position.

Question 240

The motivation for swap agreements would be:

A) the reduction of transactions costs.

B) guaranteed performance on the contracts for all parties.
C) the reduction of business risk.
Answer: A
Historically, there were two basic motivations for swaps: to exploit perceived market inefficiencies and to
attempt to obtain cheaper financing. Both of these motivations are based on the concept that the financial
markets are inefficient. This fact, unfortunately, is no longer true. Today, the swap markets are mature
and offer few arbitrage opportunities. Swap markets are now viewed as being more operationally efficient
and a more flexible means of packaging and transforming cash flows than any other method. The
reasons given now for using the swap markets are to: reduce transactions costs, avoid costly regulations,
and maintain privacy.

Question 241

Which of the following statements regarding forward contracts is NOT correct?

A) Dealers make the majority of their profits by anticipating price moves in the underlying asset.
End users of forwards most often have a business exposure to price risk from the asset
B)
covered by the contract.
C) Dealers will enter into forward contracts with other dealers.
Answer: A

Dealers do not make most of their profits from speculating on price moves or interest rate moves. They
profit from the bid-ask spread. They take offsetting positions with different end users to hedge their price
risk.

Question 242

A trader has a long position in a wheat contract.

 The initial margin is $5,000.

 The maintenance margin is $3,750.
 There are 5,000 bushels in each wheat contract.
 On July 10, the price is $2.00 per bushel.

What is the price at which the trader will receive a maintenance margin call?

A) $2.25.
B) $1.90.
C) $1.75.
Answer: C) $1.75.

The trader would have to lose $1,250, or 5,000 − 3,750 before they get a margin call. 5,000(2.00 − P) =
1,250. P = $1.75.

Question 243

Consider a forward rate agreement (FRA) that expires/settles in 90 days. The agreement is based on the
180-day LIBOR. The long position agrees to borrow $10,000,000 from the short position (i.e. the dealer).
The dealer quotes this instrument at 6 percent. Today, the 90-day LIBOR is 5.5 percent. If the 180-day
LIBOR in 90 days is quoted at 5 percent, compute the amount of the cash settlement payment made or
received by the borrower at expiration. The borrower will:

A) make a payment of $48,780.

 B) receive a payment of $48,543.
C) make a payment of $48,543.
Answer: A

At expiration, from the borrower’s perspective, the payment will be calculated as:

$10,000,000 × (0.05 − 0.06)(180/360) / (1 + 0.05 x 180/360) = -$50,000/1.025 = -$48,780

Because the amount is negative, it reflects a cash outflow, or a payment made, by the borrower.

Question 244

The short in a forward rate agreement:

A) profits if LIBOR decreases.

B) faces default risk.
C) profits if London Interbank Offered Rate (LIBOR) increases.
Answer: B) faces default risk.

Each party to a forward contract faces default risk to some extent. If the floating rate at contract expiration
(LIBOR or Euribor) is above the rate specified in the forward rate agreement (FRA), the long position in
the contract can be viewed as the right to borrow at below market rates and the long will receive a
payment from the short. If floating rates (LIBOR or Euribor) at the expiration date are below the rate
specified in the FRA the short will receive a cash payment from the long. However, "the short profits if
LIBOR decreases" is not necessarily true because LIBOR can decrease but remain above the rate
specified in the FRA.

Question 245

An investor would exercise a put option when the:

A) price of the stock is below the strike price.

B) price of the stock is equal to the strike price.
C) price of the stock is above the strike price.
Answer: A

A put option gives its owner the right to sell the underlying good at a specified price (strike price) for a
specified time period. When the stock's price is less than the strike price a put option has value and is
said to be in-the-money.

Question 246

Which of the following statements about closing a futures contract through offset is most accurate?

A) The clearinghouse nets the position to zero.

B) A low percentage of offsets take place ex-pit.
In an offset, or reversing trade, a trader makes an exact opposite trade (maturity, quantity, and
C)
good) to her current position, either through the clearinghouse or a private party.
Answer: A
An offset trade must be conducted on the floor of the exchange through the clearinghouse. Exchange for
physicals (EFP) involves private parties and takes place ex pit, or off the exchange floor.

Question 247

Over-the- counter derivatives:

A) are customized contracts.

B) have good liquidity in the over-the-counter (OTC) market.
C) are backed by the OTC Clearinghouse.
Answer: A

OTC derivative contracts (securities) are customized and have poor liquidity. The contract is with a
specific counterparty and there is default risk since there is no clearinghouse to guarantee performance.

Question 248

When one party pays a fixed rate of interest in an equity swap, which of the following is least accurate?

A) The equity-return payer will gain if the equity return is zero.

Unlike other swaps, in an equity swap the one-quarter-ahead payment is not known at the end
B)
of the previous quarter.
C) The fixed-rate receiver will never get more than the fixed rate.
Answer: C) The fixed-rate receiver will never get more than the fixed rate.

If the periodic return on the equity is negative, the fixed-rate payer must pay the fixed rate plus the
percentage of (negative) equity return, times the notional principal.

Question 249

The intrinsic value of an option is equal to:

A) the amount that it is in or out of the money.

B) its speculative value.
C) zero or the amount that it is in the money.
Answer: C) zero or the amount that it is in the money.

The intrinsic value of an option is equal to the amount that it is in the money or zero, if it is out of the
money. Option value equals speculative (time) value only for out-of-the-money options.

Question 250

Which of the following statements about futures is least accurate?

A) The exchange-mandated uniformity of futures contracts reduces their liquidity.

B) Futures contracts have a maximum daily allowable price limit.
C) The futures exchange specifies the minimum price fluctuation of a futures contract.
Answer: A
The exchange-mandated uniformity of futures contracts increases their liquidity.

Question 251

A call option has a strike price of $35 and the stock price is $47 at expiration. What is the expiration day
value of the call option?

A) $12.
B) $0.
C) $35.
Answer: A

A call option has an expiration day value of MAX (0, S − X). Here, X is $35 and S is $47.

Question 252

Which of the following statements regarding an option prior to expiration is CORRECT? The maximum
value of:

A) a European put is equal to the maximum value of an American put.

B) a European put is less than the maximum value of an American put.
C) an American call is less than the maximum value of a European call.
Answer: B) a European put is less than the maximum value of an American put.

The maximum value of a European put is X/(1+R)T and the maximum value of an American put is X.

Question 253

Which of the following statements regarding forward rate agreements (FRAs) is least accurate?

Because the cash payment will happen in the future, the forward interest rate reflects the
A)
creditworthiness of the party which is long the FRA.
If the floating rate at contract expiration is greater than the rate specified in the FRA, the long
B)
position will receive a payment.
If the floating rate at contract expiration is less than the rate specified in the FRA, the right to
C)
lend at rates higher than market rates has a positive value.
Answer: A

A forward rate agreement can be viewed as a forward contract to borrow or lend money at a certain rate
at some future date. Because no actual loan is made at the settlement date, the forward interest rate
does not need to reflect the creditworthiness of the parties to the contract (however, the parties may still
face default risk).

If the floating rate at contract expiration is above the rate specified in the forward agreement, the long
position in the contract can be viewed as the right to borrow at below market rates and the long will
receive a payment. If the reference rate at the expiration date is below the contract rate, the short can be
viewed as the right to lend at rates higher than market rates.

Question 254
A U.S. bank enters into a plain vanilla currency swap with a German bank. The swap has a notional
principal of US$15m (Euro 15.170m). At each settlement date, the U.S. bank pays a fixed rate of 6.5
percent on the Euros received, and a German bank pays a variable rate equal to LIBOR+2 percent on the
U.S. dollars received. Given the following information, what payment is made to whom at the end of year
2?

U.S. bank pays German bank pays

A) Euro 986,050 US$975,000
B) US$975,000 Euro 986,050
C) Euro 986,050 US$1,275,000
Answer: C)
Euro 986,050 US$1,275,000

The U.S. bank pays 6.5% fixed on Euro 15,170,000, which makes for an annual payment of Euro
986,050. The variable rate to be used at time period 2 is set at time period 1 (the arrears method).
Therefore, the German bank pays 6.5% + 2% = 8.5% times US$15,000,000 for a payment of
US$1,275,000.

Question 255

An option is settled in cash, with nothing delivered. The long payoff is the difference between the security
value and the strike price, multiplied by a contract multiplier. The option is a(n):

A) index option.
B) commodity option.
C) futures option.
Answer: A

Options on stock indexes are only settled in cash and require a multiplier to determine the payoff. Futures
options give the holder the right to buy or sell a futures contract, but require no multiplier. Commodity
options give the holder the right to buy or sell physical goods.

Question 256

Standardized futures contracts are an aid to increased market liquidity because:

uniformity of the contract terms broadens the market for the futures by appealing to a greater
A)
number of traders.
B) standardization of the futures contract stabilizes the market price of the underlying commodity.
C) standardization results in less trading activity.
Answer: A

Although a forward may have value to someone other than the original counterparties, the non-
standardized terms limit the level of interest, hence its marketability and liquidity. The standardized terms
of a future give it far more flexibility to traders, giving rise to a strong secondary market and greater
liquidity.

Question 257

Consider a commercial bank with a portfolio of U.S. Treasury bonds. Why would the bank wish to engage
in a swap contract? As the:

A) U.S. dollar decreases, the value of the bonds decreases.

B) interest rate increases, the value of the bonds decreases.
C) interest rate decrease, the value of the bonds decreases.
Answer: B) interest rate increases, the value of the bonds decreases.

Interest rates and bond prices are inversely related. Therefore, as interest rates increase, the value of the
T-bonds decreases. The bank may wish to engage in a swap contract wherein the bank pays fixed and
receives variable. In this case, as interest rates rise, the bank receives higher variable payments for
making the same fixed payment in the swap. The cash flows received in the swap offset the reduction in
the bond portfolio’s value.

Question 258

Which of the following statements about long positions in put and call options is most accurate? Profits
from a long call:

are negatively correlated with the stock price and the profits from a long put are positively
A)
correlated with the stock price.
B) and a long put are positively correlated with the stock price.
are positively correlated with the stock price and the profits from a long put are negatively
C)
correlated with the stock price.
Answer: C) are positively correlated with the stock price and the profits from a long put are negatively
correlated with the stock price.

For a call, the buyer's (or the long position's) potential gain is unlimited. The call option is in-the-money
when the stock price (S) exceeds the strike price (X). Thus, the buyer's profits are positively correlated
with the stock price. For a put, the buyer's (or the long position's) potential gain is equal to the strike price
less the premium. A put option is in-the-money when X > S. Thus, a put buyer wants a high exercise price
and a low stock price. Thus, the buyer's profits are negatively correlated with the stock price.

Question 259

Consider a fixed-for-floating interest rate swap based on 180-day LIBOR with a notional principal of $100
million.
Given the above diagrams, at the end of year 3:

A) A pays B $1 million.
B) A pays B $1.25 million.
C) A pays B $2.5 million.
Answer: B) A pays B $1.25 million.

The variable rate to be used at the end of year 3 is set at the end of 2½ years (the arrears method).
Therefore, the appropriate variable rate is 9%, the fixed rate is 6.5%, and the interest payments are
netted. The fixed-rate payer, counterparty B, pays according to:

(Swap Fixed Rate - LIBORt-1)(# of days/360)(Notional Principal).

In this case, we have (0.065 - 0.09)(180/360)($100 million) = $-1.25 million.

Question 260

One reason that criticism has been leveled at derivatives and derivatives markets is that:

A) derivatives have too much default risk.

B) derivatives expire.
C) they are complex instruments and sometimes hard to understand.
Answer: C) they are complex instruments and sometimes hard to understand.

The fact that derivative securities are sometimes complex and often hard for non-financial commentators
to understand has led to criticism of derivatives and derivative markets.

Question 261
The payoff of a call option on a stock at expiration is equal to:

A) the minimum of zero and the stock price minus the exercise price.
B) the maximum of zero and the exercise price minus the stock price.
C) the maximum of zero and the stock price minus the exercise price.
Answer: C) the maximum of zero and the stock price minus the exercise price.

The payoff on a call option on a stock is Max (0, S - X).

Question 262

Consider a 1-year quarterly-pay $1,000,000 equity swap based on 90-day London Interbank Offered Rate
(LIBOR) and an index return. Current LIBOR is 3.0% and the index is at 840. Below are the index level
and LIBOR at each of the four settlement dates on the swap.

Q1 Q2 Q3 Q4
LIBOR 3.2% 3.0% 3.4% 3.9%
Index 881 850 892.5 900

At the final settlement date, the equity-return payer will:

A) receive $97.
B) receive $16,903.
C) pay $16,903.
Answer: A

The equity return payer will pay the equity return and receive the floating rate return which is based on
the Q3 realized LIBOR.

[0.034 × (90/360) − (900/892.5 − 1)] × 1,000,000 = $96.64

Question 263

The settlement price of a deliverable forward contract at 6% on a $1 million 90-day Treasury bill would be:

A) determined by the market rates at expiration.

B) $940,000.
C) $985,000.
Answer: C) $985,000.

Treasury bills are quoted as a discount from face value, which is annualized based on a 360 day year.
(90/360) × 6% = 1.5%, so the contract price of the $1 million bill is [1 − 0.015] × 1,000,000 = $985,000.

Question 264

The term notional principal refers to:

A) the period of time involved.

B) the amount swapped.
 C) the cash interest payment.
Answer: B) the amount swapped.

The notional principal is the amount swapped. Note that the notional principal does not actually change
hands with plain vanilla interest rate swaps, but is used to calculate the interest payment streams to be
exchanged. Notional principal does exchange hands in a foreign currency swap.

Question 265

For two American options that differ only in time to expiration, strongest statement we can make is that:

A) the longer-term option must be worth at least as much as the shorter-term option.
B) the longer-term option must be worth less than the shorter-term option.
C) the longer-term option must be worth more than the shorter-term option.
Answer: A

While longer term options generally are worth more, for far in- or out-of-the-money options, the values
could be equal.

Question 266

Which statement best reflects the risk exposure of an option buyer?

A) Unlimited risk.
B) No risk.
C) Limited risk.
Answer: C) Limited risk.

The most any option buyer can lose is the amount paid for the option.

Question 267

The buyer (long) in a deliverable equity forward contract on a portfolio of stocks:

A) will profit on the contract if the price of the equity asset rises over the life of the contract.
B) is obligated to buy the portfolio in the future at the forward price.
C) will profit if the equity declines in price over the life of the contract.
Answer: B) is obligated to buy the portfolio in the future at the forward price.

In a deliverable contract, the long is obligated to buy the portfolio at the forward price. The forward
contract price will generally (except for a very high dividend paying portfolio) be higher than the current
market price; a rise in price from the current level is no guarantee of profits on the contract.

Question 268

A contract in which one party pays a fixed rate of interest on a notional amount in return for the return on
a single stock, paid quarterly for four quarters, is a(n):
 A) returns swap.
B) plain vanilla swap.
C) equity swap.
Answer: C) equity swap.

A swap contract in which at least one party makes payments based on the return on an equity, portfolio,
or market index, is called an equity swap.

Question 269

A put option is in-the-money• when:

A) there is no put option with a lower exercise price in the expiration series.
B) the stock price is higher than the exercise price of the option.
C) the stock price is lower than the exercise price of the option.
Answer: C) the stock price is lower than the exercise price of the option.

The put option is in-the-money if the stock price is below the exercise price.

Question 270

Which of the following is most likely an exchange-traded derivative?

A) Equity index futures contract.

B) Bond option.
C) Currency forward contract.
Answer: A

Futures are exchange-traded derivatives. Forward contracts and swaps are over-the-counter derivatives.
Bond options are traded almost entirely in the over-the-counter market.

Question 271

Suppose the price of a share of Stock A is $100. A European call option that matures one month from
now has a premium of $8, and an exercise price of $100. Ignoring commissions and the time value of
money, the holder of the call option will earn a profit if the price of the share one month from now:

A) increases to $110.
B) decreases to $90.
C) increases to $106.
Answer: A

The breakeven point is the strike price plus the premium, or $100 + $8 = $108. Any price greater than this
would result in a profit, and the only choice that exceeds this amount is $110.

Question 272
When calculating the payoff for a stock option, if the stock price is greater than the strike price at
expiration:

A) a call option expires worthless.

B) the payoff to a call option is the difference between the stock price and the strike price.
C) the payoff to a put option is equal to the strike price.
Answer: B) the payoff to a call option is the difference between the stock price and the strike price.

If the stock price is greater than the strike price at expiration, the payoff to a call option on the stock
equals the stock price minus the strike price, while a put option on the stock expires worthless.

Question 273

An FRA is:

A) the Futures Regulatory Administration.

B) a Forward Rate Agreement.
C) a Forward Riskfree Asset.
Answer: B) a Forward Rate Agreement.

An FRA is a forward rate agreement.

Question 274

An exchange-for-physicals, as it pertains to futures contracts:

A) is another term for delivering an asset to satisfy a futures contract.

B) is another term for accepting delivery of an asset to satisfy a futures contract.
C) involves an agreement off the floor of the exchange.
Answer: C) involves an agreement off the floor of the exchange.

An exchange-for-physicals involves an agreement between long and short contract holders to settle their
respective obligations by delivery and purchase of an asset. It is executed off the floor of the exchange
and reported to exchange officials who then cancel both positions.

Question 275

Which of the following statements regarding futures and forward contracts is least accurate?

A) Both forward contracts and futures contracts trade on organized exchanges.

B) Futures contracts are highly standardized.
Forwards require no cash transactions until the delivery date, while futures require a margin
C)
deposit when the position is opened.
Answer: A

Forward contracts are custom-tailored contracts and are not exchange traded while futures contracts are
standardized and are traded on an organized exchange.

Question 276
Bidco Corporation common stock has a market value of $30.00. Which statement about put and call
options available on Bidco common is most accurate?

A) A call with a strike price of $25.00 is at-the-money.

B) A put with a strike price of $35.00 is in-the-money.
C) A put with a strike price of $20.00 has intrinsic value.
Answer: B) A put with a strike price of $35.00 is in-the-money.

A put is in-the-money when its exercise price is higher than the market value of the underlying asset. A
put with a $35.00 strike price allows the trader to sell 100 shares of stock for $35.00 per share, which is
$5.00 higher than the prevailing market value. This gives the put a value, hence, it is in-the-money. For a
call to be in-the-money, its strike price would have to be lower than the market value of the underlying
common stock, allowing the trader to purchase 100 shares at a price below the prevailing market value.
At-the-money is when the strike price and asset market value are equal. A put with a strike price of
$20.00 does not have intrinsic value because it is below the $30 price of the stock. It does have time
value meaning it is worth something because there is the possibility the put will come into the money
before it expires.

Question 277

An issuer of floating rate debt can create an interest rate collar by buying:

A) an interest rate floor and selling an interest rate cap.

B) both an interest rate cap and an interest rate floor.
C) an interest rate cap and selling an interest rate floor.
Answer: C) an interest rate cap and selling an interest rate floor.

An interest rate collar combines a long interest rate cap with a short interest rate floor. Selling the floor
offsets some of the cost of buying the cap.

Question 278

Consider a $1 million 90-day forward rate agreement based on 60-day London Interbank Offered Rate
(LIBOR) with a contract rate of 5%. If, at contract expiration, 60-day LIBOR is 6%, the short must pay:

A) $1,652.89.
B) $1,650.17.
C) $1,666.67.
Answer: B) $1,650.17.

[(0.06 − 0.05)(60 / 360)(1,000,000)] / [1 + 0.06(60 / 360)] = 1,650.17.

Question 279

Currency swap markets consist of transactions in:

A) the forward market only.

B) both spot and forward contracts.
C) spot markets only.
Answer: B) both spot and forward contracts.

In this explanation, Euro is used to represent foreign currency. In a currency swap, one counterparty (D)
holds dollars and wants Euros. The other counterparty (E) holds Euros and wants dollars. They decide to
swap their currency positions at the current spot exchange rate. The counterparties exchange the full
notional principal at the onset of the swap. Then, on each settlement date, one party pays a fixed rate of
interest on the foreign currency received, and the other party pays a floating rate on the dollars received.
Interest payments are not netted. Generally, the variable interest rate on the dollar borrowings is
determined at the beginning of the settlement period and paid at the end of the settlement period. At the
conclusion of the swap, the notional currencies are again exchanged. Thus, currency swaps involved
transactions in both the spot and forward (future) markets. A fixed-for-fixed currency swap is equivalent
to a portfolio of foreign exchange forward contracts (both parties need to deliver currency in the future).

Question 280

The potential profits from writing a covered call position on a stock are:

A) limited to the premium.

B) greater than the potential profits from owning the stock.
C) limited to the premium plus stock appreciation up to the exercise price.
Answer: C) limited to the premium plus stock appreciation up to the exercise price.

The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the
inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s
price will not go up any time soon, and you want to increase your income by collecting some call option
premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the
money calls. You should know that this strategy for enhancing one’s income is not without risk. The call
writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call
to enhance income depends upon the chance that the stock price will exceed the exercise price at which
the trader writes the call. The owner of a stock has the rights to all upside potential. The profits for a short
call are limited to the premium.

For example, say that a stock owner writes a covered call at a stock price (S) of $50 and an exercise
price (X) of $55 for a premium of $4. If at expiration, the price of the stock is more than $50 but less than
$55, the buyer will not exercise, and the writer will "gain" the premium plus any stock appreciation
between $50 and $55. If at expiration, the price of the stock is more than $55, the buyer will exercise for
$55 and the writer's gain is limited to the premium plus the appreciation from $50 to $55.

Question 281

DWR Services, Ltd., arranges a plain vanilla interest rate swap between RWDY Enterprises (pays fixed)
and RED, Inc. (receives fixed). The swap has a notional value of $25,000,000 and 270 days between
payments. LIBOR is currently at 7.0%. If at the time of the next payment (due in exactly 270 days), RWDY
receives net payments of $93,750, the swap fixed rate is closest to:

A) 6.500%.
B) 7.500%.
C) 6.625%.
Answer: A

The net payment formula for the fixed-rate payer is:

Fixed Rate Paymentt = (Swap Fixed Rate − LIBORt-1) × (# days in term / 360) × Notional Principal

If the result is positive, the fixed-rate payer owes a net payment and if the result is negative, then the
fixed-rate payer receives a net inflow. Note: We are assuming a 360 day year.

We can manipulate this equation to read:

Swap Fixed Rate = LIBORt-1 + [(Fixed Rate Payment / ( # days in term / 360 × Notional Principal)

Note: the Fixed Rate payment will have a negative sign because we are told that RWDY receives a net
payment.

= 0.07 + [(-93,750 / (270 / 360 × 25,000,000) = 0.07 − 0.005 = 0.065, or 6.5%.

Note: We know that the Swap Fixed Rate will be less than the floating rate, or LIBOR, because RWDY
receives a net payment

Question 282

If the U.S. discount rate is 2.5% and the London Interbank Offered Rate (LIBOR) is +7.5%, the add-on
interest that must be paid on a 60-day, $250 million loan is closest to:

A) $4.17 million.
B) $3.13 million.
C) $3.08 million.
Answer: B) $3.13 million.

Add-on interest = LIBOR × (60/360) × $250 million

Interest = 7.5% × (1/6) × $250 million = $3.125 million

Question 283

A U.S. bank enters into a plain vanilla currency swap with a notional principal of US$250 million (GBP150
million). At each settlement date, the U.S. bank pays a fixed rate of 4.5% on the British pounds received
and the British bank pays a variable rate equal to LIBOR on the U.S. dollars received. Given the following
information, what payment is made to whom at the end of year 2?

0 1 2

LIBOR = 4% LIBOR = 4.5% LIBOR = 5%

The U.S. bank pays:

A) £6.75 million and the British bank pays US$11.25 million.

B) US$11.25 million and the British bank pays £6.75 million.
C) £6.75 million and the British bank pays US$12.5 million.
Answer: A
The U.S. bank pays 4.5% fixed on 150 million, which makes for an annual payment of 6.75 million. The
variable rate to be used at time period 2 is set at time period 1 (the arrears method). Therefore, the British
bank pays 4.5% times US$250 million for a payment of US$11.25 million.

Question 284

Consider a 1-year quarterly-pay $1,000,000 equity swap based on 90-day London Interbank Offered Rate
(LIBOR) and an index return. Current LIBOR is 3.0% and the index is at 840. Below are the index level
and LIBOR at each of the four settlement dates on the swap.

Q1 Q2 Q3 Q4
LIBOR 3.2% 3.0% 3.4% 3.9%
Index 881 850 892.5 900

At the second settlement date, the equity-return payer in the swap will:

A) receive $43,187.
B) receive $42,687.
C) receive $21,187.
Answer: A

The equity-return payer will receive the floating rate from the end of the previous period, 3.2%, plus the
negative return on the index over the second quarter.

[0.032 / 4 − (850 / 881 - 1)] × 1,000,000 = $43,187.29

Question 285

Which of the following is NOT an over-the-counter (OTC) derivative?

A) A forward contract.
B) A bond option.
C) A futures contract.
Answer: C) A futures contract.

Futures contracts are exchange-traded; forwards and most bond options are OTC derivatives.

Question 286

A standardized and exchange-traded agreement to buy or sell a particular asset on a specific date is best
described as a:

A) forward contract.
B) futures contract.
C) swap.
Answer: B) futures contract.

Futures contracts are standardized forward contracts that trade on organized exchanges. Other types of
forward contracts, as well as swaps, are custom instruments that are generally not exchange-traded.
Question 287

Consider a U.S. investor who has a portfolio of Australian government bonds that are denominated in
Australian dollars. Why would the investor wish to enter into a swap contract? As the Australian:

dollar increases in value, the interest payments from the Australian bonds translate into fewer
A)
U.S. dollars.
dollar decreases in value, the interest payments from the Australian bonds translate into fewer
B)
U.S. dollars.
C) interest rate decreases, the value of the Australian bonds decreases.
Answer: B) dollar decreases in value, the interest payments from the Australian bonds translate into fewer
U.S. dollars.

As the Australian dollar decreases in value, the interest payments from the bond (and perhaps the bond’s
face value if the bond is at maturity), translate into fewer U.S. dollars, which reduces the interest earned
on the Australian bonds.

Question 288

Consider a put option expiring in 120 days on a non-dividend-paying stock trading at 47 when the risk-
free rate is 5%. What are the lower bounds for an American put and a European put with exercise prices
of 50?

American Put European Put

A) $2.20 $2.20
B) $3.00 $2.20
C) $3.00 $3.00
Answer: B)
$3.00 $2.20

An American put can be exercised immediately for a $3 gain, the European put cannot be exercised until
expiration so its minimum value is 50 / (1.05)120/365 − 47 = $2.20.

Question 289

Which of the following relationships between arbitrage and market efficiency is least accurate?

Market efficiency refers to the low cost of trading derivatives because of the lower expense to
A)
traders.
The concept of rationally priced financial instruments preventing arbitrage opportunities is the
B)
basis behind the no-arbitrage principle.
C) Investors acting on arbitrage opportunities help keep markets efficient.
Answer: A

Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer
to the cost of trading. One necessary criterion for market efficiency is rapid adjustment of market values to
new information. Arbitrage, trading on a price difference between identical assets, causes changes in
demand for and supply of the assets that tends to eliminate the pricing difference.
Question 290

An investor sold ten March stock index futures contracts. The multiplier on the contract is 250. At
yesterday’s settlement price of 998.40 the margin balance in the account was computed as $86,450.
Today the index future had a settlement price of 1000.20. The new margin amount is:

A) $90,950.
B) $81,950.
C) $86,900.
Answer: B) $81,950.

86,450 − 10 × 250 × (1000.2 − 998.4) = $81,950

Question 291

123, Inc. has entered into a "plain-vanilla" interest rate swap on $10,000,000 notional principal. 123
company receives a fixed rate of 6.5% on payments that occur at monthly intervals. Platteville
Investments, a swap broker, negotiates with another firm, PPS, to take the pay-fixed side of the swap.
The floating rate payment is based on LIBOR (currently at 4.8%). At the time of the next payment (due in
exactly one month),123, Inc. will:

A) receive net payments of $14,167.

B) receive net payments of $42,500.
C) pay the dealer net payments of $14,167.
Answer: A

The net payment formula for the floating rate payer is:

Floating Rate Paymentt = (LIBORt-1 − Swap Fixed Rate) * (# days in term / 360) * Notional Principal

If the result is positive, the floating-rate payer owes a net payment and if the result is negative, then the
floating-rate payer receives a net inflow. Note: We are assuming a 360 day year.

Floating Rate Payment = (0.048 − 0.065) * (30 / 360) * 10,000,000 = -$14,167.

Since the result is negative,123 Inc. will receive this amount.

Question 292

Euribor is:

A) the same as EuroLIBOR.

B) the rate on U.S. dollar deposits in continental Europe.
C) published by the European Central Bank.
Answer: C) published by the European Central Bank.

Euribor is the interbank lending rate for Euro denominated loans, published by the European Central
Bank, and compiled in Frankfurt.
Question 293

James Anthony has a short position in a put option with a strike price of $94. If the stock price is below
$94 at expiration, what will happen to Anthony’s short position in the option?

A) The person who is long the put option will not exercise the put option.
B) He will let the option expire.
C) He will have the option exercised against him at $94 by the person who is long the put option.
Answer: C) He will have the option exercised against him at $94 by the person who is long the put option.

Anthony has sold the right to sell the stock at $94. That is, he received a payment upfront for the payer to
have the right but not the obligation to sell the stock at $94. Because the option is in-the-money at
expiration, MAX (0, X-S), the holder will exercise his right to sell at $94.

Question 294

Madison Bailey recently purchased a futures contract. The transaction did NOT:

A) use a structured contract.

B) include a guaranty by a clearinghouse.
C) take place through a private party.
Answer: C) take place through a private party.

A futures transaction is an exchange-traded contract. A forward contract occurs between private parties.
The following table illustrates the differences between forwards and futures:

Forwards Futures
Private contracts Exchange-traded contracts
Unique contracts Structured contracts
Default Risk Guaranteed by clearinghouse
No up front cash Margin Account
Low/no regulation Regulated

Question 295

The lower bound on European put option prices can be adjusted for cash flows of the underlying asset by:

A) subtracting the present value of the expected dividend payments from the exercise price.
B) adding the present value of the expected dividend payments to the current asset price.
C) subtracting the present value of the expected dividend payments from the current asset price.
Answer: C) subtracting the present value of the expected dividend payments from the current asset price.

The correct adjustment is to subtract the present value of the expected dividend payments from the
current asset price.

Question 296

An analyst determines that a portfolio with a 35% weight in Investment P and a 65% weight in Investment
Q will have a standard deviation of returns equal to zero.
  Investment P has an expected return of 8%.
 Investment Q has a standard deviation of returns of 7.1% and a covariance with the market of
0.0029.
 The risk-free rate is 5% and the market risk premium is 7%.

If no arbitrage opportunities are available, the expected rate of return on the combined portfolio is closest
to:

A) 6%.
B) 5%.
C) 7%.
Answer: B) 5%.

If the no-arbitrage condition is met, a riskless portfolio (a portfolio with zero standard deviation of returns)
will yield the risk-free rate of return.

Question 297

Assume that the value of a put option with a strike price of $100 and six months remaining to maturity is
$5. For a stock price of $110 and an interest rate of 6%, what value is closest to the corresponding call
option with the same strike price and same expiration as the put option?

A) $11.99.
B) $12.74.
C) $17.87.
Answer: C) $17.87.

Call value = $110 + $5 - $100 / 1.060.5 = $17.87.

Question 298

For a futures trade:

A) the buyer pays the bid price; the seller receives the ask price.
B) a single price is determined by supply and demand.
C) the seller receives the bid price; the buyer pays the ask price.
Answer: B) a single price is determined by supply and demand.

There is no bid/ask spread in futures trades; the price for the trade is determined on the floor of the
exchange and is the single price the long will pay the short for the asset at the termination of the contract.

Question 299

A short position in a forward rate agreement is equivalent to:

A) writing an interest rate call and buying an interest rate put.

 B) writing an interest rate put and buying an interest rate call.
C) writing both an interest rate put and an interest rate call.
Answer: A

A short position in a forward rate agreement is an obligation to make a hypothetical loan at the contract
rate and will be profitable when the forward rate falls. An equivalent position using interest rate options is
to buy a put and write a call.

Question 300

Jan Jurgen, CFA charterholder, recently accepted a position in the Treasury area of a conservatively
managed commercial bank. Jurgen intends to suggest the use of plain-vanilla interest rate swaps at
today’s Asset & Liability Management Committee meeting. Jurgen is least likely to argue that the use of
interest rate swaps will:

A) create arbitrage profits by exploiting market inefficiencies.

B) avoid costly regulations.
C) reduce the exposure from the mismatch between floating rate assets and fixed rate liabilities.
Answer: A

Exploiting market inefficiencies is no longer considered a motivation for entering into swap agreements.
Historically, there were two basic motivations for swaps, to exploit market inefficiencies and to attempt to
obtain cheaper financing. Both were based on the belief that financial markets were inefficient. Today, the
swap markets have matured and there are few arbitrage opportunities. The swap markets are considered
operationally efficient and flexible. Thus, the main reasons to enter into swap agreements today include:
to reduce transaction costs, to avoid costly regulations, and to maintain privacy.

Question 301

Consider a quarterly-pay currency swap where Party A pays London Interbank Offered Rate (LIBOR) on
$1,000,000 and Party B pays 4% on 900,000 euros. Current LIBOR is 3% and at the end of 90 days it is
4%. Which of the following statements regarding the first settlement date is most accurate?

A) Party A must make a payment of $10,000.

B) Party A must make a payment of $7,500.
C) The payments made depend on the exchange rate.
Answer: B) Party A must make a payment of $7,500.

Floating rate payments in a swap are based on the reference rate for the prior period. The payment is:

0.03 × 90/360 × 1,000,000 = $7,500

Question 302

Which of the following statements regarding currency forward contracts is least accurate?

If the domestic currency appreciates over the term of the contract, the party that is long the
A)
foreign currency will have losses on the contract.
A long position in a currency that appreciates more than expected over the term of the
B)
contract will have a positive value at contract expiration.
 C) Currency forward contracts can be settled in cash or by delivery.
Answer: A

The forward exchange rate in the contract will reflect the expected appreciation or depreciation of the
currency. If a currency appreciates by more than the expected appreciation implicit in the forward
exchange rate, the party that is long that currency will have gains. An appreciation of one currency does
not equate to gains to the party that is long that currency; if it appreciates by less than the appreciation
reflected in the forward exchange rate, the long will have losses.

Question 303

Given the covered call option diagram below and the following information, what are the dollar values for
points X and Y? The market price of the stock is $70, the strike price of the call is $80, and the call
premium is $5.

Point X Point Y
A) $80 $15
B) $80 $5
C) $75 $15
Answer: A

The kink in the diagram of a covered call is always at the exercise price of the option. Therefore, point X
is $80. As the stock price rises above $80, the stock is called away and the maximum gain is the call
premium plus the stock price gain ($80 − $70). The maximum gain, then, at point Y is ($5 + $10 = $15).

Question 304

Which of the following is least likely a characteristic of London Interbank Offered Rate (LIBOR)?

A) Set by the European Central Bank.

B) Adjusted daily.
 C) Paid on loans denominated in U.S. dollars.
Answer: A

LIBOR is published by the British Bankers Association based upon quotes from a number of large banks.
The rate is determined on a daily basis. LIBOR can apply to loans in U.S. dollars, as well as a variety of
other major currencies.