Study Session 16 Sample Questions. Asset Valuation: Derivative Investments

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1 1 Study Session 16 Sample Questions Asset Valuation Derivative Investments 1A Introduction 1. In the theory of finance, a complete market is a market: A. in which any rational price for a financial instrument must exclude arbitrage opportunities B. in which the owner of an option has the right to purchase the underlying good at a specific price, and this right lasts until a specific date C. in which any and all identifiable payoffs can be obtained by trading the securities available in the market D. in which an option takes a futures contract as its underlying good C. Complete market In the theory of finance, a complete market is a market in which any and all identifiable payoffs can be obtained by trading the securities available in the market Study Session , Introduction, LOS: 16,1A,e

2 2 2. Financial derivatives contribute to market completeness because: A. it is a market in which any financial instrument must exclude arbitrage opportunities B. it is a market in which the owner of an option has the right to purchase the underlying good at a specific price, and this right lasts until a specific date C. it is a market in which any and all identifiable payoffs can be obtained by trading the securities available in the market D. the market with financial derivatives allows traders to more exactly shape the risk return characteristics of their portfolios D. Market completeness Financial derivatives contribute to market completeness because the market with financial derivatives allows traders to more exactly shape the risk return characteristics of their portfolios. Study Session , Introduction, LOS: 16,1A,e 3. In the theory of finance, a/an is a market in which any and all identifiable payoffs can be obtained by trading the securities available in the market. A. complete market B. speculative market C. riskless market D. efficient market

3 3 A. Complete market In the theory of finance, a complete market is a market in which any and all identifiable payoffs can be obtained by trading the securities available in the market. Study Session , Introduction, LOS: 16,1A,e 4. Financial derivatives also provide a powerful tool for limiting risks that individuals and firms face in the ordinary conduct of their business. This is an example of: A. trading efficiency B. speculation C. risk management D. a complete market C. Risk management Financial derivatives provide a powerful tool for limiting risks that individuals and firms face in the ordinary conduct of their business. This is known as risk management. Study Session , Introduction, LOS: 16,1A,f

4 4 B. Futures Markets 1. The standardization of futures contracts promotes liquidity because: A. all the participants in the market know exactly what is being offered for sale, and they know the terms of the transactions B. it ensures that futures contracts trade in a smoothly functioning market C. it guarantees that all of the traders in the futures market will honor their obligations D. it provides a safeguard whereby traders are required to realize any losses in cash on the day they occur A. Standardization of futures contracts The standardization of futures contracts promotes liquidity because all the participants in the market know exactly what is being offered for sale, and they know the terms of the transactions. Study Session , Future Markets, LOS: 16,1B,c

5 5 2. Consider the following information: On May 1 Party A trades on the futures exchange to buy one oats contract of 10,000 bushels for delivery in September. Party B has complimentary requirements. The price is $2 per bushel. Assume that the contract closes on May 2 at 190 cents per bushel. Assume the initial margin was $3000 and the maintenance margin $2,500. Assume further that on May 3, the price has dropped to $1.80 per bushel. The price at which a maintenance margin call will be received is equal to: A. $2,500 B. $3,000 C. $500 D. $1,000 A. Margin and Daily Settlement When the losses incurred leave an equity that is less than the maintenance margin of $2,500, the trader will receive a margin call. Study Session , Future Markets, LOS: 16,1B,f

6 6 3. When using delivery as a method to close a futures contract, completion is usually achieved: A. when the trader transacts in the futures market to bring his or her net position in particular futures contract back to zero B. when two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity C. through the physical delivery of cash D. through the physical delivery of a particular good or by cash settlement D. Delivery When using delivery as a method to close a futures contract, completion is usually achieved through the physical delivery of a particular good or by cash settlement. Study Session , Future Markets, LOS: 16,1B,g

7 7 4. Indexes Futures Contracts are normally traded in: A. the Standard and Poor s 500, the S&P Mid-Cap 400, the Dow Jones Industrial Average, the New York Stock Exchange Index and the Value Line Index B. the S&P Mid-Cap 400, the Dow Jones Industrial Average, the New York Stock Exchange Index, the Value Line Index, the NASDAQ 100 and the Russel 2000 C. the Standard and Poor s 500, the S&P Mid-Cap 400, the Dow Jones Industrial Average, the New York Stock Exchange Index, the Value Line Index, the NASDAQ 100 and the Russel 2000 D. the Standard and Poor s 500, the Dow Jones Industrial Average, the New York Stock Exchange Index, the Value Line Index, the NASDAQ 100 and the Russel 2000 C. Indexes Futures Contracts Indexes Futures Contracts are normally traded in: The Standard and Poor s 500 The S&P Mid-Cap 400 The Dow Jones Industrial Average The New York Stock Exchange Index, The Value Line Index, The NASDAQ 100 and The Russel 2000 Study Session , Future Markets, LOS: 16,1B,h

8 8 C. The Options Market 1. Consider a put option with an exercise price of $80 on stock that is worth $70. The put is: A. $10 at-the-money because the immediate exercise of the put gives a $10 cash inflow B. $10 out-of-the-money because the immediate exercise of the put gives a $10 cash inflow C. $10 in-the-money because the immediate exercise of the put gives a $10 cash outflow D. $10 in-the-money because the immediate exercise of the put gives a $10 cash inflow D. In-the-money put The put is $10 in-the-money because the immediate exercise of the put gives a $10 cash inflow. Exercise price stock price = $80 $70 = $10 inflow (in-the-money) Study Session , The Options Market, LOS: 16,1C,b

9 9 2. An American call or put option must be worth at least as much as a European option because: A. the owner of the American option has the right to exercise the option at expiration if he desires and he has all the rights and privileges that the owner of the European option possesses B. it allows the owner to exercise only at expiration C. it allows the owner to exercise after expiration D. the owner of the American option has the right to exercise the option before expiration if he desires and he has all the rights and privileges that the owner of the European option possesses D. American call or put option An American call or put option must be worth at least as much as a European option because the owner of the American option has the right to exercise the option before expiration if he desires and he has all the rights and privileges that the owner of the European option possesses. Study Session , The Options Market, LOS: 16,1C,d 3. A margin payment is: A. a deferred cash payment that shows the financial integrity of the traders and helps limit the risk of the clearing member and the clearinghouse B. an immediate cash payment that shows the financial integrity of the traders and helps limit the risk of the clearing member and the clearinghouse C. the demand for more margin D. the funds that a prospective trader must deposit with a broker before trading a futures contract

10 10 B. Margin payment A margin payment is an immediate cash payment that shows the financial integrity of the traders and helps limit the risk of the clearing member and the clearinghouse. Study Session , The Options Market, LOS: 16,1C,g D. Option Payoffs and Option Strategies Use the graph below in answering Questions Exercise price of both options Long call Value 0 Short call Stock Price The graph is a depiction of a call option with an exercise price of $ The graph shows that the: A. the value of the call is $100 B. the value of the call is unknown C. the value of the call is unlimited, in principle D. the value of the call is not determinable

11 11 C. The value of a call at expiration The graph shows that the value of the call is unlimited, in principle. Study Session 16, Option Payoffs and Option Strategies, LOS: 16,1D,d 2. If the stock price were $500, at expiration, the call would be worth: A. $0 B. $100 C. $500 D. $400 D. The value of a call at expiration If the stock price were $500, at expiration, the call would be worth $400 as follows: Stock price exercise price = intrinsic value $500- $100 = $400 Study Session 16, Option Payoffs and Option Strategies, LOS: 16,1D,d

12 12 3. Consider the graph below. 15 Long put Value 0 Exercise price of both options Short put Stock Price The graph is a depiction of a put option with an exercise price of $100. If the stock trades for $97 A. the put is worth $3 B. the put is worth $103 C. the put is worth $97 D. the put is worthless A. The Value of a Put at Expiration From the graph we can deduce that: If the stock trades for $97, the put is worth $3. This can be computed as follows: Exercise price stock price $100 $97 = $3

13 13 Study Session 16, Option Payoffs and Option Strategies, LOS: 16,1D,f 4. Consider the graph below. 15 Profit / Loss 0 Stock + short call Long Stock Assume a trader owns a share currently priced at $100. She writes a call option on this share with an exercise price of $110 and an assumed price of $4. For any stock price less than or equal to $110 A. she is $14 better off with the covered call than she would be with the stock alone B. she is $4 worse off with the covered call than she would be with the stock alone C. she is $4 better off with the covered call than she would be with the stock alone Stock Price D. she is $14 worse off with the covered call than she would be with the stock alone C.

14 14 Profits and losses at Expiration for a Covered Call From the graph we can deduce that: For any stock price less than or equal to $110, she is $4 better off with the covered call than she would be with the stock alone Study Session 16, Option Payoffs and Option Strategies, LOS: 16,1D,i E. The Swaps Market: Introduction 1. The motivation for entering into a swap agreement is that: A. it provides firms that face financial risks with a flexible way to manage that risk B. it provides firms that face financial risks with a fixed way to manage that risk C. it gives you an ability to swap amongst a diverse range of products D. the reduction in costs is always high A. Motivation for entering into a swap agreement The motivation for entering into a swap agreement is that it provides firms that face financial risks with a flexible way to manage that risk Study Session , The Swaps Market: Introduction, LOS: 16,1E,a

15 15 2. Assume the following information relating to a swap agreement. The swap covers a five-year period and involves annual payments on a $1000,000 notional principal amount. Party A is the pay-fixed counterparty and agrees to pay a fixed rate of 9% to Party B. In return, Party B, the receive-fixed counterparty, agrees to pay a floating rate of LIBOR to Party A. Party A pays: A. $87,500 each year to Party B B. $90,000 each year to Party B C. Nil each year to Party B D. $2,500 each year to Party B B. Plain Vanilla Interest Rate Swaps Party A pays $90,000 each year to Party B. $1,000,000 x 9% = $90,000 Study Session , The Swaps Market: Introduction, LOS: 16,1E,c

16 16 3. Assume the following information relating to a fixed-for-fixed currency swap between Party C and D who hold German marks and U.S. dollars respectively. The spot exchange rate between German marks and U.S. dollars is 2.5 marks per dollar. The U.S. interest rate is 10% and the German interest rate is 8%. Party C holds 25 million marks and wants dollars. In return for the marks, Party D would pay: A. DM 25 million to Party C at the initiation of the swap B. $10,000,000 to Party C at the initiation of the swap C. DM 2.5 million to Party C at the initiation of the swap D. $10,000,000 to Party C at the initiation of the swap D. Foreign Currency Swaps In return for the marks, Party D would pay $10,000,000 to Party C at the initiation of the swap. DM25,000,000/2.5 = $10,000,000 Study Session , The Swaps Market: Introduction, LOS: 16,1E,f

17 17 4. Party C and D hold German marks and U.S. dollars respectively. The spot exchange rate between German marks and U.S. dollars is 2.5 marks per dollar. Party C holds 25 million marks and wants dollars. Assume the tenor of the swap is 7 years. Party C is a German firm with access to marks at a rate of 7%, while Party D must pay 8% to borrow marks. Party D, however, can borrow dollars at 9%, while Party C must pay 10% for its dollar borrowings. The annual amount received by Party C is: A. DM 25 million B. $10 million C. $800,000 D. DM 2 million D. Foreign currency swaps The annual amount received by Party C is DM 2 million. $10 million x 2.5 = DM 25 million DM 25 million x 8% = DM 2 million Study Session , The Swaps Market: Introduction, LOS: 16,1E,k