Question 1

There are six factors that influence the price of an option. Describe four of these factors. What may these factors depend on?

Accepted Answer

Six factors influence the price of an option:
1. Current price of the underlying asset
2. Strike price
3. Time to expiration of the option
4. Expected price volatility of the underlying asset over the life of the option
5. Short-term, risk-free interest rate over the life of the option
6. Anticipated cash payments on the underlying asset over the life of the option
The impact of each of these factors may depend on whether (1) the option is a call or a put, and (2) the option is an American option or a European option.

Question 2

To derive a one-period binomial option pricing model for a call option, we begin by constructing a portfolio consisting of ________.

Accepted Answer

A)  a short position in a certain amount of the asset, and a short call position in the underlying asset. 
B)  a long position in a certain amount of the asset, and a long call position in the underlying asset. 
C)  a short position in a certain amount of the asset, and a long call position in the underlying asset. 
D)  a long position in a certain amount of the asset, and a short call position in the underlying asset. 
A)  a short position in a certain amount of the asset, and a short call position in the underlying asset. 
B)  a long position in a certain amount of the asset, and a long call position in the underlying asset. 
C)  a short position in a certain amount of the asset, and a long call position in the underlying asset. 
D)  a long position in a certain amount of the asset, and a short call position in the underlying asset. D

Question 3

What do we assume when we illustrate arbitrage strategies?

Accepted Answer

When we illustrate arbitrage strategies, we assume that (1) only one asset is deliverable, and (2) the settlement date occurs at a known, fixed point in the future.

Question 4

Several models have been developed to determine the theoretical value of an option.

Accepted Answer

A) True 
 B)False

Question 5

Describe an option when (i) in the money and (ii) out of the money.

Accepted Answer

When the strike price of a call option i

Question 6

You lend $2,000 at 12% per year for three months and proceed to short sell Asset XYZ for $2,000 in the cash market. You are required to pay $200 to the lender of Asset XYZ (which is the proceeds the lender would have received). You then immediately buy a futures contract at $1,850 for delivery of asset XYZ in three months (this will cover your short position). What is the net profit or loss from your strategy of lending money, short selling, and buying the futures contract?

Accepted Answer

A)  $30 
B)  $20 
C)  $10 
D)  $0 
A)  $30 
B)  $20 
C)  $10 
D)  $0

Question 7

All other factors constant, the higher the short-term, risk-free interest rate, the ________ the cost of buying the underlying asset and carrying it to the ________ of the call option.

Accepted Answer

A)  greater; expiration date 
B)  lower; maturity date 
C)  greater; ex-dividend date 
D)  lower; salvage date 
A)  greater; expiration date 
B)  lower; maturity date 
C)  greater; ex-dividend date 
D)  lower; salvage date

Question 8

Consider the "cash and carry trade" where you sell (or take a short position in) the futures contract, purchase Asset XYZ, and borrow until the settlement date. In computing the value "from the loan," which of the below statements is TRUE?

Accepted Answer

A)  P = repayment of principal of loan 
B)  rP = interest on loan 
C)  P + rP = total outlay 
D)  All of these 
A)  P = repayment of principal of loan 
B)  rP = interest on loan 
C)  P + rP = total outlay 
D)  All of these

Question 9

Which of the below statements is FALSE?

Accepted Answer

A)  For strategies applied to stock index futures, a short sale of the stocks in the index means that all stocks in the index must be sold at different times. 
B)  When illustrating arbitrage strategies, one assumes that (1) only one asset is deliverable, and (2) the settlement date occurs at a known, fixed point in the future. 
C)  Some futures contracts involve a single asset, but other contracts apply to a basket of assets or an index. 
D)  The basic arbitrage model presented in this chapter ignores not only taxes but also different tax treatment of cash market transactions and futures transactions. 
A)  For strategies applied to stock index futures, a short sale of the stocks in the index means that all stocks in the index must be sold at different times. 
B)  When illustrating arbitrage strategies, one assumes that (1) only one asset is deliverable, and (2) the settlement date occurs at a known, fixed point in the future. 
C)  Some futures contracts involve a single asset, but other contracts apply to a basket of assets or an index. 
D)  The basic arbitrage model presented in this chapter ignores not only taxes but also different tax treatment of cash market transactions and futures transactions.

Question 10

In summarizing the effect of carry on the difference between the futures price and the cash market price in this way, which of the below statements is FALSE?

Accepted Answer

A)  If the carry is positive (y > r), then the futures price will sell at a discount to cash price (F  y), then the futures price will sell at a premium to cash price (F > P). 
C)  If the carry is zero (r = y), then the futures price will be equal to the cash price (F = P). 
D)  None of these 
A)  If the carry is positive (y > r), then the futures price will sell at a discount to cash price (F  y), then the futures price will sell at a premium to cash price (F > P). 
C)  If the carry is zero (r = y), then the futures price will be equal to the cash price (F = P). 
D)  None of these

Question 11

The equilibrium or theoretical futures price can be determined through arbitrage arguments.

Accepted Answer

A) True 
 B)False

Question 12

According to arbitrage arguments, the equilibrium or theoretical futures price can be determined on the basis of ________.

Accepted Answer

A)  the price of the asset in the options market. 
B)  the net book income on the asset until the settlement date. 
C)  the financing cost, which is the interest rate for borrowing and lending until the settlement date. 
D)  None of these 
A)  the price of the asset in the options market. 
B)  the net book income on the asset until the settlement date. 
C)  the financing cost, which is the interest rate for borrowing and lending until the settlement date. 
D)  None of these

Question 13

The option price will change as the price of the ________. For a ________, as the price of the underlying asset increases (all other factors constant), the option price increases. The opposite holds for a ________.

Accepted Answer

A)  underlying asset changes; put option; call option 
B)  underlying asset changes; call option; put option 
C)  European option changes; call option; put option 
D)  American option changes; put option; call option 
A)  underlying asset changes; put option; call option 
B)  underlying asset changes; call option; put option 
C)  European option changes; call option; put option 
D)  American option changes; put option; call option

Question 14

Consider the "cash and carry trade" where you sell (or take a short position in) the futures contract, purchase Asset XYZ, and borrow at a rate of r until the settlement date. In computing the value "from settlement of the futures contract," which of the below statements is FALSE?

Accepted Answer

A)  F = proceeds from sale of Asset XYZ to settle the futures contract 
B)  yP = payment received from investing in Asset XYZ 
C)  F - yP = total proceeds 
D)  All of these 
A)  F = proceeds from sale of Asset XYZ to settle the futures contract 
B)  yP = payment received from investing in Asset XYZ 
C)  F - yP = total proceeds 
D)  All of these

Question 15

Consider the "reverse cash and carry trade" where you buy the futures contract, short sell Asset XYZ, and invest or lend at a rate of r until the settlement date. In computing the "profit," which of the below statements is TRUE?

Accepted Answer

A)  Profit = Total proceeds + Total outlay 
B)  Profit = P - rP + (F - yP) 
C)  Profit = Total outlay Profit - Total proceeds 
D)  Profit = P + rP - (F + yP) 
A)  Profit = Total proceeds + Total outlay 
B)  Profit = P - rP + (F - yP) 
C)  Profit = Total outlay Profit - Total proceeds 
D)  Profit = P + rP - (F + yP)

Question 16

Which of the below statements is FALSE?

Accepted Answer

A)  The theoretical futures price may be at a premium to the cash market price (higher than the cash market price) or at a discount from the cash market price (lower than the cash market price), depending on the value of P(r - y). 
B)  The term, r - y, which reflects the difference between the cost of financing and the asset's cash yield, is called the net financing cost. 
C)  The net financing cost is more commonly called the cost of carry, or simply, carry. 
D)  Negative carry means that the yield earned is greater than the financing cost; positive carry means that the financing cost exceeds the yield earned. 
A)  The theoretical futures price may be at a premium to the cash market price (higher than the cash market price) or at a discount from the cash market price (lower than the cash market price), depending on the value of P(r - y). 
B)  The term, r - y, which reflects the difference between the cost of financing and the asset's cash yield, is called the net financing cost. 
C)  The net financing cost is more commonly called the cost of carry, or simply, carry. 
D)  Negative carry means that the yield earned is greater than the financing cost; positive carry means that the financing cost exceeds the yield earned.

Question 17

When developing a theory of futures pricing, which of the following is NOT a notation that is used?

Accepted Answer

A)  F = Futures price ($) 
B)  C = Cash market price ($) 
C)  r = Financing cost (%) 
D)  y = Cash yield (%) 
A)  F = Futures price ($) 
B)  C = Cash market price ($) 
C)  r = Financing cost (%) 
D)  y = Cash yield (%)

Question 18

To derive the price of a ________, we can rely on the basic principle that the hedged portfolio, being riskless, must have a return equal to the risk-free rate of interest.

Accepted Answer

A)  hedge ratio 
B)  put option 
C)  call option 
D)  futures price 
A)  hedge ratio 
B)  put option 
C)  call option 
D)  futures price

Question 19

The theoretical price of a futures contract can be determined on the basis of arbitrage arguments, but is much more complicated to determine than the theoretical price of an option because the option price depends on the expected price volatility of the underlying asset over the life of the option.

Accepted Answer

A) True 
 B)False

Question 20

The strength of the binomial model based on yields is that it satisfies the put-call parity relationship by taking into consideration the yield curve, thereby allowing arbitrage opportunities.

Accepted Answer

A) True 
 B)False

Exam 28: Pricing of Futures and Options Contracts

There are six factors that influence the price of an option. Describe four of these factors. What may these factors depend on?

To derive a one-period binomial option pricing model for a call option, we begin by constructing a portfolio consisting of ________.

What do we assume when we illustrate arbitrage strategies?

Several models have been developed to determine the theoretical value of an option.

Describe an option when (i) in the money and (ii) out of the money.

All other factors constant, the higher the short-term, risk-free interest rate, the ________ the cost of buying the underlying asset and carrying it to the ________ of the call option.

Consider the "cash and carry trade" where you sell (or take a short position in) the futures contract, purchase Asset XYZ, and borrow until the settlement date. In computing the value "from the loan," which of the below statements is TRUE?

Which of the below statements is FALSE?

In summarizing the effect of carry on the difference between the futures price and the cash market price in this way, which of the below statements is FALSE?

The equilibrium or theoretical futures price can be determined through arbitrage arguments.

According to arbitrage arguments, the equilibrium or theoretical futures price can be determined on the basis of ________.

The option price will change as the price of the ________. For a ________, as the price of the underlying asset increases (all other factors constant), the option price increases. The opposite holds for a ________.

Consider the "cash and carry trade" where you sell (or take a short position in) the futures contract, purchase Asset XYZ, and borrow at a rate of r until the settlement date. In computing the value "from settlement of the futures contract," which of the below statements is FALSE?

Consider the "reverse cash and carry trade" where you buy the futures contract, short sell Asset XYZ, and invest or lend at a rate of r until the settlement date. In computing the "profit," which of the below statements is TRUE?

Which of the below statements is FALSE?

When developing a theory of futures pricing, which of the following is NOT a notation that is used?

To derive the price of a ________, we can rely on the basic principle that the hedged portfolio, being riskless, must have a return equal to the risk-free rate of interest.

The theoretical price of a futures contract can be determined on the basis of arbitrage arguments, but is much more complicated to determine than the theoretical price of an option because the option price depends on the expected price volatility of the underlying asset over the life of the option.

The strength of the binomial model based on yields is that it satisfies the put-call parity relationship by taking into consideration the yield curve, thereby allowing arbitrage opportunities.

Introduction

Financial Institutions, Financial Intermediaries, and Asset Management Firms

Depository Institutions: Activities and Characteristics

The U.S. Federal Reserve and the Creation of Money

Monetary Policy in the United States

Insurance Companies

Investment Companies and Exchange Traded Funds

Pension Funds

Properties and Pricing of Financial Assets

The Level and Structure of Interest Rates

The Term Structure of Interest Rates

Risk/Return and Asset Pricing Models

Primary Markets and the Underwriting of Securities

Secondary Markets

Treasury and Agency Securities Markets

Municipal Securities Markets

Markets for Common Stock: The Basic Characteristics

Markets for Common Stock: Structure and Organization

Markets for Corporate Senior Instruments: I

Markets for Corporate Senior Instruments: II

The Markets for Bank Obligations

The Residential Mortgage Market

Mortgage-Backed Securities Market

Market for Commercial Mortgage Loans and Commercial Mortgage-Backed Securities

Market for Asset-Backed Securities

Financial Futures Markets

Options Markets

The Applications of Futures and Options Contracts

OTC Interest Rate Derivatives: Forward Rate Agreements, Swaps, Caps, and Floors

Market for Credit Risk Transfer Vehicles: Credit Derivatives and Collateralized Debt Obligations

The Market for Foreign Exchange and Risk Control Instruments

Filters

All other factors constant, the higher the short-term, risk-free interest rate, the the cost of buying the underlying asset and carrying it to the of the call option.

The option price will change as the price of the . For a , as the price of the underlying asset increases (all other factors constant), the option price increases. The opposite holds for a .