Deck 18: Derivatives

Question 1

In theory, reducing the volatility of its cash flows will always increase a company's value.

Answer 1

False

Question 2

There are call options on the common stock of XYZ Corporation. Which of the following best describes the factors that affect call option values?

A) The price of call options will rise if XYZ's stock price rises.
B) The higher the strike price, the higher the call option price.
C) Assuming the same strike price, a call option that expires in 1 month will sell for a higher price than one that expires in 3 months.
D) The less volatile a stock's price, the more valuable a call option on the stock is.
E) If the risk-free rate of interest increases, the value of call options will decrease.

Answer 2

A

Question 3

Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

Answer 3

False

Question 4

Which of the following is NOT a way risk management can be used to increase the value of a firm?

A) Risk management can increase debt capacity.
B) Risk management can help a firm maintain its optimal capital budget.
C) Risk management can reduce the expected costs of financial distress.
D) Risk management can help firms minimize taxes.
E) Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

Question 5

Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses.

Question 6

The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long" and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

Question 7

Which of the following statements is most CORRECT?

A) One advantage of forward contracts is that they are default free.
B) Futures contracts generally trade on an organized exchange and are marked to market daily.
C) Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
D) Forward contracts are generally standardized instruments, whereas futures contracts are generally tailor-made for the 2 parties of the contract.
E) Essentially there are no differences between forward and futures contracts, except that forward contracts are used only for financial assets while futures contracts are used only for commodities.

Question 8

A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?

A) Buying inverse floaters.
B) Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
C) Purchase principal only (PO) strips that decline in value whenever interest rates rise.
D) Enter into a short hedge where the bank agrees to sell interest rate futures.
E) Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans.

Question 9

An investor who "writes" a call option without the stock in his or her portfolio to back it up is selling a(n)

A) Call option.
B) Put option.
C) Out-of-the-money option.
D) Naked option.
E) Covered option.

Question 10

An option that gives the holder the right to sell a stock at a specified price at some time in the future is called a(n)

A) Call option.
B) Put option.
C) Out-of-the-money option.
D) Naked option.
E) Covered option.

Question 11

The value of a stock option depends on all of the following EXCEPT:

A) Exercise price.
B) Variability of the stock price.
C) Length of time until option expiration.
D) Risk-free rate of interest.
E) Bond price.

Question 12

A call option whose underlying stock value is less than the corresponding exercise price is an example of a(n)

A) Straddle option.
B) Put option.
C) Out-of-the-money option.
D) Naked option.
E) Covered option.

Question 13

An option that gives the holder the right to buy a stock at a specified price at some time in the future is called a(n)

A) Call option.
B) Put option.
C) Out-of-the-money option.
D) Naked option.
E) Covered option.

Question 14

Which of the following statements is CORRECT?

A) Put options give investors the right to buy a stock at a certain exercise price before a specified date.
B) Call options give investors the right to sell a stock at a certain exercise price before a specified date.
C) Options typically sell for less than their exercise value.
D) LEAPS are very short-term options that have begun trading on the exchanges in recent years.
E) Option holders are not entitled to receive dividends unless they choose to exercise their option.

Question 15

An investor who "writes" a call option against stock held in his or her portfolio is selling a(n)

A) Straddle option.
B) Put option.
C) Out-of-the-money option.
D) Naked option.
E) Covered option.

Question 16

One objective of risk management can be to reduce the volatility of a firm's cash flows.

Question 17

A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?

A) A swap involves the exchange of cash payment obligations.
B) The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
C) Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
D) A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
E) Swaps can involve side payments in order to get the counterparty to agree to the swap.

Question 18

Which of the following statements concerning risk management is NOT CORRECT?

A) Risk management can reduce the volatility of cash flows, and this decreases the probability of bankruptcy.
B) Risk management makes sense for firms directly engaged in activities that involve commodities whose values can be hedged, but it doesn't make much sense for most other firms.
C) Companies with volatile earnings pay more taxes than companies with more stable earnings due to the treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. Therefore, our tax system encourages risk management to stabilize earnings.
D) Risk management can reduce the likelihood of low cash flows, and therefore reduce the probability of financial distress.
E) Risk management involves identifying events that could have adverse financial consequences and then taking actions to prevent and/or to minimize the damage caused by these events.

Question 19

Deeble Construction Co.'s stock is trading at $30 a share. There are also call options on the company's stock, some with an exercise price of $25 and some with an exercise price of $35. All options expire in 3 months. Which of the following best describes the value of these options?

A) If Deeble's stock price rose by $5, the exercise value of the options with the $25 exercise price would also increase by $5.
B) The options with the $25 exercise price will sell for less than the options with the $35 exercise price.
C) The options with the $25 exercise price have an exercise value greater than $5.
D) The options with the $35 exercise price have an exercise value greater than $0.
E) The options with the $25 exercise price will sell for $5.

Question 20

Which of the following is NOT an example of a derivative security?

A) Futures.
B) Options.
C) Swaps.
D) Forward contracts.
E) Preferred stock.

Question 21

Suppose a CBOT 10-year U.S. Treasury note futures contract has a quoted price of 88-30. If annual interest rates go down by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, round the new interest rate to 4 decimal places when written as a decimal, and round the change in price up to the nearest whole dollar.)

A) $63.00
B) $65.00
C) $67.00
D) $69.00
E) $71.00

Question 22

A 6-month call option on Romer Technologies' stock has a strike price of $45 and sells in the market for $8.25. Romer's current stock price is $48. What is the exercise value of the option?

A) $3.00
B) $3.75
C) $4.69
D) $5.86
E) $7.32

Question 23

Suppose a CBOT 10-year U.S. Treasury note futures contract has a quoted price of 89-09. What is the implied annual interest rate inherent in this futures contract?

A) 6.81%
B) 7.17%
C) 7.55%
D) 7.92%
E) 8.32%

Question 24

A 6-month put option on Smith Corp.'s stock has a strike price of $45 and sells in the market for $8.90. Smith's current stock price is $41. What is the option premium?

A) $4.41
B) $4.90
C) $5.39
D) $5.93
E) $6.52

Question 25

A 6-month call option on Meyers Inc.'s stock has a strike price of $45 and sells in the market for $8.25. Meyers' current stock price is $48. What is the option premium?

A) $4.25
B) $4.73
C) $5.25
D) $5.78
E) $6.35

Question 26

Which of the following statements is CORRECT?

A) An option's value is determined by its exercise value, which is the market price of the stock less its strike price. Thus, an option can't sell for more than its exercise value.
B) As a stock's price increases, the premium portion of an option on that stock increases because the difference between the stock price and the fixed strike price increases.
C) If the company is consistently profitable, its call options will always be in the money.
D) The market value of an option depends in part on the option's length of time until expiration and on the variability of the underlying stock's price.
E) The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin becomes larger.

Question 27

Suppose a CBOT 10-year U.S. Treasury note futures contract has a quoted price of 103-18. What is the implied annual interest rate inherent in the futures contract?

A) 4.74%
B) 4.99%
C) 5.25%
D) 5.53%
E) 5.81%

Question 28

A 6-month put option on Makler Corp.'s stock has a strike price of $45 and sells in the market for $8.90. Makler's current stock price is $41. What is the exercise value of the option?

A) $2.62
B) $2.92
C) $3.24
D) $3.60
E) $4.00

Question 29

Looking at The Wall Street Journal you observe that the settlement price on a hypothetical 10-year, semiannual payment, 6% coupon Treasury note is 105-21. If the note has a $1,000 par value, what is the implied Treasury note rate?

A) 5.27%
B) 5.53%
C) 5.80%
D) 6.10%
E) 6.40%

Question 30

Which of the following events is likely to decrease the value of call options on the common stock of GCC Company?

A) An increase in GCC's stock price.
B) An increase in the exercise price of the option.
C) An increase in the amount of time until the option expires.
D) An increase in the risk-free rate.
E) GCC's stock price becomes more risky (higher variance).

Question 31

Which of the following statements regarding factors that affect call option prices is CORRECT?

A) The longer the time until the call option expires the smaller its value and the smaller its premium.
B) An option on an extremely volatile stock is worth less than one on a very stable stock.
C) The price of a call option increases as the risk-free rate increases.
D) Two call options on the same stock will have the same value even if they have different strike prices.
E) If you observe that a put option on a stock increases in value, then a call option on that same stock also increases in value.

Question 32

Lissa Co.'s stock price is currently $30.25. A 6-month call option on Lissa's stock has a strike price of $25 and has an expected volatility of 40% (i.e., expected standard deviation = 40%). The risk-free rate is 6%. According to the Black-Scholes option pricing model, what is the value of the option?

A) $5.06
B) $5.62
C) $6.24
D) $6.94
E) $7.63

Question 33

A riskless hedge can best be defined as

A) A situation in which aggregate risk can be reduced by derivatives transactions between two parties.
B) A hedge in which an investor buys a stock and simultaneously sells a call option on that stock and ends up with a riskless position.
C) Standardized contracts that are traded on exchanges and are "marked to market" daily, but where physical delivery of the underlying asset is virtually never taken.
D) Two parties agree to exchange obligations to make specified payment streams.
E) Simultaneously buying and selling a call option with the same exercise price.

Question 34

Warnes Motors' stock is trading at $20 a share. Three-month call options with an exercise price of $20 have a price of $1.50. Which of the following will occur if the stock price increases 10% to $22 a share?

A) The price of the call option will increase by $2.
B) The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
C) The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
D) The price of the call option will increase by more than $2.
E) The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.

Question 35

Suppose a CBOT 10-year U.S. Treasury note futures contract has a quoted price of 103-18. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, round the new interest rate to 4 decimal places when written as a decimal, and round the change in price up to the nearest whole dollar.)

A) -$61.00
B) -$64.00
C) -$67.00
D) -$71.00
E) -$75.00