Deck 7: Derivatives and Derivative Markets

Question 1

Forward transactions originated in the market for

A)common stock.
B)corporate bonds.
C)government bonds.
D)agricultural and other commodities.

Answer 1

agricultural and other commodities.

Question 2

Which of the following is NOT a benefit of derivatives?

A)risk sharing
B)guaranteed minimum profit
C)liquidity
D)information services

Answer 2

guaranteed minimum profit

Question 3

In derivative markets, trade takes place in

A)assets such as bonds or common stock that derive their value from the value of the companies which issue them.
B)assets whose rates of returns must be derived from information published in financial tables.
C)assets that derive their value from underlying assets.
D)assets which are not allowed to be traded on organized exchanges.

Answer 3

assets that derive their value from underlying assets.

Question 4

Forward transactions

A)provide little risk sharing.
B)are very liquid.
C)have information problems.
D)are widely used by sellers of commodities, but rarely used by buyers of commodities.

Question 5

Forward transactions would be useful to

A)a government wanting to know the size of its future debt.
B)a household wanting to reduce its future tax liability.
C)a business wanting to know the cost of its funds on future loans.
D)a business wanting to expand its operations in overseas markets.

Question 6

Speculators are primarily interested in

A)betting on anticipated changes in prices.
B)reducing their exposure to the risk of price fluctuations.
C)increasing market liquidity.
D)reducing the spread between bid and ask prices on bonds.

Question 7

Hedgers are primarily interested in

A)betting on anticipated changes in prices.
B)reducing their exposure to the risk of price fluctuations.
C)increasing market liquidity.
D)reducing the spread between bid and ask prices on bonds.

Question 8

Suppose you are a manager for a company that produces grape jelly. Which of the following is the best way for you to reduce your risk?

A)acquire a derivative that increases in value if grape prices increase
B)acquire a derivative that increases in value if grape jelly prices increase
C)sell a derivative that increases in value if grape prices increase
D)sell a derivative that increases in value if grape jelly prices increase

Question 9

Profits from speculation arise because of

A)the spread between the bid and ask prices on bonds.
B)the illiquidity of markets for derivative instruments.
C)the high information costs in markets for derivative instruments.
D)disagreements among traders about future prices of a commodity or financial instrument.

Question 10

How does hedging affect the flow of funds in the financial system?

A)It reduces it since it is a sign that investors do not like risk.
B)It reduces it because it increases risk by encouraging speculation.
C)It increases it because it reduces risk thus encouraging more people to make financial investments.
D)It increases it by encouraging more speculation.

Question 11

The most important derivative instruments are

A)futures, options, and swaps.
B)common and preferred stocks.
C)corporate bonds.
D)government bonds.

Question 12

Spot transactions

A)involve immediate settlement.
B)may only take place in face-to-face trading.
C)take place on-the-spot, rather than on an organized exchange.
D)are relatively unimportant in financial markets.

Question 13

Forward transactions

A)allow savers and borrowers to conduct a transaction now and settle in the future.
B)allow savers and borrowers to postpone a transaction from now to the future.
C)always involve increased risk compared with spot transactions.
D)may not be conducted on organized exchanges.

Question 14

Which of the following is NOT a result of the ability of investors to hedge?

A)increased access to funds by firms and households
B)investors are more willing to invest
C)increased risk aversion
D)slower economic growth

Question 15

Derivative instruments are

A)assets such as bonds or common stock that derive their value from the value of the companies which issue them.
B)assets whose rates of returns must be derived from information published in financial tables.
C)assets which derive their value from underlying assets.
D)computers which display real-time financial information.

Question 16

Describe two useful purposes served by speculators in derivatives markets.

Question 17

If insurance is available on an activity:

A)more of that activity will occur
B)less of that activity will occur
C)investors will be less likely to hedge
D)it increases the risk of engaging in that activity

Question 18

Using forward transactions allows

A)holders of common stock to lock in future dividend payments.
B)the federal government to stabilize fluctuations in tax receipts.
C)corporations to reduce problems arising from future fluctuations in their dividend payments.
D)both buyers and sellers to reduce risks associated with price fluctuations.

Question 19

Speculators in derivatives markets

A)reduce the efficiency of these markets.
B)are acting contrary to U.S. securities laws.
C)accept risk transferred to them by hedgers.
D)reduce the liquidity of these markets.

Question 20

Forward contracts are often illiquid because

A)any capital gains on them are heavily taxed, making investors reluctant to sell them.
B)government regulation has not provided for a secondary market in them.
C)they generally contain terms specific to the particular buyer and seller.
D)the brokerage fees involved in buying and selling them are very high.

Question 21

The person on the other side of a transaction is referred to as the:

A)derivator
B)counterparty
C)hedger
D)speculator

Question 22

The counterparty of someone buying a futures contract on the Chicago Board of Trade is::

A)Chicago Board of Trade
B)hedger
C)speculator
D)trader

Question 23

The buyer of a futures contract

A)assumes the short position.
B)has the obligation to deliver the underlying financial instrument at the specified date.
C)has the obligation to receive the underlying financial instrument at the specified future date.
D)may, at his or her option, deliver or receive the underlying financial instrument at the specified date.

Question 24

A futures contract is

A)an agreement that specifies the delivery of a commodity or financial instrument at an agreed-upon future date at a currently agreed-upon price.
B)an agreement that specifies the delivery of a commodity or financial instrument at an agreed-upon future date, with the price to be negotiated at the time of delivery.
C)an agreement that specifies the delivery of a commodity or financial instrument at a currently agreed-upon price, with date of delivery to be negotiated subsequently.
D)an agreement that specifies the delivery of a commodity or financial instrument, with the price and date of delivery to be negotiated subsequently.

Question 25

Financial futures contracts are regulated by

A)the Commodity Futures Trading Commission.
B)the Federal Trade Commission.
C)the Interstate Commerce Commission.
D)the Options and Futures Commission.

Question 26

The existence of counterparty risk

A)has no effect on the contracting parties.
B)is disallowed under current government regulations.
C)results in information costs for buyers and sellers when analyzing the potential creditworthiness of potential trading partners.
D)reduces the risk introduced by forward contracts.

Question 27

If you look at the financial page listings for futures contracts and find that futures prices on Treasury bonds are falling over a particular time period, futures market investors must expect that

A)Treasury bond prices will be higher in the future.
B)Treasury bond yields will be higher in the future.
C)Treasury bond yields will be lower in the future.
D)futures prices will rise again at the end of the period.

Question 28

Why are forward contracts typically illiquid?

Question 29

The seller of a futures contract

A)assumes the long position.
B)has the obligation to deliver the underlying financial instrument at the specified date.
C)has the obligation to receive the underlying financial instrument at the specified future date.
D)may, at his or her option, deliver or receive the underlying financial instrument at the specified date.

Question 30

What are the information costs associated with forward contracts?

Question 31

Forward transactions

A)provide substantial liquidity.
B)entail small information costs.
C)provide risk sharing.
D)provide reduced tax payments.

Question 32

Futures trading has traditionally been dominated by

A)the New York Stock Exchange.
B)the Chicago Board of Trade and the New York Mercantile Exchange.
C)the London Stock Exchange.
D)the Omaha Grain Exchange.

Question 33

Which of the following financial futures contracts are traded in the United States?

A)Interest rates
B)Stock indexes
C)Currencies
D)All of the above

Question 34

Standardization of derivative contracts

A)increases their liquidity.
B)is the rule with respect to contracts whose underlying asset is a financial security, but not for contracts whose underlying asset is a commodity.
C)is the rule with respect to contracts whose underlying asset is a commodity, but not for contracts whose underlying asset is a financial asset.
D)has been proposed many times by financial analysts, but has not yet been carried out by the SEC.

Question 35

The buyer of a futures contract

A)assumes the short position.
B)assumes the long position.
C)may not sell the contract without the permission of the original seller.
D)has the obligation to deliver the underlying financial instrument at the specified future date.

Question 36

When talking about forward contracts, the date on which the contracted delivery must take place is called:

A)the settlement date
B)the counterparty date
C)forward date
D)spot date

Question 37

Forward contracts

A)are highly liquid.
B)entail small information costs.
C)provide little risk sharing.
D)are subject to default risk.

Question 38

The seller of a futures contract

A)assumes the short position.
B)assumes the long position.
C)has the obligation to receive the underlying financial instrument at the specified future date.
D)is expecting the price of the underlying financial instrument to rise.

Question 39

In recent decades,

A)trading in financial futures declined in importance relative to trading in agricultural and mineral commodities futures.
B)trading in financial futures increased in importance relative to trading in agricultural and mineral commodities futures.
C)trading in agricultural and commodities futures was discontinued.
D)trading in financial futures was discontinued.

Question 40

Which of the following statements regarding futures is true?

A)trading futures contracts on agricultural and mineral commodities makes up a majority of all trading.
B)trading in financial futures involves more transactions than trading in commodity futures.
C)futures trading is allowed only for financial assets.
D)futures trading is allowed only for commodities.

Question 41

A lender who is worried that its cost of funds might rise during the term of a loan it has made can hedge against this rise by

A)buying futures contracts on Treasury bills.
B)selling futures contracts on Treasury bills.
C)buying call options on Treasury bills.
D)increasing the amount of money which it lends.

Question 42

Which of the following accurately describes possible positions taken by hedgers?

A)may take a short position in the futures market to offset a long position in the spot market
B)may take a short position in the spot market to offset a long position in the futures market
C)may take a long position in the spot market to offset a short position in the futures market
D)may take a long position in the futures market to offset a long position in the spot market

Question 43

All of the following are roles of a exchange EXCEPT

A)instituting margin requirements on futures contracts.
B)marking to market at the end of each day.
C)eliminate the need for buyers and sellers of futures contracts to be concerned about the creditworthiness of each other.
D)reducing the default risk involving forward contracts.

Question 44

Marking to market refers to

A)the determination of the prices of options contracts by the interaction of demand and supply.
B)the determination of the prices of futures contracts by the interaction of demand and supply.
C)the settlement of gains and losses on futures contracts each day.
D)the settlement of gains and losses on forward contracts each day.

Question 45

If the price of a futures contract increases, then

A)the exchange will collect the amount of the increase from the seller of the contract and transfer it to the account of the buyer of the contract.
B)the exchange will collect the amount of the increase from the buyer of the contract and transfer it to the account of the seller of the contract.
C)the exchange will collect the amount of the increase from both the buyer and the seller and place it in escrow until the delivery date.
D)the additional funds will be required from either the buyer or the seller until the delivery date.

Question 46

A speculator who believes strongly that interest rates will fall would be likely to

A)buy futures contracts on Treasury bills.
B)sell futures contracts on Treasury bills.
C)sell Treasury bonds in the spot market.
D)decrease now the amount of money which he lends.

Question 47

As the time of delivery in a futures contract gets closer

A)the futures price gets closer to the spot price.
B)the futures price generally rises further above the spot price.
C)the futures price generally falls further below the spot price.
D)the futures and spot prices remain the same as they were when the contract was first created.

Question 48

The role of the Commodity Futures Trading Commission is to

A)set the prices of futures contracts.
B)operate the Chicago Mercantile Exchange.
C)operate the Chicago Board of Trade.
D)monitor potential price manipulation in futures trading.

Question 49

The terms of futures contracts traded in the United States are

A)standardized as to amount or value, but not as to settlement dates.
B)standardized as to settlement dates, but not as to amount or value.
C)not standardized, but are determined entirely on the basis of the agreement entered into by the buyer and seller.
D)standardized as to amount or value and as to settlement dates.

Question 50

On the day of delivery

A)the spot price will equal the futures price.
B)the spot price will be greater than the futures price by an amount equal to the current interest rate times the futures price.
C)the futures price will be greater than the spot price by an amount equal to the current interest rate times the spot price.
D)there is no necessary relation between the spot price and the futures price.

Question 51

The initial deposit required by a buyer or seller of a futures contract is known as

A)credit.
B)margin requirement.
C)debit.
D)marking.

Question 52

A speculator who believes strongly that interest rates will rise would be likely to

A)buy futures contracts on Treasury bills.
B)sell futures contracts on Treasury bills.
C)buy Treasury bonds in the spot market.
D)increase now the amount of money which he lends.

Question 53

The futures price

A)reflects traders' expectations of the spot price on the day of delivery.
B)is always above the spot price on the day of delivery.
C)is always below the spot price on the day of delivery.
D)is always equal to the spot price at every point in time.

Question 54

Marking to market involves

A)changing the futures price to the spot price each day.
B)engaging in arbitrage so as to reduce the risk involved with futures contracts.
C)crediting or debiting the margin account based on the net change in the value of the futures contract.
D)updating the futures price after the market closes each day.

Question 55

Which of the following best characterizes the profit of a buyer of a futures contract?

A)spot price at settlement minus futures price at purchase
B)futures price at settlement minus spot price at purchase
C)futures price at purchase minus spot price at settlement
D)spot price at purchase minus futures price at settlement

Question 56

If you buy a futures contract for U.S. Treasury bills and on the delivery date the interest rate on T-bills is lower than you expected, you will have

A)lost money on your long position.
B)gained money on your long position.
C)lost money on your short position.
D)gained money on your short position.

Question 57

Futures trading practices in the United States are regulated by

A)the Chicago Board of Trade.
B)the Chicago Mercantile Exchange.
C)the Commodities Futures Trading Commission.
D)the Board of Futures Trading.

Question 58

Which of the following statements about the presence of speculators in futures markets is correct?

A)Their main objective is to reduce their exposure to risk.
B)They aid hedgers by increasing the liquidity in futures markets.
C)They make it difficult for hedgers to find someone to take the opposite side of their positions.
D)Once a futures market participant is known to be a speculator he or she is no longer allowed to participate in the market.

Question 59

If you sell a futures contract for U.S. Treasury bills and on the delivery date the interest rate of T-bills is higher than you expected, you will have

A)lost money on your long position.
B)gained money on your long position.
C)lost money on your short position.
D)gained money on your short position.

Question 60

Which of the following is NOT an advantage of a futures contract over a forward contract?

A)reduced counterparty risk
B)increased flexibility
C)lower information cost
D)increased liquidity

Question 61

The mathematicians and economists who have been hired by Wall Street firms to build mathematical models to aid the pricing of derivatives are generally referred to as

A)speculators.
B)hedgers.
C)rocket scientists.
D)market makers.

Question 62

Why may some investors prefer forward contracts to futures?

Question 63

An order from an exchange for a seller to add enough funds to meet the minimum balance in a margin account is called:

A)maintenance margin
B)margin option
C)margin call
D)margin put

Question 64

In comparing futures contracts with options contracts, we can say that

A)in a futures contract, the buyer and seller have symmetric rights, whereas in an options contract, the buyer and seller have asymmetric rights.
B)in a futures contract, the buyer and seller have asymmetric rights, whereas in an options contract, the buyer and seller have symmetric rights.
C)in both futures and options contracts, the buyer and seller have symmetric rights.
D)in both futures and options contracts, the buyer and seller have asymmetric rights.

Question 65

How do exchanges seek to reduce default risk in the futures market?

Question 66

The fee charged by the seller of an option is referred to as the

A)market price.
B)option premium.
C)futures fee.
D)call price.

Question 67

One difference between futures and options contracts is

A)funds change hands daily in the case of options but not with futures.
B)funds change hands daily in the case of futures, but not with options.
C)in the case of futures funds only change hands when they are exercised.
D)futures are designed to reduce risk while options are not.

Question 68

In a put options contract, the

A)seller has the obligation to receive the instrument at a specified time.
B)buyer has the obligation to deliver the instrument at a specified time.
C)buyer has the obligation to receive the instrument at a specified time.
D)seller has the obligation to deliver the instrument at a specified time.

Question 69

Why do futures have lower information costs and higher liquidity than forward contracts?

Question 70

Explain how each of the following might make use of the futures market.
(a)A lender who is worried that its cost of funds might rise during the term of a loan it has made
(b)A speculator who believes strongly that interest rates will rise

Question 71

The price at which an option may be exercised is called the

A)market price.
B)equilibrium price.
C)strike price.
D)fixed price.

Question 72

In a call options contract, the

A)seller has the obligation to deliver the instrument at a specified time.
B)buyer has the obligation to receive the instrument at a specified time.
C)seller may choose whether or not to deliver the instrument at a specified time.
D)buyer will choose to exercise his option only if the value of the underlying security falls.

Question 73

Southwest Airlines relies on jet fuel to operate its planes. If it chooses to hedge against future changes in fuel prices, what positions (long or short)will it take in the spot and futures markets?

Question 74

How can a bond investor hedge against a possible bear market in bonds?

A)sell futures contracts on Treasury notes
B)buy futures contracts on Treasury notes
C)going long in the spot market
D)going short in the spot market

Question 75

In what ways do futures contracts differ from forward contracts?

Question 76

An options contract

A)confers the rights to buy or sell an underlying asset at a predetermined price by a predetermined time.
B)is another name for a futures contract.
C)may be written for debt instruments, but not equities.
D)may be written for equities, but not for debt instruments.

Question 77

The period over which a call or put option exists is

A)determined by its delivery date.
B)determined by its expiration date.
C)determined by whether the contract is written for a commodity or for a financial instrument.
D)indeterminate; options contracts continue in existence until either the buyer or the seller desires to discontinue it.

Question 78

Why must the spot price equal the futures price on the settlement date?

Question 79

Why do investors hedge using futures contracts?

A)they are seeking to increase liquidity
B)they are willing to pay for a reduction in risk
C)in order to provide a counterparty to speculators
D)they are more flexible than forward contracts

Question 80

In an options contract, another name for the strike price is the

A)market price.
B)exercise price.
C)equilibrium price.
D)fixed price.