Deck 7: Derivatives and Derivative Markets

Question 1

Describe two useful purposes served by speculators in derivatives markets.

Answer 1

First,hedgers are able to transfer risk to speculators.In derivatives markets,as in other markets,there must be two parties to a transaction.Second,studies of derivatives markets have shown that speculators provide essential liquidity.

Question 2

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.

Answer 2

C

Question 3

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

Answer 3

A

Question 4

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.

Question 5

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 6

Forward transactions

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

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

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 9

The most important derivative instruments are

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

Question 10

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 11

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 12

Forward transactions originated in the market for

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

Question 13

Which of the following is NOT a benefit of derivatives?

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

Question 14

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 15

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 16

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 17

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 18

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 19

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 20

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 21

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 22

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 23

What are the information costs associated with forward contracts?

Question 24

Why are forward contracts typically illiquid?

Question 25

Forward contracts

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

Question 26

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 27

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 28

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 29

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 30

Currently,

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 31

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 32

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 33

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 34

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 35

The elimination of riskless profit opportunities is known as

A) arbitrage.
B) options.
C) swaps.
D) liquidity.

Question 36

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 37

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 38

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 39

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 40

Futures trading has traditionally been dominated by

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

Question 41

Clearinghouses help to reduce default risk by

A) being the intermediary in trades for buyers and sellers.
B) margin requirements.
C) marking to market.
D) all of the above.

Question 42

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

Question 43

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 44

Why may some investors prefer forward contracts to futures?

Question 45

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 46

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 47

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 48

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 49

If market participants believe that the wheat crop is likely to be unusually small,

A) the spot price of wheat is likely to be above the futures price of wheat.
B) the spot price of wheat is likely to be below the futures price of wheat.
C) it will not be possible to find a seller of a futures contract in wheat.
D) it will not be possible to find a buyer of a futures contract in wheat.

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

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 52

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 53

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 54

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 55

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

Question 56

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 57

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 58

In what ways do futures contracts differ from forward contracts?

Question 59

The terms of futures contracts traded in the United States are

A) standardized as to amount or value, but not as to location or time of delivery.
B) standardized as to location or time of delivery, 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 location or time of delivery.

Question 60

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 61

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 without eliminating the chance to profit from a decline in the cost of funds by

A) buying futures contracts on Treasury bills.
B) selling futures contracts on Treasury bills.
C) buying put options on Treasury bills.
D) buying call options on Treasury bills.

Question 62

Which of the following factors would tend to increase the size of the premium on an options contract?

A) The option is near its expiration date.
B) The current default-risk-free interest rate is high.
C) The price volatility of the underlying asset is low.
D) The option is far away from its expiration date.

Question 63

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 64

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 65

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 66

As an option nears its expiration date,the size of the premium approaches

A) zero.
B) infinity.
C) its intrinsic value.
D) an amount which varies, depending on prevailing market interest rates on the expiration date.

Question 67

A call option is said to be in the money" if

A) it is written on a Treasury bill or other money-market asset.
B) it has increased in price since it was first written.
C) the price of the underlying asset is currently greater than the strike price.
D) the price of the underlying asset is currently greater than the strike price plus the option premium.

Question 68

The intrinsic value of an option

A) is equal to the option premium.
B) is the amount the option actually is worth if it is immediately exercised.
C) is the amount the option is expected to be worth on its expiration date.
D) is impossible to determine in the absence of information on the future prices of the underlying asset.

Question 69

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 70

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

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

Question 71

Suppose that Acme Widget is currently selling for $100 per share and you own a call option to buy Acme Widget at $75 per share.The intrinsic value of your option is

A) $25.
B) $75.
C) $100.
D) not possible to determine in the absence of information on values of the share price of Acme Widget between now and the expiration date of the call.

Question 72

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 73

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 74

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 75

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 76

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 77

A put option is said to be "in the money" if

A) it is written on a Treasury bill or other money-market asset.
B) it has increased in price since it was first written.
C) the price of the underlying asset is currently less than the strike price.
D) the price of the underlying asset is currently less than the strike price plus the option premium.

Question 78

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 79

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

Question 80

A stock option is said to be "out of the money" if:

A) the strike price equals the exercise price.
B) stock price equals the strike price.
C) strike price exceeds the stock price.
D) stock price exceeds the strike price.