Quiz 9: Derivative Securities and Derivative Markets

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.

The improper use of derivatives was blamed in part for all of the following EXCEPT A)the stock market crash following September 11. B)the bankruptcy of Enron. C)the downfall of Long Term Capital Management. D)the bankruptcy of Orange County in California.

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.

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.

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.

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.

Forward transactions originated in the market for A)common stock. B)corporate bonds. C)government bonds. D)agricultural and other commodities.

If a wheat crop turns out to be unusually large, A)farmers will likely gain and millers will likely lose. B)millers will likely gain and farmers will likely lose. C)both farmers and millers will likely lose. D)both farmers and millers will likely gain.

If the orange crop turns out to be unusually small, A)orange growers will likely gain and orange juice sellers will likely lose. B)orange growers will likely lose and orange juice sellers will likely gain. C)both orange growers and orange juice sellers will likely lose. D)both orange growers and orange juice sellers will likely gain.

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.

Fluctuations in the price of the underlying security or commodity during the life of forward transactions A)have no effect on the contracting parties. B)are disallowed under current government regulations. C)confer capital gains and losses on the contracting parties. D)will occur during times of extreme economic instability.

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

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.

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.

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

The most important derivative instruments are A)futures and options contracts. B)common stocks. C)corporate bonds. D)government bonds.

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.

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.

Between 1981 and the early 2000s, 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.

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.

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.

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.

The seller 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.

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.

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

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.

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.

The futures price A)is established each year by act of Congress. B)is established each month by the Chairman of the Chicago Board of Trade. C)is specified in each futures contract. D)is set by supply and demand in the futures market.

The elimination of riskless profit opportunities is known as A)arbitrage. B)options. C)swaps. D)liquidity.

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.

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 debitting 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.

All of the following are roles of a clearinghouse 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

If a futures contract for U.S. Treasury bonds increases by "15" in the financial page listings, the value of the contract increased by A)$15.00. B)$468.75. C)$2133.33. D)$15,000.00.

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.

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.

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.

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.

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.

Which of the following is NOT a way that hedgers can benefit by participating in financial futures markets? A)They can reduce their tax liabilities. B)They can reduce their exposure to price fluctuations. C)They can access liquid markets. D)They can reduce their information costs by using organized exchanges.

Savers and borrowers began to make greater use of derivative markets during the 1980s because of the A)increased volatility of interest rates. B)fall in marginal income tax rates. C)decline in inflation rates. D)decline in unemployment rates.

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.

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.

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.

The futures hedge A)eliminates all risk from price movements. B)is most valuable for protecting against anticipated price changes. C)is most valuable for protecting against unanticipated price changes. D)is most valuable for protecting against price increases.

Basis risk refers to the risk A)associated with anticipated price movements. B)associated with unanticipated price movements. C)of default on the futures contract. D)from a change in the spread between the rate on the hedged instrument and the rate on the instrument actually traded.

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.

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.

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.

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.

The price at which an option may be exercised is called the A)market price. B)equilibrium price. C)strike price. D)fixed price.

In an options contract, another name for the strike price is the A)market price. B)exercise price. C)equilibrium price. D)fixed price.

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.

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.

Options on securities are regulated by the A)CFTC. B)Federal Reserve. C)SEC. D)FBI.

If you look at the financial page listings for options contracts and find that prices on call options on Treasury bonds are rising over a particular time period, options market investors must expect that A)Treasury bond prices will be higher in the future. B)Treasury bond prices will be lower in the future. C)Treasury bond yields will be higher in the future. D)Call option prices will fall again at the end of the period.

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.

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.

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

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.

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.

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.

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.

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.

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.

The choice between futures and options A)depends on whether the underlying instrument is a debt instrument or an equity. B)reflects a trade-off between the higher cost of using options and the extra insurance benefits that options provide. C)reflects a trade-off between the higher cost of using futures and the extra insurance benefits that futures provide. D)reflects a trade-off between the greater risk from using options and the extra insurance benefits that options provide.

An option buyer A)has a greater insurance benefit than the purchaser of a futures contract. B)bears the risk of unfavorable price movements. C)is purchasing a naked option if he or she does not also own the underlying asset. D)generally will incur a lower cost than will the purchaser of a futures contract.

Speculators in futures and options 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.

In a covered option, A)the strike price is always above the exercise price. B)the seller owns the underlying asset. C)the seller does not have an interest in the underlying asset. D)the option premium never deviates from the intrinsic value.

Index arbitrage refers to A)simultaneous trading in stock index futures and the underlying stocks. B)selling futures contracts and buying options contracts on the same stock. C)buying futures contracts and selling options contracts on the same stock. D)selling futures contracts on stocks and buying equivalent futures contracts on bonds.

The big decline in share prices on the New York Stock Exchange that occurred in October 1987 A)was almost entirely attributable to the effects of index arbitrage. B)occurred despite the complete ban on index arbitrage in existence at the time. C)was not mainly the result of index arbitrage. D)was made less severe than it might have been because of the effects of index arbitrage.

Orange County lost a great deal of money during 1994 because A)its treasurer refused to buy any derivatives for the county's financial portfolio. B)short-term interest rates rose when the county's treasurer had expected them to fall. C)short-term interest rates fell when the county's treasurer had expected them to fall. D)a short fall in tax revenue forced the county to default on its bonds.

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.

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.

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.

Futures contracts are traded A)face-to-face by investors. B)on exchanges by commodity brokers. C)over-the-counter by dealers. D)on the floor of the New York Stock Exchange.

A swap is A)another name for a put option. B)another name for a call option. C)an agreement between two or more persons to exchange sets of cash flows over some future period. D)the name for the replacement of a futures contract by an options contract.

One benefit of a swap compared to futures and options is that they A)promote liquidity. B)reduce the risk for both the buyer and seller. C)can be better tailored to meet the needs of market participants. D)can involve financial instruments and not just commodities.

Swaps differ from futures and options in all of the following ways EXCEPT: A)Intended to reduce the risk faced by participants B)More flexibility C)More privacy D)Less regulation

A shortcoming of swaps that has led to the participation of large firms and financial institutions is A)the lack of privacy. B)need to assess creditworthiness. C)desire for more flexibility. D)limited size of the market.

An interest rate swap involving the exchange of floating-rate obligations for fixed-rate obligations is known as A)swaption. B)swap option. C)forward swaps. D)plain vanilla.

An advantage of a swap over futures and options is that A)they can be written for long periods. B)they are more liquid. C)they carry less default risk. D)there is no need to assess the creditworthiness of participants.

A total return swap involves transferring both A)credit and default risk. B)interest rate and credit risk. C)default and exchange rate risk. D)credit and exchange rate risk.

A key reason that firms and financial institutions might participate in an interest rate swap is A)to transfer interest rate risk to parties that are more willing to bear it. B)the low information costs of swaps compared with other derivative contracts. C)the greater liquidity of swaps compared with other derivative contracts. D)the favorable tax implications of swaps compared with other derivative contracts.

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

Compare the rights and obligations of buyers and sellers of futures contracts with the rights of buyers and sellers of options contracts.

Suppose you purchase a call option to buy IBM common stock at $35 per share in September. The current price of IBM is 37 and the option premium is 4. What is the intrinsic value of the option? As the expiration date on the option approaches, what will happen to the size of the option premium?

Suppose that the futures index for the S&P 500 for delivery one year from now is selling for $960,000, whereas the stocks are selling for $900,000. If the one-year Treasury bill rate is 5%, is it possible to use index arbitrage to make a profit?