Question 1: Derivative Definitions (40 Total marks, 1 mark for each)
Enter your answers on the scantron bubble sheet. If more than one answer is given for any item, that item will
not be marked. Incorrect answers will be zero. Explanations provided beside the answers will not be read.
True or False?
1. There are many exchanges throughout the world trading forward contracts.
2. There are two basic types of options: forwards and futures.
3. Arbitrageurs always enter into two or more transactions simultaneously.
4. Arbitrage opportunities last for a long time.
5. When an option on Google stock is exercised, Google issues more stock.
6. A call option will always be exercised at expiration if the underlying price is greater than the strike price
7. A put option will always be exercised at expiration if the strike price is greater than the underlying price
8. Interest rate swaps involve a single cashflow
9. The value of a call generally increases when the underlying price decreases. Assume all else stays constant.
10.A futures price can be contrasted with the spot price. The spot price is for immediate, or almost immediate,
delivery. The futures price is the price for delivery at some time in the future. The two are usually equal.
11.The Chicago Mercantile Exchange has introduced futures contracts on weather.
12.All trading of forwards is done on exchanges.
13.Financial institutions often act as market makes for the more commonly trading instruments. This means that they
are always prepared to quote both a bid price and an offer price.
14.Options are only traded on exchanges.
15.A call option gives the buyer the right to buy an asset by a certain date for a certain price.
16.A put option gives the seller the right to sell an asset by a certain date for a certain price.
17.An option buyer must pay an up-front price, known as the premium, to exercise an option.
18.The price of a call option increases as the strike price increases.
19.The price of a put option increases as the strike price increases.
20.Three broad categories of trader can be identified: hedgers, speculators, and arbitrageurs.
21.Unlike futures, forwards require the payment of an up-front fee.
22.Arbitrage involves locking in a risky profit by simultaneously entering into transactions in two or more markets.
23.There are three types of options: call, puts, and swaps.
24.As the delivery period for a futures contract is approached, the futures price converges to the spot price of the
25.Credit risk has traditionally been a feature of the over-the-counter markets. There is always a chance that the party
on the other side of an over-the-counter trade will default.
26.A short hedge could be used by a farmer who owns some hogs and knows that they will e ready for sale at the
local market in two months.
27.LIBOR is short for London Interbank Opening Rate.
28.Large banks and other financial institutions quote LIBOR for maturities up to 12 months in all major currencies.
29.A repo is a contract where an investment dealer who owns securities agrees to sell them to another company now
and buy them back later.
30.The relationship between futures prices and spot prices can be summarized in terms of the cost of carry. This
measures the storage cost minus the interest that is paid to finance the asset less the income earned on the asset.
31.Contracts such as swaps that are private agreements between two companies entail no credit risk.
32.An option gives the holder the right to do something. The holder does not have to exercise this right.
33.Whereas the purchaser of a call option is hoping that the stock price will decrease, the purchaser of a put option is
hoping that it will increase.
34.For an investor who has written a call, if the option is exercised, the investor is required to sell stock at the strike
35.For an investor who has written a put, if the option is exercised, the investor is required to sell stock at the strike
36.Many companies are in the position where their performance is liable to be adversely affected by the weather.
These companies can now consider hedging their weather risks using weather derivatives.
37.When there are risks to be managed, derivative markets are slow and have historically lacked innovation when
38.Since the mid-1980s there have been very few losses in the derivatives markets.
39.It is less important that companies monitor risks carefully when derivatives are used.
40.When derivatives are used for hedging, they have only a few of the same characteristics as insurance contracts.
1 Forwards and Futures (10 total marks, 1 mark each)
Specify whether each of the below is a characteristic of a:
a) forward b) future c) neither d) both
41. An agreement to buy or sell an asset at a certain time in the future for a certain price
42. Private contract between 2 parties
43. Non-standard contract
44. Exchange traded
45. Range of delivery dates
46. Usually 1 specified delivery date
47. Delivery or final cash settlement usually occurs
48. Contract usually closed out prior to maturity
49. Settled at the beginning of the contract
50. Settled daily
Multiple Choice (30 Total marks, 2 marks for each answer)
51. If there is no arbitrage opportunity, (rounded to the nearest dollar) what is price of a 6-month
future contract on the TSX stock index which has a current value of the index 13,500, the
continuous compounded riskfree interest rate is 3.5%, and the stocks in the TSX index provide
a dividend yield of 1.0%?
52. A short forward contract on a non-dividend paying stock was entered into some time ago at a
delivery price of $24. It currently has six months to maturity. The risk-free interest rate is 5%
and the current stock price is $25. Find the current value of the forward contract.
a) – $1.63
b) – $1.59
53. On May 1, an investor takes a short position in ten December gold Futures contracts on the
New York Commodity Exchange (COMEX). The current Futures price is $1,600, the contract
size is 100 ounces, the initial margin is $2,000 per contract, and the maintenance margin is
$1,500. If by the end of May 1 the Futures price has dropped to $1,598:
a) the margin balance increases by $200.
b) the margin balance increases by $2000.
c) the margin balance decreases by $2000.
d) the investor receives a margin call.
e) the broker automatically closes out the position.
54. Which option, given only the difference below, assuming all else is the same, has the lower
a) 40 Call or
b) 50 Call
2 55. Consider a 1-year Futures contract to buy one corporate bond. The current spot price of the
bond is $920.00, the continuous interest rate for 1-year is 10%. One coupon payment of
$10.00 will be paid in 9-months. If the Futures price of the bond in the market is $1003, an
arbitrage profit can be generated by:
a) shorting the Futures contract and short selling one Bond.
b) shorting the Futures contract and buying one Bond.
c) taking a long position in the Futures contract 9-months from today.
d) taking a long position in the Futures contract and buying one Bond.
e) taking a long position in the Futures contract and short selling one Bond.
56. An investor has an asset that is currently worth $500, and the continuously compounded rate at
all risk-free maturities is 3 percent. If the asset pays a continuous dividend of 3 percent, which
of the following is the closest to the no arbitrage price of the 3-month forward contract?
57. The three month interest rates in New Zealand and Canada are 6% and 4% per annum
respectively, with continuous compounding. The spot price of one New Zealand Dollar is
Canadian Dollars 0.80. (i.e. 1 NZD = 0.80 CAD). What is the theoretical value of the 3 month
58. Which option, given only the difference below, assuming all else is the same, has the lower
a) 100 Put or
b) 80 Put
59. In the Chicago Board of Trade’s corn futures contract, the following delivery months are
available: March, May, July, September, and December. State the contract that should be used
for hedging when the expiration of the hedge is in June: