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Practice questions

1. An advantage of a forward contract over a futures contract is that


a. The terms of the contract are flexible
b. It is more liquid
c. It trades through a centralized market exchange
d. It is easier to unwind due to contract homogeneity
e. None of the above

2. A forward contract is similar to an option contract because they both


a. Can provide insurance against the price of the underlying stock
b. Are paid for up front in the form of premiums
c. Are paid for at the end of the contract in the form of premiums
d. Require a future settlement payment
e. None of the above

3. An expiration date payoff and profit diagram for forward positions illustrates
a. Gains and losses are usually small
b. The payoffs to both long and short positions in the forward contract are asymmetrical around the
contract price
c. Forward contracts are zero-sum games
d. Long positions benefit from falling prices
e. None of the above

4. A one year call option has a strike price of 50, expires in 6 months, and has a price of $5.04. If the risk free rate is
5%, and the current stock price is $50, what should the corresponding put be worth?
a. $3.04
b. $4.64
c. $6.08
d. $3.83
e. $0
5. A one year call option has a strike price of 50, expires in 6 months, and has a price of $4.74. If the risk free rate is
3%, and the current stock price is $45, what should the corresponding put be worth?
a. $12.74
b. $10.48
c. $5.00
d. $9.00
e. $8.30

6. A one year call option has a strike price of 60, expires in 6 months, and has a price of $2.5. If the risk free rate is 7%,
and the current stock price is $55, what should the corresponding put be worth?
a. $5.00
b. $4.56
c. $5.50
d. $7.08
e. $7.54

7. A one year call option has a strike price of 70, expires in 3 months, and has a price of $7.34. If the risk free rate is
6%, and the current stock price is $62, what should the corresponding put be worth?
a. $5.34
b. $8.00
c. $10.68
d. $14.33
e. $13.33
Exhibit 1

December futures on the S&P 500 stock index trade at 250 times the index value of 1187.70. Your broker requires an
initial margin of 10% percent on futures contracts. The current value of the S&P 500 stock index is 1178.

8. Refer to Exhibit 1. How much must you deposit in a margin account if you wish to purchase one contract?
a. $267,232.5
b. $29,450
c. $29,692.50
d. $30,000
e. $265,050

9. Refer to Exhibit 1. Suppose at expiration the futures contract price is 250 times the index value of 1170. Disregarding
transaction costs, what is your percentage return?
a. 1.87%
b. 0.68%
c. 14.90%
d. 10.36%
e. None of the above

10. Refer to Exhibit 1. Calculate the return on a cash investment in the S&P 500 stock index if the ending index value is
1170 over the same time period.
a. 1.87%
b. 0.68%
c. 14.90%
d. 10.36%
e. None of the above

Exhibit 2

Assume you are the Treasurer for the Johnson Pharmaceutical Company and in late July 2004, the company is
considering the sale of $500 million in 20-year debentures that will most likely be rated the same as the firm's other
debt issues. The firm would like to proceed at the current rate of 8.5%, but you know that it will probably take until
November to bring the issue to market. Therefore, you suggest that the firm hedge the pending issue using Treasury
bond futures contracts which each represent $100,000.

Case 1 Case 2
Current Value July 2004
Bond Rate 8.5% 8.5%
Dec. 2004 Treasury Bonds 87.75 87.75
Estimated Values Nov. 2004
Bond Rate 9.5% 7.5%
Dec. 2004 Treasury Bonds 85.60 91.65

11. Refer to Exhibit 2. How you would go about hedging the bond issue?
a. Buy 5,000 contracts
b. Buy 50,000 contracts
c. Sell 5,000,000 contracts
d. Sell 5,000 contracts
e. None of the above
12. Refer to Exhibit 2. What is the dollar gain or loss assuming that future conditions described in Case 1 actually
occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.)
a. $47,316,683.00 gain
b. $36,566,683.00 loss
c. $10,750,000.00 gain
d. $10,750,000.00 loss
e. None of the above
13. Refer to Exhibit 2. What is the dollar gain or loss assuming that future conditions described in Case 2 actually
occur? (Ignore commissions and margin costs, and assume a naive hedge ratio.)
a. $19,500,000.00 gain
b. $27,816,683.04 gain
c. $27,816,683.04 loss
d. $19,500,000.00 loss
e. None of the above

Exhibit 3

As a relationship officer for a money-center commercial bank, one of your corporate accounts has just approached you
about a one-year loan for $3,000,000. The customer would pay a quarterly interest expense based on the prevailing level
of LIBOR at the beginning of each quarter. As is the bank's convention on all such loans, the amount of the interest
payment would then be paid at the end of the quarterly cycle when the new rate for the next cycle is determined. You
observe the following LIBOR yield curve in the cash market:

90-day LIBOR 4.70%


180-day LIBOR 4.85%
270-day LIBOR 5.10%
360-day LIBOR 5.40%

14. Refer to Exhibit 3. If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar
level of the bank's interest receipt be at the end of the first quarter?
a. $35,250.00
b. $36,375.00
c. $38,250.00
d. $40,500.00
e. None of the above

15. Refer to Exhibit 3. What is the implied 90-day forward rate at the beginning of the second quarter?
a. 4.70%
b. 4.85%
c. 4.60%
d. 4.94%
e. None of the above

16. A bond portfolio manager expects a cash outflow of $35,000,000. The manager plans to hedge potential risk with a
Treasury futures contract with a value of $105,215. The conversion factor between the CTD and the bond specified in
the Treasury futures contract is 0.85. The duration of bond portfolio is 8 years, and the duration of the CTD bond is 6.5
years. Indicate the number of contracts required and whether the position to be taken is short or long.
a. 333 contracts short
b. 333 contracts long
c. 348 contract short
d. 348 contracts long
e. None of the above

17. Assume that you observe the following prices in the T-Bill and Eurodollar futures markets
T-Bill Eurodollar
September 95.24 94.6

If you expected the TED spread to narrow over the next month then an appropriate strategy would be to
a. Go long T-Bill futures and long Eurodollar futures.
b. Go short T-Bill futures and short Eurodollar futures.
c. Go long T-Bill futures and short Eurodollar futures.
d. Go short T-Bill futures and long Eurodollar futures.
e. None of the above.

Exhibit 4

Consider the following information on put and call options for Citigroup

Strike Price Put Price Call Price


$32.50 $2.85 $1.65

18. Refer to Exhibit 4. Calculate the net value of a protective put position at a stock price at expiration of $20, and a
stock price at expiration of $45.
a. $6.35, $18.85
b. $29.65, $42.15
c. $21.65, $34.15
d. $8, $8
e. $8, $8

19. Refer to Exhibit 4. A protective put is an appropriate strategy if


a. An investor wishes to generate additional income.
b. An investor wished to insure against a decline in share values.
c. An investor expected share prices to be volatile.
d. An investor expected share prices to remain in a trading range.
e. An investor expected share prices to be volatile, but was inclined to be bullish.

20. Refer to Exhibit 4. Calculate the net value of a covered call position at a stock price at expiration of $20, and a stock
price at expiration of $45.
a. $6.35, $18.85
b. $29.65, $42.15
c. $21.65, $34.15
d. $8, $8
e. $8, $8

21. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson Walker put
option with an exercise price of $105.00 for $20.00. What is his dollar gain if at expiration the stock is selling for
$80.00 per share?
a. $200 loss
b. $700 loss
c. $200 gain
d. $700 gain
e. None of the above

22. Tom Gettback buys 100 shares of Johnson Walker stock for $87.00 per share and a 3-month Johnson Walker put
option with an exercise price of $105.00 for $20.00. What is Tom's dollar gain/loss if at expiration the stock is selling
for $105.00 per share?
a. $1000 gain
b. $200 loss
c. $1000 loss
d. $200 gain
e. None of the above
23. In late January 2011, Starlight Corporation is considering the sale of $50 million in 10-year debentures rated AAA.
The issue will most likely be registered and sold some time in April. Therefore, Starlight Corporation desires to hedge
the pending issue using Treasury bond futures contracts each representing $100,000. Explain how you would go about
hedging the bond issue?
a. Sell 500 contracts
b. Buy 500 contracts
c. Sell 50 contracts
d. Buy 50 contracts
e. None of the above
Exhibit 5

The following information is provided in the context of a two period (two six month periods) binomial option pricing
model. A stock currently trades at $60 per share, a call option on the stock has an exercise price of $65. The stock is
equally likely to rise by 15% or fall by 15% during each six month period. The one-year risk free rate is 3%.

24. Refer to Exhibit 5. Calculate the possible prices of the stock at the end of one year.
a. $69, $51, $79.35
b. $51, $79.35, $58.65
c. $79.35, $58.65, $43.35
d. $58.65, $43.35, $14.35
e. None of the above

25. Refer to Exhibit 5. Calculate the price of the call option after the stock price has already moved up in value (C u).
a. $7.77
b. $14.35
c. $0
d. $4.21
e. $6.44

26. Refer to Exhibit 5. Calculate the price of the call option after the stock price has already moved down in value once
(Cd).
a. $7.77
b. $14.35
c. $0
d. $4.21
e. $6.44

27. Refer to Exhibit 5. Calculate the price of the call option today (C0).
a. $7.77
b. $14.35
c. $0
d. $4.21
e. $6.44
Exhibit 6

Black Gold Industries (BGI) is an independent oil producer with production capacity of 500,000 barrels per month. Due
to the cost structure of the business, BGI needs to receive $56.50 per barrel in order to remain solvent. On the other side
of this situation is Petrochemicals Unlimited (PU) which uses an average of 500,000 barrels of West Texas crude oil in
its normal production operations. The nature of PU's business is such that they will financially suffer if they have to pay
more than an average of $57.80 per barrel for oil over the next six years. To hedge against their exposure to volatile oil
prices, BI and PU contact a swap dealer to arrange the six-year oil swap described below:

Settlement is made monthly.


The notional principal is for 500,000 barrels per month.
The monthly WTI index value is determined as the average of the daily settlement prices for the
crude oil futures contract traded on the New York Mercantile Exchange (NYMEX).
The swap dealer pays BGI $57.00 per barrel.
BGI pays the swap dealer the average NYMEX Oil futures price per barrel.
PU pays the swap dealer $57.50 per barrel.
The swap dealer pays PU dealer the average NYMEX Oil futures price per barrel.

28. Refer to Exhibit 6. Describe the transaction that occurs between BGI and the swap dealer if the monthly average oil
futures settlement price is $58.45.
a. BGI pays the swap dealer $725,000.
b. The swap dealer pays BGI $725,000.
c. BGI pays the swap dealer $675,000.
d. The swap dealer pays BGI $675,000.
e. None of the above.

29. Refer to Exhibit 6. Describe the transaction that occurs between PU and the swap dealer if the monthly average oil
futures settlement price is $58.45.
a. PU pays the swap dealer $725,000.
b. The swap dealer pays PU $725,000.
c. PU pays the swap dealer $475,000.
d. The swap dealer pays PU $475,000.
e. None of the above.

30. Refer to Exhibit 6. Describe the transaction that occurs between BGI and the swap dealer if the monthly average oil
futures settlement price is $55.50.
a. BGI pays the swap dealer $750,000.
b. The swap dealer pays BGI $800,000.
c. BGI pays the swap dealer $800,000.
d. The swap dealer pays BGI $750,000.
e. None of the above.
Question 1

Consider a European put option on an index. The index level is 1,000, the strike price is 1050, the time to
maturity is six months, the risk-free rate is 4% per annum, and the dividend yield on the index is 2% per
annum. What is a lower bound to the option price? (Give two decimal places.)

Question 2

Consider a European call option on a currency. The exchange rate is 1.0000, the strike price is 0.9100, the time
to maturity is one year, the domestic risk-free rate is 5% per annum, and the foreign risk-free rate is 3% per
annum. What is a lower bound to the option price? (Give four decimal places.)

Question 3

The gain from a one-year project is uniformly distributed between $2 million and +$8 million.

Required:
i. What is the one-year 99% value at risk?

ii. What is the one-year 99% expected shortfall?

Question 4

Stock A has a daily volatility of 2% and stock B has a daily volatility of 8%. The correlation between the two
stock price returns is 0.5.

Required:
i. What is the standard deviation of the return from stock A over 10 days?

ii. What is the standard deviation of the return from stock B over 10 days?

iii. What is the standard deviation (to the nearest $000) of the 10-day change in the value of a portfolio
consisting of a $100,000 investment in stock A and a $100,000 investment in stock B?

Question 5

Consider the following information for four portfolios, the market and the risk free rate (RFR):

Portfolio Return Beta SD


A1 0.15 1.25 0.182
A2 0.1 0.9 0.223
A3 0.12 1.1 0.138
A4 0.08 0.8 0.125
Market 0.11 1 0.2
RFR 0.03 0 0
Calculate the Jensen Measure for each portfolio.

Question 6

Consider a six month American put option on index futures where the current futures price is 450, the exercise
price is 450, the risk-free rate of interest is 7 percent per annum, the continuous dividend yield of the index is 3
percent, and the volatility of the index is 30 percent per annum. The futures contract underlying the option
matures in seven months. Using a three-step binomial tree, calculate
i. the price of the American put option now ,
ii. the delta of the option with respect to the futures price ,
iii. the delta of the option with respect to the index level, and
iv. the price of the corresponding European put option on index futures .