Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 26: Exotic Options

Multiple Choice Test Bank: Questions with Answers

1. An Asian option is a term used to describe which of the following

A. An option where the payoff depends on whether a barrier is hit
B. An option where the payoff depends on the average value of a variable over a period of
time
C. An option that trades on an exchange in the Far East
D. Any option with a nonstandard payoff

Answer: B

An Asian option is an option whose payoff is calculated from the average value of a variable
over a period of time

2. As the barrier is observed more frequently, which of the following is true of a knock-out option
A. It becomes more valuable
B. It becomes less valuable
C. There is no effect on value
D. It may become more valuable or less valuable

Answer: B

As the barrier is observed more frequently it is more likely to be hit. A knock-out option
therefore becomes less valuable

3. There are two types of regular options (calls and puts). How many types of compound options
are there?
A. Two
B. Four
C. Six
D. Eight

Answer: B

There are four: call on call, call on put, put on call, and put on put

4. There are two types of regular options (calls and puts). How many types of barrier options are
there?
A. Two
B. Four
C. Six
D. Eight

Answer: D
 There are eight: up and in call, up and in put, down and in call, down and in put, up and out call,
up and out put, down and out call, and down and out put.

5. In a shout call option the strike price is $30. The holder shouts when the asset price is $40. What
is the payoff from the option if the final asset price is $35?
A. $0
B. $5
C. $10
D. $15

Answer: C

The holder gets the intrinsic value at the time of the shout or the usual final payoff
whichever is greater. In this case the holder gets 40−30 = $10

6. A floating lookback call option pays off which of the following

A. The amount by which the final stock price exceeds the minimum stock price
B. The amount by which the maximum stock price exceeds the final stock price
C. The amount by which the strike price exceeds the minimum stock price
D. The amount by which the maximum stock price exceeds the strike price

Answer: B

A floating lookback call pays off the amount by which the maximum stock price exceeds the
final stock price

7. A fixed lookback put option pays off which of the following

A. The amount by which the final stock price exceeds the minimum stock price
B. The amount by which the maximum stock price exceeds the final stock price
C. The amount by which the strike price exceeds the minimum stock price
D. The amount by which the maximum stock price exceeds the strike price

Answer: C

A fixed lookback put pays off the amount by which the strike price exceeds the minimum
stock price, if this is positive

8. Which of the following is equivalent to a long position in a European call option?

A. A short position in a cash-or-nothing put option plus a long position in an asset-or-
nothing put option
B. A long position in an asset-or-nothing put option plus a long position in a cash-or-
nothing put option
C. A long position in an asset-or-nothing call option plus a long position in a cash-or-
nothing call option
D. A long position in an asset-or-nothing call option plus a short position in a cash-or-
nothing call option
 Answer: D

A long position in a European call is equivalent to a long position in an asset-or-nothing call

option (this is worth S0N(d1)) and a short position in a cash-or-nothing call option (this is
worth –Ke-rTN(d2))

9. Which of the following is equivalent to a short position in a European put option?

A. A short position in a cash-or-nothing put option plus a long position in an asset-or-
nothing put option
B. A long position in an asset-or-nothing put option plus a long position in a cash-or-
nothing put option
C. A long position in an asset-or-nothing call option plus a long position in a cash-or-
nothing call option
D. A long position in an asset-or-nothing call option plus a short position in a cash-or-
nothing call option

Answer: A

A short position in a European put is equivalent to a short cash-or-nothing put option

(−KN(−d2)e-rT) and a long position in an asset-or-nothing put (S 0N(−d1))

10. Which of the following describes a cliquet option

A. An option to exchange one asset for another
B. An instrument when the holder can choose between several alternative options
C. An option on an option with predetermined strike prices for the two options
D. A series of options with rules for determining strike prices

Answer: D

A cliquet option is a series of options where there are rules for determining strike prices. For
example, there could be a series of one-year options where the strike price for each option is
the asset price at the beginning of its life.

11. An employer has promised that it will grant employees three year options in one year’s time and
that the options will be at the money at the time they are granted. What describes these
options?
A. Chooser options
B. Forward start options
C. Compound options
D. Shout options

Answer: B
 These are referred to as forward start options because they are options that are certain to
start at a particular future time.

12. When can Bermudan options be exercised?

A. Any time during the life of the options
B. Any time after a certain date up to the end of the life of the life
C. Any time before a certain date or at the end of the option’s life
D. On dates specified at the start of the option

Answer: D

Bermudan options can be exercised on specified dates but not all dates. (Bermuda is
between Europe and America!)

13. Which of the following is the payoff from an average strike call option?
A. The excess of the strike price over the average stock price, if positive
B. The excess of the final stock price over the average stock price, if positive
C. The excess of the average stock price over the strike price, if positive
D. The excess of the average stock price over the final stock price, if positive

Answer: B

An average strike call pays off the excess of the final stock price over the average stock price
if this is positive

14. Which of the following is the payoff from an average strike put option?
A. The excess of the strike price over the average stock price, if positive
B. The excess of the final stock price over the average stock price, if positive
C. The excess of the average stock price over the strike price, if positive
D. The excess of the average stock price over the final stock price, if positive

Answer: D

An average strike put pays off the excess of the average stock price over the final stock price
if this is positive

15. A binary option pays off $100 if a non-dividend-paying stock price is greater than its current
value in three months. The risk-free rate is 3% and the volatility is 40%. Which of the following is
its value?
A. 99.25N(-0.1375)
B. 99.25N(0.1375)
C. 99.25N(-0.0625)
D. 99.25N(0.0625)

Answer: C
 The binary call option is worth 100N(d2)e-0.03×0.25. In this case S0 = K so than ln(S0/K) = 1 and
(0.03  0.4 2 / 2)  0.25
d2   0.0625
0.4  0.25

16. A volatility swap is

A. An instrument that swaps the change in the value of a market variable for a fixed
amount
B. A swap involving an asset whose volatility is greater than a certain level
C. An exchange of the implied volatility of an option at a future time for a fixed volatility
D. An exchange of the realized volatility of an asset for a fixed volatility

Answer: D

A volatility swap is an exchange of the realized volatility of an asset over a period of time for
a prespecified fixed volatility with both being multiplied by a notional principal.

17. Which of the following is true of a gap option

A. The strike price determining whether a payoff is made is not the same as the strike price
determining the size of the payoff
B. There is a straightforward valuation formula similar to Black-Scholes-Merton
C. It describes an option where there is a cost to exercising
D. All of the above

Answer: D

All of A, B, and C are true. A gap call option provides a payoff of S T – K1 when ST>K2. A gap
put option provides a payoff of K1-ST when ST<K2

18. Which of the following is true

A. A variance swap is worth the square of a volatility swap
B. The payments on a variance swap are the square of the payments on a volatility swap
C. Variance swaps can be valued in terms of European call and put options.
D. None of the above

Answer: C

Variance swaps can be valued in terms of European put and call options

19. Static options replication for a portfolio of American options on a stock involves
A. Finding a hedge portfolio to match daily changes
B. Finding a hedge portfolio to match values on a boundary that is certain to be reached
C. Finding a hedge portfolio to match values at one particular time
D. Constructing a hedge taking both gamma and delta into account

Answer: B
 Static option replication involves finding a hedge portfolio that matches values on some
boundary in {S,t} space that is certain to be crossed eventually. Once the boundary is
reached the hedge must be unwound and a new hedge created.

20. Exotic options

A. Can always be hedged just as easily as regular options
B. Are easier to hedge than regular options
C. Are more difficult to hedge than regular options
D. Are sometimes easier and sometimes more difficult to hedge than regular options.

Answer: D

Average price options are usually easier to hedge than regular options because as time
passes there is progressively less uncertainty about what the final average will be. Barrier
options are more difficult to hedge because of discontinuities.