Chapter 9 Derivatives: Futures, Options, and Swaps: Multiple Choice Questions

Chapter 9 Derivatives: Futures, Options, and Swaps
Multiple Choice Questions
1. Derivatives are financial instruments that:

A) Present high levels of risk and should only be used by the wealthy.
B) When used correctly can actually lower risk.
C) Should only be used by people seeking high returns from high risk.
D) a and c
Answer: B LOD: 1 Page: 202

A-Head: The Basics: Defining Derivatives.
2. The value of a derivative is determined by:

A) The Federal Reserve
B) SEC regulation.
C) The value of the underlying asset.
D) The risk-free rate.
Answer: C LOD: 1 Page: 202

3. In a derivative transaction:
A) The dollar amount of the transaction increases as the contract date approaches.
B) The risk is less than if actually purchasing the underlying asset.
C) What one-party gains the counterparty loses.
D) All of the above.

4. The purpose of derivatives is to:

A) Increase the risk so the return is larger.
B) Eliminate risk for both parties in the transaction.
C) Postpone the risk for both parties in the transaction.
D) Transfer the risk from one person to another.
Answer: D LOD: 1 Page: 203

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5. Forward contracts are:

A) An agreement between two parties.
B) Contracts usually involving the exchange of a commodity or financial
instrument.
C) Highly customized.
E) a and b
Answer: E LOD: 2 Page: 203

A-Head: Forwards and Futures.
6. The short position in a futures contract is the party that will:

A) Deliver a commodity or financial instrument to the buyer at a future date.
B) Suffer the loss.
C) Accept the risk.
D) Benefit from increases in price of the underlying asset.
Answer: A LOD: 1 Page: 204

7. The long position is a futures contract is the party that will:

A) Benefit from decreases in the price of the underlying asset.
B) Agree to accept delivery of a commodity or financial instrument at a future date.
C) Benefit from increases in the price of the underlying asset.
D) None of the above
E) b and c

8. With a futures contract:

A) Payment is made when the contract is created.
B) No payment is made until the settlement date.
C) The short position agrees to purchase the underlying asset.
D) The risk is eliminated for both parties.
E) b and c

2 Cecchetti: Money, Banking, and Financial Markets

9. The key difference between a forward and a futures contract is:

A) A forward contract is highly customized where a futures contract is not.
B) A forward contract is bought and sold on organized exchanges.
C) Only the forward contracts have settlement dates.

10. The clearing corporation's main role in the futures market is to:
A) Set the market price of the contract.
B) Act as the counterparty to both sides of the transaction guaranteeing payment.
C) Provide the underlying assets so the contracts can be created.

11. The process of marking to market:

A) Is done by the clearing corporation to reduce risk in futures contracts.
B) Involves the margin accounts of buyers and sellers of future contracts.
C) Usually requires margin accounts to be adjusted daily by the clearing
corporation.

12. Marking to market is a process that:

A) Involves a transfer of risk.
B) Ensures that the buyers and sellers receive what the contract promises.
C) Always requires the sellers of contracts to transfer funds to the buyers of
contracts.
D) Buyers and sellers can request for an additional fee when the contract is created.


13. There is a futures contract for the purchase of 100 bushes of wheat at $2.50 per
bushel. If the market price of wheat increases to $3.00 per bushel:
A) The buyer (long position) needs to transfer $50 to the seller (short position).
B) Nothing happens since with a futures contract all payments are made at the
settlement date.
C) Nothing happens since marked to market adjustments only take place when the
market price falls below the contract price.
D) None of the above.

14. There is a futures contract for the purchase of 1000 bushels of corn at $3.00 per
bushel. If the market price of corn falls to $2.50:
A) The buyer (long position) needs to transfer $500 to the seller (short position).
B) Nothing happens since marked to market adjustments only occur if the market
price rises above the contract price.
C) Nothing happened since no funds are transferred until the settlement date.

15. A U.S. Treasury bond dealer who sells a futures contract for U.S. Treasury bonds is:
A) Taking on additional risk in hopes of getting a larger return.
B) Ensuring the sales price of the bond through hedging.
C) Not likely to find a counterparty to this transaction.
D) Should see the value of the futures contract increase as bond prices rise.

16. A pension fund manager who plans on purchasing bonds in the future:
A) Wants to insure against the price of bonds falling.
B) Can offset the risk of bond prices rising by selling a futures contract.
C) Will take the long position in a futures contract.
D) Will take the short position in a futures contract.


17. A baker of bread who has a long term fixed price contract to supply bread can reduce
her risk by:
A) Taking the long position in wheat futures contract.
B) Hedging this risk in the wheat futures market.
C) Finding a wheat farmer who will take the short position in a wheat futures
contract.

18. A wheat farmer who must purchase his inputs now but will sell his wheat at a market
price at a future date:
A) Faces a market risk that cannot be offset.
B) Is a good example of what the chapter refers to as a speculator.
C) Would hedge by taking the short position in a wheat futures contract.
D) Would hedge by taking the long position in a wheat futures contract.

19. Users of commodities are:

A) Usually not participants in futures contracts.
B) Speculators preferring to get the large returns which result from large risk.
C) The short position in a futures contract.

20. Speculators differ from hedgers in the sense that:

A) Speculators do not like risk.
B) Hedgers seek to transfer risk.
C) Speculators seek to profit from risk.
D) Speculators are hedgers, there isn't any difference.
E) b and c


21. One argument why farmers in poor countries remain poor is:
A) They know very little about farming techniques needed for the crop they are
growing.
B) They are poor assessors of the risks they face.
C) Risk taking is a deterrent to growth.
D) Poor farmers in many countries lack access to commodity futures markets.
E) c and d

22. Futures markets and derivatives contribute to economic growth by:

A) Decreasing speculation.
B) Increase risk taking capacity of the economy.
C) Deterring the transfer of risk.
D) Forcing people to accept the risk their decisions create.

23. On the settlement date of a futures contract:

A) The future's price is always above the price of the underlying asset.
B) The future's price is always below the price of the underlying asset.
C) The future's price is equal to the price of the underlying asset.
D) The future's price may be above or below the price of the underlying asset but not
equal to it.

24. As the time of settlement gets closer:

A) The price of the future's contract will diverge from the price of the underlying
asset.
B) The price of the future's contract will always be above the price of the underlying
asset.
C) The price of the underlying asset and the future's price will show no correlation
at all.


25. Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the
interest rate on U.S. Treasury bonds is lower than Tom expected. Tom will have:
A) Lost money on his long position.
B) Gained money on his long position.
C) Lost money on his short position
D) Gained money on his short position.

26. Sue sells a futures contract for U.S. Treasury bonds and on the settlement date the
interest rate on U.S. Treasury bonds is lower than Sue expected. Sue will have:
A) Lost money on her short position.
B) Gained money on her long position.
C) Gained money on her short position.
D) Lost money on her long position.

27. Tom buys a futures contract for U.S. Treasury bonds and on the settlement date the
interest rate on U.S. Treasury bonds is higher than Tom expected. Tom will have:
A) Gained money on his short position.
B) Lost money on his long position.
C) Gained money on his long position.
D) Lost money on his short position.

28. Sue buys a futures contract for U.S. Treasury bonds and on the settlement date the
interest rate on U.S. Treasury bonds is higher than Sue expected. Sue will have:
A) Gained money on her short position.
B) Gained money on her long position.
C) Lost money on her long position.
D) Lost money on her short position.


29. If market participants believe the corn crop is likely to be unusually large:
A) The market price of corn is likely to be below the futures price of corn.
B) The market price of corn is likely to be above the futures price of corn.
C) It would be impossible to find someone to take the short position in a futures
contract.
D) It will be impossible to find someone to take the long position in a futures
contract.

30. An arbitrageur is someone who:

A) Always takes the long position in a futures contract.
B) Always takes the short position in a futures contract.
C) Seeks the high returns that come from the high risk inherent in futures markets.
D) Simultaneously buy and sell financial instruments to benefit from temporary
price differences.

31. If a futures contract for U.S. Treasury bonds increases by “12” in the financial page
listings, the value of the contract increased by:
A) $120.00
B) $1200.00
C) $375.00
D) $240.00
E) None of the above.

32. If a futures contract for U.S. Treasury bonds decreases by “17” in the financial page
listings, the price of the contract decreased by:
A) $531.25
B) $170.00
C) $340.00
D) $1700.00


33. If a futures contract for U.S. Treasury bonds increases by “8” in the financial page
listings, the price of the contract increased by:
A) $80.00
B) $800.00
C) $8.00
D) $8,000.00

34. The user of a commodity who is trying to insure against the price of the commodity
rising would:
A) Take the short position in a futures contract.
B) Take the long position in a futures contract.
C) Be better off speculating on price movements and earning higher profits.
D) Want to hedge by selling a futures contract.

35. An individual who neither uses nor produces a commodity but sells a futures contract
for the asset is:
A) Speculating that the price of the commodity is going to fall.
B) Speculating that the price of the commodity is going to increase.
C) Is a hedging trying to transfer risk.
D) Is using arbitrage to earn profits without taking a risk.

36. An individual who neither uses nor produces a commodity but buys a futures contract
for the asset is:
A) Speculating that the price of the commodity is going to fall.
B) Speculating that the price of the commodity is going to increase.
C) Is using arbitrage to earn profits without taking a risk.
D) Is hedging and transferring risk.


37. The option holder is:

A) The seller of an option.
B) Another name for the clearinghouse used in futures contracts.
C) The buyer of an option.
D) The person who initiates the option.

A-Head: Options.
38. The option writer is:

A) The seller of an option.
B) The buyer of an option.
C) The underlying asset of the option.
D) The individual who obtains the rights.

A-Head: Options.
39. The right to buy a given quantity of an underlying asset at a predetermined price on
or before a specific date is called a(n):
A) Put option.
B) Option writer.
C) A call option.

A-Head: Options.
40. A call option is:

A) Any option written more than sixty days into the future.
B) An option giving the holder the right to buy a given quantity of an asset at a
specific price on or before a specified date.
C) An option giving the seller the right to sell a given quantity of an asset at a
specific price on or before a specified date.
D) An option where all rights are granted to the seller of the option.

A-Head: Options.

41. The strike price of an option is:

A) The market price at the time the option is written.
B) The market price at the time the option is exercised.
C) The price at which the option holder has the right to buy or sell.
D) Always above the market price.

A-Head: Options.
42. With a call option, the option holder:

A) Has the right to sell the asset.
B) Has the right to buy the asset.
C) Can buy or sell, it is their option.
D) Can buy the asset but only on the date specified.

A-Head: Options.
43. With a put option, the option holder:

A) Has the right to buy the asset.
B) Can buy or sell the asset, it is their option.
C) Has the right to sell the asset.
D) Can buy the asset but only on the date specified.

A-Head: Options.
44. There's a call option written for 100 shares of GM stock for $85.00 a share, prior to
the third Friday of October 2006: The option writer:
A) Has the option but not the requirement of selling 100 shares of GM for $85.00.
B) Will sell 100 shares of GM for $85.00 on the third Friday of October 2006.
C) Has the option to back out of this contract prior to the third Friday of October
2006.

A-Head: Options.

45. There's a call option written for 100 shares of GM stock for $85.00 a share, prior to
the third Friday of October 2006: The option writer:
A) Has the requirement to sell 100 shares of GM for $85 a share on or before the
third Friday of October 2006 if the option holder wants to exercise the option.
B) Has the option to sell 100 shares of GM for $85 a share on or before the third
Friday of October 2006.
C) Can cancel the option before the third Friday of October 2006.

A-Head: Options.
46. With a call option that is described as in the money:

A) The market price of the stock is below the strike price.
B) The market price of the stock equals the strike price.
C) The market price of the stock is above the strike price.
D) The option has been exercised.

A-Head: Options.
47. A put option that is described as in the money would find:

A) The market price of the stock above the strike price.
B) The strike price is above the market price of the stock.
C) The market and strike prices are the same.
D) The option has been exercised.

A-Head: Options.
48. A call option described as at the money would find:

A) The market price of the stock is above the strike price.
B) The market price of the stock is below the strike price.
C) The option has been exercised.
D) The market price of the stock equals the strike price.

A-Head: Options.

49. A put option described as out of the money would find:

A) The strike price is below the market price of the stock.
B) The market price of the stock and the strike price are equal.
C) The market price of the stock is below the strike price.
D) The option has expired.

A-Head: Options.
50. A call option described as out of the money would find:

A) The market price of the stock is above the strike price.
B) The option has been exercised.
C) The option has expired.
D) The strike price is above the market price of the stock.

A-Head: Options.
51. The main difference between European and American options is:
A) Holders of European options have more options than holders of American
options.
B) American option holders have more options than European option holders.
C) European option holders can exercise the option prior to expiration.
D) a and c

A-Head: Options.
52. One key difference between options contracts and futures contracts is:
A) In a futures contract, one part has more rights than the other.
B) With an options contract both parties have equal rights.
C) In an options contract, the rights belong to one party.
D) In a futures contract all rights are held by just one party.

A-Head: Options.

53. Which of the following statements is true?

A) Call options can be sold prior to expiration but put options cannot.
B) Put options can be sold prior to expiration but call options cannot.
C) No option can be sold prior to expiration.
D) None of the above is correct.

A-Head: Options.
54. The seller of a put option is transferring the risk:

A) Of a price decrease of the stock to the buyer of the option.
B) Of a price increase of the stock to the buyer of the option.
C) This statement is incorrect since options do not transfer risk.

A-Head: Options.
55. Someone who purchases a call option is really buying insurance to protect against:
A) The stock not being available when they want to purchase it.
B) The price of the stock falling.
C) A seller not being able to deliver the stock.
D) The price of the stock rising.

A-Head: Options.
56. Comparing an option to a futures contract it would be correct to say:

A) The risk involved in each is equal.
B) A futures contract carries more risk than the option contract.
C) An option contract carries more risk than the futures contract.
D) Neither involves risk; they are tools to eliminate risk.

A-Head: Options.

57. An investor who purchases a call option is:

A) Highly leveraged for a gain but is limited in losses.
B) Is limited in their gain but is highly leveraged in losses.
C) Both their gains and losses are highly leveraged.
D) Both their gains and losses are limited.

A-Head: Options.
58. Options are popular because:

A) Stock prices are volatile.
B) They offer a tool to transfer risk.
C) They present a tool to limit losses.
D) They offer opportunities for high leverage.
E) All of the above.

A-Head: Options.
59. An individual who speculates by selling a call option:

A) Wants to bet that that the market price of the underlying asset will rise.
B) Wants to bet that the option expires worthless.
C) Wants to bet that the price of the underlying asset will not rise.
D) Wants to bet that the price of the underlying asset will not fall.

A-Head: Options.
60. An individual who speculates by selling a put option:

A) Wants to bet that the market price of the underlying asset will not fall.
B) Wants to bet that the market price of the underlying asset will not rise.
C) Wants to bet that the option expires worthless.
D) Wants to buy the underlying asset in the future.

A-Head: Options.

61. The two parts that make up an option's price are:

A) Extrinsic value and the option premium.
B) The commission and the option premium.
C) The intrinsic value and the option premium.
D) The price of the underlying asset and the option premium.

A-Head: Options.
62. The intrinsic value of an option:

A) Is the amount the investor believes the option will be worth on the expiration
date.
B) Is the amount the option is worth if it is exercised immediately.
C) Is equal to price of the underlying asset.
D) Cannot be determined without knowing the future price of the underlying asset.

A-Head: Options.
63. As an option approaches its expiration date, the size of the option premium
approaches:
A) The intrinsic value.
B) The price of the underlying asset.
C) Zero
D) Infinity.

A-Head: Options.
64. The option premium can best be defined as:

A) The commission earned by a broker.
B) The fee earned for the potential benefits from buying the option.
C) The service fee charged by the SEC for regulating the option market.
D) The fee paid for the potential benefits from buying an option.

A-Head: Options.

65. Assume we have a stock currently worth $100. We also assume the interest rate is
zero, and we can buy options for this stock with a strike price of $100. If the stock
can rise or fall by $20 with equal probability over the option period, and the option
cannot be exercised until the expiration date, what is the option premium?
A) $20
B) $0
C) 10
D) $100

A-Head: Options.
zero, and we can buy options for this stock with a strike price of $100. If the stock
can rise or fall by $5 with equal probability over the option period, and the option
A) $10
B) $5
C) $0
D) None of the above

A-Head: Options.
zero, and we can buy options for this stock with a strike price of $50. If the stock can
rise or fall by $10 with equal probability over the option period, and the option
A) $5
B) $10
C) $50
D) $40

A-Head: Options.

68. As the volatility of the stock price increases, the option premium:
A) Decreases.
B) Is worthless.
C) Increases.
D) Doesn't change.

A-Head: Options.
69. An option's value will never be less than zero because:

A) The intrinsic value is always less than zero.
B) The option seller is required to make up any shortfall faced by the option buyer.
C) An option holder will never make an additional payment to exercise the option.

A-Head: Options.
70. The intrinsic value of an option:

A) Is the difference between the option price and the option premium.
B) Must be greater than or equal to zero.
C) Is the difference between the price of the underlying asset and the strike price of
the option.

A-Head: Options.
71. At expiration, the value of an option:

A) Is greater than the intrinsic value.
B) Is less than the intrinsic value.
C) Is equal to the option premium.
D) Is zero.

A-Head: Options.

72. At expiration, the value of an option:

A) Is equal to the intrinsic value.
B) Is greater than the intrinsic value.
C) Is zero.
D) Is less than the intrinsic value.

A-Head: Options.
73. The option premium should:

A) Decrease the longer the time to expiration.
B) Increase the longer the time to expiration.
C) Not change with time to expiration.
D) Approach infinity at expiration.

A-Head: Options.
74. If the price of an underlying asset has a standard deviation of zero:

A) Options for this asset would likely not exist.
B) Option for this asset would be highly valued.
C) The intrinsic value of options for this asset would equal the asset's price.
D) Options for this asset would have an option premium equal to the price of the
asset.

A-Head: Options.
75. Considering a put option; if the price of the underlying asset increases:
A) The value of the put option also increases.
B) The intrinsic value of the option increases.
C) The value of the option decreases.
D) The intrinsic value of the option decreases.
E) c and d

A-Head: Options.

76. Considering a call option; if the price of the underlying asset decreases:
A) The intrinsic value of the option decreases.
B) The intrinsic value of the option increases.
C) The strike price decreases.
D) The value of the option increases.

A-Head: Options.
77. Considering a put option; an increase in the strike price:

A) Causes the intrinsic value of the option to decrease.
B) Causes the intrinsic value of the option to increase.
C) Causes the value of the option to decrease.
D) Makes the option worthless.

A-Head: Options.
78. If we have a stock selling for $95.00 and a call option for this stock has a strike price
of $82.00 and an option price of $13.60:
A) The intrinsic value of the option is $0.60 and the option premium is $13.00.
B) The intrinsic value is $82.00 and the option premium is $13.60.
C) The intrinsic value of the option is $13.00 and the option premium is $0.60.
D) The intrinsic value is $0 since the option is out of the money.

A-Head: Options.
79. We have a stock selling for $90.00. There is a put option for this stock with a strike
price of $85 and an option price of $1.20:
A) The intrinsic value of this option is $0.00 and the option premium is $1.20.
B) The intrinsic value of this option is $90.00 and the option premium is $1.20
C) The intrinsic value of this option is -$5.00 and the option premium is $1.20
D) You cannot determine the intrinsic value or option premium since the strike price
is less than the underlying asset price.

A-Head: Options.

80. For a given call option price, which of the following statements is correct?
A) The closer the strike price is to the current price of the underlying asset, the
smaller the option premium.
B) The closer the strike price is to the current price of the underlying asset, the
larger is the option premium.
C) As the strike price approaches the price of the underlying asset, the option
premium approaches zero.
D) As the strike price approaches the price of the underlying asset, the intrinsic
value of the option increases and the option premium decreases.

A-Head: Options.
81. Which of the following would tend to decrease the size of the option premium?
A) The price volatility of the underlying asset is high.
B) The time to expiration of the contract is far away.
C) The interest rate on U.S. Treasury bonds increases.
D) The time to expiration of the options contract is near.

A-Head: Options.
82. Interest rate swaps are:

A) Exchanges of equity securities for debt securities.
B) Agreements between two counterparties to exchange periodic interest rate
payments over some future period.
C) Agreements involving swapping of option contracts.
D) Agreements that allow both counterparties to convert floating interest rates to
fixed interest rates.

A-Head: Swaps.
83. A key use of interest rate swaps is to:

A) Eliminate risk for both parties involved in the transaction.
B) Earn the fees for constructing the swaps.
C) Transfer interest rate risk to the parties most willing to bear it.

A-Head: Swaps.

84. The principal in an interest rate swap is:

A) Always transferred from the originator to the counterparty of the swap.
B) Is usually held by a clearinghouse to guarantee payment.
C) Usually borrowed from a third party.
D) Is not borrowed, lent, or exchanged. It just exists on “paper”.

A-Head: Swaps.
85. Considering interest rate swaps, the swap rate is:

A) The benchmark rate plus a premium.
B) The rate being offered on U.S. Treasury securities of similar maturities.
C) Another name for the swap spread.
D) A measure of overall risk in the economy.
E) a and d

A-Head: Swaps.
86. Considering interest rate swaps, the swap spread is:

A) Another name for the swap rate.
B) The difference between the benchmark rate and the swap rate.
C) The benchmark rate plus the swap rate.
D) A measure of the overall risk in the economy.
E) b and d

A-Head: Swaps.
87. One key difference between swaps and option contracts is:
A) Swaps are derivative agreements and options are not.
B) Swaps do not involve any risk and options do.
C) Options transfer risk, swaps create risk.
D) Options trade on organized exchanges and swaps do not.

A-Head: Swaps.

88. The U.S. Government debt managers use interest rate swaps primarily because:
A) The U.S. Government runs large deficits.
B) The debt managers prefer to issue long term bonds but prefer short-term variable
rate obligations to match revenues.
C) The debt managers find it difficult to borrow from traditional debt markets.
D) They are required to keep the cost of borrowing to a minimum by law.

A-Head: Swaps.
89. The primary risk(s) in swaps is:

A) Interest rates will not change.
B) One of the parties will default.
C) They are highly liquid and the market price will change.

A-Head: Swaps.
90. Standardization of derivative contracts:

A) Result in increased risk for the parties involved.
B) Makes them more difficult to understand and therefore leads to increased misuse.
C) Makes the premiums involved with these contracts increase.
D) Leads to greater liquidity and lower risk.

Short Answer Questions
91. As the chapter points out, there have been many cases where derivatives have led to a
lot of abuse. If this is the case, why do derivatives exist?
Answer: When used properly derivatives are very helpful financial instruments. They
allow people to transfer risk to those most willing to bear it and as a result they enter
into agreements they otherwise wouldn't. The economy, as a result, performs more
efficiently.
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92. Explain how an interest rate futures contract differs from an outright purchase of a
bond.
Answer: An investor who purchases a bond does so with the thought that the price of
a bond is going to rise. There really is no way to profit from a price decline when you
actually purchase the bond. On the other hand, an investor can profit from price
declines in bonds by using an interest rate futures contract. With such a contract, two
individuals agree that they will make payments to the counterparty based on interest
rate movements over some specified time period. Another key difference is that with
the futures contract (derivative) one person's lost is the counterparty's gain. The
amount on the table never changes, it just moves between the counterparties.
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93. What are the three main ways to categorize derivatives?
Answer: Derivatives can be categorized as: Forwards and futures, Options, and
Swaps. LOD: 1 Page: 203
94. Explain why a forward contract may actually carry more risk than a futures contract.
Answer: A forward contract is a private agreement between two parties that is

customized for the two parties. As a result, the high degree of customization makes
them very difficult if not impossible to resell. Futures contracts on the other hand are
highly standardized. The high level of standardization allows them to be bought and
sold on organized exchanges, which increases their liquidity and reduces risk. In
addition, forward contracts, because they are private agreements carry greater default
risk, where futures contracts are usually settled through clearing corporations where
procedures such as marked to market greatly reduce default risk.
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95. In a futures contract, explain why, technically, the two parties do not make a bilateral
agreement with each other.
Answer: With a futures contract, the high degree of standardization allows for the use
of a clearing corporation. Of the many roles the clearing corporation performs, one is
to actually be the counterparty. The two parties to a futures contract actually make an
agreement with the clearing corporation which really acts like an insurance company
guaranteeing that the other party will meet their obligations. This increases the
efficiency and use of futures contracts.
LOD: 2 Page: 204
96. Explain how the Clearing corporation reduces the risk it faces in the futures market
through the use of margin accounts and marking-to-market.
Answer: The clearing corporation requires each party to a futures contract to place a
deposit with the corporation. This practice is called posting margin in a margin
account. The margin account serves as a guarantee that when the contract comes due
the parties can meet their obligations. Minimum deposits must be maintained in these
accounts or the contracts are sold. The process of marking to market has the
corporation posting gains and losses to each parties account daily. Again, this
guarantees that obligations are met. If an individual's margin account falls below the
minimum required the contract will be sold.
LOD: 2 Page: 204
97. We have a futures contract for the purchase of 10,000 bushels of wheat at $3.00 per
bushel. If the price of wheat were to increase to $3.50, explain what happens to the
parties involved in the contract in terms of marking to market. Be sure to identify
who is long and short and specifically how much is transferred.
Answer: The buyer of the contract, the long position, will pay $30,000 for 10,000
bushels of wheat. The seller of the contract, the short position, delivers 10,000
bushels of wheat and receives $30,000. Now if before expiration the market price of
wheat increases to $3.50 the seller, (short) will have to give the buyer, (long) $5000
so that the buyer will still only have to pay $30,000 for the wheat. So the buyer's
margin account will be marked to market (credited) with $5000, which comes from
the seller's margin account which is marked to market (debited) for the $5000.
LOD: 3 Page: 205

98. A lender obtains funds from depositors by offering short term interest rates on
savings accounts. The lender uses these funds to make longer term installment loans.
Explain how the lender might make use of the futures market to hedge the risk taken.
Answer: The lender faces the risk that short term interest rates will increase. She can
hedge this risk by selling futures contracts for U.S. Treasury bills which are also
short term. If interest rates do increase the lender will profit from the futures
contracts. LOD: 3 Page: 206
99. How can we link the lack of futures markets in poor countries to the fact that farmers
in poor countries are likely to remain poor?
Answer: As the chapter points out, the access to and use of futures markets allows
individuals to transfer risk to those most willing to bear it. For example, a wheat
farmer in the U.S. does not need to worry about the price of wheat falling when their
crop comes in, they can sell a futures contract at a specified price. As a result of
transferring this risk, the farmer will plant a larger crop and have a higher income.
But as we also saw in the chapter, the use of futures requires the posting of margins.
This is something that poor farmers would find very difficult to do, as a result, many
poor farmers do not have access to the futures market, cannot transfer risk and as a
result plant smaller crops and have lower incomes.
LOD: 2 Page: 207
100. What is the process that makes sure the market price of an underlying asset equals
the price of a futures contract at the settlement date? Provide an example.
Answer: The process that makes sure the price of the underlying asset and the price
of the futures contract are the same at the settlement date is arbitrage. Arbitrage is the
process where an individual earns a profit without incurring any risk. For example,
let's say six months before the settlement date the futures price for delivery of a 5%
bond is $1000. Currently the spot (market) price of the bond is $1100 and the
investor could borrow at 5%. Here an individual would find it profitable to borrow
$1000 at 5% annually (offset by the interest earned from the bond) to purchase the
bond for $1000. At the same time, the investor will sell a bond future for the $1100,
promising delivery in six months. This transaction is completely riskless and nets the
investor $100.
LOD: 3 Page: 208

101. Consider a call option; in terms of the option writer and option holder, who is the
buyer? Who is the seller? Finally, who has the option? Explain.
Answer: In the case of a call option, the option writer is the seller. Here the option
writer is stating the underlying asset, strike price, and expiration or delivery date. The
option holder is the buyer of the option. The option holder buys the right to have the
option of actually purchasing the underlying asset on or before the expiration date for
the strike price. The option holder has the option, because she could let the option
expire and not “call away” the underlying asset, just foregoing the price paid for the
option.
LOD: 2 Page: 209
A-Head: Options.
102. With a put option, what specifically does the option holder receive for the price paid
for the option?
Answer: The option holder (buyer) receives the right but not the obligation, to sell
the underlying asset at a specific (strike) price on or before the expiration date of the
option. If the strike price is above the spot or current market price the option holder
will profit from exercising the option. If the strike price is below the spot price of the
underlying asset, the option holder will let the option simply expire.
LOD: 2 Page: 210
A-Head: Options.
103. Describe the condition that would have a call option in the money? Now describe the
condition that has a put option out of the money.
Answer: A call option will be in the money when the strike price is below the spot or
current market price. The option holder has the right to call the asset away from the
option writer at a price below what the asset could be sold for on the spot market. A
put option is out of the money when the strike price is below the spot or market price.
Here the option holder has the right to put (sell) the asset to the option writer at a
predetermined (strike) price. If the strike price is below the market price the option
holder would be better off selling the asset on the spot market versus selling it to the
option writer.
LOD: 2 Page: 210
A-Head: Options.

104. Explain the difference between American and European options.
Answer: American options can be exercised on any date from the time they are
written until the date they expire. As a result, the holder of an American option has
three choices; (1) continue to hold the option; (2) sell the option to someone else; (3)
exercise the option immediately. The holder of a European option has only two
options on a date prior to expiration, hold or sell.
LOD: 2 Page: 210
A-Head: Options.
105. If the option holder is the individual with the options, why is anyone an option
writer?
Answer: Option writers really fall into two categories. One group is simply
speculators. These individuals are willing to bet that the market price will not move
against them and they will take this risk for the fee they obtain. Another group is
dealers who make a market in the underlying asset. This means they are willing to
buy and sell the underlying asset. When you own the underlying asset writing a call
option that obligates you to sell it at a fixed price does not carry as much risk.
LOD: 2 Page: 211
A-Head: Options.
106. Suppose you purchase a call option to purchase General Motors common stock at
$80 per share in March. The current price of GM stock is $83 and the option
premium is $5. What is the intrinsic value of the option? As the expiration date
approaches, what will happen to the size of option premium?
Answer: The intrinsic value of an option is equal to the difference between the
current market price and the strike price, which in this case is $83 - $80, or $3. The
option premium at expiration is zero since the option value equals the intrinsic value.
LOD: 3 Page: 213
A-Head: Options.

107. Suppose you purchase a put option to sell General Motors common stock at $80 per
share in March. The current price of GM stock is $83 and the option premium is $1.
What is the intrinsic value of the option?
Answer: In this case the intrinsic value of the option is zero, the intrinsic value of a
put option is the strike price less the price of the underlying asset, which in this case
is a negative 3; however an option will never have an intrinsic value less than zero
since the option doesn't have to be exercised.
LOD: 3 Page: 214
A-Head: Options.
108. Why does the option premium tend to vary directly with the time to expiration?
Answer: Prior to expiration there is always the chance that the market price of the
underlying asset will move to make the option valuable. Since probability of this
happening is greater with more time to expiration, the option premium moves
directly with time to expiration since the option premium reflects this potential
benefit. LOD: 2 Page: 216
A-Head: Options.
109. What would be the value of an option on a stock that sells at a fixed price with a
standard deviation of zero? Explain.
Answer: A stock that has no volatility in its price has an option that will never pay
off, so no one would have any interest in owning it and the options would be
worthless so they would not exist. In order for options to have value, the price of the
underlying asset must have some volatility to it, (a standard deviation equal to
something other than zero).
LOD: 2 Page: 214
A-Head: Options.
110. Identify four factors that will cause the value of call options to increase.
Answer: Call options will increase in value if there is a decrease in the strike price; if
there is an increase in the market price of the underlying asset, if there is an increase
in the time to expiration, or if there is an increase in the volatility in the price of the
underlying asset.
LOD: 2 Page: 215
A-Head: Options.

111. Identify four factors that will cause the value of put options to decrease.
Answer: Put options will decrease in value if there is a decrease in the strike price, if
there is an increase in the market price of the underlying asset, if there is a decrease
in the time to maturity, or if there is a decrease in the volatility in the price of the
underlying asset.
LOD: 2 Page: 215
A-Head: Options.
112. If the current closing price in the stock of XYZ, Inc. is $87.50 and the July expiration
call options with a strike price of $80 are selling for $9.45, what is the intrinsic value
of the option? What is the option premium?
Answer: The intrinsic value of a call option is the market price less the strike price,
or in this case $7.50. The option premium is the option price less the intrinsic value,
which in this case is $9.45 less $7.50 or $1.95.
LOD: 3 Page: 216
A-Head: Options.
113. If the current closing price in the stock of XYZ, Inc. is $87.50 and the July expiration
put options with a strike price of $80 are selling for $1.05, what is the intrinsic value
of the option? What is the option premium?
Answer: The intrinsic value of a put option is the strike price less the market price,
which in this case is a negative $7.50. An option cannot have an intrinsic value less
than zero, however, since the option does not have to be exercised. So in this case the
intrinsic value is zero. The option premium is the option price less the intrinsic value,
so the option premium is $1.05.
LOD: 3 Page: 216
A-Head: Options.
114. Why do government debt managers often use interest rate swaps?
Answer: Government debt managers find that often times they can minimize
borrowing costs by issuing longer term bonds. There is a strong market for these
bonds. The problem, however, is that government revenues tend to rise during
economic good times and fall during bad times. Short term interest rates tend to
follow the economy as well, rising during good times, falling during recessions.
Government debt managers can often obtain both the benefits of offering long term
bonds and matching these with revenues by using interest rate swaps.
LOD: 2 Page: 219
A-Head: Swaps.

115. Explain the concept of notional principal used in swaps.
Answer: Notional principal is used in swaps because it really represents a principal

amount that serves as the basis for the calculations involved with swaps. The actual
principal is never borrowed, lent, or exchanged.
LOD: 2 Page: 219
A-Head: Swaps.
Essay Questions
116. Imagine a baker who has the opportunity to bid on a contract to supply a local
military base with bread for an entire year. The problem is the baker must commit to
a price today and hold to that price for the entire year. Identify the risk faced by the
baker, and explain how the use of a futures contract could transfer the risk.
LOD: 3 Page: 206
Answer:
The baker faces the problem of not knowing what the future price of flour (wheat)
will be. He may feel quite comfortable developing a price for the bread based on the
current prices of wheat, but if the price of wheat should increase the bread making
profits will fall and may turn into significant losses. Without the ability to transfer
this risk the baker would probably have to pass on this opportunity. Fortunately the
baker could purchase a wheat futures contract that would expire in a year, giving him
the right to purchase some quantity of wheat at a price reflecting today's market
price. If the market price of wheat does increase he will lose on the baking operation
but the value of his futures contract will increase. If the price of wheat falls, his
futures contract loses value but his baking profits will increase.

117. Explain the popularity of options in the sense of the potential gains and losses they
offer.
LOD: 2 Page: 212
Answer:
Option contracts are popular because for the option holder the upside of the option is
very high. In the case of a call option, if the market price of the stock rises above the
strike price the option gains significantly in value, and since theoretically market
prices are not capped, the potential gains are very high. On the other hand, the option
holder finds that the most they can lose is the fee they paid for the option since they
have the right to not exercise the option. From the option writer's perspective, many
writers are speculating that the price of the asset will not move against them and for
the option fee are willing to take that bet. It is hard to say that this is the group that
makes the options popular. More likely the hedgers, the market makers in the
underlying assets that transfer risk, that add to the popularity of options.
A-Head: Options.
118. Explain why for speculation, the purchase of an option may be more attractive than a
futures contract or the outright purchase of the underlying asset.
LOD: 3 Page: 211
Answer:
Let's say an investor believes that interest rates are going to fall over the next few
months. There are three ways to bet on this possibility. One is to purchase a bond and
if you guess correctly, the bond price will rise as the interest rate falls. This is
expensive since it requires the purchase of the bond. Another strategy is to purchase a
futures contract, take the long position. If the market price of the bond does increase
with falling interest rates, the investor will reap the profits. This approach requires a
small investment, but this approach is also very risky since the investment is highly
leveraged since the market price can move against the investor. A third strategy
involves the use of an option. The investor could purchase a call option on a Treasury
bond. If he is right and interest rates fall, the value of the call option will rise, the
upside. On the other hand, if the investor bets wrong and interest rates rise, the option
will expire worthless and the investor just loses the fee they paid for the option. The
bet is both highly leveraged and limited in its potential losses.
A-Head: Options.

Chapter 9 Derivatives: Futures, Options, and Swaps: Multiple Choice Questions

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Chapter 9 Derivatives: Futures, Options, and Swaps: Multiple Choice Questions

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Chapter 9 Derivatives: Futures, Options, and Swaps

Multiple Choice Questions

1. Derivatives are financial instruments that:

Answer: B LOD: 1 Page: 202

2. The value of a derivative is determined by:

Answer: C LOD: 1 Page: 202

Answer: C LOD: 2 Page: 203

4. The purpose of derivatives is to:

Answer: D LOD: 1 Page: 203

Cecchetti: Money, Banking, and Financial Markets 1

5. Forward contracts are:

Answer: E LOD: 2 Page: 203

6. The short position in a futures contract is the party that will:

Answer: A LOD: 1 Page: 204

7. The long position is a futures contract is the party that will:

Answer: E LOD: 2 Page: 204

8. With a futures contract:

Answer: B LOD: 2 Page: 204

2 Cecchetti: Money, Banking, and Financial Markets

9. The key difference between a forward and a futures contract is:

Answer: A LOD: 1 Page: 204

Answer: B LOD: 2 Page: 204

11. The process of marking to market:

Answer: D LOD: 2 Page: 205

12. Marking to market is a process that:

Answer: B LOD: 2 Page: 205

Cecchetti: Money, Banking, and Financial Markets 3

Answer: D LOD: 2 Page: 205

Answer: A LOD: 2 Page: 205

Answer: B LOD: 2 Page: 206

Answer: C LOD: 2 Page: 206

4 Cecchetti: Money, Banking, and Financial Markets

Answer: D LOD: 2 Page: 206

Answer: C LOD: 2 Page: 206

19. Users of commodities are:

Answer: D LOD: 2 Page: 207

20. Speculators differ from hedgers in the sense that:

Answer: E LOD: 2 Page: 206

Cecchetti: Money, Banking, and Financial Markets 5

Answer: D LOD: 2 Page: 207

22. Futures markets and derivatives contribute to economic growth by:

Answer: B LOD: 2 Page: 207

23. On the settlement date of a futures contract:

Answer: C LOD: 2 Page: 208

24. As the time of settlement gets closer:

Answer: D LOD: 2 Page: 208

6 Cecchetti: Money, Banking, and Financial Markets

Answer: A LOD: 3 Page: 208

Answer: C LOD: 3 Page: 208

Answer: C LOD: 3 Page: 208

Answer: D LOD: 3 Page: 208

Cecchetti: Money, Banking, and Financial Markets 7

Answer: B LOD: 2 Page: 209

30. An arbitrageur is someone who:

Answer: D LOD: 2 Page: 208

Answer: C LOD: 3 Page: 207

Answer: A LOD: 3 Page: 207

Cecchetti: Money, Banking, and Financial Markets 9

Answer: E LOD: 3 Page: 207

Answer: B LOD: 2 Page: 209

Answer: A LOD: 2 Page: 209

Answer: B LOD: 2 Page: 209

10 Cecchetti: Money, Banking, and Financial Markets