Question 1

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.

Accepted Answer

By buying put options on Treasury bills, the lender can hedge against a rise in the cost of funds and limit its potential losses, while still benefiting from a decline in the cost of funds. Option contracts give holders the right, but not the obligation, to buy or sell the underlying security at a predetermined price and time. Buying put options on Treasury bills would allow the lender to sell the securities at a predetermined price (the strike price) if the cost of funds rises, protecting against losses. However, if the cost of funds decreases, the lender can still benefit from holding the Treasury bills without any obligation to sell them at the strike price. Buying futures contracts on Treasury bills (A) and selling futures contracts on Treasury bills (B) only offer protection against rising costs and eliminate potential gains from a decline in costs. Buying call options on Treasury bills (D) offers the right to buy, rather than sell, the securities at a predetermined price, which would not provide protection against rising costs.

Question 2

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.

Accepted Answer

A put option is said to be in the money if the price of the underlying asset is currently less than the strike price, meaning that the option holder has the right to sell the asset at a higher price than the current market price.

Question 3

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.

Accepted Answer

Index arbitrage involves simultaneously trading in stock index futures and the underlying stocks to profit from any price discrepancies between the two markets. The goal is to take advantage of any temporary mispricing between the futures and cash markets.

Question 4

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.

Accepted Answer

In a covered option, the seller (or writer) of the option owns the underlying asset. This means if the option is exercised, the seller can deliver the asset without needing to purchase it at the current market price, reducing risk.

Question 5

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

Accepted Answer

An option is said to be "out of the money" if its strike price exceeds the current stock price. This means that if the option were exercised, the investor would not profit from it.

Question 6

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.

Accepted Answer

The intrinsic value of a call option is equal to the difference between the current stock price and the strike price. In this case, the current stock price of Acme Widget is $100 per share, and the strike price of the call option is $75 per share. Therefore, the intrinsic value of the call option is $100 - $75 = $25. Option A) is the correct choice.

Question 7

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.

Accepted Answer

As an option approaches its expiration date, the time value of the option diminishes and the premium decreases until it reaches its intrinsic value, which is the difference between the stock price and the strike price. Therefore, the size of the premium approaches its intrinsic value.

Question 8

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.

Accepted Answer

The fee charged by the seller of an option is called the option premium. The market price refers to the current price of the underlying asset, futures fee is a fee charged in futures trading, and call price is the price at which the holder of a call option can buy the underlying asset.

Question 9

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.

Accepted Answer

When call option prices on Treasury bonds are rising, it indicates that investors are willing to pay more for the right to purchase Treasury bonds in the future at a specific price (strike price). This suggests that investors believe Treasury bond prices will be higher in the future, which means lower yields on those bonds.

Question 10

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

Accepted Answer

Securities are regulated by the Securities and Exchange Commission (SEC), whereas the Commodity Futures Trading Commission (CFTC) regulates futures and options on futures contracts. The Federal Reserve and FBI do not have regulatory authority over securities options.

Question 11

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.

Accepted Answer

An option buyer has a greater insurance benefit than the purchaser of a futures contract because they have the right, but not the obligation, to exercise the option, limiting their risk to the premium paid.

Question 12

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.

Accepted Answer

The intrinsic value of an option is the actual value that an investor would gain if they exercised the option immediately. It is calculated based on the difference between the current price of the underlying asset and the strike price of the option, for options that are in the money.

Question 13

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.

Accepted Answer

The answer of Which of the following factors would tend...

Question 14

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.

Accepted Answer

The period over which a call or put option exists is determined by its expiration date, which is the date on which the option contract ceases to exist. The expiration date is determined at the time the contract is written and is typically several months in the future. After the expiration date, the option holder no longer has the right to exercise the option and the contract becomes worthless.

Question 15

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.

Accepted Answer

Speculators in futures and options markets accept risk transferred to them by hedgers. They provide liquidity to the markets and help in discovering the market prices. However, their actions may not always align with the expectations of the hedgers, which can lead to reduced efficiency in the markets. Speculators are not acting contrary to U.S. securities laws unless they engage in insider trading or fraudulent activities. They do not necessarily reduce the liquidity of these markets.

Question 16

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

Accepted Answer

The strike price is the price at which the underlying asset can be bought or sold, depending on the type of option contract. It is also known as the exercise price because it is the price at which the option buyer has the right to exercise their option. The other options listed, such as market price and equilibrium price, refer to different concepts related to pricing in economics and finance, but are not specifically related to options contracts.

Question 17

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.

Accepted Answer

The mathematicians and economists hired by Wall Street to build mathematical models are commonly referred to as "rocket scientists."

Question 18

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.

Accepted Answer

The choice between futures and options often reflects a trade-off between the higher cost of using options (due to the premium paid for the option) and the extra insurance benefits that options provide (such as the right, but not the obligation, to buy or sell the underlying asset, which limits downside risk).

Question 19

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.

Accepted Answer

While index arbitrage was a contributing factor to the decline, it was not the main cause. Other factors such as high interest rates, international events, and overvaluation of stocks also played a role.

Question 20

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.

Accepted Answer

A call option is in the money when the current price of the underlying asset is greater than the strike price. This means that if the option holder were to exercise the option, they would be able to buy the asset at a lower price (the strike price) than what it is currently worth on the market. Therefore, the option has real value and is considered in the money. The other choices are incorrect. A call option can be written on various assets, not just money-market assets (A). The increase in price of the option itself does not determine whether it is in the money (B). The option premium is already factored into the strike price, so it does not need to be added back in (D).

Quiz 9: Derivative Securities and Derivative Markets

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 put option is said to be in the money if

Index arbitrage refers to

In a covered option,

A stock option is said to be "out of the money" if:

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

As an option nears its expiration date, the size of the premium approaches

The fee charged by the seller of an option is referred to as the

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

Options on securities are regulated by the

An option buyer

The intrinsic value of an option

Which of the following factors would tend to increase the size of the premium on an options contract?

The period over which a call or put option exists is

Speculators in futures and options markets

In an options contract, another name for the strike price is the

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

The choice between futures and options

The big decline in share prices on the New York Stock Exchange that occurred in October 1987

A call option is said to be in the money if