Question 1

You are a hedge fund and you enter a contract which involves 3 players: You, the American Bank and WePro Ltd. The American Bank lends $1,000 to WePro and they want you to share the risk in case WePro fails to pay back. If you give the American Bank $1,000, you will get a fixed monthly payment worth 10% of $1,000 for the duration of the contract-as long as WePro doesn't default. However, if WePro defaults on its debt, you will have to pay $1,000 to the American Bank and the contract is terminated. What type of contract is this?
A)Credit default swap.
B)Long-term loan.
C)Hedging.
D)Insurance.

Accepted Answer

This type of contract is a credit default swap (CDS). It is a derivative contract in which the buyer of the CDS--the American Bank--makes a series of payments to the seller--you--and, in exchange, receives a payoff if WePro Ltd. fails to pay the loan. A CDS is a way to protect from losses when bonds default. It transfers the credit risk to another party while keeping the loan on its books.
Key Takeaway: Think of owning a CDS as owning an insurance policy on the failure of a company to repay a bond.

Question 2

A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed future point in time at a pre-agreed price. What of the following statements is true?
A)A futures contract is more unpredictable than a forward contract.
B)A futures contract is standardized while each forward contract is unique.
C)A futures contract is a forward contract that is traded on an exchange.
D)A futures contract almost has no risk of default, while a forward contract has some risk of default involved.
E)All correct.

Accepted Answer

These statements are all correct.
Key Takeaway: A forward contract can be used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil).

Question 3

You want to commit to purchasing oil at the price 30 days from now. What is this type of deal?
A)A futures contract.
B)A call option.
C)A put option.
D)A forward.

Accepted Answer

This is a futures contract. It is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future at a specified price.
Key Takeaway: A futures contract is different from an option contract in that a futures contract gives the holder the obligation to buy or sell, while an option contract gives the holder the right, but not the obligation, to do so.

Question 4

Suppose you are interested in buying 100 shares of WePro Ltd. and the current price of its stock is $30. You are thinking to buy these shares at $32 from the stock exchange market. In case the market price is above $32, you buy the shares at $32 and you agree to pay the stock exchange market $2 for each share, or $200 in total. If the market price is below $32, then you will not buy the shares. Whether or not you continue the deal, the stock exchange keeps $200 as the risk premium and to make it a fair deal. What is this type of deal?
A)A futures contract.
B)A call option.
C)An over-the-counter contract.
D)A forward contract.

Accepted Answer

This type of deal is known as a "call option." A call option is a contract that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period.
Key Takeaway: A call option gives you the right to buy an asset. You profit on a call when the underlying asset increases in price.

Question 5

When stocks are traded via a dealer network as opposed to on a centralized exchange, what is the deal called?
A)A futures contract.
B)A swap contract.
C)An option contract.
D)An over-the-counter contract.

Accepted Answer

This type of deal is called an over-the-counter (OTC) contract.
Key Takeaway: Generally, small companies choose to trade stocks over the counter because they are unable to meet exchange listing requirements. These stocks are traded in an informal exchange rather than on a formal exchange such as the NYSE, TSX, AMEX, etc.

Question 6

You have a loan on a fixed annual interest rate of 7% over five years. Tom has a similar loan, over the same period, but on a floating interest rate. You and Tom are thinking to take over each other's obligations, so that you pay the floating interest rate and Tom pays the fixed rate. What kind of deal is this?
A)An option.
B)A forward contract.
C)A swap contract.
D)A futures contract.

Accepted Answer

This deal is a swap contract. A swap is a contract by which two parties exchange the cash flow linked to an asset.
Key Takeaway: If you and Tom live in separate countries that have comparative advantages on interest rates, then a swap could benefit both of you. If you have a lower fixed interest rate, while Tom has access to a lower floating interest rate, then you two could swap to take advantage of the lower rates.

Question 7

What do an option, a swap, a forward, and an OTC have in common?
A)They are all derivatives.
B)They are traded in the same market.
C)They have the same value.
D)They have nothing in common.
E) All of the above.

Accepted Answer

All four of them are derivatives, which are financial assets that derive their values from other assets.
Key Takeaway: Derivatives help to measure and manage risk more effectively. But don't use it if you don't know it, because it can bring harmful consequences to your financial management.

Quiz 4: Contract

A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed future point in time at a pre-agreed price. What of the following statements is true?

You want to commit to purchasing oil at the price 30 days from now. What is this type of deal?

When stocks are traded via a dealer network as opposed to on a centralized exchange, what is the deal called?

What do an option, a swap, a forward, and an OTC have in common?