Derivatives Exam 1 UPDATED Exam
Questions and CORRECT Answers
hedging - CORRECT ANSWER - company hedges when it has exposure to the price of an
asset and takes a position in futures/options market to offset exposure
speculation - CORRECT ANSWER - company has no exposure to offset; simply betting
on the future movements in the price of the asset
arbitrage - CORRECT ANSWER - involves taking a position in two or more different
markets to lock in a profit
"There is no point in our using oil futures. There is just
as much chance that the price of oil in the future will be less than the futures price as there is that
it will be greater than this price. " - CORRECT ANSWER - In this case of the airline
executive, we're using the oil future for hedging, not for speculation. We don't care about our
odds if it goes up or down; Instead of exposing itself to future prices of oil, the company should
hedge their risk by locking in a price now
Explain how margin accounts protect futures traders against the possibility of default. -
CORRECT ANSWER - margin is deposited by a trader with their broker and is used to act
as a guarantee that any losses on the futures contract will be covered; if losses are above a certain
level, the trader is required to deposit more money or exit the trade
"Speculation in futures markets is pure gambling. It is not in the public interest to allow
speculators to trade on a futures exchange." - CORRECT ANSWER - speculators are
important since they add liquidity to the market; contracts should be useful to hedgers and
speculators and should be made in the interest of them
"When a futures contract is traded on the floor of the exchange, it may be the case that
the open interest increases by one, stays the same, or decreases by one." - CORRECT
ANSWER - if both the buyer and seller enter into a new contract = open interest is 1; if
, both the buyer and seller exit the contract = open interest is -1; if the buyer/seller exits the
contract but the buyer/seller keeps the contract open = open interest unchanged
Explain what happens when an investor shorts a certain share. - CORRECT ANSWER -
the investor borrows the share from another client's account and sells them in the market; to
close the position they must buy back the shares; these go back to the original client's account
from whom they were borrowed from; the broker who borrowed must give back dividends to the
client and any other paid income; investor can be short squeezed out of position; short selling
requires you to pay dividends or other income back to whom you borrowed from and requires
margin
derivative - CORRECT ANSWER - a financial instrument whose value depends on the
values of other more basic underlying assets/variables (forwards, futures, options, swaps)
forward/futures contract - CORRECT ANSWER - an agreement to buy/sell an asset at a
certain time in the future for a certain price
forward - CORRECT ANSWER - OTC; popular with currencies and interest rates;
forwards are flexible, but it's costly to search for an agreement (finding a counterparty), it's
subject to default risk and lacks liquidity
future - CORRECT ANSWER - standardized agreements and are traded on an exchange;
traditionally were traded using open outcry; the exchanges clear, settle, and guarantee all
transactions that occur; most contracts are closed out before maturity
options - CORRECT ANSWER - call- an option to buy a certain asset by a certain date for
a certain price; put- an option to sell a certain asset by a certain date for a certain price
American option - CORRECT ANSWER - can be exercised at any time
european option - CORRECT ANSWER - can only be exercised at maturity
Questions and CORRECT Answers
hedging - CORRECT ANSWER - company hedges when it has exposure to the price of an
asset and takes a position in futures/options market to offset exposure
speculation - CORRECT ANSWER - company has no exposure to offset; simply betting
on the future movements in the price of the asset
arbitrage - CORRECT ANSWER - involves taking a position in two or more different
markets to lock in a profit
"There is no point in our using oil futures. There is just
as much chance that the price of oil in the future will be less than the futures price as there is that
it will be greater than this price. " - CORRECT ANSWER - In this case of the airline
executive, we're using the oil future for hedging, not for speculation. We don't care about our
odds if it goes up or down; Instead of exposing itself to future prices of oil, the company should
hedge their risk by locking in a price now
Explain how margin accounts protect futures traders against the possibility of default. -
CORRECT ANSWER - margin is deposited by a trader with their broker and is used to act
as a guarantee that any losses on the futures contract will be covered; if losses are above a certain
level, the trader is required to deposit more money or exit the trade
"Speculation in futures markets is pure gambling. It is not in the public interest to allow
speculators to trade on a futures exchange." - CORRECT ANSWER - speculators are
important since they add liquidity to the market; contracts should be useful to hedgers and
speculators and should be made in the interest of them
"When a futures contract is traded on the floor of the exchange, it may be the case that
the open interest increases by one, stays the same, or decreases by one." - CORRECT
ANSWER - if both the buyer and seller enter into a new contract = open interest is 1; if
, both the buyer and seller exit the contract = open interest is -1; if the buyer/seller exits the
contract but the buyer/seller keeps the contract open = open interest unchanged
Explain what happens when an investor shorts a certain share. - CORRECT ANSWER -
the investor borrows the share from another client's account and sells them in the market; to
close the position they must buy back the shares; these go back to the original client's account
from whom they were borrowed from; the broker who borrowed must give back dividends to the
client and any other paid income; investor can be short squeezed out of position; short selling
requires you to pay dividends or other income back to whom you borrowed from and requires
margin
derivative - CORRECT ANSWER - a financial instrument whose value depends on the
values of other more basic underlying assets/variables (forwards, futures, options, swaps)
forward/futures contract - CORRECT ANSWER - an agreement to buy/sell an asset at a
certain time in the future for a certain price
forward - CORRECT ANSWER - OTC; popular with currencies and interest rates;
forwards are flexible, but it's costly to search for an agreement (finding a counterparty), it's
subject to default risk and lacks liquidity
future - CORRECT ANSWER - standardized agreements and are traded on an exchange;
traditionally were traded using open outcry; the exchanges clear, settle, and guarantee all
transactions that occur; most contracts are closed out before maturity
options - CORRECT ANSWER - call- an option to buy a certain asset by a certain date for
a certain price; put- an option to sell a certain asset by a certain date for a certain price
American option - CORRECT ANSWER - can be exercised at any time
european option - CORRECT ANSWER - can only be exercised at maturity
