Derivatives Exam 1 UPDATED ACTUAL
Exam Questions and CORRECT Answers
Derivative - CORRECT ANSWER - A security with a price that is dependent upon or
derived from one or more underlying assets
Uses of Derivatives - CORRECT ANSWER - - hedging (risk management)
- speculation
- increasing leverage
Call Option - CORRECT ANSWER - Represents the right, not the obligation, to purchase
specified asset at specified price
Put Option - CORRECT ANSWER - Represents the right, but not the obligation, to sell an
underlying asset at a particular price
Strike Price/Exercise Price - CORRECT ANSWER - price of the underlying at which
owner can transact
Forwards - CORRECT ANSWER - -Contract between 2 parties to buy/sell something at a
later date for a price agreed upon today
-It is a contract with a guarantee by both parties to perform (no optionality)
Futures - CORRECT ANSWER - -Agreement between 2 parties to buy/sell something at a
later date for a price agreed upon today but in an exchange-traded market subject to daily
valuation and settlement
-Futures are basically liquid forward contracts
-This liquidity allows the parties to buy/sell their respective obligations before settlement
, Swaps - CORRECT ANSWER - -An agreement between 2 parties to exchange future cash
flows
-Can be viewed as a combination of forward contracts
-Can be more efficient than both parties buying/selling components of a hedge
-No need to do so because parties agree to pay each other the respective differentials in cash
flows
Implied volatility - CORRECT ANSWER - The volatility that option traders use to price
an option, implied by the price of the option and a particular option-pricing model.
Why use options? - CORRECT ANSWER - Allow for exposure to direction of an
underlying asset for hedging/speculating but at a fixed amount of risk
Short selling - CORRECT ANSWER - speculating that the price of an asset will go down
by selling the shares before you own them
-> You must typically must own a stock before selling it, though, so if you want to sell short you
must borrow the shares to sell with an obligation to buy it back at some point (hopefully at a
lower price)
Short Selling Amazon Example - CORRECT ANSWER - -Amazon at $1000/share-To sell
short one could sell the stock at $1000-If it goes to $1500, lose $500 (unlimited upside loss
potential)-Alternatively, one could buy an Dec 20 2022 $950 put option for $25 which gives one
the right to sell Amazon at $950 until the 3rd Friday of Dec-The lower Amazon goes the more
valuable the right to sell it at $950 becomes (it's a short-delta strategy)-The put option will be
worth 0 if the stock is above $950 by expiration or worth the amount the stock is under $950 by
expiration (i.e. marked to parity)-The premium paid is the most the owner of the put option can
lose
Trade-off of an option contract - CORRECT ANSWER - the option contract has an
expiration date and requires payment of a premium where the short-sale is open-ended and
requires no premium outlay
Exam Questions and CORRECT Answers
Derivative - CORRECT ANSWER - A security with a price that is dependent upon or
derived from one or more underlying assets
Uses of Derivatives - CORRECT ANSWER - - hedging (risk management)
- speculation
- increasing leverage
Call Option - CORRECT ANSWER - Represents the right, not the obligation, to purchase
specified asset at specified price
Put Option - CORRECT ANSWER - Represents the right, but not the obligation, to sell an
underlying asset at a particular price
Strike Price/Exercise Price - CORRECT ANSWER - price of the underlying at which
owner can transact
Forwards - CORRECT ANSWER - -Contract between 2 parties to buy/sell something at a
later date for a price agreed upon today
-It is a contract with a guarantee by both parties to perform (no optionality)
Futures - CORRECT ANSWER - -Agreement between 2 parties to buy/sell something at a
later date for a price agreed upon today but in an exchange-traded market subject to daily
valuation and settlement
-Futures are basically liquid forward contracts
-This liquidity allows the parties to buy/sell their respective obligations before settlement
, Swaps - CORRECT ANSWER - -An agreement between 2 parties to exchange future cash
flows
-Can be viewed as a combination of forward contracts
-Can be more efficient than both parties buying/selling components of a hedge
-No need to do so because parties agree to pay each other the respective differentials in cash
flows
Implied volatility - CORRECT ANSWER - The volatility that option traders use to price
an option, implied by the price of the option and a particular option-pricing model.
Why use options? - CORRECT ANSWER - Allow for exposure to direction of an
underlying asset for hedging/speculating but at a fixed amount of risk
Short selling - CORRECT ANSWER - speculating that the price of an asset will go down
by selling the shares before you own them
-> You must typically must own a stock before selling it, though, so if you want to sell short you
must borrow the shares to sell with an obligation to buy it back at some point (hopefully at a
lower price)
Short Selling Amazon Example - CORRECT ANSWER - -Amazon at $1000/share-To sell
short one could sell the stock at $1000-If it goes to $1500, lose $500 (unlimited upside loss
potential)-Alternatively, one could buy an Dec 20 2022 $950 put option for $25 which gives one
the right to sell Amazon at $950 until the 3rd Friday of Dec-The lower Amazon goes the more
valuable the right to sell it at $950 becomes (it's a short-delta strategy)-The put option will be
worth 0 if the stock is above $950 by expiration or worth the amount the stock is under $950 by
expiration (i.e. marked to parity)-The premium paid is the most the owner of the put option can
lose
Trade-off of an option contract - CORRECT ANSWER - the option contract has an
expiration date and requires payment of a premium where the short-sale is open-ended and
requires no premium outlay
