Q1. C.
Contracts are flexible, often cleared and settled between transacting parties with a low
level of regulatory oversight.
Solution: Exchange-traded derivative contracts are standardized, cleared, and settled through a
centralized clearinghouse and accompanied by a high level of regulatory reporting. OTC
contracts are far more flexible and less regulated.
Q2. B. An OTC market, since the contract can be customized to match ABC’s desired risk profile.
Solution: The over-the-counter market allows the customization of risk to suit a client’s exposure
profile. It would be difficult for ABZ Limited to find an exact 150-day match in an exchange-traded
market.
Q3. B. −$3.703
Solution: Time value = pt − max(0, X(1 + r)−(T−t) − St) = −3.703.
Q4. A. $4.06
Solution: Lower bound = max(0, X(1 + r)−(T−t) − St) = max(0, 4.064) = $4.064.
Q5. A. High risk-free rate and negative cost of carry.
Solution: Both a high risk-free rate and low cost of carry increase the value of a call option.
Q6. A. Fixed rate at each period.
Solution: Considering a swap as a series of FRAs, we would have a different fixed rate for each
period, but a single fixed rate in an interest rate swap.
Q7. A. $970
Solution: Periodic settlement value = (2.5% − 0.56%) × 100,000 × 0.5 = $970.
Q8. B. The futures price is fixed at the start, and the value starts at zero and changes throughout
the contract’s life.
Solution: Futures price is fixed initially; the contract’s value begins at zero and fluctuates as the
market moves.
Q9. A. If there is a positive correlation between futures prices and interest rates, a long futures
contract is more profitable than comparable long forward contracts.
Solution: When futures prices rise with interest rates, profits from the long futures position can
be reinvested at higher rates.
Q10. B. 22.63
Solution: Vt(T) = CAD 239(1.035)−(0.1670) − 215 = CAD 22.63 MTM gain.
Q11. B. 2.81%
Solution: 0.92 = 1 / (1 + z )³ z = 2.81845%.
Q12. C. The institution receives USD 50,000.
Solution: Net cash flow = (3.5% − 3.0%) × 10,000,000 = USD 50,000.
Q13. B. Arbitrage refers to the ability to profit from price mismatches that last a very short time.
Solution: Arbitrage involves buying in the cheaper market and selling in the more expensive one
for a risk-free profit.
Q14. B. Options.
Solution: Options are the primary contingent claims — trade occurrence depends on one of the
counterparties.
Q15. C. Value = $0; Profit = $3
Solution: Since ST ≥ X, the option expires worthless; profit to seller = option premium = $3.
Q16. A. A forward commitment creates an obligation to transact, whereas a contingent claim
allows a transaction to be optional.
Solution: Forwards = obligation; Contingent claims (like options) = right, not obligation.
Q17. B. The expected value of the derivative deviates unexpectedly from that of the underlying.
Solution: Basis risk occurs when the expected relationship between a derivative and its
underlying breaks down.
Q18. A. Cash flow hedges.
Solution: Cash flow hedges are derivatives intended to stabilize a company’s fluctuating cash
flows.