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Deriv. TEST bank MST

Introduction to Derivative Securities (Curtin University)

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Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 1: Introduction
Multiple Choice Test Bank: Questions with Answers

1. A one-year forward contract is an agreement where

A. One side has the right to buy an asset for a certain price in one year’s time.
B. One side has the obligation to buy an asset for a certain price in one year’s time.
C. One side has the obligation to buy an asset for a certain price at some time during the
next year.
D. One side has the obligation to buy an asset for the market price in one year’s time.

Answer: B

A one-year forward contract is an obligation to buy or sell in one year’s time for a
predetermined price. By contrast, an option is the right to buy or sell.

2. Which of the following is NOT true

A. When a CBOE call option on IBM is exercised, IBM issues more stock
B. An American option can be exercised at any time during its life
C. An call option will always be exercised at maturity if the underlying asset price is greater
than the strike price
D. A put option will always be exercised at maturity if the strike price is greater than the
underlying asset price.

Answer: A
When an IBM call option is exercised the option seller must buy shares in the market to sell to
the option buyer. IBM is not involved in any way. Answers B, C, and D are true.

3. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the
stock with a strike price of $30 costs $4. Suppose that a trader buys two call options and one put
option. The breakeven stock price above which the trader makes a profit is
A. $35
B. $40
C. $30
D. $36

Answer: A
When the stock price is $35, the two call options provide a payoff of 2×(35−30) or $10. The put
option provides no payoff. The total cost of the options is 2×3+ 4 or $10. The stock price in A,
$35, is therefore the breakeven stock price above which the position is profitable because it is
the price for which the cost of the options equals the payoff.

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4. A one-year call option on a stock with a strike price of $30 costs $3; a one-year put option on the
stock with a strike price of $30 costs $4. Suppose that a trader buys two call options and one put
option. The breakeven stock price below which the trader makes a profit is
A. $25
B. $28
C. $26
D. $20

Answer: D
When the stock price is $20 the two call options provide no payoff. The put option provides a
payoff of 30−20 or $10. The total cost of the options is 2×3+ 4 or $10. The stock price in D, $20,
is therefore the breakeven stock price below which the position is profitable because it is the
price for which the cost of the options equals the payoff.

5. Which of the following is approximately true when size is measured in terms of the underlying
principal amounts or value of the underlying assets
A. The exchange-traded market is twice as big as the over-the-counter market.
B. The over-the-counter market is twice as big as the exchange-traded market.
C. The exchange-traded market is ten times as big as the over-the-counter market.
D. The over-the-counter market is ten times as big as the exchange-traded market.

Answer: D
The OTC market is about $600 trillion whereas the exchange-traded market is about $60 trillion.

6. Which of the following best describes the term “spot price”

A. The price for immediate delivery
B. The price for delivery at a future time
C. The price of an asset that has been damaged
D. The price of renting an asset

Answer: A
The spot price is the price for immediate delivery. The futures or forward price is the price for
delivery in the future

7. Which of the following is true about a long forward contract

A. The contract becomes more valuable as the price of the asset declines
B. The contract becomes more valuable as the price of the asset rises
C. The contract is worth zero if the price of the asset declines after the contract has been
entered into

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D. The contract is worth zero if the price of the asset rises after the contract has been
entered into

Answer: B
A long forward contract is an agreement to buy the asset at a predetermined price. The contract
becomes more attractive as the market price of the asset rises. The contract is only worth zero
when the predetermined price in the forward contract equals the current forward price (as it
usually does at the beginning of the contract).

8. An investor sells a futures contract an asset when the futures price is $1,500. Each contract is on
100 units of the asset. The contract is closed out when the futures price is $1,540. Which of the
following is true
A. The investor has made a gain of $4,000
B. The investor has made a loss of $4,000
C. The investor has made a gain of $2,000
D. The investor has made a loss of $2,000

Answer: B
An investor who buys (has a long position) makes a gain when a futures price increases. An
investor who sells (has a short position) takes a loss when a futures price increases.

9. Which of the following describes European options?

A. Sold in Europe
B. Priced in Euros
C. Exercisable only at maturity
D. Calls (there are no European puts)

Answer: C
European options can be exercised only at maturity. This is in contrast to American options
which can be exercised at any time. The term “European” has nothing to do with geographical
location, currencies, or whether the option is a call or a put.

10. Which of the following is NOT true

A. A call option gives the holder the right to buy an asset by a certain date for a certain
price
B. A put option gives the holder the right to sell an asset by a certain date for a certain
price
C. The holder of a call or put option must exercise the right to sell or buy an asset
D. The holder of a forward contract is obligated to buy or sell an asset

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Answer: C
The holder of a call or put option has the right to exercise the option but is not required to do
so. A, B, and C are correct

11. Which of the following is NOT true about call and put options:
A. An American option can be exercised at any time during its life
B. A European option can only be exercised only on the maturity date
C. Investors must pay an upfront price (the option premium) for an option contract
D. The price of a call option increases as the strike price increases

Answer: D
A call option is the option to buy for the strike price. As the strike price increases this option
becomes less valuable. A, B, and C are true.

12. The price of a stock on July 1 is $57. A trader buys 100 call options on the stock with a strike
price of $60 when the option price is $2. The options are exercised when the stock price is $65.
The trader’s net profit is
A. $700
B. $500
C. $300
D. $600

Answer: C
The payoff from the options is 100×(65-60) or $500. The cost of the options is 2×100 or $200.
The net profit is therefore 500−200 or $300.

13. The price of a stock on February 1 is $124. A trader sells 200 put options on the stock with a
strike price of $120 when the option price is $5. The options are exercised when the stock price
is $110. The trader’s net profit or loss is
A. Gain of $1,000
B. Loss of $2,000
C. Loss of $2,800
D. Loss of $1,000

Answer: D
The payoff that must be made on the options is 200×(120−110) or $2000. The amount received
for the options is 5×200 or $1000. The net loss is therefore 2000−1000 or $1000.

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14. The price of a stock on February 1 is $84. A trader buys 200 put options on the stock with a
strike price of $90 when the option price is $10. The options are exercised when the stock price
is $85. The trader’s net profit or loss is
A. Loss of $1,000
B. Loss of $2,000
C. Gain of $200
D. Gain of $1000

Answer: A
The payoff is 90−85 or $5 per option. For 200 options the payoff is therefore 5×200 or $1000.
However the options cost 10×200 or $2000. There is therefore a net loss of $1000.

15. The price of a stock on February 1 is $48. A trader sells 200 put options on the stock with a strike
price of $40 when the option price is $2. The options are exercised when the stock price is $39.
The trader’s net profit or loss is
A. Loss of $800
B. Loss of $200
C. Gain of $200
D. Loss of $900

Answer: C
The payoff is 40−39 or $1 per option. For 200 options the payoff is therefore 1×200 or $200.
However the premium received by the trader is 2×200 or $400. The trader therefore has a net
gain of $200.

16. A speculator can choose between buying 100 shares of a stock for $40 per share and buying
1000 European call options on the stock with a strike price of $45 for $4 per option. For second
alternative to give a better outcome at the option maturity, the stock price must be above
A. $45
B. $46
C. $55
D. $50

Answer: D
When the stock price is $50 the first alternative leads to a position in the stock worth 100×50 or
$5000. The second alternative leads to a payoff from the options of 1000×(50−45) or $5000. Both
alternatives cost $4000. It follows that the alternatives are equally profitable when the stock price is
$50. For stock prices above $50 the option alternative is more profitable.

17. A company knows it will have to pay a certain amount of a foreign currency to one of its
suppliers in the future. Which of the following is true

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A. A forward contract can be used to lock in the exchange rate

B. A forward contract will always give a better outcome than an option
C. An option will always give a better outcome than a forward contract
D. An option can be used to lock in the exchange rate

Answer: A
A forward contract ensures that the effective exchange rate will equal the current forward
exchange rate. An option provides insurance that the exchange rate will not be worse than a
certain level, but requires an upfront premium. Options sometimes give a better outcome and
sometimes give a worse outcome than forwards.

18. A short forward contract on an asset plus a long position in a European call option on the asset
with a strike price equal to the forward price is equivalent to
A. A short position in a call option
B. A short position in a put option
C. A long position in a put option
D. None of the above

Answer: C

Suppose that ST is the final asset price and K is the strike price/forward price. A short forward
contract leads to a payoff of K−ST. A long position in a European call option leads to a payoff of
max(ST−K, 0). When the payoffs are added together, it can be seen that the total position leads
to a gain of max(0, K−ST) which is the payoff from a long position in a put option. C can also be
seen to be true by plotting the payoffs as a function of the final stock price.

19. A trader has a portfolio worth $5 million that mirrors the performance of a stock index. The
stock index is currently 1,250. Futures contracts trade on the index with one contract being on
250 times the index. To remove market risk from the portfolio the trader should
A. Buy 16 contracts
B. Sell 16 contracts
C. Buy 20 contracts
D. Sell 20 contracts

Answer: B
One futures contract protects a portfolio worth 1250×250. The number of contract required is
therefore 5,000,000/(1250×250)=16. To remove market risk we need to gain on the contracts
when the market declines. A short futures position is therefore required.

20. Which of the following best describes a central clearing party

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A. It is a trader that works for an exchange

B. It stands between two parties in the over-the-counter market
C. It is a trader that works for a bank
D. It helps facilitate futures trades

Answer: B

A central clearing party (CCP) is a clearing house that stands between two parties in the over-
the-counter market. It serves the same purpose as an exchange clearing house.

Hull: Fundamentals of Futures and Options Markets, Ninth Edition

Chapter 2: Mechanics of Futures Markets
Multiple Choice Test Bank: Question with Answers

1. Which of the following is true

A. Both forward and futures contracts are traded on exchanges.
B. Forward contracts are traded on exchanges, but futures contracts are not.
C. Futures contracts are traded on exchanges, but forward contracts are not.
D. Neither futures contracts nor forward contracts are traded on exchanges.

Answer: C

Futures contracts trade only on exchanges. Forward contracts trade only in the over-the-counter
market.

2. Which of the following is NOT true

A. Futures contracts nearly always last longer than forward contracts
B. Futures contracts are standardized; forward contracts are not.
C. Delivery or final cash settlement usually takes place with forward contracts; the same is
not true of futures contracts.
D. Forward contracts usually have one specified delivery date; futures contract often have
a range of delivery dates.

Answer: A

Forward contracts often last longer than futures contracts. B, C, and D are true

3. In the corn futures contract a number of different types of corn can be delivered (with price
adjustments specified by the exchange) and there are a number of different delivery
locations. Which of the following is true
A. This flexibility tends increase the futures price.
B. This flexibility tends decrease the futures price.
C. This flexibility may increase and may decrease the futures price.

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D. This flexibility has no effect on the futures price

Answer: B

The party with the short position chooses between the alternatives. The alternatives therefore
make the futures contract more attractive to the party with the short position. The lower the
futures price the less attractive it is to the party with the short position. The benefit of the
alternatives available to the party with the short position is therefore compensated for by the
futures price being lower than it would otherwise be.

4. A company enters into a short futures contract to sell 50,000 units of a commodity for 70
cents per unit. The initial margin is $4,000 and the maintenance margin is $3,000. What is
the futures price per unit above which there will be a margin call?
A. 78 cents
B. 76 cents
C. 74 cents
D. 72 cents

Answer: D

There will be a margin call when more than $1000 has been lost from the margin account so
that the balance in the account is below the maintenance margin level. Because the company is
short, each one cent rise in the price leads to a loss or 0.01×50,000 or $500. A greater than 2
cent rise in the futures price will therefore lead to a margin call. The future price is currently 70
cents. When the price rises above 72 cents there will be a margin call.

5. A company enters into a long futures contract to buy 1,000 units of a commodity for $60 per
unit. The initial margin is $6,000 and the maintenance margin is $4,000. What futures price
will allow $2,000 to be withdrawn from the margin account?
A. $58
B. $62
C. $64
D. $66

Answer: B

Amounts in the margin account in excess of the initial margin can be withdrawn. Each $1
increase in the futures price leads to a gain of $1000. When the futures price increases by $2 the
gain will be $2000 and this can be withdrawn. The futures price is currently $60. The answer is
therefore $62.

6. One futures contract is traded where both the long and short parties are closing out existing

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positions. What is the resultant change in the open interest?

A. No change
B. Decrease by one
C. Decrease by two
D. Increase by one

Answer: B

The open interest goes down by one. This is because the trade eliminates one outstanding long
position and one outstanding short position.

7. Who initiates delivery in a corn futures contract

A. The party with the long position
B. The party with the short position
C. Either party
D. The exchange

Answer: B

The party with the short position initiates delivery by sending a “Notice of Intention to Deliver”
to the exchange. The exchange has a procedure for choosing a party with a long position to take
delivery.

8. You sell one December futures contracts when the futures price is $1,010 per unit. Each
contract is on 100 units and the initial margin per contract that you provide is $2,000. The
maintenance margin per contract is $1,500. During the next day the futures price rises to
$1,012 per unit. What is the balance of your margin account at the end of the day?
A. $1,800
B. $3,300
C. $2,200
D. $3,700

Answer: B

The price has increased by $2. Because you have a short position you lose 2×100 or $200. The
balance in the margin account therefore goes down from $3,500 to $3,300.

9. A hedger takes a long position in a futures contract on a commodity on November 1, 2012

to hedge an exposure on March 1, 2013. The initial futures price is $60. On December 31,
2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on
March 1, 2013. What gain is recognized in the accounting year January 1 to December 31,
2013? Each contract is on 1000 units of the commodity.
A. $0
B. $1,000
C. $3,000

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D. $4,000

Answer: D

Hedge accounting is used. The whole of the gain or loss on the futures is therefore recognized in
2013. None is recognized in 2012. In this case the gain is $4 per unit or $4,000 in total.

10. A speculator takes a long position in a futures contract on a commodity on November 1,

2012 to hedge an exposure on March 1, 2013. The initial futures price is $60. On December
31, 2012 the futures price is $61. On March 1, 2013 it is $64. The contract is closed out on
March 1, 2013. What gain is recognized in the accounting year January 1 to December 31,
2013? Each contract is on 1000 units of the commodity.
A. $0
B. $1,000
C. $3,000
D. $4,000

Answer: C

In this case there is no hedge accounting. Gains or losses are accounted for as they are accrued. The
price per unit increases by $3 in 2013. The total gain in 2013 is therefore $3,000.

11. The frequency with which futures margin accounts are adjusted for gains and losses is
A. Daily
B. Weekly
C. Monthly
D. Quarterly

Answer: A

In futures contracts margin accounts are adjusted for gains or losses daily.

12. Margin accounts have the effect of

A. Reducing the risk of one party regretting the deal and backing out
B. Ensuring funds are available to pay traders when they make a profit
C. Reducing systemic risk due to collapse of futures markets
D. All of the above

Answer: D

Initial margin requirements dramatically reduce the risk that a party will walk away from a
futures contract. As a result they reduce the risk that the exchange clearing house will not have
enough funds to pays profits to traders. Furthermore, if traders are less likely to suffer losses
because of counterparty defaults, there is less systemic risk.

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13. Which entity in the United States takes primary responsibility for regulating futures market?
A. Federal Reserve Board
B. Commodities Futures Trading Commission (CFTC)
C. Security and Exchange Commission (SEC)
D. US Treasury

Answer: B

The CFTC has primary responsibility for regulating futures markets

14. For a futures contract trading in April 2012, the open interest for a June 2012 contract,
when compared to the open interest for Sept 2012 contracts, is usually
A. Higher
B. Lower
C. The same
D. Equally likely to be higher or lower

Answer: A

The contracts which are close to maturity tend to have the highest open interest. However,
during the maturity month itself the open interest declines.

15. Clearing houses are

A. Never used in futures markets and sometimes used in OTC markets
B. Used in OTC markets, but not in futures markets
C. Always used in futures markets and sometimes used in OTC markets
D. Always used in both futures markets and OTC markets

Answer: C

Clearing houses are always used by exchanges trading futures. Increasingly, OTC products are
cleared through CCPs, which are a type of clearing house.

16. A haircut of 20% means that

A. A bond with a market value of $100 is considered to be worth $80 when used to
satisfy a collateral request
B. A bond with a face value of $100 is considered to be worth $80 when used to satisfy
a collateral request
C. A bond with a market value of $100 is considered to be worth $83.3 when used to
satisfy a collateral request
D. A bond with a face value of $100 is considered to be worth $83.3 when used to
satisfy a collateral request

Answer: A

A haircut is the amount the market price of asset is reduced by for the purposes of determining

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its value for collateral purposes. A is therefore correct.

17. With bilateral clearing, the number of agreements between four dealers, who trade with
each other, is
A. 12
B. 1
C. 6
D. 2

Answer: C
Suppose the dealers are W, X, Y , and Z. The agreements are between W and X, W and Y, W and
Z, X and Y, X and Z, and Y and Z. There are therefore a total of 6 agreements.

18. Which of the following best describes central clearing parties

A. Help market participants to value derivative transactions
B. Must be used for all OTC derivative transactions
C. Are used for futures transactions
D. Perform a similar function to exchange clearing houses

Answer: D

CCPs do for the OTC market what exchange clearing houses do for the exchange-traded market.
The correct answer is therefore D. CCPs must be used for most standard OTC derivatives
transactions, but not for all derivatives transactions.

19. Which of the following are cash settled

A. All futures contracts
B. All option contracts
C. Futures on commodities
D. Futures on stock indices

Answer: D

Futures on stock indices are usually cash settled. The rest are settled by delivery of the
underlying assets

20. A limit order

A. Is an order to trade up to a certain number of futures contracts at a certain price
B. Is an order that can be executed at a specified price or one more favorable to the
investor
C. Is an order that must be executed within a specified period of time
D. None of the above

Answer: B

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In a limit order a trader specifies the worst price (from the trader’s perspective) at which the
trade can be carried out.

Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 3: Hedging Strategies Using Futures
Multiple Choice Test Bank: Questions with Answers

1. The basis is defined as spot minus futures. A trader is hedging the sale of an asset with a short
futures position. The basis increases unexpectedly. Which of the following is true?
A. The hedger’s position improves.
B. The hedger’s position worsens.
C. The hedger’s position sometimes worsens and sometimes improves.
D. The hedger’s position stays the same.

Answer: A

The price received by the trader is the futures price plus the basis. It follows that the trader’s
position improves when the basis increases.

2. Futures contracts trade with every month as a delivery month. A company is hedging the
purchase of the underlying asset on June 15. Which futures contract should it use?
A. The June contract
B. The July contract
C. The May contract
D. The August contract

Answer: B

As a general rule the futures maturity month should be as close as possible to but after the
month when the asset will be purchased. In this case the asset will be purchased in June and so
the best contract is the July contract.

3. On March 1 a commodity’s spot price is $60 and its August futures price is $59. On July 1 the
spot price is $64 and the August futures price is $63.50. A company entered into futures
contracts on March 1 to hedge its purchase of the commodity on July 1. It closed out its position
on July 1. What is the effective price (after taking account of hedging) paid by the company?
A. $59.50
B. $60.50
C. $61.50
D. $63.50

Answer: A

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The user of the commodity takes a long futures position. The gain on the futures is 63.50−59 or
$4.50. The effective paid realized is therefore 64−4.50 or $59.50. This can also be calculated as
the March 1 futures price (=59) plus the basis on July 1 (=0.50).

4. On March 1 the price of a commodity is $1,000 and the December futures price is $1,015. On
November 1 the price is $980 and the December futures price is $981. A producer of the
commodity entered into a December futures contracts on March 1 to hedge the sale of the
commodity on November 1. It closed out its position on November 1. What is the effective price
(after taking account of hedging) received by the company for the commodity?
A. $1,016
B. $1,001
C. $981
D. $1,014

Answer: D

The producer of the commodity takes a short futures position. The gain on the futures is
1015−981 or $34. The effective price realized is therefore 980+34 or $1014. This can also be
calculated as the March 1 futures price (=1015) plus the November 1 basis (=−1).

5. Suppose that the standard deviation of monthly changes in the price of commodity A is $2. The
standard deviation of monthly changes in a futures price for a contract on commodity B (which
is similar to commodity A) is $3. The correlation between the futures price and the commodity
price is 0.9. What hedge ratio should be used when hedging a one month exposure to the price
of commodity A?
A. 0.60
B. 0.67
C. 1.45
D. 0.90

Answer: A

The optimal hedge ratio is 0.9×(2/3) or 0.6.

6. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an
index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary
to reduce beta to 0.9?
A. Long 192 contracts
B. Short 192 contracts
C. Long 48 contracts
D. Short 48 contracts

Answer: D

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To reduce the beta by 0.3 we need to short 0.3×36,000,000/(900×250) or 48 contracts.

7. A company has a $36 million portfolio with a beta of 1.2. The futures price for a contract on an
index is 900. Futures contracts on $250 times the index can be traded. What trade is necessary
to increase beta to 1.8?
A. Long 192 contracts
B. Short 192 contracts
C. Long 96 contracts
D. Short 96 contracts

Answer: C

To increase beta by 0.6 we need to go long 0.6×36,000,000/(900×250) or 96 contracts

8. Which of the following is true?

A. The optimal hedge ratio is the slope of the best fit line when the spot price (on the y-axis) is
regressed against the futures price (on the x-axis).
B. The optimal hedge ratio is the slope of the best fit line when the futures price (on the y-
axis) is regressed against the spot price (on the x-axis).
C. The optimal hedge ratio is the slope of the best fit line when the change in the spot price
(on the y-axis) is regressed against the change in the futures price (on the x-axis).
D. The optimal hedge ratio is the slope of the best fit line when the change in the futures price
(on the y-axis) is regressed against the change in the spot price (on the x-axis).

Answer: C

The optimal hedge ratio reflects the ratio of the change in the spot price to the change in the
futures price.

9. Which of the following describes tailing the hedge?

A. A strategy where the hedge position is increased at the end of the life of the hedge
B. A strategy where the hedge position is increased at the end of the life of the futures
contract
C. A more exact calculation of the hedge ratio when forward contracts are used for hedging
D. None of the above

Answer: D

Tailing the hedge is a calculation appropriate when futures are used for hedging. It corrects for
daily settlement

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10. A company due to pay a certain amount of a foreign currency in the future decides to hedge
with futures contracts. Which of the following best describes the advantage of hedging?
A. It leads to a better exchange rate being paid
B. It leads to a more predictable exchange rate being paid
C. It caps the exchange rate that will be paid
D. It provides a floor for the exchange rate that will be paid

Answer: B

Hedging is designed to reduce risk not increase expected profit. Options can be used to create a
cap or floor on the price. Futures attempt to lock in the price

11. Which of the following best describes the capital asset pricing model?
A. Determines the amount of capital that is needed in particular situations
B. Is used to determine the price of futures contracts
C. Relates the return on an asset to the return on a stock index
D. Is used to determine the volatility of a stock index

Answer: C

CAPM relates the return on an asset to its beta. The parameter beta measures the sensitivity of
the return on the asset to the return on the market. The latter is usually assumed to be the
return on a stock index such as the S&P 500.

12. Which of the following best describes “stack and roll”?

A. Creates long-term hedges from short term futures contracts
B. Can avoid losses on futures contracts by entering into further futures contracts
C. Involves buying a futures contract with one maturity and selling a futures contract with a
different maturity
D. Involves two different exposures simultaneously

Answer: A

Stack and roll is a procedure where short maturity futures contracts are entered into. When
they are close to maturity they are replaced by more short maturity futures contracts and so on.
The result is the creation of a long term hedge from short-term futures contracts.

13. Which of the following increases basis risk?

A. A large difference between the futures prices when the hedge is put in place and when it is
closed out
B. Dissimilarity between the underlying asset of the futures contract and the hedger’s
exposure
C. A reduction in the time between the date when the futures contract is closed and its
delivery month
D. None of the above

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Answer: B

Basis is the difference between futures and spot at the time the hedge is closed out. This
increases as the time between the date when the futures contract is put in place and the
delivery month increases. (C is not therefore correct). It also increases as the asset underlying
the futures contract becomes more different from the asset being hedged. (B is therefore
correct.)

14. Which of the following is a reason for hedging a portfolio with an index futures?
A. The investor believes the stocks in the portfolio will perform better than the market but
is uncertain about the future performance of the market
B. The investor believes the stocks in the portfolio will perform better than the market and
the market is expected to do well
C. The portfolio is not well diversified and so its return is uncertain
D. All of the above

Answer: A

Index futures can be used to remove the impact of the performance of the overall market on the
portfolio. If the market is expected to do well hedging against the performance of the market is
not appropriate. Hedging cannot correct for a poorly diversified portfolio.

15. Which of the following does NOT describe beta?

A. A measure of the sensitivity of the return on an asset to the return on an index
B. The slope of the best fit line when the return on an asset is regressed against the return
on the market
C. The hedge ratio necessary to remove market risk from a portfolio
D. Measures correlation between futures prices and spot prices for a commodity

Answer: D

A, B, and C all describe beta. It has nothing to do with the correlation between futures and spot
prices for a commodity

16. Which of the following is true?

A. Hedging can always be done more easily by a company’s shareholders than by the
company itself
B. If all companies in an industry hedge, a company in the industry can sometimes reduce
its risk by choosing not to hedge
C. If all companies in an industry do not hedge, a company in the industry can reduce its
risk by hedging
D. If all companies in an industry do not hedge, a company is liable increase its risk by
hedging

Answer: D

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If all companies in a industry hedge, the prices of the end product tends to reflect movements in
relevant market variables. Attempting to hedge those movements can therefore increase risk.

17. Which of the following is necessary for tailing a hedge?

A. Comparing the size in units of the position being hedged with the size in units of the
futures contract
B. Comparing the value of the position being hedged with the value of one futures
contract
C. Comparing the futures price of the asset being hedged to its forward price
D. None of the above

Answer: B

When tailing a hedge the optimal hedge ratio is applied to the ratio of the value of the
position being hedged to the value of one futures contract.

18. Which of the following is true?

A. Gold producers should always hedge the price they will receive for their production of
gold over the next three years
B. Gold producers should always hedge the price they will receive for their production of
gold over the next one year
C. The hedging strategies of a gold producer should depend on whether it shareholders
want exposure to the price of gold
D. Gold producers can hedge by buying gold in the forward market

Answer: C

Some shareholders buy gold stocks to gain exposure to the price of gold. They do not want
the company they invest in to hedge. In practice gold mining companies make their hedging
strategies clear to shareholders.

19. A silver mining company has used futures markets to hedge the price it will receive for
everything it will produce over the next 5 years. Which of the following is true?
A. It is liable to experience liquidity problems if the price of silver falls dramatically
B. It is liable to experience liquidity problems if the price of silver rises dramatically
C. It is liable to experience liquidity problems if the price of silver rises dramatically or falls
dramatically
D. The operation of futures markets protects it from liquidity problems

Answer: B

The mining company shorts futures. It gains on the futures when the price decreases and
loses when the price increases. It may get margin calls which lead to liquidity problems
when the price rises even though the silver in the ground is worth more.

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20. A company will buy 1000 units of a certain commodity in one year. It decides to hedge 80%
of its exposure using futures contracts. The spot price and the futures price are currently
$100 and $90, respectively. If the spot price and the futures price in one year turn out to be
$112 and $110, respectively. What is the average price paid for the commodity?
A. $92
B. $96
C. $102
D. $106

Answer: B

On the 80% (hedged) part of the commodity purchase the price paid will 112−(110−90) or
$92. On the other 20% the price paid will be the spot price of $112. The weighted average
of the two prices is 0.8×92+0.2×112 or $96.

Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 4: Interest Rates
Multiple Choice Test Bank: Questions with Answers

21. The compounding frequency for an interest rate defines

A. The frequency with which interest is paid
B. A unit of measurement for the interest rate
C. The relationship between the annual interest rate and the monthly interest rate
D. None of the above

Answer: B

The compounding frequency is a unit of measurement. The frequency with which interest is paid
may be different from the compounding frequency used for quoting the rate.

22. An interest rate is 6% per annum with annual compounding. What is the equivalent rate with
continuous compounding?
A. 5.79%
B. 6.21%
C. 5.83%
D. 6.18%

Answer: C

The equivalent rate with continuous compounding is ln(1.06) = 0.0583 or 5.83%.

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23. An interest rate is 5% per annum with continuous compounding. What is the equivalent rate
with semiannual compounding?
A. 5.06%
B. 5.03%
C. 4.97%
D. 4.94%

Answer: A

The equivalent rate with semiannual compounding is 2×(e 0.05/2−1) = 0.0506 or 5.06%.

24. An interest rate is 12% per annum with semiannual compounding. What is the equivalent rate
with quarterly compounding?
A. 11.83%
B. 11.66%
C. 11.77%
D. 11.92%

Answer: A

√
The equivalent rate per quarter is 1.06−1=2.956 % . The annualized rate with quarterly
compounding is four times this or 11.83%.

25. The two-year zero rate is 6% and the three year zero rate is 6.5%. What is the forward rate for
the third year? All rates are continuously compounded.
A. 6.75%
B. 7.0%
C. 7.25%
D. 7.5%

Answer: D

The forward rate for the third year is (3×0.065−2×0.06)/(3−2) = 0.075 or 7.5%.

26. The six-month zero rate is 8% per annum with semiannual compounding. The price of a one-
year bond that provides a coupon of 6% per annum semiannually is 97. What is the one-year
continuously compounded zero rate?
A. 8.02%
B. 8.52%
C. 9.02%
D. 9.52%

Answer: C

If the rate is R we must have

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3
+103 e−R×1=97
1. 04
or
97−3/1. 04
e−R = =0 . 9137
103
so that R = ln(1/0.9137) = 0.0902 or 9.02%.

27. The yield curve is flat at 6% per annum. What is the value of an FRA where the holder receives
interest at the rate of 8% per annum for a six-month period on a principal of $1,000 starting in
two years? All rates are compounded semiannually.
A. $9.12
B. $9.02
C. $8.88
D. $8.63

Answer: D

The value of the FRA is the value of receiving an extra 0.5×(0.08−0.06)×1000 = $10 in 2.5 years.
This is 10/(1.035) = $8.63.

28. Under liquidity preference theory, which of the following is always true?
A. The forward rate is higher than the spot rate when both have the same maturity.
B. Forward rates are unbiased predictors of expected future spot rates.
C. The spot rate for a certain maturity is higher than the par yield for that maturity.
D. Forward rates are higher than expected future spot rates.

Answer: D

Liquidity preference theory argues that individuals like their borrowings to have a long maturity
and their deposits to have a short maturity. To induce people to lend for long periods forward
rates are raised relative to what expected future short rates would predict.

29. The zero curve is upward sloping. Define X as the 1-year par yield, Y as the 1-year zero rate and Z
as the forward rate for the period between 1 and 1.5 year. Which of the following is true?
A. X is less than Y which is less than Z
B. Y is less than X which is less than Z
C. X is less than Z which is less than Y
D. Z is less than Y which is less than X

Answer: A

When the zero curve is upward sloping, the one-year zero rate is higher than the one-year par
yield and the forward rate corresponding to the period between 1.0 and 1.5 years is higher than
the one-year zero rate. The correct answer is therefore A.

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30. Prior to the credit crisis that started in 2007 which of the following was the proxy used by
derivatives traders for the risk-free rate
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate

Answer: B

Pre-crisis derivatives traders used LIBOR as a proxy for the risk-free rate.

31. Since the credit crisis that started in 2007 which of the following have derivatives traders
started to use as the risk-free rate for some transactions
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate

Answer: D

Since the crisis traders have tended to use The OIS rate as the risk-free discount rate for
collateralized transactions.

32. At what interest rate does a government borrow in its own currency?
A. Treasury rate
B. LIBOR
C. LIBID
D. Repo rate

Answer: A

The Treasury rate is the term used for the rate at which a government borrows in its own
currency

33. Which of the following is true of LIBOR

A. The LIBOR rate is free of credit risk
B. A LIBOR rate is lower than the Treasury rate when the two have the same maturity
C. It is a rate used when borrowing and lending takes place between banks
D. It is subject to favorable tax treatment in the U.S.

Answer: C

LIBOR is a rate used for interbank transactions.

34. Which of following describes forward rates?

A. Interest rates implied by current zero rates for future periods of time
B. Interest rate earned on an investment that starts today and last for n-years in the future

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without coupons
C. The coupon rate that causes a bond price to equal its par (or principal) value
D. A single discount rate that gives the value of a bond equal to its market price when
applied to all cash flows

Answer: A

The forward rate is the interest rate implied by the current term structure for future periods of
time. For example, earning the zero rate for one year and the forward rate for the period
between one and two years gives the same result as earning the zero rate for two years.

35. Which of the following is NOT a theory of the term structure

A. Expectations theory
B. Market segmentation theory
C. Liquidity preference theory
D. Maturity preference theory

Answer: C

Maturity preference theory is not a theory of the term structure. The other three are.

36. A repo rate is

[Link] uncollateralized rate
B.A rate where the credit risk is relative high
[Link] rate implicit in a transaction where securities are sold and bought back at a higher
price
[Link] of the above

Answer: C

A repo transaction is one where a company agrees to sell securities today and buy them back
later at a future time. It is a form of collateralized borrowing. The credit risk is very low.

37. Bootstrapping involves

[Link] the yield on a bond
[Link] from short maturity instruments to longer maturity instruments determining zero
rates at each step
[Link] from long maturity instruments to shorter maturity instruments determining zero
rates at each step
[Link] calculation of par yields

Answer: B

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Bootstrapping is a way of constructing the zero coupon yield curve from coupon-bearing bonds.
It involves working from the shortest maturity bond to progressively longer maturity bonds
making sure that the calculated zero coupon yield curve is consistent with the market prices of
the instruments.

38. The zero curve is downward sloping. Define X as the 1-year par yield, Y as the 1-year zero rate
and Z as the forward rate for the period between 1 and 1.5 year. Which of the following is true?
A. X is less than Y which is less than Z
B. Y is less than X which is less than Z
C. X is less than Z which is less than Y
D. Z is less than Y which is less than X

Answer: D

The forward rate accentuates trends in the zero curve. The par yield shows the same trends but
in a less pronounced way.

39. Which of the following is true?

A. When interest rates in the economy increase, all bond prices increase
B. As its coupon increases, a bond’s price decreases
C. Longer maturity bonds are always worth more that shorter maturity bonds when the
coupon rates are the same
D. None of the above

Answer: D

When interest rates increase the impact of discounting is to make future cash flows worth less.
Bond prices therefore decline. A is therefore wrong. As coupons increase a bond becomes more
valuable because higher cash flows will be received. B is therefore wrong. When the coupon is
higher than prevailing interest rates, longer maturity bonds are worth more than shorter
maturity bonds. When it is less than prevailing interest rates, longer maturity bonds are worth
less than shorter maturity bonds. C is therefore not true. The correct answer is therefore D.

40. The six month and one-year rates are 3% and 4% per annum with semiannual compounding.
Which of the following is closest to the one-year par yield expressed with semiannual
compounding?
A.3.99%
B.3.98%
C.3.97%
D.3.96%

Answer: A

The six month rate is 1.5% per six months. The one year rate is 2% per six months. The one year
par yield is the coupon that leads to a bond being worth par. A is the correct answer because
(3.99/2)/1.015+(100+3.99/2)/1.02 2 = 100. The formula in the text can also be used to give the

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par yield as [(100-100/1.022 )×2]/(1/1.015+1.022 )=3.99.

Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 5: Determination of Forward and Futures Prices
Multiple Choice Test Bank: Questions with Answers

41. Which of the following is a consumption asset?

A. The S&P 500 index
B. The Canadian dollar
C. Copper
D. IBM stock

Answer: C

A, B, and D are investment assets (held by at least some investors purely for investment
purposes). C is a consumption asset.

42. An investor shorts 100 shares when the share price is $50 and closes out the position six months
later when the share price is $43. The shares pay a dividend of $3 per share during the six
months. How much does the investor gain?
A. $1,000
B. $400
C. $700
D. $300

Answer: B

The investor gains $7 per share because he or she sells at $50 and buys at $43. However, the
investor has to pay the $3 per share dividend. The net profit is therefore 7−3 or $4 per share.
100 shares are involved. The total gain is therefore $400.

43. The spot price of an investment asset that provides no income is $30 and the risk-free rate for
all maturities (with continuous compounding) is 10%. What is the three-year forward price?
A. $40.50
B. $22.22
C. $33.00
D. $33.16

Answer: A

The 3-year forward price is the spot price grossed up for 3 years at the risk-free rate. It is 30e0.1×3
=$40.50.

44. The spot price of an investment asset is $30 and the risk-free rate for all maturities is 10% with
continuous compounding. The asset provides an income of $2 at the end of the first year and at
the end of the second year. What is the three-year forward price?

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A. $19.67
B. $35.84
C. $45.15
D. $40.50

Answer: B

The present value of the income is 2e-0.1×1+2e-0.1×2= $3.447. The three year forward price is
obtained by subtracting the present value of the income from the current stock price and then
grossing up the result for three years at the risk-free rate. It is (30−3.447)e0.1×3 = $35.84.

45. An exchange rate is 0.7000 and the six-month domestic and foreign risk-free interest rates are
5% and 7% (both expressed with continuous compounding). What is the six-month forward
rate?
A. 0.7070
B. 0.7177
C. 0.7249
D. 0.6930

Answer: D

The six-month forward rate is 0.7000e−(0.05−0.07)×0.5=0.6930.

46. Which of the following is true?

A. The convenience yield is always positive or zero.
B. The convenience yield is always positive for an investment asset.
C. The convenience yield is always negative for a consumption asset.
D. The convenience yield measures the average return earned by holding futures contracts.

Answer: A

The convenience yield measures the benefit of owning an asset rather than having a
forward/futures contract on an asset. For an investment asset it is always zero. For a
consumption asset it is greater than or equal to zero.

47. A short forward contract that was negotiated some time ago will expire in three months and has
a delivery price of $40. The current forward price for three-month forward contract is $42. The
three month risk-free interest rate (with continuous compounding) is 8%. What is the value of
the short forward contract?
A. +$2.00
B. −$2.00
C. +$1.96
D. −$1.96

Answer: D

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The contract gives one the obligation to sell for $40 when a forward price negotiated today
would give one the obligation to sell for $42. The value of the contract is the present value of −
$2 or −2e-0.08×0.25 = −$1.96.

48. The spot price of an asset is positively correlated with the market. Which of the following would
you expect to be true?
A. The forward price equals the expected future spot price.
B. The forward price is greater than the expected future spot price.
C. The forward price is less than the expected future spot price.
D. The forward price is sometimes greater and sometimes less than the expected future spot
price.

Answer: C

When the spot price is positively correlated with the market the forward price is less than the
expected future spot price. This is because the spot price is expected to provide a return greater
than the risk-free rate and the forward price is the spot price grossed up at the risk-free rate.

49. Which of the following describes the way the futures price of a foreign currency is quoted by the
CME group?
A. The number of U.S. dollars per unit of the foreign currency
B. The number of the foreign currency per U.S. dollar
C. Some futures prices are always quoted as the number of U.S. dollars per unit of the
foreign currency and some are always quoted the other way round
D. There are no quotation conventions for futures prices

Answer: A

The futures price is quoted as the number of US dollars per unit of the foreign currency.
Spot exchange rates and forward exchange rates are sometimes quoted this way and
sometimes quoted the other way round.

50. Which of the following describes the way the forward price of a foreign currency is quoted?
A. The number of U.S. dollars per unit of the foreign currency
B. The number of the foreign currency per U.S. dollar
C. Some forward prices are usually quoted as the number of U.S. dollars per unit of the
foreign currency and some are usually quoted the other way round
D. There are no quotation conventions for forward prices

Answer: C

The futures price is quoted as the number of US dollars per unit of the foreign currency.
Spot exchange rates and forward exchange rates are sometimes quoted this way and
sometimes quoted the other way round.

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51. Which of the following is NOT a reason why a short position in a stock is closed out?
A. The investor with the short position chooses to close out the position
B. The lender of the shares issues instructions to close out the position
C. The broker is no longer able to borrow shares from other clients
D. The investor does not maintain margins required on his/her margin account

Answer: B

A, C, and D are all reasons why the short position might be closed out. B is not. The lender of
shares cannot issue instructions to close out the short position.

52. Which of the following is NOT true?

A. Gold and silver are investment assets
B. Investment assets are held by significant numbers of investors for investment purposes
C. Investment assets are never held for consumption
D. The forward price of an investment asset can be obtained from the spot price, interest
rates, and the income paid on the asset

Answer: C

Investment assets are sometimes held for consumption. Silver is an example. To be an

investment asset, an asset has to be held for investment by at least some traders

53. What should a trader do when the one-year forward price of an asset is too low? Assume that
the asset provides no income.
A. The trader should borrow the price of the asset, buy one unit of the asset and enter into
a short forward contract to sell the asset in one year.
B. The trader should borrow the price of the asset, buy one unit of the asset and enter into
a long forward contract to buy the asset in one year.
C. The trader should short the asset, invest the proceeds of the short sale at the risk-free
rate, enter into a short forward contract to sell the asset in one year
D. The trader should short the asset, invest the proceeds of the short sale at the risk-free
rate, enter into a long forward contract to buy the asset in one year

Answer: D

If the forward price is too low relative to the spot price the trader should short the asset in
the spot market and buy it in the forward market.

54. Which of the following is NOT true about forward and futures contracts?
A. Forward contracts are more liquid than futures contracts
B. The futures contracts are traded on exchanges while forward contracts are traded in the
over-the-counter market
C. In theory forward prices and futures prices are equal when there is no uncertainty about
future interest rates
D. Taxes and transaction costs can lead to forward and futures prices being different

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Answer: A

Futures contracts are more liquid than forward contracts. To unwind a futures position it is
simply necessary to take an offsetting position. The statements in B, C, and D are correct

55. As the convenience yield increases, which of the following is true?

A. The one-year futures price as a percentage of the spot price increases
B. The one-year futures price as a percentage of the spot price decreases
C. The one-year futures price as a percentage of the spot price stays the same
D. Any of the above can happen

Answer: B

As the convenience yield increases, the futures price declines relative to the spot price. This is
because the convenience of owning the asset (as opposed to having a futures contract) becomes
more important.

56. As inventories of a commodity decline, which of the following is true?

A. The one-year futures price as a percentage of the spot price increases
B. The one-year futures price as a percentage of the spot price decreases
C. The one-year futures price as a percentage of the spot price stays the same
D. Any of the above can happen

Answer: B

When inventories decline, the convenience yield increases and the futures price as a percentage
of the spot price declines.

57. Which of the following describes a known dividend yield on a stock?

A. The size of the dividend payments each year is known
B. Dividends per year as a percentage of today’s stock price are known
C. Dividends per year as a percentage of the stock price at the time when dividends are
paid are known
D. Dividends will yield a certain return to a person buying the stock today

Answer: C

The dividend yield is the dividend per year as a percent of the stock price at the time when the
dividend is paid.

58. Which of the following is an argument used by Keynes and Hicks?

A. If hedgers hold long positions and speculators holds short positions, the futures price
will tend to be higher than the expected future spot price
B. If hedgers hold long positions and speculators holds short positions, the futures price

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will tend to be lower than the expected future spot price

C. If hedgers hold long positions and speculators holds short positions, the futures price
will tend to be lower than today’s spot price
D. If hedgers hold long positions and speculators holds short positions, the futures price
will tend to be higher than today’s spot price

Answer: A

Keynes and Hicks argued that hedgers will be prepared to accept negative returns on average
because of the benefits of hedging whereas speculators require positive returns on average. This
leads to A.

59. Which of the following describes contango?

A. The futures price is below the expected future spot price
B. The futures price is below today’s spot price
C. The futures price is a declining function of the time to maturity
D. The futures price is above the expected future spot price

Answer: D

Contango is defined as the futures price being above the expected future spot price. It is also
sometimes used to describe the situation where the futures price is above the spot price.

60. Which of the following is true for a consumption commodity?

A. There is no limit to how high or low the futures price can be, except that the futures
price cannot be negative
B. There is a lower limit to the futures price but no upper limit
C. There is an upper limit to the futures price but no lower limit, except that the futures
price cannot be negative
D. The futures price can be determined with reasonable accuracy from the spot price and
interest rates

Answer: C

If the futures price of a consumption commodity becomes too high an arbitrageur will buy the
commodity and sell futures to lock in a profit. An arbitrageur cannot follow the opposite
strategy of buying futures and selling or shorting the asset when the futures price is low. This is
because consumption assets cannot be shorted . Furthermore, people who hold the asset in
general do so because they need the asset for their business. They are not prepared to swap
their position in the asset for a similar position in a futures. Consequently, there is an upper limit
but no lower limit to the futures price.

Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 6: Interest Rate Futures
Multiple Choice Test Bank: Questions and Answers

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61. Which of following is applicable to corporate bonds in the United States?

A. Actual/360
B. Actual/Actual
C. 30/360
D. Actual/365

Answer: C

Corporate bonds in the U.S are usually quoted with a 30/360 day count. This means that
there are assumed to be 30 days per month and 360 days per year when the length of an
accrual period is calculated.

62. It is May 1. The quoted price of a bond with an Actual/Actual (in period) day count and 12%
per annum coupon (paid semiannually) in the United States is 105. It has a face value of 100
and pays coupons on April 1 and October 1. What is the cash price?
A. 106.00
B. 106.02
C. 105.98
D. 106.04

Answer: C

The cash price is the quoted price plus accrued interest. There are 30 actual days between April
1 and May 1 and 183 actual days between April 1 and October 1. In this case the quoted price is
105 and the accrued interest is 0.06×100×30/183=0.98. The answer is therefore 105.98.

63. It is May 1. The quoted price of a bond with a 30/360 day count and 12% per annum
coupon in the United States is 105. It has a face value of 100 and pays coupons on April 1
and October 1. What is the cash price?
A. 106.00
B. 106.02
C. 105.98
D. 106.04

Answer: A

The cash price is the quoted price plus accrued interest. There are 30 assumed days between
April 1 and May 1 and 180 assumed days between April 1 and October 1. In this case the quoted
price is 105 and the accrued interest is 0.06×100×30/180 = 1.00. The answer is therefore 106.00.

64. The most recent settlement bond futures price is 103.5. Which of the following four bonds is
cheapest to deliver?

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A. Quoted bond price = 110; conversion factor = 1.0400.

B. Quoted bond price = 160; conversion factor = 1.5200.
C. Quoted bond price = 131; conversion factor = 1.2500.
D. Quoted bond price = 143; conversion factor = 1.3500.

Answer: C

The cost of delivering a bond is the quoted bond price minus the most recent settlement price
times the conversion factor. This is 2.36, 2.68, 1.625, and 3.275 for bonds in A, B, C, and D,
respectively. The bond in C is therefore cheapest to deliver.

65. Which of the following is NOT an option open to the party with a short position in the Treasury
bond futures contract?
A. The ability to deliver any of a number of different bonds
B. The wild card play
C. The fact that delivery can be made any time during the delivery month
D. The interest rate used in the calculation of the conversion factor

Answer: D

A, B, and C describe options that the party with the short position has. D does not

66. A trader enters into a long position in one Eurodollar futures contract. How much does the
trader gain when the futures price quote increases by 6 basis points?
A. $6
B. $150
C. $60
D. $600

Answer: B

The trader gains $25 for each basis point. The gain is therefore 25×6 or $150.

67. A company invests $1,000 in a five-year zero-coupon bond and $4,000 in a ten-year zero-
coupon bond. What is the duration of the portfolio?
A. 6 years
B. 7 years
C. 8 years
D. 9 years

Answer: D
The duration of the first bond is 5 years and the duration of the second bond is 10 years. The
duration of the portfolio is a weighted average with weights corresponding to the amounts
invested in the bonds. It is 0.2×5+0.8×10=9 years.

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68. The modified duration of a bond portfolio worth $1 million is 5 years. By approximately how
much does the value of the portfolio change if all yields increase by 5 basis points?
A. Increase of $2,500
B. Decrease of $2,500
C. Increase of $25,000
D. Decrease of $25,000

Answer: B

When yields increase bond prices decrease. The proportional decrease is the modified duration
times the yield increase. In this case it is 5×0.0005=0.0025. The decrease is therefore
0.0025×1,000,000 or $2,500.

69. A portfolio is worth $24,000,000. The futures price for a Treasury note futures contract is 110
and each contract is for the delivery of bonds with a face value of $100,000. On the delivery
date the duration of the bond that is expected to be cheapest to deliver is 6 years and the
duration of the portfolio will be 5.5 years. How many contracts are necessary for hedging the
portfolio?
A. 100
B. 200
C. 300
D. 400

Answer: B

The contract price is 110,000. The number of contracts is (24,000,000×5.5)/(110,000×6.0)=200

70. Which of the following is true?

A. The futures rates calculated from a Eurodollar futures quote are always less than the
corresponding forward rate
B. The futures rates calculated from a Eurodollar futures quote are always greater than the
corresponding forward rate
C. The futures rates calculated from a Eurodollar futures quote should equal the
corresponding forward rate
D. The futures rates calculated from a Eurodollar futures quote are sometimes greater than
and sometimes less than the corresponding forward rate

Answer: B

The futures rate must be reduced by what is known as a convexity adjustment to get the
forward rate.

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71. How much is a basis point?

A. 1.0%
B. 0.1%
C. 0.01%
D. 0.001%

Answer: C

A basis point is 0.01%.

72. Which of the following day count conventions applies to a US Treasury bond?
A. Actual/360
B. Actual/Actual (in period)
C. 30/360
D. Actual/365

Answer: B

Actual/Actual (in period) is used for US Treasury bonds. This means that the interest earned
during a period that lies between two coupon payment dates is calculated by dividing the
actual number of days in the period by the number of days between the coupon payments
and multiplying the result by the next coupon payment

73. What is the quoted discount rate on a money market instrument?

A. The interest rate earned as a percentage of the final face value of a bond
B. The interest rate earned as a percentage of the initial price of a bond
C. The interest rate earned as a percentage of the average price of a bond
D. The risk-free rate used to calculate the present value of future cash flows from a bond

Answer: A

The quoted discount rate is the interest earned as a percentage of the final face value

74. Which of the following is closest to the duration of a 2-year bond that pays a coupon of 8% per
annum semiannually? The yield on the bond is 10% per annum with continuous compounding.
A. 1.82
B. 1.85
C. 1.88
D. 1.92

Answer: C

The duration of the bond is the weighted average of the times when cash flows are received
with weights proportional to the present values of the cash flows. This is

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−0 .10×. 5 −0.10×1 −0. 10×1. 5 −0 .10×2

4e ×0 .5+4×e ×1+4×e ×1. 5+104×e ×2
−0 . 10×. 5 −0 .10×1 −0. 10×1. 5
=1. 88 years
4e +4×e +4×e +104×e−0 .10×2

75. Which of the following is NOT true about duration?

A. It equals the years-to-maturity for a zero coupon bond
B. It equals the weighted average of payment times for a bond, where weights are
proportional to the present value of payments
C. Equals the weighted average of individual bond durations for a portfolio, where weights
are proportional to the present value of bond prices
D. The prices of two bonds with the same duration change by the same percentage
amount when interest rate moves up by 100 basis points

Answer: D

D is only approximately true. A, B, and C are exactly true.

76. The conversion factor for a bond is approximately

A. The price it would have if all cash flows were discounted at 6% per annum
B. The price it would have if it paid coupons at 6% per annum
C. The price it would have if all cash flows were discounted at 8% per annum
D. The price it would have if it paid coupons at 8% per annum

Answer: A

The calculation of the conversion factor involves discounting the cash flows on the bond at 6%.

77. The time-to-maturity of a Eurodollars futures contract is 4 years and the time-to-maturity of the
rate underlying the futures contract is 4.25 years. The standard deviation of the change in the
short term interest rate,  = 0.011. What does the model in the text give as the difference
between the futures and the forward interest rate.
A. 0.105%
B. 0.103%
C. 0.098%
D. 0.093%

Answer: B

With the notation in the text, the futures rate exceeds the forward rate by 0.52T1T2. In this
case =0.011, T1=4 and T2=4.25 so the difference between the forward and futures price is
0.5×0.011×4×4.25=0.00103.

78. A trader uses 3-month Eurodollar futures to lock in a rate on $5 million for six months. How
many contracts are required?
A. 5
B. 10
C. 15

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D. 20

Answer: B

Each contract locks in the rate on $1 million dollars for three months. The six month rate has
twice the duration of the three-month rate. 5×2 = 10 contracts are therefore required

79. In the U.S. what is the longest maturity for 3-month Eurodollar futures contracts?
A: 2 years
B: 5 years
C: 10 years
D: 20 years

Answer: C

Eurodollar futures have maturities out to 10 years.

80. Duration matching immunizes a portfolio against

A. Any parallel shift in the yield curve
B. All shifts in the yield curve
C. Changes in the steepness of the yield curve
D. Small parallel shifts in the yield curve

Answer: D

Duration matching only protects against small parallel shifts. It does not provide protection
against large parallel shifts and non-parallel shifts.

Hull: Fundamentals of Futures and Options Markets, Eighth Edition

Chapter 9: Mechanics of Options Markets
Multiple Choice Test Bank: Questions with Answers

81. Which of the following describes a call option?

E. The right to buy an asset for a certain price
F. The obligation to buy an asset for a certain price
G. The right to sell an asset for a certain price
H. The obligation to sell an asset for a certain price

Answer: A

A call option is the right, but not the obligation to buy.

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82. Which of the following is true?

A. A long call is the same as a short put
B. A short call is the same as a long put
C. A call on a stock plus a stock the same as a put
D. None of the above

Answer: D

None of the statements are true. Long calls, short calls, long puts, and short puts all have
different payoffs as indicated by Figure 9.5. A put on a stock plus the stock provides a payoff
that is similar to a call, as explained in Chapters 10 and 11. But a call on a stock plus a stock
does not provide a similar payoff to a put.

83. An investor has exchange-traded put options to sell 100 shares for $20. There is a 2 for 1 stock
split. Which of the following is the position of the investor after the stock split?
A. Put options to sell 100 shares for $20
B. Put options to sell 100 shares for $10
C. Put options to sell 200 shares for $10
D. Put options to sell 200 shares for $20

Answer: C

When there is a stock split the number of shares increases and the strike price decreases. In
this case, because it is a 2 for 1 stock split, the number of shares doubles and the strike price
halves.

84. An investor has exchange-traded put options to sell 100 shares for $20. There is 25% stock
dividend. Which of the following is the position of the investor after the stock dividend?
A. Put options to sell 100 shares for $20
B. Put options to sell 75 shares for $25
C. Put options to sell 125 shares for $15
D. Put options to sell 125 shares for $16

Answer: D

The stock dividend is equivalent to a 5 for 4 stock split. The number of shares goes up by
25% and the strike price is reduced to 4/5 of its previous value.

85. An investor has exchange-traded put options to sell 100 shares for $20. There is a $1 cash
dividend. Which of the following is then the position of the investor?
A. The investor has put options to sell 100 shares for $20
B. The investor has put options to sell 100 shares for $19
C. The investor has put options to sell 105 shares for $19
D. The investor has put options to sell 105 shares for $19.05

Answer: A

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Cash dividends unless they are unusually large have no effect on the terms of an option.

86. Which of the following describes a short position in an option?

A. A position in an option lasting less than one month
B. A position in an option lasting less than three months
C. A position in an option lasting less than six months
D. A position where an option has been sold

Answer: D

A short position is a position where the option has been sold (the opposite to a long
position).

87. Which of the following describes a difference between a warrant and an exchange-traded stock
option?
A. In a warrant issue, someone has guaranteed the performance of the option seller in the
event that the option is exercised
B. The number of warrants is fixed whereas the number of exchange-traded options in
existence depends on trading
C. Exchange-traded stock options have a strike price
D. Warrants cannot be traded after they have been purchased

Answer: B

A warrant is a fixed number of options issued by a company. They often trade on an

exchange after they have been issued.

88. Which of the following describes LEAPS?

A. Options which are partly American and partly European
B. Options where the strike price changes through time
C. Exchange-traded stock options with longer lives than regular exchange-traded stock
options
D. Options on the average stock price during a period of time

Answer: C

LEAPS are long-term equity anticipation securities. They are exchange-traded options with
relatively long maturities.

89. Which of the following is an example of an option class?

A. All calls on a certain stock
B. All calls with a particular strike price on a certain stock
C. All calls with a particular time to maturity on a certain stock

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D. All calls with a particular time to maturity and strike price on a certain stock

Answer: A

An option class is all calls on a certain stock or all puts on a certain stock.

90. Which of the following is an example of an option series?

A. All calls on a certain stock
B. All calls with a particular strike price on a certain stock
C. All calls with a particular time to maturity on a certain stock
D. All calls with a particular time to maturity and strike price on a certain stock

Answer: D

All options on a certain stock of a certain type (calls or put) with a certain strike price and
time to maturity are referred to as an option series.

91. Which of the following must post margin?

A. The seller of an option
B. The buyer of an option
C. The seller and the buyer of an option
D. Neither the seller nor the buyer of an option

Answer: A

The seller of the option must post margin as a guarantee that the payoff on the option (if
there is one) will be made. The buyer of the option usually pays for the option upfront and
so no margin is required.

92. Which of the following describes a long position in an option?

A. A position where there is more than one year to maturity
B. A position where there is more than five years to maturity
C. A position where an option has been purchased
D. A position that has been held for a long time

Answer: C

A long position is a position where an option has been purchased. It can be contrasted with
a short position which is a position where an option has been sold.

93. Which of the following is NOT traded by the CBOE?

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A. Weeklys
B. Monthlys
C. Binary options
D. DOOM options

Answer: B

Monthlys are not a CBOE product. The others are.

94. When a six-month option is purchased

A. The price must be paid in full
B. Up to 25% of the option price can be borrowed using a margin account
C. Up to 50% of the option price can be borrowed using a margin account
D. Up to 75% of the option price can be borrowed using a margin account

Answer: A

Only options lasting more than 9 months can be bought on margin.

95. Which of the following are true for CBOE stock options?
A. There are no margin requirements
B. The initial margin and maintenance margin are determined by formulas and are equal
C. The initial margin and maintenance margin are determined by formulas and are
different
D. The maintenance margin is usually about 75% of the initial margin

Answer: B

Margin accounts for options must be brought up to the initial/maintenance margin level
every day.

96. The price of a stock is $67. A trader sells 5 put option contracts on the stock with a strike price of
$70 when the option price is $4. The options are exercised when the stock price is $69. What is
the trader’s net profit or loss?
A. Loss of $1,500
B. Loss of $500
C. Gain of $1,500
D. Loss of $1,000

Answer: C

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The option payoff is 70−69 = $1. The amount received for the option is $4. The gain is $3 per
option. In total 5×100 = 500 options are sold. The total gain is therefore $3 × 500 = $1,500.

97. A trader buys a call and sells a put with the same strike price and maturity date. What is the
position equivalent to?
A. A long forward
B. A short forward
C. Buying the asset
D. None of the above

Answer: A

From adding up the two payoffs we see that A is true: max(S T−K,0)−max(K−ST,0)= ST−K

98. The price of a stock is $64. A trader buys 1 put option contract on the stock with a strike price of
$60 when the option price is $10. When does the trader make a profit?
A. When the stock price is below $60
B. When the stock price is below $64
C. When the stock price is below $54
D. When the stock price is below $50

Answer: D

The payoff must be more than the $10 paid for the option. The stock price must therefore
be below $50.

99. Consider a put option and a call option with the same strike price and time to maturity. Which of
the following is true?
A. It is possible for both options to be in the money
B. It is possible for both options to be out of the money
C. One of the options must be in the money
D. One of the options must be either in the money or at the money

Answer: D

If the stock price is greater than the strike price the call is in the money and the put is out of
the money. If the stock price is less than the strike price the call is out of the money and the
put is in the money. If the stock price is equal to the strike price both options are at the
money.

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100. In which of the following cases is an asset NOT considered constructively sold?
A. The owner shorts the asset
B. The owner buys an in-the-money put option on the asset
C. The owner shorts a forward contract on the asset
D. The owner shorts a futures contract on the stock

Answer: B

Profits on the asset have to be recognized in A, C, and D. The holder of the asset cannot
defer recognition of profits with the trades indicated. In the case of B the asset is not
considered constructively sold. Buying a deep-in-the-money put option is a way of almost
certainly locking in a profit on an asset without triggering an immediate tax liability.

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