7.

Derivatives
7.1. Derivatives Market and Instruments

7.1.1.

7.1.1.1. : A derivative is a financial instrument (contract) that derives its

performance from the performance of an underlying asset.

7.1.1.2.

➢ forward commitment & contingent claim

◼ Forward commitment (firm commitment): is an agreement between two

parties in which one party, the buyer, agrees to buy from the other party, the
seller, an underlying asset at a future date at a price established at the start
→ forward, futures and swap contracts
◼ Contingent claim: is derivative in which the payoffs occur if a specific event
happens → option contracts
◆ Credit default swaps (CDS) is essentially an insurance contract for the
reference, the reference obligation is the fixed income security on
which the swap is written-usually a bond but potentially also a loan.
◆ The protection buyer pays the seller a premium. The default swap
premium is also referred to as the CDS spread.
◆ Protection buyer receives a payment from the protection seller if
default occurs on the reference entity.

➢ exchange-traded & over-the-counter traded

◼ Exchange-traded:

A—>Clearinghouse—>B

◼ OTC traded: A—>B

Exchange-traded Over-the-counter
:

Standardized —> Liquid Customized/Specific needs

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Backed by a clearinghouse Trade with counterparty (default risk)

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Trade in the a physical exchange Not trade in organized markets

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Regulated Unregulated
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◆ Market makers: buy at one price (the bid), sell at a higher price (the
ask).

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7.1.2.

Q-1. Which of the following derivatives is least likely to be classified as a contingent claim?
A. A futures contract
B. A call option contract
C. A credit default swap

Q-2. In contrast to over-the-counter options, futures contracts most likely: 2019

A. are not exposed to default risk.

B. represent a right rather than a commitment.
C. are private, customized transactions

Q-3. Which of the following is least likely to be an example of a derivative? 18

A. An exchange-traded fund
B. A contract to sell Alphabet Inc.’s shares at a fixed price
C. A contract to buy Australian dollars at a predetermined exchange rate

7.2. Advantages & Disadvantages of Derivatives

7.2.1.

7.2.1.1. Advantages & disadvantages of derivatives

➢ Advantage
◼ Price discovery
◼ Risk management: hedge and speculation
◼ Lowering transaction costs
◼ Low capital requirement
◼ Greater liquidity
◼ Ease of going short
◼ Enhance market efficiency
➢ Disadvantage
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◼ Too risky and high leverage

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◼ Complex instruments
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◼ Sometimes likened to gambling

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7.2.2.

Q-4. Which of the following is not an advantage of derivative markets?

A. They are less volatile than spot markets

B. They facilitate the allocation of risk in the market
C. They incur lower transaction costs than spot markets

Q-5. Which of the following is not accurate? The derivative markets tend to:
A. bring investors more difficulties to go short than to go long.
B. allow trading the risk without trading the instrument itself.
C. improve the allocation of risk and facilitate more effective risk management for both
companies and economies.

2208 2023BT.8.1.37

7.3. Issuer & Investor Use of Derivatives

7.3.1.

7.3.1.1. Issuer Use of Derivatives

➢ Issuers predominantly use derivatives to offset or hedge market-based underlying
exposures incidental to their commercial operations and financing activities.
➢ Hedge accounting allows an issuer to offset a hedging instrument (usually a
derivative) against a hedged transaction or balance sheet item to reduce financial
statement volatility.
Hedge Accounting Types Description Examples
Cash Flow Absorbs variable cash ✓ Interest rate swap to a fixed
flow of floating-rate rate for floating-rate debt
asset or liability ✓ FX forward to hedge
(forecasted transaction) forecasted sales
Fair Value Offsets fluctuation in ✓ Interest rate swap to a floating
fair value of an asset or rate for fixed-rate debt
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liability ✓ Commodity future to hedge

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inventory
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Net Designated as offsetting ✓ Currency swap

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Investment the FX risk of the equity ✓ Currency forward

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of a foreign operation
7.3.1.2. Investor Use Derivatives to
➢ Replicate a cash market strategy:
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 ◼ greater liquidity and reduced capital required to trade derivatives.
➢ Hedge a fund’s value against adverse movements in underlying:
◼ derivative hedges enable investors to isolate certain underlying exposures in
the investment process while retaining a position in others.
➢ Modify or add exposures using derivatives, which in some cases are unavailable
in cash markets:
◼ the flexibility to take short positions or to increase or otherwise modify
exposure using derivatives beyond cash alternatives.

7.3.2.

Q-6. Which of the following statement is most likely correct according to hedge designation:
A. A cash flow hedge is a derivative used to offset the fluctuation in fair value of an asset or
liability.
B. A fair value hedge is a derivative designated as absorbing the variable cash flow of a floating-
rate asset or liability.
C. A net investment hedge is a derivative designated as offsetting the foreign exchange risk of
the equity of a foreign operation.

2023BT.8.1.38 Knowledge check

7.4. Forward Contract

7.4.1.

7.4.1.1. Classification of forward contract

➢ Commodity forward contract
➢ Financial forward contract
7.4.1.2. Characteristics forward contract
➢ Each party are exposed to default risk (or counterparty risk)
➢ Zero-sum game

7.4.2.
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Q-7. The usefulness of a forward contract is limited by some problems. Which of the following
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is most likely one of those problems?

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A. Once you have entered into a forward contract, it is difficult to exit from the contract
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B. Entering into a forward contract requires the long party to deposit an initial amount with the
short party

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C. If the price of the underlying asset moves adversely from the perspective of the long party,
periodic payments must be made to the short party

Q-8. Two counterparties sign a forward contract on a stock, the underlying stock price goes
up afterward, who will most likely suffer from credit default risk?
A. The long position only.
B. The short position only.
C. Both long and short position.

2022BT.8.1.6 视频重录

7.5. Forward Rate Agreements(FRA)

7.5.1.

7.5.1.1.

➢ Definition: viewed as a forward contract for the long to get a loan from the short
at a specific future date at a fixed rate in the contract.
➢ A forward rate agreement (FRA) is a forward contract on an interest rate (LIBOR).

➢ Quotation: A 60-day FRA on 90-day LIBOR 2×5 FRA means Settlement or

expiration is 60 days from now and the payment at settlement is based on 90-day
LIBOR 60 days from now.
7.5.1.2. LIBOR and Euribor
➢ LIBOR
◼ USD interest rates.
◼ Quoted as an annualized rates based on a 360-day a year
◼ Add-on rate
◼ Single interest
➢ Euribor is a similar rate for borrowing and lending in Euros.
7.5.1.3. Settlement
➢ Settle in cash, but no actual loan is made at the settlement date.
➢ Payoff
:

◼ If the reference rate at the expiration date is above the specified contract
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rate, the long will receive cash payment from the short;
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◼ If the reference rate at the expiration date is below the contract rate, the
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short will receive cash payment from the long

7.5.1.4. Synthetic FRA:
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7.5.2.

Q-9. A 90-day FRA on 180-day LIBOR is quoted as: mock

A. 3×6 FRA
B. 9×3 FRA
C. 3×9 FRA

Q-10. Conceptually, a FRA most likely allows a company that wants to invest money in the
future to lock in a rate by making a: 2017 Mock PM

A. variable payment and receiving a fixed payment.

B. fixed payment and receiving a different fixed payment.
C. fixed payment and receiving a variable payment.

7.6. Futures Contract

7.6.1.

7.6.1.1. Futures contract

➢ Margin
◼ Initial margin: the first deposit is called the initial margin. Initial margin must
be posted before any trading takes place;
◼ Maintenance margin: is the amount of money that each participant must
maintain in the account after the trade is initiated. If the margin balance is
lower than the maintenance margin, the trader will get a margin call;
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◼ Variation margin: used to bring the margin balance back up to the initial
margin level.
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➢ Daily price limit: price limits are exchanged-imposed limits on how much the
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contract price can change from the previous day’s settlement price.
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➢ Marking to market: the margin requirement of a futures contract is low because

at the end of every day there is a daily settlement process called marking to
market.
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 ➢ Difference between forward and futures
Forwards Futures
Private contracts Exchange-traded
Unique customized contracts Standardized contracts
Little or no regulation Regulated
Default risk is present Guaranteed by clearinghouse
Settlement at maturity Daily settlement(mark to market)
No margin deposit required Margin required and adjusted

7.6.1.2.

margin margin

margin initial margin maintenance margin

➢ Clearinghouse
◼ Each exchange has a clearing house which is a third participant guaranteeing
to each party that it ensures against the other party defaulting.
◼ A clearinghouse acts as the counterparty to each participant. The
clearinghouse is the buyer to the seller and the seller to the buyer by
crediting gains to the winners and charging losses to the losers.
◼ There is no need to worry about the counterparty default risk.
◼ Each participant are allowed by the clearinghouse to reverse their positions
in the future.

7.6.2.
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Q-11. Tony Harris is planning to start trading in commodities. He has heard about the use of
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futures contracts on commodities and is learning more about them. Which of the
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following is Harris least likely to find associated with a futures contract?

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A. Existence of counterparty risk

B. Standardized contractual terms
C. Payment of an initial margin to enter into a contract

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Q-12. When receive a margin call, an investor must deposit more money to meet the in the

futures market, whereas to meet the in the stock market:

A. Initial margin Initial margin

B. Maintenance margin Maintenance margin
C. Initial margin Maintenance margin

Q-13. In futures markets, contract performance is most likely guaranteed by: 18

A. Clearing houses.
B. The futures exchanges.
C. Regulatory agencies

7.7. Swap Contract

7.7.1.

7.7.1.1.

➢ Swap contract: A swap contract obligates two parties to exchange a series of cash
flows on periodic settlement dates over a certain time period
➢ Three kinds of swaps
◼ Interest rate swaps
◆ Interest rate swap in which one party pays a fixed rate and the other
pays a floating rate.
◼ Currency swaps

◆ Notional principle will be changed in a currency swap.

◼ Equity swaps
◆ Permit investors to pay the return on one stock index and receive the
return on another index or a fixed rate.
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7.7.1.2. forward
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➢ No payment required by either party at initiation except the principal values

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exchanged in currency swaps.

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➢ Custom instruments.
➢ Not traded in any organized secondary market.
➢ Largely unregulated.

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 ➢ Default risk is a critical aspect of the contracts.
➢ Institutions dominate.
7.7.1.3. Plain vanilla interest rate swap: involves trading fixed interest rate payments for
floating-rate payment (paying fixed and receiving floating).
➢ Counterparties: The parties involved in any swap agreement are called the
counterparties
➢ Pay-fixed side: The counterparty that makes fixed-rate interest payment in
exchange for variable interest rate.
➢ Pay-floating side: The counterparty that makes variable-rate interest payment in
exchange for fixed payment.

7.7.2.

Q-14. In a currency swap, the underlying principal amount is exchanged: 18

A. only at the start of the swap.

B. only at the end of the swap.
C. both at the start and at the end of the swap.

7.8. Basic Concept of Options

7.8.1.

7.8.1.1. Basic characteristics of options (4 positions of options)

➢ Definition of option
◼ A derivative contract in which one party, the buyer, pays a sum of money to
the other party, the seller or writer, and receives the right to either buy or
sell an underlying asset at a fixed price either on a specific expiration date or
at any time prior to the expiration date.

◼ Call option long call and short call

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◼ Put option long put and short put

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➢
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◼ option premium: paid by the buyer of option

◼ exercise price: represent the exercise price specified in the

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 contract.
➢ An option to buy an asset at a particular price is termed a call option
Buyer of a call Right to buy
Seller of a call Obligation to sell
➢ An option to sell an asset at a particular price is termed a put option
Buyer of a put Right to sell
Seller of a put Obligation to buy
➢ Payoff

➢ Payoff for options

◼ Long call: 𝑐𝑇 = 𝑀𝑎𝑥(0, 𝑆𝑇 − 𝑋)
◼ Short call: 𝑐𝑇 = −𝑀𝑎𝑥(0, 𝑆𝑇 − 𝑋)
◼ Long put: 𝑝𝑇 = 𝑀𝑎𝑥(0, 𝑋 − 𝑆𝑇 )
◼ Short put: 𝑝𝑇 = −𝑀𝑎𝑥(0, 𝑋 − 𝑆𝑇 )
➢ Gain or loss
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 ➢ Profits for options
◼ Long call: 𝑐𝑇 = 𝑀𝑎𝑥(0, 𝑆𝑇 − 𝑋) − 𝑐0
◼ Short call: 𝑐𝑇 = −𝑀𝑎𝑥(0, 𝑆𝑇 − 𝑋) + 𝑐0
◼ Long put: 𝑝𝑇 = 𝑀𝑎𝑥(0, 𝑋 − 𝑆𝑇 ) − 𝑝0
◼ Short put: 𝑝𝑇 = −𝑀𝑎𝑥(0, 𝑋 − 𝑆𝑇 ) + 𝑝0

7.8.2.

Q-15. Which of the following is most similar to a short position in the underlying asset?
A. Buying a put
B. Writing a put
C. Buying a call

7.9. Risk Neutrality

7.9.1.

7.9.1.1. Risk-neutral investors are willing to buy risky investments for which they expect to
earn only the risk-free rate. They do not expect to earn a premium for bearing risk.
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7.9.1.2. The expected payoff of the derivative can be discounted at the risk-free rate. And
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should yield the risk-free rate of return, if it generates certain payoffs.

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7.9.2.

Q-16. Derivatives pricing models use the risk-free rate to discount future cash flows because
these models:
A. are based on portfolios with uncertain payoffs.
B. assume that derivatives investors are risk-neutral.
C. assume that risk can be eliminated by diversification.

7.10. Moneyness, Intrinsic Value, Time Value

7.10.1.

7.10.1.1. Option

➢ Financial option
◼ Equity options
◼ Interest options
◼ Foreign currency options
◼ Bond options
◼ Index options
➢ Commodity option

7.10.1.2. Moneyness long

➢ In the money: immediate exercise would generate a positive payoff.

➢ At the money: immediate exercise would generate no payoff.
➢ Out of the money: immediate exercise would generate a negative payoff.
Moneyness Call option Put option
In-the-money S>X S<X
At-the-money S=X S=X
Out-of-the-money S<X S>X
7.10.1.3. Intrinsic Value and Time Value
➢ The intrinsic value or exercise value of an option is the amount that it is in the
:

money, and zero otherwise.

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◼ Intrinsic value of call option: C=max[0, S-X]

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◼ Intrinsic value of put option: P=max[0, X-S]

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➢ Time value
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◼ The difference between the price of an option (called its premium) and its
intrinsic value is due to its time value.
◼ European put option: time value can be larger than, smaller than or equal to
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 zero.
◼ For others, time value is not less than zero.
➢ Option value=intrinsic value + time value
◼ Before expiration: option value>intrinsic value
◼ At expiration: option value=intrinsic value
7.10.1.4. Replication
➢ Long call + short put=long forward/long asset

7.10.2.

Q-17. At expiration, an option that is in the money will most likely have: 2019 mock A PM

A. time value, but no exercise value.

B. exercise value, but no time value.
C. both time value and exercise value.

Q-18. Which of the following statements most closely relates to the concept of moneyness?
A. The sum of money the option buyer pays the seller is called the premium
B. Both call and put option prices decline as the time to expiration becomes shorter
C. One would never exercise a call option if the price of the underlying is below the strike
price

Q-19. The recent price per share of Hua Big, Inc. is €80 per share. Selina Woods buys 150 shares
at €80. To protect against a falling price, Woods buys one put, covering 150 shares of Hua
Big, with a strike price of €70. The put premium is €1.5 per share. If Hua Big closes at €76
per share at the expiration of the put and Woods sells her shares at €76, Woods’ profit
from the stay/put is closest to:
A. - €825.
B. - €600.
C. €375.
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7.11. Option Sensitivity

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7.11.1.
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7.11.1.1. option
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 Factor European call European put American call American put

Underlying asset price + - + -

Strike price - + - +

Time + * + +

Risk-free rat e + - + -

Volatility + + + +

Payments on the
- + - +
underlying

Carrying cost + - + -

*There is an exception to the general rule that European put option thetas are negative. The put
value may increases as the option approaches maturity if the option is deep in-the-money and
close to maturity. The higher the risk-free rate, the stronger the negative relationship.

7.11.2.

Q-20. Which statement best describes the early exercise of non-dividend paying American
options? Early exercise may be advantageous for: 2016 mock PM

A. deep-in-the-money calls.
B. both deep-in-the-money calls and deep-in-the-money puts.
C. deep-in-the-money puts.

Q-21. If there are two call options for two different underlying assets, and related information
is shown in the table below. 1906

Option 1 Option 2
Payments on the underlying Positive Zero
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Carrying cost Zero Positive

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Based on the table, which of the option is most likely to have higher value?
A. Option 1
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B. Option 2
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C. The same

Q-22. The value of a call option can be positively correlated to the: 18

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A. exercise price & risk-free rate
B. risk-free rate & volatility
C. exercise price & volatility

7.12. Put-Call Parity

7.12.1.

7.12.1.1. Put-call parity

➢ Put call parity: consists two portfolio: fiduciary call and protective put.
◼ c0+ X/(1+Rf)T = S0 + p0
◆ fiduciary call: c0+ X/(1+Rf)T
◆ protective put: S0 + p0

➢ Put-call parity

◼ Pricing
◼ Positions replicating
◼ Risk free arbitrary

X
C+ S+P
◆ E.g., (1 + RFR )T long

long security, long put, short short call, short bonds.

➢ Replication ( put-call parity ):

◼ S = C - P + X / (1 + RFR)T

◼ P = C - S + X / (1 + RFR)T

◼ C = S + P - X / (1 + RFR)T

◼ X / (1 + RFR)T = S + P - C
◆ Note that the options much be European-style and the puts and calls
mush have the same exercise price for these relations to hold.
◆ Fiduciary call: buy riskless bond that pays X at maturity and a call with
exercise price X.
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◆ Protective put: buy security and long put.

➢ Put-call-forward parity can be written as
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◼ p-c=[X-F (T)]/(1+r)^T
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◼ This means that the difference between the price of a put and the price of a
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call is equal to the difference between exercise price and forward price
discounted at the risk-free rate.

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7.12.2.

Q-23. A description that will least likely be used to explain put-call parity is:

A. The (exercise) prices of calls and puts on an underlying asset must be consistent with each
other to remove arbitrage opportunities.
B. A fiduciary call option strategy and a protective put option strategy for an underlying asset
are equal in value.
C. A put is equivalent to long a call, a long position in the underlying asset, and a long position
in the risk-free asset.

Q-24. A stock is selling at $40, a 3-month put at $50 is selling for $11, a 3-month call at $50 is
selling for $1, and the risk-free rate is 6%. How much, if anything, can be made on an
arbitrage?
A. $0 (no arbitrage)
B. $0.28
C. $0.72

Q-25. According to put–call–forward parity, the difference between the price of a put and the

price of a call is most likely equal to the difference between: 18

A. forward price and spot price discounted at the risk-free rate.

B. spot price and exercise price discounted at the risk-free rate.
C. exercise price and forward price discounted at the risk-free rate.

Q-26. Which of the following investment cannot provide diversification benefits, allowing risk
to be reduced without necessarily affecting or compromising return, to an investor?
A. Purchasing stocks and taking long position in put options.
B. Holding highly correlated assets.
C. Allocating a portion of a portfolio to alternative investments.

2208
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Q-27. Instead of entering into a short position in risk free bond, the investors can also replicate
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the risk free bond by: 1906

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A. combining short stock, a short positions in a put option, and a long position in call option.
B. combining long stock, a long positions in a put option, and a short position in call option.
C. combining short stock, a short positions in a put option, and a short position in call option.

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7.13. Option Put–Call Parity Applications: Firm Value

7.13.1.

7.13.1.1. Option Put–Call Parity Applications: Firm Value

➢ V0 = E0 + PV(D).
◼ V0: market value of firm; E0: equity value; PV(D): present value of zero-coupon
debt.
➢ When the debt matures at T, depending on the firm’s value (VT):
➢ Solvency: If VT > D, the firm is solvent and able to return capital to both its
shareholders and debtholders.
◼ Debtholders receive D and are repaid in full.
◼ Shareholders receive the residual: ET = VT – D.
➢ Insolvency: If VT < D, the firm is insolvent. In the event of insolvency, shareholders
receive nothing, and debtholders are owed more than the value of the firm’s
assets. Debtholders therefore receive VT to settle their debt claim of D at time T.
◼ Debtholders have a priority claim on assets and receive VT < D.
◼ Shareholders receive the residual, ET = 0.
➢ Firm value distribution between shareholders and debtholders.
◼ Shareholder payoff = max(0, VT – D)
◼ Debtholder payoff = min(VT, D)

7.13.2.

Q-28. Based on put-call parity application, the firm value is least likely be described as:
A. If the value of the firm (VT) is below the face value of its debt outstanding, debtholders will
receive less than the face value (D) to settle their debt claim.
B. A debtholder’s payoff is min(D, VT) and equals the debt face value (D) minus a put option on
firm value (VT) with an exercise price of D.
C. A debtholder’s position may be considered similar to the long put option on firm value.

Knowledge check 2023BT.8.1.40

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7.14. Arbitrage and No-Arbitrage Principle

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7.14.1.
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7.14.1.1. Risk-free arbitrage and no-arbitrage rule

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➢ Arbitrage involves earning over the risk-free rate with no risk or earning an
immediate gain with no future liabilities.
◼ Arbitrage opportunities: arbitrage occurs when equivalent assets or
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 combinations of assets sell for two different prices.
➢ Law of one price: the condition in a financial market in which two equivalent
financial instruments or combinations of financial instruments can sell for only
one price. Equivalent to the principle that no arbitrage opportunities are possible.
➢ The role of arbitrage is to eliminate mispricing and lead to the market efficiency.
That is why arbitrage also plays a role in pricing.
➢ Hedge portfolio: Derivatives usually take their values from the underlying by
constructing a hypothetical combination of the derivatives and the underlyings
that eliminates risk. This combination is typically called a hedge portfolio. With
the risk eliminated, it follows that the hedge portfolio should earn the risk-free
rate.

7.14.2.

Q-29. The law of one price is best described as:

A. the true fundamental value of an asset.
B. earning a risk-free profit without committing any capital.
C. two assets that will produce the same cash flows in the future must sell for equivalent prices.

Q-30. Which of the following best describes an arbitrage opportunity? It is an opportunity to:
A. Earn a risk premium in the short run.
B. Buy an asset at less than its fundamental value.
C. Make a profit at no risk with no capital invested.

7.15. Forward Pricing and Valuation

7.15.1.

7.15.1.1. Forward pricing and valuation

➢ Pricing a forward contract is the process of determining the no-arbitrage price
:

that will make the value of the contract be zero to both sides at the initiation of
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the contract
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◼ General Equation: FP=(S0-PVB0+PVC0) x (1+Rf)T

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◆ Monetary benefits: dividends, coupons, interest, etc.

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◆ Non-monetary benefits: convenience yield.

◆ Convenience yield are primarily associated with commodities and
generally exist as a result of difficulty in either shorting the commodity

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 or unusually tight supplies.
◆ The net cost and benefit is often referred to by the term carry, or
sometimes cost of carry. (Benefit-cost)
➢ Valuation of a forward contract means determining the value of the contract to
the long (or the short) at some time during the life of the contract.
Time Forward Contract Valuation
t=0 Zero, because the contract is priced to prevent arbitrage
FP FP
t=t Vlong = St - T-t
Vshort = - Vlong = T-t
- St
(1 + R )
f (1 + R )
f

t=T
ST - FP

➢ T-bill (zero-coupon bond) forwards

◼ FP=S0 x (1+Rf)T
➢ Forward contracts on a dividend-paying stock
◼ FP=(S0-PVD0) x (1+Rf)T
◼ Vlong=(St-PVDt) - FP/(1+Rf)T-t

7.15.2.

Q-31. Consider a three-month commodity forward contract, the underlying asset is selling for
$40 in which the present value of carrying benefit and carrying cost are $5 and $3,
respectively. If the risk free rate is 4%, the forward price is closest to: (2012 考题回顾自编
A. 41.60
B. 39.52
C. 38.38

Q-32. Over time, a forward contract most likely has variable: 19

A. value and constant price.

B. price and constant value.
C. value and variable price.
:
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教

Q-33. Procam Investments wants to purchase a 100-ounce gold three months later. The current
spot price is $100 per ounce, the risk-free rate is 2.0%. We assume, during next three
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months, gold may be stored at a bank with a current cost of $2.5 per 100-ounce and
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produce a current benefit of $3.5 per 100-ounce. Calculate the no arbitrage forward
price, F0(T), for settlement in 90 days (T = 90/360 or 0.25):
A. $101.50.
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B. $99.49
C. $100.

2208 2023BT.8.1.41

Q-34. Stocks BWQ and ZER are each currently priced at $100 per share. Over the next year,
stock BWQ is expected to generate significant benefits whereas stock ZER is not expected
to generate any benefits. There are no carrying costs associated with holding either stock
over the next year. Compared with ZER, the one-year forward price of BWQ is most likely:
A. lower.
B. the same.
C. higher.

Q-35. An investor have a short forward contract to sell the stock at a price of $32 one year from
now. The risk-free rate is 4%. If three month later, the stock will be priced at $27.5, the
value of this forward contract will be:
A. -4.3696
B. 4.3269
C. 4.3696

2208 2023BT.8.1.42

Q-36. A high convenience yield is most likely associated with holding: 18

A. commodities.
B. equities.
C. bonds.

Q-37. Which of the following statements best describes changes in the value of a long forward
position during its life?
A. As interest rates go down, the value of the position goes up.
:

B. As the price of the underlying goes up, the value of the position goes up.
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C. As the time to maturity goes down, the value of the position goes up.
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2016 Mock AM
程

7.16. Futures Pricing and Valuation

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7.16.1.

7.16.1.1. Futures pricing and valuation: futures price and forward price
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此预测为考点预测，考题仅为复习参考
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 If the correlation between the
underlying asset value and interest Investors will…
rate is…
Prefer to go long in a futures contract, and
the futures price will be greater than the
Positive
price of an otherwise comparable forward
contract.
Zero Have no preference
Prefer to go long in a forward contract, and
the forward price will be greater than the
Negative
price of an otherwise comparable futures
contract.

7.16.2.

Q-38. Which of the following statements is least accurate concerning differences in the pricing
of forwards and futures?
A. Interest rate volatility can explain pricing differences.
B. Pricing differences can arise if futures prices and interest rates are uncorrelated.
C. Differences in the pattern of cash flows of forwards and futures can explain pricing differences.

2017 Mock PM

7.17. Swap Pricing and Valuation

7.17.1.

7.17.1.1. Swap pricing and valuation

➢ Equivalence of swaps to bonds: An interest rate swap is identical to issuing a
fixed-rate bond and using the proceeds to buy a floating-rate bond.
➢ Equivalence of swaps to forward contracts (FRA): A forward contract is an
agreement to exchange future cash flows once, so a swap can be viewed as a
series of forward contracts.
:

7.17.2.
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Q-39. The price of an interest rate swap that involves the exchange of a fixed payment for a
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floating payment is most likely?

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A. equal to its value at expiration.

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B. set at initiation and constant over time.

C. affected by changes in the floating payment

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7.18. Option Pricing and Valuation

7.18.1.

7.18.1.1. Option pricing and valuation

➢ Binomial model
◼ A binomial model is for pricing options in which the underlying price can
move to only one of two possible new prices.
◼ We start off by having only one binomial period, which means that the
underlying price moves to two new prices at option expiration. We let S0 be
the price of the underlying stock now. One period later, the stock price can
move up to S1+ or down to S1−. We then identify a factor, u, as the up move
on the stock and d as the down move. Thus, S1+ =S0u and S1− =S0d. We further
assume that u = 1/d.

+
S =S u
1 0
S
0

_
S =S d
1 0

◼ Risk-neutral probability of an up move is πu ; Risk-neutral probability of an

down move is πd

1+ Rf − d
u =
◆ u−d
◆ πd=1- πu
◼ We should notice that:
◆ On the first point, if volatility increases, the difference between S1+ and
S1- increases, which widens the range between c1+ and c1-, leading to a
higher option value. The upper payoff, c1+, will be larger and the lower
payoff, c1- , will be lower.
◆ On the second point, the actual probabilities of the up and down moves
do not matter. This result is because of our ability to construct a hedge
:
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and the rule of arbitrage.

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◼ On the third point, the irrelevance of the actual probabilities is replaced by

the relevance of a set of synthetic or pseudo probabilities, π and 1-π, which
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are called risk-neutral probabilities.

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7.18.1.2. Early Exercise of American Options

➢ American call options

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 ◼ When the underlying makes no cash payments (dividends and coupon
interest), no reason to exercise the call early, C0 = c0.
◼ When the underlying makes cash payments (dividends and coupon interest)
during the life of the option, early exercise can happen, C0 > = c0.
➢ American put options
◼ P0 > p0 , nearly always true, as long as there is a possibility of bankruptcy, P0
always > p0, (consider an American put on a bankrupt company, stock →0,
cannot go any lower, then put option holder may exercise it ).

7.18.2.

Q-40. The most correct statement about the binomial option pricing formula is that:
A. The discount rate to calculate the option price is the risk-free rate.
B. The discount rate to calculate the option price is the risk-free rate plus a risk premium
C. The spot price is compounded at the risk-free rate to get the expected payoff

Q-41. If the implied volatility for options on a broad-based equity market index goes up, then
it is most likely that:
A. The broad-based equity market index has gone up in value.
B. Market interest rates have gone up.
C. The general level of market uncertainty has gone up.

2016 Mock AM

Q-42. A 1-year put option on the stock with the strike price of $32, and the price of the stock
is $32 now, and the size of an up-move is 1.1. The risk-free rate is 6%. The value of the
put option is closest to:
A. 0.30.
B. 0.60.
C. 1.20.

(mock )
:
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 Solutions
:
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24-32
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 :
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 7. Fixed Income

7.1.

Q-1. Solution: A.
A futures contract is classified as a forward commitment in which the buyer undertakes to purchase
the underlying asset from the seller at a later date and at a price agreed on by the two parties
when the contract is initiated. A call option contract is a contingent claim in which the buyer of the
option has a right to purchase the underlying asset at a fixed price on or before a pre-specified
expiration date. A credit default swap is a contingent claim in which the credit protection seller
provides protection to the credit protection buyer against the credit risk of a third party.

Q-2. Solution: A.
Over-the-counter options are exposed to default risk, but futures contracts are standardized
transactions that take place on futures exchanges and are not exposed to default risk.

Q-3. Solution: A.
Although an exchange-traded fund derives its value from the underlying assets it holds, it does not
transform the performance of those assets and so is not a derivative.
A contract to sell Alphabet Inc.’s shares transforms the performance of the underlying shares of
Alphabet Inc and is an example of an option derivative.
A contract to buy Australian dollars transforms the performance of the underlying currency and is
an example of a currency derivative.

Q-4. Solution: A.
Derivative markets are not by nature more or less volatile than spot markets. They facilitate risk
allocation by making it easier and less costly to transfer risk, and their transaction costs are lower
than those of spot markets.

Q-5. Solution: A.
One other extremely valuable operational advantage of derivative markets is the ease with which
:

one can go short. With derivatives, it is nearly as easy to take a short position as to take a long
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position, whereas for the underlying asset, it is almost always much more difficult to go short than
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to go long. In fact, for many commodities, short selling is nearly impossible.

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金

Q-6. Solution: C.
A fair value hedge is a derivative used to offset the fluctuation in fair value of an asset or liability.
A cash flow hedge is a derivative designated as absorbing the variable cash flow of a floating-rate
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asset or liability.

Q-7. Solution: A.
As opposed to a futures contract, trading out of a forward contract is quite difficult. There is no
exchange of cash at the origination of a forward contract. There is no exchange on a forward
contract until the maturity of the contract.

Q-8. Solution: C.
Both long and short positions are exposed to default risk in a forward contract, even the spot price
of the underlying is higher than forward price.

Q-9. Solution: C.
3×9 FRA is a forward rate agreement whose expiration date is 90 days from now and the
payment at settlement is based on 180-day LIBOR 90 days from now.

Q-10. Solution: A.
FRAs are forward contracts that conceptually allow lenders to lock in a fixed payment on a future
investment by receiving a known payment and making an unknown payment which offsets the
unknown future interest payment.

Q-11. Solution: A.
Harris is least likely to find counterparty risk associated with a futures contract. There is limited
counterparty risk in a futures contract because the clearinghouse is on the other side of every
contract.

Q-12. Solution: C.
In stock market, additional margin must be deposited to bring the ending balance up to the
Maintenance margin requirement; however, in futures market, additional margin must be
deposited to bring the ending balance up to the initial margin requirement.
:
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Q-13. Solution: A.
Clearing houses arrange for financial settlement of trades. In futures markets, they guarantee
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contract performance.
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金

Q-14. Solution: C.
In a currency swap, the underlying principal is denominated in different currencies and is
typically exchanged at the start and end of the swap.
27-32
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In a currency swap, the underlying principal is denominated in different currencies and would
typically be exchanged not only at the start of the swap but also at the end of the swap.
In a currency swap, the underlying principal is denominated in different currencies and would
typically be exchanged not just at the end of the swap but at the start of the swap as well.

Q-15. Solution: A.
Buying a put is most similar to a short position in the underlying asset because the put increase
the value if the underlying asset value decreases. The writer of a put and the holder of call have a
long exposure to the underlying asset because their positions increase in value if the underlying
asset value increase.

Q-16. Solution: B.
Derivatives pricing models use the risk-free rate to discount future cash flows (risk-neutral pricing)
because they are based on constructing arbitrage relationships that are theoretically riskless.
These models are based on portfolios with certain payoffs (Rf).
Risk cannot eliminated by diversification.

Q-17. Solution: B.
At expiration, options have no time value; if they are in the money, they have exercise value (also
called intrinsic value)

Q-18. Solution: C.
Only an in-the-money option would be exercised. Moneyness describes the relationship between
the price of the underlying and an option’s exercise price.

Q-19. Solution: A.
The loss on her stock is (€76-€80) X 150 = - €600. She also paid €1.5 X 150=€225 for the put. The
put expires worthless, making her total loss €825.

Q-20. Solution: C.
:

Only deep-in-the-money put options may be exercised early. The price cannot fall below zero
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and thus the additional upside of such an option is limited.

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程

Q-21. Solution: B.
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A call option’s value is negatively correlated to the payments on the underlying, and positively
related to the carrying cost, so the option 2 would have higher value.

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Q-22. Solution: B.
A call option’s value is negatively correlated to the exercise price. The call option’s value increases
as the risk-free rate increases. And the volatility is positively related to both call and put options.

Q-23. Solution: C.
For P=C+X / (1+rf)T -S
A put is equivalent to long a call, a short position in the underlying asset, and a long position in the
risk free asset.

Q-24. Solution: C.
A synthetic stock is S=C-P+X/ [(1+RFR) T] =$1-$11+50/ [(1.06)0.25] =39.28. Since the stock is selling
for $40, you can short a share of stock for $40 and buy the synthetic for an immediate arbitrage
profit of $0.72.

Q-25. Solution: C.
Put-call-forward parity can be written as:
P0 – C0 = [X – F0(T)]/(1 + r)T
This means that the difference between the price of a put and the price of a call is equal to the
difference between exercise price and forward price discounted at the risk-free rate.

Q-26. Solution: C.
Holding highly correlated assets cannot provide diversification benefits to an investors.
Portfolio insurance is a hedging strategy used to limit portfolio losses when stocks decline in value
without having to sell off, e.g., purchasing stocks and taking long position in put options.
Adding alternative investments to a portfolio may provide diversification benefits because of these
investments’ less-than-Perfect correlation with other assets in the portfolio. As a result, allocating
a portion of one’s funds to alternatives could potentially result in an improved risk–return
relationship.

Q-27. Solution: A.
:
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Put-call parity is P0+S0 =C0+X/(1+r)T

教

𝑿
Solving for the risk free bond is, (𝟏+𝑹𝑭𝑹)𝑻
=𝑺+𝑷−𝑪
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Therefore, the synthetic long assets are a combination of long the call, short stock, and short the
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put option.

Q-28. Solution: C.
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此预测为考点预测，考题仅为复习参考
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If the value of the firm (VT) is below the face value of its debt outstanding, or VT < D at time T, we
say the firm is insolvent and debtholders receive less than the face value (D) to settle their debt
claim.
Stated differently, a debtholder’s payoff is min(D, VT) = D – max(0, D – VT) and equals the debt face
value (D) minus a put option on firm value (VT) with an exercise price of D, which represents a sold
put on firm value.

Q-29. Solution: C.
The law of one price occurs when market participants engage in arbitrage activities so that identical
assets sell for the same price in different markets.
Law of one price refers to identical assets, not the true fundamental value of an asset.
Earning a risk-free profit without committing any capital refers to arbitrage not the law of one price.

Q-30. Solution: C.
“Make a profit at no risk with no capital invested” is the only answer that is based on the notion of
when an arbitrage opportunity exists: when two identical assets or portfolios sell for different
prices. A risk premium earned in the short run can easily have occurred through luck. Buying an
asset at less than fair value might not even produce a profit.

Q-31. Solution: C.
By using the formula: FP=(S0-PVB0+PVC0) x (1+Rf)T
Forward price=(40-5+3) x (1+4%)0.25=38.38

Q-32. Solution: A.
The price of a forward contract remains constant throughout its life. It is set as part of the contract
specifications. The value varies with changes in the price of the underlying.

Q-33. Solution: B.
FP= F0(T)=(100+2.5-3.5)x(1+2%)^0.25=$99.49
The no arbitrage forward price, F0(T), for settlement in 90 days does not equal to current spot price
:

with the consideration of the storage costs, benefits and risk free rate together.
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Q-34. Solution: A.
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The forward price of each stock is found by compounding the spot price by the risk-free rate for
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the period and then subtracting the future value of any benefits and adding the future value of any
costs. In the absence of any benefits or costs, the one-year forward prices of BWQ and ZER should
be equal.
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After subtracting the benefits related to BWQ, the one-year forward price of BWQ is lower than
the one-year forward price of ZER.

Q-35. Solution: C.
Value of the forward contract for a short position: (32-27.5)/(1.04)^(3/4)=4.3696.

Q-36. Solution: A.
Convenience yield is primarily associated with commodities and generally exists as a result of
difficulty in shorting the commodity or unusually tight supplies.

Q-37. Solution: B.
Given the formula for the value of a forward contract, it follows that the value of the contract goes
up as the price of the underlying goes up.
𝑉𝑡 (𝑇) = 𝑆𝑡 − 𝐹0 (𝑇)(1 + 𝑟)−(𝑇−𝑡)

Q-38. Solution: B.
If futures prices and interest rates are uncorrelated, the prices of forwards and futures will be
identical.

Q-39. Solution: B.
Swaps have both a price and a value. Price in the context of a swap is a reference to the fixed-rate
payment on the swap, which is constant over time. The value of a swap is zero at initiation but can
change over the life of the swap as market interest rates change.

Q-40. Solution: A.
Risk-neutral probabilities are used, and discounting is at the risk-free rate. There is no risk premium
incorporated into option pricing because of the use of arbitrage.

Q-41. Solution: C.
One benefit of derivatives markets is information discovery. Implied volatility reveals information
:
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about the risk of the underlying. Increases in implied volatility are an implication of increased
market uncertainty.
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Q-42. Solution: B.
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u=1.1; d=1/u=0.9
Su=32×1.1=35.2
Sd=32×0.9=28.8
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p+ = Max (0, 32-35.2) = 0
p− = Max (0, 32-28.8) = 3.2
πu = (1+0.06−0.9)/(1.1−0.9) = 0.8
πd =1− πu = 0.2
P = (0.8×0 + 0.2×3.2)/1.06 = 0.64/1.06 = 0.60

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此预测为考点预测，考题仅为复习参考
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