Introduction to Derivatives

I. Multiple Choice Questions

1) A European call option can be exercised

A) only on the expiration date.
B) any time in the future.
C) if the price of the underlying asset declines below the exercise price.
D) immediately after dividends are paid.

2) The maximum loss a buyer of a stock put option can suffer is equal to
A) the stock price minus the strike price.
B) the strike price minus the value of the put.
C) the strike price
D) the put premium

3) The maximum loss a buyer of a stock call option can suffer is equal to
A) the strike price minus the stock price.
B) the stock price minus the value of the call.
C) the premium paid for the call.
D) the stock price.

4) The difference between the current market value of an option and its intrinsic value is its
a) contingent value.
b) option value
c) in-the-money value
d) time value

5) If a call option is “in-the-money," this means that

a. its strike price is smaller than the stock price.
b. its strike price is greater than the stock price.
c. its strike price is equal to the stock price.
d. the call is under priced since exercising it would generate a positive payoff.

6) The intrinsic value of a put option equals

a) the maximum of either zero or the difference between the current price of the underlying
asset and the exercise price of the option.
b) the maximum of either zero or the difference between the exercise price of the option and
the current price of the underlying asset.
c) the net proceeds from exercising the option given the current price of the underlying asset.
d) all of the above

7) A put option on a stock is said to be out-of-the-money if

a. the exercise price is higher than the stock price.

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b. the exercise price is less than the stock price.
c. the exercise price is equal to the stock price.
d. the price of the put is higher than the price of the call.

8) Suppose EEE stock is selling at Rs.45 per share. A call option on the stock with an exercise
price of Rs.65 expiring in 3 months has a current premium of Rs.5 per share. What is the
intrinsic value of the option?
a) zero.
b) Rs.20.
c) Rs.45
d) Rs.65.

9) If an investor paid a Rs.2.75 premium to obtain a long position in a call option with an
exercise price of Rs.85. The underlying asset break-even point corresponds to a price of
a) Rs 82.25.
b) Rs.87.75
c) Rs.90.50
d) none of the above.

10) If an investor paid a Rs.3.75 premium to obtain a long position in a put option with an
exercise price of Rs.48. The underlying asset break-even point corresponds to a price of
A) Rs.40.50
B) Rs.44.25
C) Rs.48.00
D) Rs.51.75

11) According to the put-call parity theorem, the value of a European put option on a non-
dividend paying stock is equal to:
A) the call premium plus the present value of the exercise price plus the stock price.
B) the present value of the stock price minus the exercise price minus the call premium.
C) the call premium plus the present value of the exercise price minus the stock price.
D) the present value of the stock price plus the exercise price minus the call premium.

12) A trader sells 100 European put options (1 contract) with a strike price of Rs. 50 and a
time to maturity of six months. The price received for each option is Rs. 4. The price of the
underlying asset is Rs. 41 in six months. What is the trader's gain or loss?
A. Rs. 300 gain
B. Rs. 300 loss
C. Rs. 500 gain
D. Rs. 500 loss

13) A trader buys 100 European call options (one contract) with a strike price of Rs. 20 and a
time to maturity of one year. The cost of each option is Rs. 2. The price of the underlying asset
turns out to be Rs. 25 in one year. What is the trader's gain or loss?
A) Rs. 300 loss

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B) Rs. 500 loss
C) Rs. 300 gain
D) Rs. 500 gain

14) The difference between the current market value of an option and its intrinsic value is its
a) contingent value.
b) option value
c) in-the-money value
d) time value

15) Macomb Corporation is a U.S. firm that invoices some of its exports in Japanese yen. If it
expects the yen to weaken, it could _______ to hedge the exchange rate risk on those exports.
A) sell yen put options
B) buy yen call options
C) buy futures contracts on yen
D) sell futures contracts on yen

16) An exporter is expecting a payment of $ 5 million to arrive in three months. He is planning

to hedge the position using options. He should:
a) Buy call options
b) Buy put options
c) Write put options
d) None of the above

17) A futures contract

a) is an agreement to buy or sell a specified amount of an asset at the spot price on the
expiration date of the contract.
b) is a contract to be signed in the future by the buyer and the seller of the commodity.
c) gives the buyer the right, but not the obligation, to buy an asset some time in the future.
d) is an agreement to buy or sell a specified amount of an asset at a predetermined price on
the expiration date of the contract.

18) In a futures contract the futures price is

a) determined by the buyer and the seller when they initiate the contract.
b) determined by the futures exchange.
c) determined by the buyer and the seller when the delivery of the commodity takes place.
d) determined independently by the provider of the underlying asset.

19) On futures markets, the probability of contract default is lowered through the use of
margin requirements and the process of
a) careful credit rating checks.
b) daily realizations of gains and losses.
c) keeping a required imbalance between long and short positions.
d) allowing only a discrete number of price changes per day.

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20) Speculators take positions in futures markets in order to
a) hedge risk exposures.
b) coordinate the equilibrium price.
c) profit from superior forecasts of future spot prices.
d) balance spot market positions.

21) Futures contracts are liquid forward contracts made homogenous by having
standardized
a) exercice prices.
b) expiration dates
c) counterparty risk via a clearinghouse.
d) all of the above.

22) Which of the following contract terms is not set by the futures exchange?
A) the price
B) the underlying asset
C) the date of expiration of the contract
D) the size of the contract
E) none of the above

II. Theory Questions

1. What are “contract size” and “lot size” in derivatives trading?

2. What is “marked to market” and “daily settlement” in trading of futures contracts? Illustrate
with the help of an example.

3. How are Exchange traded derivatives different from Over the Counter (OTC) traded
derivatives?

4. What is closing out a Futures Position?

5. What are the main features of forward contracts? How are they different from futures
contracts?

6. What is a margin? Why is it used in trading of futures contracts? What is initial margin?
What is maintenance margin?

IV. Numericals

1) Six-month European call options with strike prices of Rs.35 and Rs.40 have cost (premium)
Rs.6 and Rs.3, respectively. A bull spread is created by buying the call option with a strike
price of Rs 35 and selling the call option with a strike price of Rs 40.
a) What is the maximum gain from this bull spread?

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b) What is the maximum loss from this bull spread?
c) What is the break- even point?

2) Six-month call options with strike prices of Rs.45 and Rs.50 cost (premium) Rs.7 and Rs.4,
respectively. A bear spread is created by selling the call option with a strike price of Rs 45 and
buying the call option with a strike price of Rs 50.
a) What is the maximum gain from this bull spread?
b) What is the maximum loss from this bull spread?
c) What is the break- even point?

3) A three-month European call option with a strike price of Rs.65 has a premium of Rs 3. A
three-month European put option with a strike price of Rs.55 has a premium of Rs 2.
A strangle combination is created by buying both the call option and the put option.
a) What is the maximum loss from this strangle combination?
b) What are the two break- even points?

4) A Six-month European call option with a strike price of Rs.50 has a premium of Rs 4. A Six-
month European put option with a strike price of Rs.50 has a premium of Rs 3.
A straddle combination is created by buying both the call option and the put option.
a) What is the maximum loss from this straddle combination?
b) What are the two break- even points?

5. Your company had entered a long time ago a forward contract to buy 1000 ounces of gold
at $1125 per ounce. The contract now still has 9 months to maturity. The future price today for
gold for a contract with 9 months to maturity is $1000 per ounce. The nine-month risk-free rate
is 6% per annum with continuous compounding. What is the total value of the contract to your
company at the present time?

6) Consider a 3-month futures contract on the Nifty. The stocks underlying the index provide
a dividend yield of 2% per annum, the current value of the index is 20,000 and the continuously
compounded risk-free rate is 5% per annum. Based on these figures, what should the price of
a three-month future contract on the index be?

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Answers:

I. Multiple Choice Questions

1) A European call option can be exercised

*A) only on the expiration date.
B) any time in the future.
C) if the price of the underlying asset declines below the exercise price.
D) immediately after dividends are paid.

2) The maximum loss a buyer of a stock put option can suffer is equal to
A) the stock price minus the strike price.
B) the strike price minus the value of the put.
C) the strike price
*D) the put premium

3) The maximum loss a buyer of a stock call option can suffer is equal to
A) the strike price minus the stock price.
B) the stock price minus the value of the call.
*C) the premium paid for the call.
D) the stock price.

4) The difference between the current market value of an option and its intrinsic value is its
a) contingent value.
b) option value
c) in-the-money value
*d) time value

5) If a call option is “in-the-money," this means that

*a. its strike price is smaller than the stock price.
b. its strike price is greater than the stock price.
c. its strike price is equal to the stock price.
d. the call is under priced since exercising it would generate a positive payoff.

6) The intrinsic value of a put option equals

a) the maximum of either zero or the difference between the current price of the underlying
asset and the exercise price of the option.
*b) the maximum of either zero or the difference between the exercise price of the option and
the current price of the underlying asset.
c) the net proceeds from exercising the option given the current price of the underlying asset.
d) all of the above

7) A put option on a stock is said to be out-of-the-money if

a. the exercise price is higher than the stock price.
*b. the exercise price is less than the stock price.

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c. the exercise price is equal to the stock price.
d. the price of the put is higher than the price of the call.

8) Suppose EEE stock is selling at Rs.45 per share. A call option on the stock with an exercise
price of Rs.65 expiring in 3 months has a current premium of Rs.5 per share. What is the
intrinsic value of the option?
*a) zero.
b) Rs.20.
c) Rs.45
d) Rs.65.

Max (S-X,0)= Max (45-65,0)= 0

9) If an investor paid a Rs.2.75 premium to obtain a long position in a call option with an
exercise price of Rs.85. The underlying asset break-even point corresponds to a price of

a) Rs 82.25.
*b) Rs.87.75
c) Rs.90.50
d) none of the above.

Max (S-85,0)-2.75=0
S=85+2.75= 87.75

10) If an investor paid a Rs.3.75 premium to obtain a long position in a put option with an
exercise price of Rs.48. The underlying asset break-even point corresponds to a price of
A) Rs.40.50
*B) Rs.44.25
C) Rs.48.00
D) Rs.51.75

Max (48-S,0) – 3.75= 0

S= 48-3.75= 44.25

11) According to the put-call parity theorem, the value of a European put option on a non-
dividend paying stock is equal to:
A) the call premium plus the present value of the exercise price plus the stock price.
B) the present value of the stock price minus the exercise price minus the call premium.
*C) the call premium plus the present value of the exercise price minus the stock price.
D) the present value of the stock price plus the exercise price minus the call premium.

c + Xe^(-rt)= p + S
p = c + Xe^(-rt) -S

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12) A trader sells 100 European put options (1 contract) with a strike price of Rs. 50 and a
time to maturity of six months. The price received for each option is Rs. 4. The price of the
underlying asset is Rs. 41 in six months. What is the trader's gain or loss?
A. Rs. 300 gain
B. Rs. 300 loss
C. Rs. 500 gain
*D. Rs. 500 loss

Receive 100 x Rs 4= Rs 400 premium (as the trader has sold the option)
Loss on exercise of option= 100 x Max (X-S,0) = 100 x Max (50-41,0) =900
Net loss =400-900 =-500

13) A trader buys 100 European call options (one contract) with a strike price of Rs. 20 and a
time to maturity of one year. The cost of each option is Rs. 2. The price of the underlying asset
turns out to be Rs. 25 in one year. What is the trader's gain or loss?
A) Rs. 300 loss
B) Rs. 500 loss
*C) Rs. 300 gain
D) Rs. 500 gain
Pay 100 x Rs 2= Rs 200 premium (as the trader has bought the option)
Gain on the exercise of option= 100 x Max (S-X,0) = 100 x Max (25-20,0) =500
Net gain =500-200 =Rs 300

14) The difference between the current market value of an option and its intrinsic value is its
a) contingent value.
b) option value
c) in-the-money value
*d) time value

15) Macomb Corporation is a U.S. firm that invoices some of its exports in Japanese yen. If it
expects the yen to weaken, it could _______ to hedge the exchange rate risk on those exports.

A) sell yen put options

B) buy yen call options
C) buy futures contracts on yen
*D) sell futures contracts on yen

Macomb Corporation needs to sell yen.

Selling put options on yen means buying yen if the buyer of the put option decides to sell
yen. Selling an option cannot be a hedge as the buyer of the option may choose not to
exercise the option.
Similarly, buying yen call options and buying futures contracts on yen means buying yen

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A short position on futures contract (selling futures contract) means selling the underlying
asset , i.e. yen

16) An exporter is expecting a payment of $ 5 million to arrive in three months. He is planning

to hedge the position using options. He should:
a) Buy call options
*b) Buy put options
c) Write put options
d) None of the above
Exporter needs to sell $.
The option to sell is the put option.
Buying call options $ means buying $
Selling (writing) an option cannot be a hedge as the buyer of the option may choose not to
exercise the option. In this case even if the exporter writes put option, it means that if the
buyer of the put option chooses to exercise the put option, he/she will sell $ to the writer of
the put option.

17) A futures contract

a) is an agreement to buy or sell a specified amount of an asset at the spot price on the
expiration date of the contract.
b) is a contract to be signed in the future by the buyer and the seller of the commodity.
c) gives the buyer the right, but not the obligation, to buy an asset some time in the future.
*d) is an agreement to buy or sell a specified amount of an asset at a predetermined price on
the expiration date of the contract.

18) In a futures contract the futures price is

*a) determined by the buyer and the seller when they initiate the contract.
b) determined by the futures exchange.
c) determined by the buyer and the seller when the delivery of the commodity takes place.
d) determined independently by the provider of the underlying asset.

19) On futures markets, the probability of contract default is lowered through the use of
margin requirements and the process of
a) careful credit rating checks.
*b) daily realizations of gains and losses.
c) keeping a required imbalance between long and short positions.
d) allowing only a discrete number of price changes per day.

20) Speculators take positions in futures markets in order to

a) hedge risk exposures.

b) coordinate the equilibrium price.
*c) profit from superior forecasts of future spot prices.
d) balance spot market positions.

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21) Futures contracts are liquid forward contracts made homogenous by having
standardized
a) exercice prices.
b) expiration dates
c) counterparty risk via a clearinghouse.
*d) all of the above.

22) Which of the following contract terms is not set by the futures exchange?
*A) the price
B) the underlying asset
C) the date of expiration of the contract
D) the size of the contract
E) none of the above

II. Theory Questions

1. What are “contract size” and “lot size” in derivatives trading?

Contract size: The contract size specifies the value (in Rs) of the asset that has to be
delivered under one contract.
Lot size refers to number of underlying securities in one contract.

The lot size refers to the standardized quantity of an underlying asset that is traded in a
single contract. Lot sizes are predetermined by the stock exchange on which the derivative
is traded and can vary depending on the type of derivative and the underlying asset.

For example, if the lot size of derivatives trading on stock XYZ is 100 it means that each
derivative contract is for buying or selling 100 shares of stock XYZ.

Contract Size is the value of the contract. Thus, if the lot size is 150 and the delivery price of
the underlying stock is Rs 4000 per share, the contract size is Rs 150 x 4000= Rs 6 lakh

IV. Numericals

1) Six-month European call options with strike prices of Rs.35 and Rs.40 have cost (premium)
Rs.6 and Rs.3, respectively. A bull spread is created by buying the call option with a strike
price of Rs 35 and selling the call option with a strike price of Rs 40.
a) What is the maximum gain from this bull spread?
b) What is the maximum loss from this bull spread?
c) What is the break- even point?

a) Maximum gain is when the stock price is at the higher strike price. (Option with lower strike
price has been exercised; option with higher strike price is not exercised)

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Net premium paid = Rs.3 (received for selling the option at strike price Rs 40)-Rs.6 (paid for
buying the option at strike price Rs 35)-= -Rs.3
Profit from call option with strike price Rs 35 = Rs.40-Rs.35= Rs.5
Maximum gain = Rs 5- Rs 3= Rs 2
b) Maximum loss is when none of the options has been exercised = Rs 3
c) Break even is when the gain from the option with the exercise price of Rs 35 is just enough
to offset the amount of premium paid
S-35 – 3= 0 or S= 38

2) Six-month call options with strike prices of Rs.45 and Rs.50 cost (premium) Rs.7 and Rs.4,
respectively. A bear spread is created by selling the call option with a strike price of Rs 45 and
buying the call option with a strike price of Rs 50.

a) What is the maximum gain from this bull spread?

b) What is the maximum loss from this bull spread?
c) What is the break- even point?

a) Maximum gain is when none of the options has been exercised. Maximum gain is the net
premium received= Rs 3
Net premium received = Rs.7 (received for selling the option at strike price Rs 45)-Rs 4 (paid
for buying the option at strike price Rs 50)-= Rs.3
b) Maximum loss is when the stock price is at the higher strike price. (Option with lower strike
price has been exercised; option with higher strike price is not exercised)
Since the option with the lower strike price has been sold
Loss = Rs 50 – Rs 45= Rs 5
Net premium received= Rs 3
Maximum loss = Rs 3-Rs 5= -Rs 2
c) Break even is when the premium received is just enough to offset the loss from the option
with the exercise price of Rs 45
3- (S-45) = 0 or S= Rs 48

3) A three-month European call option with a strike price of Rs.65 has a premium of Rs 3. A
three-month European put option with a strike price of Rs.55 has a premium of Rs 2.
A strangle combination is created by buying both the call option and the put option.
a) What is the maximum loss from this strangle combination?
b) What are the two break- even points?

a) Both options have been purchased. So, the total premium paid= Rs 3+ Rs 2= Rs 5
Call option is exercised when stock price is more than Rs 65.
Put option is exercised when stock price is less than Rs 55.
Between Rs 55 and Rs 65, none of the two options are exercised. Therefore, maximum loss
occurs between these two prices and that is the total premium paid= Rs 5
b) Profit happens when stock price falls below Rs 55 (put option exercised) or the stock price
rises above Rs 65 (call option exercised).
i) Break even when stock price falls below Rs 55 (Put option is exercised)
(55-S)- Rs 5= 0 or S= Rs 50

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i) Break even when stock price rises above Rs 65 (call option exercised).
(S-65)- Rs 5 = 0 or S= Rs 70

4) A Six-month European call option with a strike price of Rs.50 has a premium of Rs 4. A Six-
month European put option with a strike price of Rs.50 has a premium of Rs 3.
A straddle combination is created by buying both the call option and the put option.
a) What is the maximum loss from this straddle combination?
b) What are the two break- even points?

a) Both options have been purchased. So, the total premium paid= Rs 4+ Rs 3= Rs 7
Call option is exercised when stock price is more than Rs 50.
Put option is exercised when stock price is less than Rs 50.
At a stock price of Rs 50, none of the two options has any payoff. Therefore, maximum loss
occurs at the stock price of Rs 50 and that is the total premium paid= Rs 7
b) Profit happens when stock price falls below Rs 50 (put option exercised) or the stock price
rises above Rs 50 (call option exercised).
i) Break even when stock price falls below Rs 50 (Put option is exercised)
(50-S)- Rs 7= 0 or S= Rs 43
i) Break even when stock price rises above Rs 50 (call option exercised).
(S-50)- Rs 7 = 0 or S= Rs 57

5. Your company had entered a long time ago a forward contract to buy 1000 ounces of gold
at $1125 per ounce. The contract now still has 9 months to maturity. The future price today for
gold for a contract with 9 months to maturity is $1000 per ounce. The nine-month risk-free rate
is 6% per annum with continuous compounding. What is the total value of the contract to your
company at the present time?

Your company will have to pay $1125 per ounce for gold to buy 1000 ounces of gold, 9 months
from now.
The future price for gold on a nine-month contract is $1000 per ounce. It means that your
company is locked into a contract where it will have to pay ($1125 - $ 1000= $ 125) per ounce
extra compared to someone entering into the contract today.
Therefore, the total loss = $ 125 / ounce x 1000 ounce= # 125,000 nine months from now
If this value is discounted to today, the value of the contract at the present time= $125,000 x
e^(-6% x 9/12) =$119,500

6) Consider a 3-month futures contract on the Nifty. The stocks underlying the index provide
a dividend yield of 2% per annum, the current value of the index is 20,000 and the continuously
compounded risk-free rate is 5% per annum. Based on these figures, what should the price of
a three-month future contract on the index be?

F= Se^((r-q)t)= 20,000 e^((5%-2%)*3/12)= 20,150.56

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