Chapter 10 Review Questions - Solutions

1. Which of the following is not true with respect to features common to

all derivatives?

a) All derivatives have a price.

b) All derivatives have an expiration date.
c) All derivatives can be considered a zero-sum game.
d) All derivatives require a performance bond or good-faith deposit.

2. One of the attractive features of OTC derivatives is that…

a) standardization exists.
b) liquidity – offsetting is possible.
c) there is no default or credit risk.
d) contracts can be custom designed.

3. The two major categories of underlying assets for derivative contracts are…

a) calls and puts

b) stocks and bonds
c) futures and forwards
d) commodities and financials

4. Hedging is the attempt to eliminate or reduce the risk of either holding an asset for
future sale or anticipating a future purchase of an asset. Hedging with derivatives
involves…

a) taking a position in a derivative with a payoff that is similar to that

of the asset to be hedged.
b) not taking a position in a derivative with a payoff that is similar to
that of the asset to be hedged.
c) taking a position in a derivative with a payoff that is opposite to
that of the asset to be hedged.
d) Derivatives are not used for hedging purposes.

5. With respect to option contracts, the specified price at which an investor can buy
or sell is known as the…

a) premium.
b) exercise price.
c) opening transaction.
d) in-the-money amount.
6. An investor wrote 100 MSFT January 30 calls. As a result, he will have the…

a) right to sell 100 shares.

b) obligation to sell 10,000 shares.
c) right to buy 10,000 shares.
d) obligation to buy 10,000 shares

7. Options that can be exercised at any time up to and including the expiration date
are referred to as…

a) Asian-style options.
b) American-style options.
c) European-style options.
d) offsetting transaction options.

8. Which of the following options would most likely be exercised at any given point
in time?

a) An American style put option that is in the money.

b) A European style call option that is deep in the money.
c) An American style put option that out of the money.
d) A European style call option that is out of the money.

9. An opening sell transaction in an option results in a…

a) long position.
b) short position.
c) closing position.
d) offsetting position.
 10. An investor purchased a $20 Intel (INTC) Call, paying a premium of $7. If
Intel were currently trading at $25, we would say that the option has or
time value.

a) $ 2
b) $ 5
c) $ 7
d) $25

11. An investor purchased one $20 ABC Call @ $3.00. When ABC was $30.00, she
exercised the option and subsequently sold ABC when it was trading at $45.
What was her total profit?
1 call = 100 shares. Profit on call = $30-$20- $3=$7. X 100 = $700
Profit on Shares = $45-$30 = $15 X 100 = $1,500
Total profit = $700 + $1,500 = $2,200

a) $ 700
b) $1,500
c) $2,200
d) $2,500

12. LUV Airlines trades on the NYSE. It is concerned that the price of jet fuel it
needs may go up significantly in six months, but it doesn’t want to be locked
into buying in case the price declines. You would recommend that LUV…

a) buys a forward contract on jet fuel.

b) sells a forward contract on jet fuel.
c) buys six month call options on jet fuel.
d) sells six month call options on jet fuel.

13. By definition, covered call writers…

a) own the underlying stock and sell calls against that position.
b) do not own the underlying stock but wish to purchase it.
c) own the underlying stock and deliver the calls if assigned.
d) do not own the underlying stock and do not wish to own it.
 14. When a forward contract is traded on an exchange, it is known as a(n)…

a) swap.
b) future.
c) option.
d) forward.

15. Which of the following is an example of a futures contract that is always

cash settled?

a) oil
b) gold
c) lumber
d) equity index

16. One of the important features of futures trading is the daily settlement of gains
and losses. This is known as…

a) hedging.
b) speculating.
c) risk management.
d) marking-to-market.

17. Which of the following products are issued by companies to raise capital?
i) Rights
ii) Warrants
iii) Options

a) i) only
b) i) & ii) only
c) ii) & iii) only
d) i), ii) & iii)

18. The exercise price of a right is also known as its offering or price.

a) exercise
b) privilege
c) subscription
d) acceptance
 19. XYZ shares are currently trading at $15 per share. The company undertakes a rights
offering where each outstanding share receives one right, and five rights plus $12
will allow the investor to purchase one additional treasury share. What is the value of
one right during the ex-rights period?
($15-$12)/5 = $.60

a) $ .50
b) $ .60
c) $ 3.00
d) $12.00

20. Refer to the information in Question #19. If there were 10,000,000 shares issued and
outstanding, how many shares would there be if the rights offering were fully
subscribed?
There are 10 million shares, therefore 10 million rights. If it takes five rights to buy one
additional share, then 2 million new shares will be created, resulting in 12,000,000 altogether.

a) 11,000,000
b) 12,000,000
c) 15,000,000
d) 60,000,000

21. The main attraction of warrants is their…

a) liquidity.
b) leverage potential.
c) longer expiration, compared to rights.
d) shorter expiration, compared to rights.