Role of Financial Markets and Institutions  101

A) True
B) False
ANSWER: B

64. Which of the following statements is incorrect regarding organized exchanges trading financial
futures contracts?
A) Organized exchanges establish and enforce rules for the trading of financial futures contracts.
B) Organized exchanges ensure that the seller of the futures contract always delivers the securities
covered by the contract, whether the contract was settled prior to the settlement date or not.
C) Organized exchanges clear, settle, and guarantee all transactions that occur on their exchanges.
D) The operations of financial futures exchanges are regulated by the Commodity Futures Trading
Commission (CFTC).
E) All of the above are correct.

ANSWER: B

65. Stock index futures are priced ___________ than the stock index itself.
A) higher
B) lower
C) either higher or lower
D) none of the above

ANSWER: C

66. An unexpected __________ in the consumer price index tends to create expectations of ___________
interest rates and places ____________ pressure on Treasury bond futures prices.
A) increase; higher; downward
B) increase; lower; downward
C) increase; higher; upward
D) decrease; higher; downward
E) none of the above

ANSWER: A

67. Bill Baher, a private investor, purchased a futures contract on Treasury bonds at a price of 102-12.
Two months later, Baher sells the same futures contract in order to close out the position. At that
time, the futures contract specifies 103-15. What is Baher’s nominal profit? The par value of the
futures contract is $100,000.
A) $1,030.00; profit
B) $1,030.00; loss
C) $1,093.75; profit
D) $1,093.75; loss
E) none of the above

ANSWER: C

68. Clarke Bank plans to satisfy cash needs in nine months by selling its Treasury bond holdings for $4

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 Role of Financial Markets and Institutions  102

million. However, Clarke is concerned that interest rates might increase over the next three months.
To hedge against this possibility, Clarke plans to sell Treasury bond futures. Thus, Clarke sells
______ futures contract for a price of 99-12. Assuming that the actual price of the futures contract
declined to 97-20, Clarke would make a ________ of $________ from closing out the futures
position.
A) 40; profit; $76,800
B) 40; loss; $76,800
C) 50; profit; $70,000
D) 40; profit; $70,000
E) none of the above

ANSWER: D

69. Which of the following statements is incorrect with respect to cross-hedging?

A) Even when the futures contract is highly correlated with the portfolio being hedged, the value of
the futures contract may change by a higher or lower percentage than the portfolio’s market
value.
B) If the futures contract value is more volatile than the portfolio value, hedging will require a
greater amount of principal represented by the futures contracts.
C) The effectiveness of a cross-hedge depends on the degree of correlation between the market
values of the two financial instruments.
D) If the price of the underlying security of the futures contract moves closely in tandem with the
security hedged, the futures contract can provide an effective hedge.
E) All of the above are correct with respect to cross-hedging.

ANSWER: B

70. If index futures are priced ________ relative to the stocks representing the index, an arbitrageur may
_________ index futures and simultaneously __________ stocks.
A) low; purchase; sell
B) low; sell; purchase
C) high; purchase; sell
D) Answers b and c are correct.
E) None of the above are correct.

ANSWER: A

71. __________ risk is the risk that the position being hedged by a futures contract is not affected in the
same manner as the instrument underlying the futures contract.
A) Market
B) Liquidity
C) Credit
D) Basis
E) none of the above

ANSWER: D

Chapter 14

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 Role of Financial Markets and Institutions  103

Options Markets

1. A ______ grants the owner the right to purchase a specified financial instrument for a specified price
within a specified period of time.
A) call option
B) put option
C) sale of a futures contract
D) purchase of a futures contract

ANSWER: A

2. A ______ requires a premium above and beyond the price to be paid for the financial instrument.
A) futures contract
B) call option
C) put option
D) B and C

ANSWER: D

3. A call option is “in the money” when the

A) market price of the underlying security exceeds the exercise price.
B) market price of the underlying security equals the exercise price.
C) market price of the underlying security is less than the exercise price.
D) premium on the option is less than the exercise price.

ANSWER: A

4. A put option is “out of the money” when the

A) market price of the security exceeds the exercise price.
B) market price of the security equals the exercise price.
C) market price of the security is less than the exercise price.
D) premium on the option is less than the exercise price.

ANSWER: A

5. When the market price of the underlying security exceeds the exercise price, the
A) call option is in the money.
B) put option is in the money.
C) call option is at the money.
D) call option is out of the money.

ANSWER: A

6. When the exercise price exceeds the market price of the underlying security, the
A) call option is in the money.
B) put option is in the money.
C) call option is at the money.

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 Role of Financial Markets and Institutions  104

D) put option is out of the money.

ANSWER: B

7. Sellers (writers) of call options can offset their position at any point in time by
A) selling a put option on the same stock.
B) buying identical call options.
C) selling additional call options on the same stock.
D) A and B
E) all of the above

ANSWER: B

8. The _______________ is the most important exchange for trading options.

A) New York Stock Exchange (NYSE)
B) Chicago Board of Options Exchange (CBOE)
C) Chicago Mercantile Exchange (CME)
D) Philadelphia Stock Exchange

ANSWER: B

9. The Options Clearing Corporation (OCC) serves as a guarantor on option contracts traded in the
United States.
A) True
B) False

ANSWER: A

10. ___________ execute transactions desired by investors and trade stock options for their own account.

A) Floor brokers
B) Specialists
C) Market-makers
D) none of the above

ANSWER: C

11. A speculator buys a call option for $3, with an exercise price of $50. The stock is currently priced at $49, and rises to $55 on the
expiration date. The speculator will exercise the option on the expiration date (if it is feasible to do so). What is the speculator’s profit per
unit?

A) $1
B) $5
C) $2
D) $1
E) $2

ANSWER: C
12. A speculator buys a call option for $3, with an exercise price of $50. The stock is currently priced at $49, and rises to $55 on the
expiration date. What is the stock price at which the speculator would break even?

A) $50

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 Role of Financial Markets and Institutions  105

B) $58
C) $52
D) $53
E) $49

ANSWER: D

13. A speculator purchases a put option for a premium of $4, with an exercise price of $30. The stock is
presently priced at $29, and rises to $32 before the expiration date. What is the maximum profit per
unit to the speculator who owned the put option assuming he or she exercises the option at the ideal
time?
A) $4
B) $3
C) $2
D) $2
E) $3

ANSWER: B

14. A speculator purchases a put option for a premium of $4, with an exercise price of $30. The stock is
presently priced at $29, and rises to $32 before the expiration date. What is the stock price at which
the speculator would break even?
A) $26
B) $34
C) $28
D) $29
E) $32

ANSWER: A

15. The ________, the higher the call option premium, other things being equal.
A) lower the existing price of the security relative to the exercise price
B) lower the variability of the security’s market price
C) longer the maturity of the option
D) A and B

ANSWER: C

16. The ________, the lower the premium on a put option, other things being equal.
A) higher the existing price of the security relative to the exercise price
B) greater the variability of the security’s market value
C) longer the maturity of the option
D) A and B

ANSWER: A
17. The longer the time to maturity, the ___________ the call option premium and the _________ the put
option premium.
A) higher; lower
B) lower; higher

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 Role of Financial Markets and Institutions  106

C) higher; higher
D) lower; lower

ANSWER: C

18. The greater the volatility of the underlying stock, the ___________ the call option premium and the
_________ the put option premium.
A) higher; lower
B) lower; higher
C) higher; higher
D) lower; lower

ANSWER: C

19. The sale of a call option on a stock the seller already owns is referred to as
A) a covered call.
B) a naked call.
C) call on futures.
D) futures on options.

ANSWER: A

20. Assume a pension fund purchased stock at $53. Call options at a $50 exercise price presently have a
$4 premium per share. The pension fund sells a call option on the stock it owns. If the call option is
exercised when the price of the stock is $56, what is the gain or loss per share to the pension fund
(including its gain from holding the stock as well)?
A) $4 gain
B) $6 loss
C) $2 loss
D) $1 gain
E) $0

ANSWER: D

21. Covered call writing ______ the upside potential return and ______ the risk of an investment in stock.
A) increases; increases
B) increases; decreases
C) limits; increases
D) limits; decreases

ANSWER: D

22. Put options are typically used to hedge

A) when portfolio managers are mainly concerned with a permanent decline in a stock’s value.
B) when portfolio managers are mainly concerned with a permanent increase in a stock’s value.
C) when portfolio managers are mainly concerned with a temporary decline in a stock’s value.
D) when portfolio managers are mainly concerned with a temporary increase in a stock’s value.

ANSWER: C

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 Role of Financial Markets and Institutions  107

23. A savings and loan association has long-term fixed rate mortgages supported by short-term funds. A
put option on Treasury bond futures could be used to (ignore the premium paid for the option when
you answer this question)
A) maintain its interest rate spread if interest rates rise, and increase its spread if interest rates fall.
B) maintain its interest rate spread if interest rates fall, and increase its spread if interest rates rise.
C) maintain its interest rate spread whether interest rates rise or fall.
D) increase its interest rate spread whether interest rates rise or fall.

ANSWER: A

24. A speculator purchases a put option on Treasury bond futures with a September delivery date with a
strike price of 85-00. The option has a premium of 2-00. Assume that the price of the futures
contract decreases to 82-00 on the expiration date and the option is exercised at that point (if it is
feasible). What is the net gain?
A) $1,968.75
B) $3,750.00
C) $3,000.00
D) $2,000.00
E) $1,000.00

ANSWER: E
25. Assume an insurance company purchases a call option on an S&P 500 Index futures contract for a
premium of 14, with an exercise price of 1800. The value of an S&P 500 futures contract is 250
times the index. If the index on the futures contract increases to 1830, what is the gain on the sale of
the futures contract?
A) $15,000
B) $7,500
C) $3,300
D) $4,000
E) $1,500

ANSWER: D

26. Corporations involved in international business transactions can ______ to hedge future ______.
A) sell currency call options; payables
B) purchase currency put options; receivables
C) purchase currency call options, receivables
D) purchase currency put options, payables
E) A and B

ANSWER: B

27. If a corporation hedges payables with currency call options, it will ______ if the value of the foreign
currency is ______ than the exercise price when the payables are due.
A) exercise the option; greater
B) exercise the option; less
C) let the option expire; greater
D) let the option expire; less

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 Role of Financial Markets and Institutions  108

E) A and D

ANSWER: E

28. Speculators purchase currency ______ on currencies they expect to ______ against the dollar.
A) call options; weaken
B) put options; strengthen
C) futures; weaken
D) put options; weaken

ANSWER: D

29. Speculators may be willing to write ______ options on foreign currencies they expect to ______
against the dollar.
A) put; strengthen
B) put; weaken
C) call; strengthen
D) call; weaken
E) A and D

ANSWER: E

30. European-style stock options

A) are long-term options (at least one year until expiration at the time they are created).
B) can be exercised after the expiration date.
C) can be exercised any time until the expiration date.
D) none of the above

H) ANSWER: D

31. A speculator purchased a call option with an exercise price of $31 for a premium of $4. The option
was exercised a few days later when the stock price was $34. What was the return to the speculator?
A) 25 percent
B) 25 percent
C) 3.2 percent
D) 2.9 percent

ANSWER: B

32. A speculator purchased a put option with an exercise price of $56 for a premium of $10. The option
was exercised a few days later when the stock price was $44. What was the return to the speculator?
A) 20 percent
B) 120 percent
C) 100 percent
D) 20 percent
ANSWER: D

33. The premium on an existing call option should ______ when the underlying stock price decreases.
A) be negative

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 Role of Financial Markets and Institutions  109

B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: B

34. The premium on an existing put option should ______ when the underlying stock price increases.
A) be negative
B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: B

35. The premium on an existing put option should ______ when there is an increase in the expected
short-term volatility of the stock price.
A) be negative
B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: C

36. The premium on an existing call option should ______ when there is a reduction in the expected
short-term volatility of the stock price.
A) be negative
B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: B

37. The premium on an existing put option should ______ when there is an increase in the expected short-term volatility of the
stock price.

A) be negative
B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: C

38. The premium on an existing call option should ______ when there is a reduction in the expected
short-term volatility of the stock price.
A) be negative

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 Role of Financial Markets and Institutions  110

B) decline
C) increase
D) be unaffected
E) A and B

ANSWER: B

39. When a stock index option is exercised, the cash payment is equal to a specified dollar amount
A) multiplied by the index level.
B) multiplied by the exercise price.
C) multiplied by the difference between the index level and the exercise price.
D) multiplied by the sum of the index level and the exercise price.

ANSWER: C

40. Long-term equity anticipations (LEAPS) represent

A) stocks that have a maturity date.
B) stocks that are converted to bonds once the price reaches a specified level.
C) stock options with longer terms to expiration than the more traditional stock options.
D) stock index futures that can have a more distant settlement date than the more typical stock
options.

I) ANSWER: C

41. When stock portfolio managers use dynamic asset allocation by purchasing call options on a stock
index, they __________ their exposure to stock market conditions.
A) reduce
B) completely eliminate
C) have no effect on
D) increase

ANSWER: D

42. When stock portfolio managers use dynamic asset allocation by writing call options on a stock index,
they __________ their exposure to stock market conditions.
A) reduce
B) completely eliminate
C) have no effect on
D) increase

ANSWER: A

43. Options on stock indexes representing non-U.S. stocks are __________; options exchanges have been
established __________.
A) available; in numerous non-U.S. countries
B) not available; in numerous non-U.S. countries
C) available; only in the United States
D) not available; only in the United States

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