Final Term Pre Questions

1. Which of the following creates a bull spread?

A. Buy a low strike price call and sell a high strike price call.
B. Buy a high strike price call and sell a low strike price call.
C. Buy a low strike price call and sell a high strike price put.
D. Buy a low strike price put and sell a high strike price call.

Answer: A

A bull spread is created by buying a low strike call and selling a high strike call. Alternatively,
it can be created by buying a low strike put and selling a high strike put.

2. Which of the following creates a bear spread?

A. Buy a low strike price put and sell a high strike price put.
B. Buy a high strike price put and sell a low strike price put.
C. Buy a high strike price call and sell a low strike price put.
D. Buy a high strike price put and sell a low strike price call.

Answer: B

A bear spread is created by buying a high strike call and selling a low strike call.
Alternatively, it can be created by buying a high strike put and selling a low strike put.

3. How can a straddle be created?

A. Buy one call and one put with the same strike price and same expiration date.
B. Buy one call and one put with different strike prices and same expiration date.
C. Buy one call and two puts with the same strike price and expiration date.
D. Buy two calls and one put with the same strike price and expiration date.

Answer: A

A straddle consists of one call and one put where the strike price and time to maturity are
the same. It has a V-shaped payoff.

4. Which of the following describes a protective put?

A. A long put option on a stock plus a long position in the stock.
B. A long put option on a stock plus a short position in the stock.
C. A short put option on a stock plus a short call option on the stock.
D. A short put option on a stock plus a long position in the stock.

Answer: A
 A protective put consists of a long put plus the stock. The holder of the put owns the stock
that might become deliverable.

5. A trader creates a long butterfly spread from options with strike prices $60, $65, and $70 by
trading a total of 400 options. The options are worth $11, $14, and $18. What is the maximum
net gain (after the cost of the options is taken into account)?
A. $100
B. $200
C. $300
D. $400

Answer: D

The butterfly spread involves buying 100 options with strike prices $60 and $70 and selling
200 options with strike price $65. The maximum gain is when the stock price equals the
middle strike price, $65. The payoffs from the options are then, $500, 0, and 0, respectively.
The total payoff is $500. The cost of setting up the butterfly spread is
11 × 100 + 18 × 100 – 14 × 200 = $100. The gain is 500 − 100 or $400.

6. Six-month call options with strike prices of $35 and $40 cost $6 and $4, respectively. What is the
maximum gain when a bull spread is created by trading a total of 200 options?
A. $100
B. $200
C. $300
D. $400

Answer: C

The bull spread involves buying 100 calls with strike $35 and selling 100 calls with strike
price $40. The cost is 6 × 100 – 4 × 100 = $200. The maximum payoff (when the stock price is
greater than or equal to $40) is $500. The maximum gain is therefore 500 − 200 = $300.

7. The current price of a non-dividend-paying stock is $30. Over the next six months it is expected
to rise to $36 or fall to $26. Assume the risk-free rate is zero. An investor sells six-month call
options with a strike price of $32. Which of the following hedges the position?
A. Buy 0.6 shares for each call option sold.
B. Buy 0.4 shares for each call option sold.
C. Short 0.6 shares for each call option sold.
D. Short 0.4 shares for each call option sold.

Answer: B
 The value of the option will be either $4 or zero. If D is the position in the stock, we require
36D − 4 = 26D
so that D = 0.4. It follows that 0.4 shares should be purchased for each option sold.

8. The current price of a non-dividend-paying stock is $30. Over the next six months, it is expected
to rise to $36 or fall to $26. Assume the risk-free rate is zero. An investor sells call options with a
strike price of $32. What is the value of each call option?
A. $1.6
B. $2.0
C. $2.4
D. $3.0

Answer: A

The formula for the risk-neutral probability of an up movement is

e rT - d
p=
u-d
In this case u = 36/30 or 1.2 and d = 26/30 = 0.8667. Also r = 0 and T = 0.5. The formula
gives
p = (1 − 0.8667/(1.2 − 0.8667) = 0.4.
The payoff from the call option is $4 if there is an up movement and $0 if there is a down
movement. The value of the option is therefore 0.4 × 4 + 0.6 × 0 = $1.6. (We do not do any
discounting because the interest rate is zero.)

9. The current price of a non-dividend-paying stock is $40. Over the next year, it is expected to rise
to $42 or fall to $37. An investor buys put options with a strike price of $41. What is the value of
each option? The risk-free interest rate is 2% per annum with continuous compounding.
A. $3.93
B. $2.93
C. $1.93
D. $0.93

Answer: D

The formula for the risk-neutral probability of an up movement is

e rT - d
p=
u-d

In this case, r = 0.02, T = 1, u = 42/40 = 1.05 and d = 37/40 = 0.925 so that p = 0.76 and the
value of the option is (0.76 × 0 + 0.24 × 4)e-0.02×1 = 0.93
10. In a binomial tree created to value an option on a stock, the expected return on stock is:
A. Zero
B. The return required by the market
C. The risk-free rate
D. It is impossible to know without more information.

Answer: C

The expected return on the stock on the tree is the risk-free rate. This is an application of
risk-neutral valuation.

11. Which of the following is true for a call option on a stock worth $50?
A. As a stock’s expected return increases, the price of the option increases.
B. As a stock’s expected return increases, the price of the option decreases.
C. As a stock’s expected return increases, the price of the option might increase or
decrease.
D. As a stock’s expected return increases, the price of the option on the stock stays the
same.

Answer: D

The option price when expressed in terms of the underlying stock price is independent of
the return on the stock. To put this another way, everything relevant about the expected
return is incorporated in the stock price.

12. The current price of a non-dividend paying stock is $30. Use a two-step tree to value a European
call option on the stock with a strike price of $32 that expires in 6 months. Each step is 3 months,
the risk free rate is 8% per annum with continuous compounding. What is the option price when
u = 1.1 and d = 0.9?
A. $1.29
B. $1.49
C. $1.69
D. $1.89

Answer: B

The probability of an up movement is

e rDt - d e 0.08´0.25 - 0.9
p= = = 0.6010
u-d 1.1 - 0.9
The tree is
 36.3
4.3
33
2.533
30 29.7
1.492 0
27
0
24.3
0

13. The current price of a non-dividend paying stock is $30. Use a two-step tree to value a European
put option on the stock with a strike price of $32 that expires in 6 months with u = 1.1 and d =
0.9. Each step is 3 months, the risk free rate is 8%.
A. $2.24
B. $2.44
C. $2.64
D. $2.84

Answer: A

The probability of an up movement is

e rDt - d e 0.08´0.25 - 0.9
p= = = 0.6010
u-d 1.1 - 0.9
The tree is

36.3
0
33
0.9
30 29.7
2.238 2.3
27
4.366
24.3
7.7
 \

14. If the volatility of a non-dividend-paying stock is 20% per annum and a risk-free rate is 5% per
annum, which of the following is closest to the parameter p for a tree with a three-month time
step?
A. 0.50
B. 0.54
C. 0.58
D. 0.62

Answer: B

The formula for p is

e rDt - d e 0.05´0.25 - 0.9048

p= = =0.538
u-d 1.1052 - 0.9048

15. The current price of a non-dividend paying stock is $50. Use a two-step tree to value an American
put option on the stock with a strike price of $48 that expires in 12 months. Each step is 6
months, the risk free rate is 5% per annum, and the volatility is 20%. Which of the following is
the option price?
A. $1.95
B. $2.00
C. $2.05
D. $2.10

Answer: B

In this case
u = es Dt
= e 0.2´ 0.5
= 1.152 d = 1 / u = 0.868
e rDt - d e 0.05´0.5 - 0.868
p= = = 0.5539
u-d 1.152 - 0.868
The tree is
 66.34482
0
57.5955
0
50 50
1.999 0
43.40617
4.593828
37.68192
10.31808

16. Which of the following is a definition of volatility?

A. The standard deviation of the return, measured with continuous compounding, in one
year.
B. The variance of the return, measured with continuous compounding, in one year.
C. The standard deviation of the stock price in one year.
D. The variance of the stock price in one year.

Answer: A

Volatility when multiplied by the square root of Dt is the standard deviation of the return in
a short period of time of length Dt. It is also the standard deviation of the continuously
compounded return in one year.

17. A stock provides an expected return of 10% per year and has a volatility of 20% per year. What is
the expected value of the continuously compounded return in one year?
A. 6%
B. 8%
C. 10%
D. 12%

Answer: B
The expected value of the continuously compounded return per year is µ - s 2 / 2. In this
case, it is 0.1 – 0.22/2 = 0.08 or 8%.

18. When the non-dividend paying stock price is $20, the strike price is $20, the risk-free rate is 6%,
the volatility is 20% and the time to maturity is 3 months which of the following is the price of a
European call option on the stock?
E. 20N(0.1) –19.7N(0.2)
F. 20N(0.2) –19.7N(0.1)
 G. 19.7N(0.2) –20N(0.1)
H. 19.7N(0.1) –20N(0.2)

Answer: B

The formula for the option price is

S 0 N (d 1 ) - Ke - rT N (d 2 )
ln(S 0 / K ) + (r + s 2 / 2)T
d1 = and d 2 = d1 - s T
s T
In this case, S0 = K = 20, r = 0.06, s = 0.2, and T = 0.25 so that Ke-rT = 20e-0.06×0.25 = 19.7. Also
d1 = [ln(1) + (0.06 + 0.04/2) × 0.25]/(0.2 × 0.5) = 0.2 and d2 = 0.2 – 0.2 × 0.5 = 0.1.
B is therefore the correct answer.

19. The volatility of a stock is 18% per year. Which is closest to the volatility per month?
I. 1.5%
J. 3.0%
K. 5.2%
L. 6.3%

Answer: C

The volatility per month is the volatility per year multiplied by the square root of 1/12. The
square root of 1/12 is 0.2887 and 18% multiplied by this is 5.2%.

20. A portfolio manager in charge of a portfolio worth $10 million is concerned that stock prices
might decline rapidly during the next six months and would like to use put options on an index to
provide protection against the portfolio falling below $9.5 million. The index is currently standing
at 500 and each contract is on 100 times the index. What position is required if the portfolio has
a beta of 1?
A. Short 200 contracts
B. Long 200 contracts
C. Short 100 contracts
D. Long 100 contracts

Answer: B

The number of contracts required is 10,000,000/(500 × 100) = 200. A long put position is
required because the contracts must provide a positive payoff when the market declines.

21. A portfolio manager in charge of a portfolio worth $10 million is concerned that the market
 might decline rapidly during the next six months and would like to use put options on an index to
provide protection against the portfolio falling below $9.5 million. The index is currently standing
at 500 and each contract is on 100 times the index. What position is required if the portfolio has
a beta of 0.5?
A. Short 200 contracts
B. Long 200 contracts
C. Short 100 contracts
D. Long 100 contracts

Answer: C

The number of contracts required is 0.5 × 10,000,000/(500 × 100) = 100. A short position is
required because the contracts must provide a positive payoff when the market declines.

22. For a European put option on an index, the index level is 1,000, the strike price is 1050, the time
to maturity is six months, the risk-free rate is 4% per annum, and the dividend yield on the index
is 2% per annum. How low can the option price be without there being an arbitrage opportunity?
A. $50.00
B. $43.11
C. $29.21
D. $39.16

Answer: D

A lower bound for the put option price is Ke-rT−S0e-qT. In this case, K = 1050, S0 = 1000, T =
0.5, r = 0.04 and q = 0.02. The lower bound is therefore 1050e-0.04×0.5− 1000e-0.02×0.5 = 39.16.
The put price cannot fall below this without there being an arbitrage opportunity.

23. A binomial tree with three-month time steps is used to value a currency option. The domestic
and foreign risk-free rates are 4% and 6%, respectively. The volatility of the exchange rate is 12%.
What is the probability of an up movement?
A. 0.4435
B. 0.5267
C. 0.5565
D. 0.5771

Answer: A

The parameter u is e 0.12 0.25 = 1.0618 and d = 1/u = 0.9418. The probability of an up
movement is [e(0.04−0.06)×0.25− 0.9418]/[1.0618 − 0.9418] = 0.4435.

24. A binomial tree with one-month time steps is used to value an index option. The interest rate is
 3% per annum and the dividend yield is 1% per annum. The volatility of the index is 16%. What is
the probability of an up movement?

A. 0.4704
B. 0.5065
C. 0.5592
D. 0.5833

Answer: B

The parameter u is e 0.16 1/12 = 1.0473 and d = 1/u = 0.9549. The probability of an up
movement is [e(0.03−0.01)×1/12− 0.9549]/[1.0473 − 0.9549] = 0.5065.

25. A European at-the-money call option on a currency has four years until maturity. The exchange
rate volatility is 10%, the domestic risk-free rate is 2% and the foreign risk-free rate is 5%. The
current exchange rate is 1.2000. What is the value of the option?
A. 0.98N(0.25) − 1.11(0.05)
B. 0.98N(−0.3) − 1.11N(−0.5)
C. 0.98N(−0.5) − 1.11N(−0.7)
D. 0.98N(0.10) − 1.11N(0.06)

Answer: C

The formula is
- rf T
c = S0e N (d1 ) - Ke - rT N (d 2 )
ln(S 0 / K ) + (r - rf + s 2 / 2)T
d1 = d 2 = d1 - s T
s T
- rf T
In this case S0 e = 1.2e-0.05´4 = 0.9825 and Ke - rT = 1.2e -0.02´4 = 1.1077
ln(1) + (0.02 - 0.05 + 0.12 / 2)4
d1 = = -0.5 d 2 = d1 - s T = -0.7
0.1 4
The correct answer is therefore C.

26. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34 cents in
the next six months. The risk-free interest rate is 6%. What is the probability of an up movement
in a risk-neutral world?
A. 0.4
B. 0.5
C. 0.72
D. 0.6

Answer: D
 The probability of an up movement is (1 − d)/(u − d). In this case, u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25 = 0.6.

27. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34 cents in
the next six months. The risk-free interest rate is 6%. What is the value of a six-month put option
with a strike price of 37 cents?
A. 3.00 cents
B. 2.91 cents
C. 1.16 cents
D. 1.20 cents

Answer: C

The probability of an up movement is (1 − d)/(u − d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25 = 0.6. The option pays off zero if there is
an up movement and 3 cents if there is a down movement. The value of the option is therefore
0.4 × 3 × e-0.06×0.5= 1.16 cents.

28. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34 cents in
the next six months. The risk-free interest rate is 6%. What is the value of a six month call option
with a strike price of 39 cents?
A. 5.00 cents
B. 2.91 cents
C. 3.00 cents
D. 4.21 cents

Answer: B

The probability of an up movement is (1−d)/(u−d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25 = 0.6. The option pays off 5 cents if there
is an up movement and zero if there is a down movement. The value of the option is therefore
0.6 × 5 × e-0.06×0.5 = 2.91 cents.

29. What is the value of a European call futures option where the futures price is 50, the strike price
is 50, the risk-free rate is 5%, the volatility is 20% and the time to maturity is three months?
A. 49.38N(0.05) – 49.38N(–0.05)
B. 50N(0.05) –50N(–0.05)
C. 49.38N(0.1) –49.38N(–0.1)
D. 50N(0.1) –49.38N(–0.1)

Answer: A

The formula is
 c = F0e- rT N (d1 ) - Ke - rT N (d 2 )
ln( F0 / K ) + s2T / 2
d1 = d 2 = d1 - s T
s T

In this case Ke - rT = F0e - rT = 50e -0.05´0.25 = 48.38

ln(1) + 0.22 ´ 0.25 / 2
d1 = = 0.05 d2 = d1 - s T = -0.05
0.2 0.25
The correct answer is therefore A.

30. Consider a European one-year call futures option and a European one-year put futures options
when the futures price equals the strike price. Which of the following is true?
A. The call futures option is worth more than the put futures option.
B. The put futures option is worth more than the call futures option.
C. The call futures option is sometimes worth more and sometimes worth less than the put
futures option.
D. The call futures option is worth the same as the put futures option.

Answer: D

Put call parity is

c + Ke-rT = p + F0e-rT
When F0 = K it follows that c = p.

31. A call option on a stock has a delta of 0.3. A trader has sold 1,000 options. What position should
the trader take to hedge the position?
A. Sell 300 shares
B. Buy 300 shares
C. Sell 700 shares
D. Buy 700 shares

Answer: B

When the stock price increases by a small amount, the option price increases by 30% of this
amount. The trader therefore has a hedged position if he or she buys 300 shares. For small
changes, the gain or loss on the stock position is equal and opposite to the loss or gain on the
option position.

32. What does gamma measure?

A. The rate of change of delta with the asset price.
B. The rate of change of the portfolio value with the passage of time.
 C. The sensitivity of a portfolio value to interest rate changes.
D. None of the above.

Answer: A

Gamma measures the rate of change of delta with the asset price.

33. What does vega measure?

A. The rate of change of delta with the asset price.
B. The rate of change of the portfolio value with the passage of time.
C. The sensitivity of a portfolio value to interest rate changes.
D. None of the above.

Answer: D

Vega measures the rate of change of the value of the portfolio value with volatility.

34. Which of the following is true?

A. The delta of a European put equals minus the delta of a European call.
B. The delta of a European put equals the delta of a European call.
C. The gamma of a European put equals minus the gamma of a European call.
D. The gamma of a European put equals the gamma of a European call.

Answer: D

The delta of a put on a non-dividend-paying stock equals the delta of the call minus one. The
gamma of a put equals the gamma of call even when there are dividends.

35. A portfolio of derivatives on a stock has a delta of 2400 and a gamma of –10. An option on the
stock with a delta of 0.5 and a gamma of 0.04 can be traded. What position in the option is
necessary to make the portfolio gamma neutral?
A. Long position in 250 options
B. Short position in 250 options
C. Long position in 20 options
D. Short position in 20 options

Answer: A

The options must have a gamma of +10 to neutralize the gamma of the portfolio. Each option
has a gamma of 0.04. Hence a long position of 10/0.04 = 250 options is required.

36. A trader uses a stop-loss strategy to hedge a short position in a three-month call option with a
strike price of 0.7000 on an exchange rate. The current exchange rate is 0.6950 and value of the
option is 0.1. The trader covers the option when the exchange rate reaches 0.7005 and uncovers
(i.e., assumes a naked position) if the exchange rate falls to 0.6995. Which of the following is NOT
true?
 A. The exchange rate trading might cost nothing so that the trader gains 0.1 for each option
sold.
B. The exchange rate trading might cost considerably more than 0.1 for each option sold so
that the trader loses money.
C. The present value of the gain or loss from the exchange rate trading should be about 0.1
on average for each option sold.
D. The hedge works reasonably well.

Answer: D

A good hedging system will ensure that the cost of selling an option is close to its theoretical value.
The stop-loss hedging procedure does not have this property. It can lead to the option costing
nothing or costing considerably more than its theoretical value. On average, the cost of the option
is its Black–Scholes value, but there is a wide variation. D is the correct answer.

37. Maintaining a delta-neutral portfolio is an example of which of the following?

A. Stop-loss strategy
B. Dynamic hedging
C. Hedge and forget strategy
D. Static hedging

Answer: B

Delta-neutral hedging is an example of dynamic hedging. The hedge has to be adjusted

periodically. (In theory, to maintain a delta-neutral hedge, the hedge must be adjusted
continuously.)

38. Which of the following is NOT true about gamma?

A. A highly positive or highly negative value of gamma indicates that a portfolio needs
frequent rebalancing to stay delta neutral.
B. The magnitude of gamma is a measure of the curvature of the portfolio value as a function
of the underlying asset price.
C. A big positive value for gamma indicates that a big movement in the asset price in either
direction will lead to a loss.
D. A long position in either a call or a put has a positive gamma.

Answer: C

C is not true. The change in the value is a gain of 0.5GDS2. There is a gain from a big movement
when gamma is positive and a loss from a big movement when gamma is negative.
39. Which of the following is true for a call option on a non-dividend-paying stock when the stock’s
price equals the strike price?
A. It has a delta of 0.5.
B. It has a delta less than 0.5.
C. It has a delta greater than 0.5.
D. Delta can be greater than or less than 0.5.

Answer: C

The delta is N(d1) where

ln(S0 / K ) + (r + s2 / 2)T
d1 =
s T

From this it can be seen that, when S0 = K, d1 is

( r + s 2 / 2) T
s
This is always positive. Hence, delta is always greater than 0.5.

40. A call option on a non-dividend-paying stock has a strike price of $30 and a time to maturity of six
months. The risk-free rate is 4% and the volatility is 25%. The stock price is $28. What is the delta
of the option?
A. N(–0.1342)
B. N(–0.1888)
C. N(–0.2034)
D. N(–0.2241)

Answer: B

The delta is N(d1) where

ln(S0 / K ) + (r + s2 / 2)T
d1 =
s T
In this case
ln(28 / 30) + (0.04 + 0.252 / 2) ´ 0.5
d1 = = -0.1888
0.25 0.5