Chapter Test (12 questions, 18 minutes)
(1) Which of the following statements about arbitrage transaction is most likely to be correct?
(a) The net inflow of funds occur at the end of the holding period
(b) It is more likely to occur when the price differential between assets is large and cost of short selling are high
(c) It brings the prices to the levels that are consistent with the law of one price
(2) If the total costs of holding an asset exceed the total benefits, then what value the forward contract of that asset will have at the initiation for the long party?
(a) Positive value
(b) Negative value
(b) Zero value
(3) What will be the most likely impact on the forward price of a stock if the company announces a dividend during the contract whose ex-dividend would fall after the expiration date of the contract?
(a) Increase in price
(b) Decrease in price
(c) No impact
(4) The real estate industry is sensitive to the interest rates. The companies operating in the real estate market make more profit when the interest rates decrease. Which of the following contracts is most likely to have a higher price for such companies?
(a) Forward contract
(b) Futures contract
(c) Both will have the same price
(5) A futures contract was initiated at a price of $18.00. Currently, the futures contract is trading at $22.50. The last settlement price of the futures contract was $21.00. What is the value of the contract to the long party?
(a) $1.50
(b) $3.00
(c) $4.50
(6) Which of the following statements about a swap contract is most accurate?
(a) Its price and value fluctuate over the contract period
(b) Its value fluctuates and the price remains fixed over the contract period
(c) Its price fluctuates and the value remains fixed over the contract period
(7) Which of the following makes the early exercise of an American put option less likely?
(a) Higher risk-free rate
(b) Presence of dividends
(c) Sharp decrease in underlying price and volatility
(8) Kris takes a long position in a call option having an exercise price of $55.00 for $1.40. What will be the most likely value of the call option on the same underlying having an exercise price of $50.00?
(a) $3.40
(b) $1.40
(c) $0.70
(9) What is the most likely impact of an increase in the risk-free rate on the risk-neutral upside probability in a binomial model?
(a) No impact
(b) Increase in probability
(c) Decrease in probability
(10) Which of the following options is likely to be most expensive?
(a) At-the-money European call option
(b) In-the-money European put option
(c) Out-of-money European call option
(11) Which of the following factors is most likely to impact the pricing of a European put option using binomial model?
(a) The magnitude of up move and down move
(b) The probability of up move and down move
(c) The probability distribution of the price of underlying at expiration
(12) Which positions should be taken to create a short synthetic position in a European put option for a stock per put-call parity equation?
(a) Long call, long stock, short bond
(b) Short call, long stock, short bond
(c) Long call, short stock, long bond
Solutions to the Chapter Test
(1) Correct Answer is C: The net inflow of the arbitrage transaction occur at the beginning of the period and it brings back the prices to the level that are consistent with the law of one price. The arbitrage transaction is more likely to occur when the price differential between the identical assets is high and the cost of short selling is low.
(2) Correct Answer is C: A forward contract will have a zero value at the initiation regardless whether the costs are higher or benefits are higher. The costs and benefits impact the pricing of the contract but not the value of the contract at the initiation.
(3) Correct Answer is C: If the cash flows are not expected to occur during the contract, then those cash flows will have no impact on the forward price.
(4) Correct Answer is A: The asset price is inversely proportional to the interest rates. Therefore, the forward contracts are more likely to have a higher price than futures contracts.
(5) Correct Answer is A: The value of the futures contract is the difference between the current price minus the last settlement price.
(6) Correct Answer is B: The price of a swap contract remains fixed over the contract period and the value fluctuates.
(7) Correct Answer is B: The presence of dividends makes the early exercise of American put options less likely. A higher risk-free rate and a large decrease in stock price with a decrease in volatility make the early exercise of American put options more likely.
(8) Correct Answer is A: The lower the exercise price; the higher is the value of the European call options.
(9) Correct Answer is B: The upside risk-neutral probability = (1+r-D)/(U-D). Therefore, an increase in risk-free rate will increase the upside risk-neutral probability.
(10) Correct Answer is A: In-the-money options are the most expensive options followed by at-the-money and out-of-money options.
(11) Correct Answer is A: The magnitude of up move (U) and down move (D) impact the pricing of options using Binomial model. The probabilities of up move and down move do not impact the pricing as the pricing is based on the risk-neutral probabilities. The Binomial model assumes that the price can take only two values at expiration. So, the probability distribution of the stock is also not needed.
(12) Correct Answer is B: As per put-call parity equation, the short position in a put option can be created by shorting the call, shorting the bond, and taking long in the stock.
Next Reading: Risk Management Applications of Option Strategies
