Chapter Test (8 questions, 12 minutes)
(1) What is the primary difference between a derivative instrument and a mutual fund?
(a) A derivative instrument derives its performance by passing through the returns of the underlying while a mutual fund replicates the performance of the underlying
(b) A derivative instrument derives its performance by replicating the performance of the underlying while a mutual fund derives its performance by passing through the returns of the underlying
(c) A derivative instrument derives its performance by transforming the performance of the underlying while a mutual fund derives its performance by passing through the returns of the underlying
(2) How is the profit earned by the market makers in the derivatives market?
(a) By charging a commission on each trade
(b) By scalping
(c) By holding position for a longer time in hope of earning a profit
(3) Which of the following parties provide the credit protection in the credit default swap?
(a) CDS buyer
(b) CDS seller
(c) Exchange
(4) Which of the following parties takes the credit risk of the underlying security in a credit-linked note?
(a) Buyer of the credit-linked note
(b) Seller of the credit-linked note
(c) Third party
(5) If the underlying value is less than the exercise price for a put option, then the option is said to be:
(a) in the money
(b) at the money
(c) out of money
(6) What is the primary difference between a swap contract and a forward contract?
(a) Forward contract is OTC instrument while the swap contract is exchange traded
(b) Forward contract has only a single payment while the swap contract has multiple payments
(c) Forward contract is settled daily while the swap contract is not settled daily
(7) When a margin call occurs then the trader has to deposit money in the margin account to bring his balance up to the:
(a) Initial margin
(b) Maintenance margin
(c) Variation margin
(8) Which of the following is least likely an advantage of derivatives market over the underlying spot market?
(a) Low transaction costs
(b) Low leverage
(c) Greater liquidity
Solutions to the Chapter Test
(1) Correct Answer is C: A derivative instrument derives its performance by transforming the performance of the underlying while a mutual fund derives its performance by passing through the returns of the underlying.
(2) Correct Answer is B: The dealers (market makers) hope to make a small profit by buying and selling the derivatives instruments simultaneously (a process known as scalping) at different prices. They do not charge the commission on the trade. The speculators hold the position for a longer time in the hope of earning a profit from their position.
(3) Correct Answer is B: The CDS seller provides the credit protection and the seller receives the CDS spread as a premium for it from the CDS buyer.
(4) Correct Answer is A: The credit risk of the underlying security in a credit-linked note is taken by the buyer of the note. If the price of the note decreases due to the default then the buyer suffers the loss.
(5) Correct Answer is A: For a put option, the option is in the money if the exercise price is higher than the underlying price.
(6) Correct Answer is B: Both swap contracts and forwards are OTC instruments. Both are not marked to market daily. Forwards involve only a single payment at expiry while the swaps have multiple payments at scheduled dates.
(7) Correct Answer is A: On receiving the margin call, the trader has to deposit money to bring his balance up to the initial margin.
(8) Correct Answer is B: The derivative markets have low transaction costs, high leverage, and greater liquidity as compared to the underlying spot markets.
Next Reading: Basics of Derivative Pricing and Valuation
