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Fundamentals of Derivatives Markets (McDonald)
Chapter 1 Introduction to Derivatives
1.1 Multiple Choice Questions
1) Which of the following is not a derivative instrument?
A) Contract to sell corn
B) Option agreement to buy land
C) Installment sales agreement
D) Mortgage backed security
2) Who from the following list would be considered a speculator by entering into a futures or
options contract on commodities?
A) Farmer
B) Corn delivery truck driver
C) Food manufacturer
D) None of the above
3) A mutual fund is engaged in the short term and temporary purchase of index futures, for
purposes of minimizing its cash exposures. Which "use" most closely explains their actions?
A) Risk management
B) Speculation
C) Reduced transaction costs
D) Regulatory arbitrage
4) During the growing season a corn farmer sells short corn futures contracts in an amount
equal to her crop. If upon harvesting and selling her crop she maintains the contracts, she is
then considered a:
A) Hedger
B) Speculator
C) Arbitrager
D) None of the above
5) All of the following are financially engineered products, except:
A) Mortgage
B) Mortgage backed security
C) Interest only
D) Principal only
6) Select the family member who is offering the most diversification to the rest of the family.
A) Dad works for General Motors
B) Mom works for Goodyear
C) Daughter works for Jiffy Lube
D) Son works for Eli Lilly & Company
7) What is the cost of 100 shares of Jiffy, Inc. stock given that the bid-ask prices are $31.25 -
$32.00 and a $15.00 commission per transaction exists?
A) $3215
B) $3140
C) $3125
D) $3200
8) Assume that you purchase 100 shares of Jiffy, Inc. common stock at the bid-ask prices of
$32.00 - $32.50. When you sell the bid-ask prices are $32.50 - $33.00. If you pay a commission
rate of 0.5%, what is your profit or loss?
A) $0
B) $16.25 loss
C) $32.50 gain
D) $32.50 loss
9) Assume that you open a 100 share short position in Jiffy, Inc. common stock at the bid-ask
price of $32.00 - $32.50. When you close your position the bid-ask prices are $32.50 - $33.00. If
you pay a commission rate of 0.5%, calculate your profit or loss on the short investment?
A) $32.50 gain
B) $16.25 loss
C) $132.50 loss
D) $100.00 gain
10) Assume that you open a 100 share short position in Jiffy, Inc. common stock at the bid-ask
prices of $32.00 - $32.50. When you close your position the bid-ask prices are $32.50 - $33.00.
You pay a commission rate of 0.5%. The market interest rate is 5.0% and the short rebate rate
is 3.0%. What is your additional gain or loss due to leasing the asset?
A) $64.00 loss
B) $160.00 loss
C) $96.00 gain
D) $0
11) Assume that an investor lends 100 shares of Jiffy, Inc. common stock to a short seller. The
bid-ask prices are $32.00 - $32.50. When the position is closed the bid-ask prices are $32.50 -
$33.00. The commission rate is 0.5%. The market interest rate is 5.0% and the short rebate
rate is 3.0%. Calculate the gain or loss to the lender. Assume the lender is not subject to a
bid-ask loss or commissions.
A) $164.00 gain
B) $164.00 loss
C) $100.00 gain
D) $100.00 loss
12) According to trading volume data tabulated for 2002, which international futures exchange
market experienced the highest total trading volume in the world?
A) Chicago Board of Trade
B) Chicago Mercantile Exchange
C) Eurex
D) New York Mercantile Exchange
13) A firm provides a service that benefits from decreasing employment. This firm has a risk
exposure to macro event. All other variables being equal, which of the following derivative
securities is the firm most likely use to hedge its exposure?
A) Short position in an economic futures
B) Long position in an economic futures
C) Short position in an interest rate futures
D) Long position in an interest rate futures
14) This measures the number of financial claims that change hands either daily or annually.
A) Trading volume
B) Market value
C) Notational value
D) Open Interest
15) What phrase is often used interchangeably with the phrase market capitalization?
A) Trading volume
B) Market value
C) Notational value
D) Open Interest
16) The scale by which a derivative instrument is measured and references the underlying asset
is called the ________________.
A) Trading volume
B) Market value
C) Notational value
D) Open Interest
17) The total number of contracts which exist and are delivery or payment is referred to as the
___________________.
A) Trading volume
B) Market value
C) Notational value
D) Open Interest
18) What phrase might be used to describe the initial transaction a short seller initiates when
shorting an equity security?
A) Buy
B) Sell
C) Borrow
D) Covering
19) What phrase might be used to describe the final transaction a short seller conducts when
shorting an equity security?
A) Buy
B) Sell
C) Borrow
D) Covering
4
20) What kind of risk does not disappear when spread across many investors?
A) Diversifiable
B) Nondiversifiable
C) Catastrophic
D) Predictive
1.2
Short Answer Essay Questions
1) Why might a variable rate mortgage be considered a "derivative" and a fixed rate mortgage
not?
2) Why would a corn farmer, who maintains a short futures contract after harvesting and
selling her crop, be considered a speculator?
3) For families employed and living in "company towns" (i.e., where the major employer owns
all homes, retail stores, etc.), explain the lack of diversification.
4) Describe the concept of a bid-ask spread and how that impacts the cash flows of an investor.
5) What would cause the spread between the market rate of interest and the repo rate to be
small?
1.3 Class Discussion Question
1) Discuss the origins of derivatives in terms of risk reduction using the concept of evolution to
integrate the additional uses of derivatives into the discussion. Conclude by asking students
to list methods by which third parties could make fees by interjecting themselves into the
process.
